ESG funds that invest in regimes linked to conflict are at of risk compromising sustainability standards and promises to clients, according to sustainable investment professionals. However, data shows European and UK sustainable funds hold almost £5bn in defence and aerospace companies.

As conflicts rage on in Eastern Europe and the Middle East, Pacific Asset Management’s chief sustainability officer said countries using force for territory expansion should not be part of a responsible investor’s portfolio.

“It is obvious that responsible investors should not take a position in a country that uses force solely for the purposes of territory expansion,” said Will Thompson, who is also a portfolio manager at Pacific AM.

“Clearly all conflicts are first and foremost humanitarian crises, but there are knock-on effects of conflict to themes within ESG, such as decarbonisation and several social issues, such as forced migration,” he said.

Pacific AM uses an ‘ESGP’ score, where ‘P’ stands for politics, to assess countries’ scores across conventional ESG metrics, but also to assess them on political freedoms and democratic status. “This helps inform our decision making when thinking about conflict,” Thompson said.

Investors have heightened expectations of sustainability funds, and the countries they invest in, especially during periods of conflict, as currently in Russia’s two-year long war with Ukraine and Israel’s more than 100 day assault on Gaza. 

Meanwhile, Amanda Young, chief sustainability officer at Abrdn, said fund managers need to ask themselves hard questions to ensure they stay on the right side of what investors want from them.

She said they should consider: “Would the client promise linked with the sustainability standards be compromised if exposed or associated with regimes linked to conflict?”

Issues investors may wish to consider could include human rights, harm of civilians, displacement of peoples, native rights, oppressive regimes, funding of conflict and sanctions.

This is particularly the case for so-called ‘dark-green’ ethical investors, those who are strictest in their boundaries, “who may take a very strong stance against any exposure to weapons/warfare”, Young said.

“In these cases, if you are associated with any funding linked with the conflict, this will arise in reputational damage for the investor and its clients and exclusions could apply,” she added.

Defence companies in sustainable funds

Avoiding weapons manufacturers is often a key exclusion factor for sustainable investors. However, data shows sustainable European and UK investment funds have almost £5bn in aerospace and defence companies, with £4.2bn and £559m respectively, according to Morningstar Direct.

The average investment in those sectors among sustainable European funds is 1.17%, while for UK funds it is 0.62%.

The three UK sustainable funds with the most invested in aerospace and defence companies are: Royal London UK Core Equity Tilt (£155m exposure), Royal London Europe ex UK Eq Tilt (£27m exposure), and Royal London UK Broad Equity Tilt (£15m exposure).  All are active funds.

A Royal London Asset Management spokesperson said the funds “are part of the Royal London Asset Management range of passive alternatives” and “have specified, aggregate climate targets but do not have sustainable investment as an objective”.

“Given the funds’ objectives to deliver capital growth and income by investing typically 90% of assets in the relevant index, there will be relatively close to benchmark weight in Aerospace & Defence and, indeed, any other sector,” they added.

In Europe, the three sustainable funds with the biggest exposure to aerospace and defence are: passive fund VanEck Space Innovators ETF (£2m invested), and two active funds, BNPP Energie & Industrie Europe (£2m invested), Amundi France Engagement (£106m invested). 

Conflict costs

Non-ESG investors are not immune from having their portfolios impacted by conflicts. The increase in conflict will likely lead to a reduction in the ‘peace dividend’ enjoyed by many countries in the past few decades, Pacific AM’s Thompson said.

Geopolitical risks and conflicts “transcend the label of ESG risks”, and the macroeconomic consequences of geopolitics are important for all investors to consider, “whether they have a sustainable mandate or not”, he added.

Russia’s invasion of Ukraine in February 2022, for example, led to sanctions that proved costly for companies and investors. Many companies voluntarily curtailed their operations in Russia beyond the bare minimum legally required, primarily for ethical and reputational reasons, because “it was the right thing to do”, said Hortense Bioy, global director of sustainability research at Morningstar.

This was also to protect their customers and employees, which are social considerations. Some companies, however, have continued to operate in Russia, and continue to face reputational risks.

Bioy added “human capital and human rights are key ESG risks that companies and investors need to consider carefully in situations of conflict”.

With the current Israeli siege on Gaza, Bioy expected investors who feel strongly about not holding companies that can do harm already made sure they didn’t hold defence and aerospace companies involved in that conflict after the invasion of Ukraine almost two years ago.    

Green economy wars

Potential conflicts that bring in other, more hidden aspects of ESG investing are also emerging, she pointed out, further complicating the field.

For example, political tensions with China over Taiwan and other issues have prompted Western companies to reconsider their relationships with China, said Bioy, which is a significant player in the global supply chain and a leader in critical areas of the green economy including renewable energy technologies and electric vehicle batteries. 

Through fiscal incentives, the US is encouraging companies to produce EV batteries locally, instead of relying on China. Only EVs without battery components manufactured in China will be eligible for a tax credit worth $7,500 per vehicle.

Conversely, said Bioy, ESG issues can also give rise to geopolitical issues, climate change and water scarcity being the best examples. And she warned geopolitical tensions will likely grow as countries argue over how to accelerate the reductions in net greenhouse gas emissions that are needed to meet the Paris Agreement. 

“Most countries face difficult economic choices,” said Bioy. “Measures such as the EU’s Carbon Border Adjustment Mechanism, considered by some as protectionism, risk adding to geopolitical friction, so will rising sea levels, droughts, and other extreme weather events that will displace people in the decades to come.”