ESG funds in Europe could substantially increase their allocations to the defense industry should existing restrictions be fully removed, according to analysts at Morgan Stanley.
Funds registered as Article 8 and Article 9 — the European Union’s two main ESG disclosure categories — would have the potential to drive between $53 billion and $119 billion in flows into the aerospace and defense sector, Morgan Stanley analysts including Arushi Agarwal and Rachel Fletcher wrote in a note on March 24.
“Any potential exclusions easing would seem likely to focus on conventional and nuclear weapons,” they wrote. “A full-scale easing of exclusions could drive significant flows.”
Fund managers claiming to target environmental, social and governance goals are already stepping up their holdings of defense assets, amid a wider shift in investment sentiment toward the sector. The move is being encouraged by policymakers in Europe, as the bloc responds to souring ties with the U.S. and an increasingly aggressive Russian war machine.
The average exposure to Europe’s aerospace and defense sector in funds labeled Article 8 (intended to “promote” ESG) and Article 9 (where ESG is the “objective”) is currently equivalent to about 2% of the sector’s market cap, according to the Morgan Stanley analysts.
The Morgan Stanley analysts also urged caution in predicting how much ESG cash might flow into the defense sector going forward.
“We note that if exclusion policies were to be changed, this could take time,” the analysts wrote. “Additionally, the existence of international treaties” as well as their “ratification into national legislation, mean we would not expect to see a full scale easing of exclusions,” they said. That applies especially in the case of so-called controversial weapons, which can span everything from biological weapons to cluster bombs.
At the same time, the analysts said there is “concrete” evidence that Europe is taking steps to remove obstacles that might prevent investment managers from increasing their exposure to the defense industry, citing examples in Germany and the U.K.
And in France, Finance Minister Eric Lombard recently said that the notion that ESG rules prohibit defense investing reflects a “misunderstanding.”
“Investment in the defense sector is a responsible investment, all the more so because it protects our sovereignty and the principles we uphold,” he said last week.
In a separate note, analysts at Barclays said they’re “starting to see signs of a different approach to the defense sector being adopted by ESG funds.”
“Underweights in stocks with exposure to defense have decreased, whilst concurrently the average exposure of ESG funds to the aerospace and defense sector has increased over time,” Barclays analysts including Magesh Kumar Chandrasekaran and Maggie O’Neal wrote in a note.
