Should ESG investors invest in defense stocks?

By Larissa Fernand |  20-11-20 | 

At the recent Morningstar Investment Conference, Sanjoy Bhattacharyya, commented on defense companies in the context of ESG – the acronym for Environmental, Social and Governance investing.  

The sector is viewed by many as a touch-me-not. Are defence companies socially responsible? I think they are.

Given that we live in an intertwined, unpredictable and risky world. Given the needs of society and people who require the safety and protection of their national boundaries.

On another level, these companies embody the changes that are taking place in technology today and going forward, are likely to be disruptive.

He was spot on.

Companies in the Aerospace and Defense, or A&D, industry are involved primarily in the design and manufacturing of aircraft products and weapons products. While a few are specifically focused on either, most companies are involved in both segments.

It is considered a high-technology industry and covers a diverse set of companies providing products and services to civil and military customers.

Here’s what’s interesting. According to GlobalData, cyber security was the most discussed topic for the A&D sector in 2019 as combatting cyber threats to critical defense and civil infrastructures became a priority. This year, a U.S. federal government website was hacked and Australia's government and institutions were being targeted by sophisticated state-based cyber hacks. When viewed through that prism, it should not surprise you that some U.S. defense contractors rank among the world’s top 25 cyber security companies.

Point to note: ESG cannot be defined by one metric, such as carbon footprint.

ESG investing has evolved. In the past, an entire industry would be avoided due to negative screening. Think tobacco or alcohol or defense.

However, there could be a defense company that produces weapons but has a strong focus on environmental sustainability and corporate governance.

In fact, there are numerous issues that one can consider from an ESG perspective when analysing the A&D industry:

  • Bribery and Corruption
  • Product Quality and Safety
  • Energy Use and GHG emissions
  • Supply Chain
  • Human Capital
  • Sustainable Products and Services
  • Corporate Governance

Point to note: ESG is not restricted to exclusionary filters.

In a July 2020 report, Sustainalytics listed a few parameters they consider when evaluating the ESG score of A&D firms.

  • ESG Risk Rating

Average ESG Risk Rating score is 36.5, which ranks 37th out of 42 industries. The A&D industry is generally seen as high risk; 62% of companies considered high risk (ESG Risk Rating scores between 30 and 40), 21% considered severe risk (ESG Risk Rating scores above 40), primarily due to high exposure and mixed management.

  • Material ESG Issues

Relatively high exposure to material ESG risk due to several factors, including its concentration in highly regulated markets and high degree of regulatory scrutiny.

  • Product Governance

This is among the highest in the entire research universe, as quality and safety regulations are extremely tight, and even minor defects can have significant impacts. More than two thirds of the industry (68%) has high exposure score (i.e. >8);  49% of companies show weak management scores (i.e. scores 50). The combination of high exposure and weak management means that 17% of the industry have severe unmanaged risk (i.e. scores >8).

  • Bribery and Corruption

A&D companies have medium exposure (i.e. scores between 4-8). The industry is potentially exposed to bribery and corruption due to its close business relationships with governments, its competition for a limited number of high-value contracts and secrecy surrounding military procurement.

  • Business Ethics

As part of a heavily regulated industry with a global presence, A&D companies are subject to intense scrutiny on anti-competitive practices and ethical conduct related to products sold in sensitive areas. Exposure is medium for the subindustry as a whole, but tends to be higher for defense companies, which can be involved in weapons-related incidents.

  • Carbon – Products and Services

The industry has medium exposure (i.e. scores between 4-8) to Carbon – Products and Services risks. These risks tend to be higher for aircraft and components producers, whose clients are energy intensive and operate in a tightening regulatory environment around the carbon impact of air travel. Despite the increasing visibility of carbon--related issues, the industry has not recently faced any related events.

  • Data Privacy and Security

The industry’s exposure comes mainly from companies’ heavy reliance on sensitive data. A&D companies are among the largest government contractors and are entrusted with managing, storing and processing highly confidential information. The inherent secrecy of government contracts explains, in part, the low levels of company reporting on data privacy and security issues.  Almost half (43%) of the companies in the industry have weak management scores (i.e. scores of 0-25). However, the increasing pressure to secure highly sensitive data from espionage is driving companies to improve their safeguards. Overall, more than half (60%) of the industry shows low unmanaged risk (i.e. scores of 2- 4) while 38% face medium risk (i.e. scores of 4-6).

Certain perceptions of ESG are outdated, but it has never been more relevant. And the awareness that pursuing a sustainability agenda need not run counter to the wishes of shareholders is what is gaining even more traction.  

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