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The war on ESG: An evolving quagmire of arms investments

By Maja Garaca Djurdjevic
9 minute read

In the nuanced world of ethical investing, fund managers find themselves at a crossroads as questions arise regarding their adherence to ESG principles while navigating investments in the military sector.

A recent report titled Finance for War. Finance for Peace has revealed a staggering reality: the global financial sector invested some US$1 trillion in the arms industry between 2020 and 2022.

The report, commissioned by Fondazione Finanza Etica and Global Alliance for Banking on Values (GABV) and produced by Berlin-based consultancy Merian Research, reveals that financial institutions globally are utilising over US$959 billion to support arms production and trade, with a significant portion coming from the US and top European investors.

The report also highlights a surge in arms manufacturers' shares after conflicts in Ukraine (2022) and Palestine (2023), driven by record armament orders, leading to substantial increases in aerospace and defence stock indices.

The overarching theme in the research is that defence companies capitalise on armed conflicts, both through increased military spending and private investments, while portraying themselves as social impact investments and advocating for recognition as contributors to social sustainability under ESG criteria - a portrayal fund managers find easier to stomach.

Contrasting approaches

As the drumbeat for responsible investing grows louder, local fund managers showcase contrasting approaches.

While VanEck's sustainability ETFs “meticulously” screen out companies linked to controversial weaponry, including civilian firearms and conventional arms, Vanguard's exclusionary index funds offer investors a choice to bypass certain ESG risks. Yet, the line blurs when military investments enter the equation, challenging the notion of ethical boundaries in investment portfolios.

Speaking to InvestorDaily, VanEck’s portfolio manager, Alice Shen said: "As an ETF provider, the majority of our funds track an index and therefore companies are screened as per that index methodology. VanEck’s sustainability ETFs incorporate rigorous ESG screening, provided by MSCI.”

She clarified the VanEck MSCI International Sustainable Equity ETF (ESGI) and the VanEck MSCI Australian Sustainable Equity ETF (GRNV) employ screening criteria that set gross revenue threshold hurdles to exclude companies engaged in civilian firearms, conventional weapons, controversial weapons, and nuclear weapons.

Moreover, she said: “VanEck is a signatory to the Principles for Responsible Investment (PRI), an investor initiative in partnership with UNEP Finance Initiative and UN Global Compact. Being a signatory means that we formally agree to incorporate ESG factors and analysis into our investment processes. VanEck uses its voting rights to promote positive behaviour in environmental, social, governance and similar matters."

However, VanEck’s US-based parent company has a military weapons grade of C, as per Weapon Free Funds - a search platform that compiles data on US fund managers and their military ties.

A grade C means the “fund manager is invested in nuclear weapons and/or controversial weapons below the threshold of 2.5 per cent”.

Broken down, the data alleges VanEck has 41 holdings in military contracts worth US$823.88 million, 25 holdings in nuclear weapons worth US$765.62 million, and US$13.37 million invested in controversial weapons.

Vanguard’s parent company emerges among the worst offenders, receiving a D grade for investments in military weapons, with 3 per cent invested across 103 funds. The fund manager has substantial investments, including US$175.1 billion in military weapons, US$127.27 billion in nuclear weapons, and US$55.2 billion in controversial weapons.

Speaking to InvestorDaily, a spokesperson for Vanguard Australia office said the fund manager believes in providing investors with “high-quality investment choices”.

“Investors select the investments most appropriate for them from our broad range of options based on their individual preferences, priorities, and risk tolerance,” the spokesperson said.

“Our product range includes exclusionary screened index funds that apply specific exclusions to a broad market index, allowing investors to avoid exposure to certain ESG risks, or business activities that don’t align with their preferences.

“For example, the index tracked by our Ethically Conscious International Shares Index excludes the securities of companies that have a specified level of business involvement in fossil fuels, nuclear power, alcohol, tobacco, cannabis, gambling, adult entertainment and weapons.”

Also on Weapon Free Funds’ worst offenders list is BlackRock/iShares, with the fund manager earning a D grade for investments in military weapons with 3.1 per cent invested across 309 funds, adding up to US$67.29 billion.

Fidelity Investments also received a D with 3.2 per cent invested across 304 funds, while State Street has 3.1 per cent invested across 105 funds and an equal D rating.

Avoid significant harm

The Responsible Investment Association Australasia (RIAA), which is considered a beacon for transparency and ethical accountability in investment practices, does not completely prohibit funds from investing in the military, instead adhering to an "Avoid Significant Harm" principle.

Co-CEO, Estelle Parker, told InvestorDaily the association “approaches military/defence investments from a couple of different angles”.

“Our longstanding Certification Program is underpinned by a Responsible Investment Standard that includes an ‘Avoid Significant Harm’ principle, applied to certain harms over which there are broadly accepted international treaties or conventions,” said Parker.

“The ‘Avoid Significant Harm’ principle has specific applications related to the manufacture of controversial and nuclear weapons. For all other types of military/defence investment, the Standard requires products to be true-to-label and to have policies, processes and disclosures in place that demonstrate its Responsible Investment practices.”

What this means is that if the product includes holdings directly linked to controversial and nuclear weapons manufacturing, remediation is necessary before certification progresses, likewise, other military or defence investments must align with the product's claims.

“Our certification requires public disclosure of a product’s portfolio holdings, voting outcomes, ESG engagement processes, and how the product issuer exercises ownership influence. By ensuring that products are transparent in this way, stakeholders are informed and empowered to make discerning choices about the product they are investing in,” Parker said.

She explained that many financial products use materiality thresholds to screen companies based on revenue, benchmark positioning, and sustainability, allowing product issuers to focus on specific sustainability topics while managing the impact on returns in the Australian market.

“At RIAA we always suggest looking under the hood of any fund, at their responsible investment practices, the materiality thresholds in use, and ‘portfolio holdings’ or companies that make up the fund, to check that they are aligned with the specific issues deemed important to investors," Parker added.

But cutting all ties to the arms industry is becoming more prevalent among companies globally, as highlighted in GABV’s report, which noted a growing number of funds and banks adopting policies to exclude weapons from both investments and lending.

For example, there’s been an increase in the number of financial institutions that completely refrain from any financial involvement with nuclear weapons manufacturers, currently numbering 55 - including Bank Australia.

This indicates that divestment from defence companies is expanding into new territory, extending beyond the investment portfolios of investors explicitly identified as 'values-based', 'ethical', or 'sustainable', as noted by GABV.

Australian Mutual Bank, as a member of GABV, stands as a representative of these conscientious investors, adhering to a policy that refrains from issuing loans to or investing in companies operating in sectors directly causing social harm or environmental damage, such as fossil fuels, gambling, armaments (production and supply), persistent chemicals, or animal testing.

Bank Australia too does not lend to or invest in businesses that produce or sell armaments. As stated in its Responsible Banking Policy, Bank Australia recognises that “arms are a necessary part of defence; however, the sale and manufacture of arms can be problematic when sold to countries with repressive regimes, militia organisations and organised crime syndicates”.

Future Fund’s ‘F’ result

Unlike Bank Australia, Australia’s sovereign wealth fund, the Future Fund has a longstanding history of involvement in notably controversial investments.

Back in 2021, FF was accused of profiting from companies arming the Myanmar military, with data (obtained under the Freedom of Information Act) at the time revealing the body’s $157.9 million investment in 14 publicly listed companies with either a direct and longstanding commercial tie to the Myanmar military or its conglomerates through joint ventures and land leases.

A few months later, in 2022, the FF said it had divested some $5 million in taxpayers’ cash from five subsidiaries of Chinese arms conglomerate Aviation Industry Corporation of China (AVIC) – a supplier of extensive equipment to the Myanmar military over the last decade.

At the time, defending its position, FF told InvestorDaily in a written statement: "In line with its mandate from government, the Future Fund has built a broadly diversified portfolio which includes passive investments through external investment managers in thousands of entities globally.

"The Fund has a well-established policy on environmental, social and governance matters and exclusions which takes account of its objectives, legislation, investment strategy, Australian law and the treaties that the Australian government has entered and ratified."

However, in December last year, documents obtained by Greens Senator David Shoebridge revealed the Future Fund invested more than $600 million in public funds in global weapons companies.

The documents, current to 31 October 2023, show the Future Fund has direct holdings in 30 weapons and aerospace companies including Thales, Lockheed Martin and BAE Systems.

The documents, according to Shoebridge, also reveal the fund has invested nearly half a million dollars into the Israel-based Elbit Systems despite being banned from investing in the firm since at least 2021 due to “exclusions related to military weapons-related Conventions or Treaties ratified by Australia”.

The Future Fund has, however, rebutted this claim, telling InvestorDaily that: "While Elbit had previously been excluded from the portfolio, it was removed from the exclusions list in April 2023 based on our regular review process and consideration of expert third party advice.”

Shoebridge, the Greens' defence spokesperson, has called on the Albanese government to implement mandatory ethical investment rules for the Future Fund.

“The majority of Australians want peace and justice, not just in Palestine, but around the world, yet the country's wealth is instead being funnelled into companies that fuel violence,” he said.

“The Future Fund is meant to benefit future generations. That rings very hollow when they are investing in companies making equipment that ends future generations."

Is this greenwashing?

The argument that arms companies have become less controversial is being made in political circles worldwide, especially following the Russian invasion of Ukraine.

In November 2023, EU defence ministers approved a joint declaration advocating for the inclusion of the arms industry in ESG investment frameworks.

Similarly, in the UK, defence secretary Grant Shapps said: “The important values within ESG should not undermine capabilities developed to help us preserve peace and security.”

It has since been reported that investment funds, claiming to be ESG adherent, have quietly been adding arms to their portfolios.
Australia has significantly upped its military spending in recent years, with projections suggesting it will rise to 2.4 per cent of GDP by the early 2030s, above the 2 per cent set by NATO allies.

"This decision we are making right now sees a significant increase in defence spending ... and it is needed, given the complexity of the strategic circumstances that our country faces," said Defence Minister Richard Marles.

The current geopolitical situation triggers defensive responses from nations and its people, raising questions about the inherent ethics of weapons producers. While they may be seen as helping defend a nation's independence against an invading force, the same weapons could be used elsewhere against an ethnic minority. This lack of control over which conflicts one supports when investing in such companies, or the sort of weapons one funds, creates ethical dilemmas.

Similar ethical dilemmas emerge when looking at fund managers. Namely, are fund managers really ESG aligned if they offer a couple of ESG-related funds? Does the substantial investment in arms, including nuclear weapons, negate any positive impact these ESG-aligned products might have? Or do their ESG-related investments balance out their misdeeds?

And finally, how do we evaluate the significance of harm? Or was Henry Ford right when he said: “Show me who makes a profit from war, and I'll show you how to stop the war”?