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We Said Farewell to Arms in ESG, Let's Not U-Turn

Including arms and defence contractors in ESG funds in response to Ukraine could be a grave error and one that risks compromising decades of progress

Ollie Smith 3 March, 2022 | 9:15AM
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G36 Assault Rifle

Among comedian Peter Serafinowicz’s best sketches is a three-minute skit entitled You Passed The Test. You can watch it for yourself here, but, for those without the time or inclination, the joke goes like this.

An interview candidate called Greg sits in front of his prospective employer, who tells him that, though his CV is impressive, he is not quite right for the job. Greg is magnanimous, and thanks his interviewer for the opportunity with a smile.

“That was a test,” replies the interviewer, observing he needs a cool-headed man like Greg who can take disappointment like a champion.

“So I’ve got the job?” exclaims Greg, delightedly. “No!” exclaims the boss, “of course not, I don’t employ gullible fools! That was the test Greg, and you failed.”

I’ll save you a full write-up, but suffice to say this back and forth continues with multiple layers of “no Greg, that was the test” until the boss eventually rings Greg in the middle of the night to see if he’s committed enough to pick up the phone after hours. I won’t spoil the entirely predictable end.

As the climate debate rumbled on during COP26 last November, I was convinced climate change was ESG's biggest test. But ESG’s biggest test is surely the ongoing battle over its heart and soul, its purpose, and its impact. The problems are mounting.

More evidence of this battle emerged this week, with the apparent suggestion arms companies might be granted “ESG” status to allow them access to better liquidity.

The justification? Well, Ukraine has reminded us all that national security is not a given. Could weapons form a more credible part of ESG than we’d all thought? It’s tempting to think so, but my answer is still a no.

Stoppage Problem

Let’s just look at the context for a second. War is raging, and our TVs are plastered with heart-rending images of citizens taking up arms against an aggressor.

As Ukraine’s president is repeatedly pictured wearing a helmet and plate carrier in defiance of the Russian onslaught, there is a strong sense of history happening before our eyes. It is intoxicating. Things are happening we did not imagine possible even four weeks ago. Civilians are dying in mainland Europe. Germany is re-arming.

In this environment, it’s easy to be hasty. But as my colleague Jon Hale, Morningstar’s director of sustainability research for the Americas points out, changing ESG on a whim would end long-standing conventions surrounding how we exclude companies from ESG status. (To be honest, conventions is putting it lightly – what they are is pillars.)

“Any industry could make an argument it has a positive purpose under certain circumstances. But the ESG taxonomy can rely on long-standing conventions that limit investment in controversial weapons,” he says.

“The ESG taxonomy is supposed to help investors direct their investments to companies and activities that on an ongoing basis clearly add to social sustainability. Also, the weapons industry doesn't control whether their products are used to promote social sustainability.”

Those final two points are important. It’s absurd to give a free pass to companies making materiel whose very use involves the destruction of public, social, and economic infrastructure. From shops to telephone lines and libraries, war eradicates the physical glue that holds communities together, let alone the human beings living within them.

Secondly, we need to be clear about the incentives. There is a direct trade off between money and control. Supposedly strict rules on the distribution of weapons might help you to sleep better at night if you’re invested in arms companies. But in practice it doesn’t work as smoothly as you’d think.

Prior to the invasion, an investigation by Sky News located sniper rifles made by a specialist British arms company being used by Russian forces in Europe, despite the UK's stringent restrictions on their distribution.

Bullet Points

In the UK, meanwhile, there has been a marked rise in the number of illegal guns seized by the National Crime Agency, from 104 in 2017/18, to 425 in 2019/20. It is not difficult to conclude the problem is out of control, and that handing arms companies of any kind a new distribution mandate is a distinctly bad idea. 

Guns also have a nasty habit of sticking around. Though they need regular cleaning to work properly, they are made of durable metal. It’s a basic point, but a rifle produced today for the Ukrainian army will end up in a conflict much less "morally justifiable" decades later.

Who decides what is morally justifiable is a big question, but it probably shouldn’t be arms companies (who receive money for their wares) or even ESG fund managers (who receive money for their performance).

On top of Hale’s points, I’d ask the following questions:

  • If we're willing to ditch such an important ESG exclusion so quickly, what else are we willing to ditch, and why?
  • If having arms stocks in ESG is such a good idea, why is it only being debated now?
  • If you’re really worried about security, is there anything stopping you from investing in arms companies outside the perimeter of ESG? I’d argue no;
  • Does the idea in some way involve you suspending your disbelief about the behaviour of arms companies themselves? For context, Morningstar’s sustainable ratings wing Sustainalytics labels the controversies involving defence contractor Lockheed Martin as a “Category Three – Significant”;
  • Given the preponderance of conflict across the world, are we only reacting in this way because war is on NATO’s doorstep? I would suggest we are. Nobody was asking this question when Syria was in the news, when conflict was further away and the faces were different. That should make us more aware of our own biases, not less.

 

The Real Test

In a recent column on greenwashing, I argued behavioural factors make investors particularly vulnerable to the innate desire we all have to help in a crisis.

I called this phenomenon “Wiggum’s Razor”, after the loveably vulnerable Simpsons character. I believe its effects are as significant as any other behavioural bias, because it risks rendering ESG a lot less effective than we want to believe, as investors unknowingly back funds and products that may have a much less material impact on ills like climate change, inequality, or homelessness than they think (or are led to believe).

The same could be said to apply here. "Desperate to feel like they were helping, investors scrambled to move the goalposts on ESG, unleashing a liberalisation that put short-term rocket boosters on defence companies’ share prices (see the BAE share price), and fuelled a new paradigm of arms distribution." It’s not an unthinkable development, given our capacity for myopic human mistakes.

Before anything of the sort is allowed to happen to ESG, it’s perhaps time to give arms and defence companies another job interview. Investors may have renewed faith in their ability to make money, but that is not the test we are talking about. The question is whether decades of work to establish ESG as a long-term positive influence is sacrificed on the altar of impulse. The capacity to avoid such situations is what’s at stake. That is the test.

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Ollie Smith   is editor of Morningstar UK.

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