LONDON/PARIS, March 11 (Reuters) – Largely ignored by the growing ranks of European social investors, defense companies are seeing a new chance to make the case for a place in portfolios following Russia’s invasion of Ukraine.

An asset manager announced last week that it would allow defense investments again, a sign that cracks are emerging in widespread opposition to the ownership of defense companies by sustainable investors in Europe.

Analysts expect others to follow. But for many with a sustainable inclination – defined by some as investing in businesses that aim to have a positive impact on the world – this will prove a difficult question.

Rolls Royce (RR.L), Thales and Airbus (AIR.PA) have joined a corporate chorus over the past two weeks calling on investors to treat the sector more favorably, arguing that security and stability are key to the durability.

It comes after a year of industry lobbying European authorities not to rule out defending an upcoming framework or “taxonomy” on socially good investing.

It also follows years in which investors across Europe shunned the sector in favor of companies with stronger environmental, social and governance (ESG) profiles, hurting defense stocks and increasing financing costs.

Most of the sustainability-focused funds that Reuters has reported on remain cold on defence. But some are eyeing the returns offered by the region’s efforts to increase security spending.

Swedish firm SEB Investment Management announced last week that it had reversed a blanket ban on any company deriving more than 5% of its revenue from defense for six of its funds, although the majority of its product range is unchanged, including sustainable funds.

SEB attributed the change to client pressure for defense exposure as Russian troops massed on the Ukrainian border, stressing that fund companies must respond to clients as well as their own sustainability promises.

“We see evidence that a number of large European asset managers are reassessing the sector,” said Luke Sussams, head of ESG Europe, Middle East and Africa for investment bank Jefferies. “The Ukraine-Russia conflict has been a real wake-up call for ESG investors in general.”

Yet others say the sudden overhaul of Europe’s security architecture doesn’t mean fighter, missile and tank makers are suddenly sustainable.

“Sustainable investments must meet the ‘Do no significant harm’ criterion – this is not the case with armaments,” said Henrik Pontzen, head of ESG at Union Investment. It sticks to excluding from its sustainable funds any company that derives more than 5% of its income from armaments.

Sasja Beslik, head of sustainability at Danish pension fund PFA, said investors were wrong if they thought they could guarantee that any defense investment would only go to border defence.

“What are we going to include tomorrow? Let’s include chemical companies that pollute some parts of the world, but not the rest. Come on, that’s ridiculous,” he told Reuters.

While funds with a specific sustainable or ethical mandate may struggle to change course, others with a softer requirement to “integrate ESG risks” have more flexibility.

Sustainable managers generally avoid companies that derive more than 5% of their revenue from defense, while the vast majority of risk-oriented funds simply ban those involved in unconventional weapons such as cluster munitions. .

UBS analysts have noted that rather than outright exclusions, some ESG managers prefer engagement.

According to Morningstar, sustainable funds have a 0.2% weighting in aerospace and defense versus 1.1% for the Vanguard Total World Stock ETF. In Europe, the underweight is more pronounced — 0.2% versus 1.6%.

SOCIALLY GOOD OR BAD?

Yet defense lobbyists believe they are now winning the argument, particularly after a strong indication that Europe’s willingness to help channel investment into socially and environmentally friendly activities would not preclude not their industry.

A report prepared for the European Commission on its “social taxonomy” last month omitted an earlier reference to defense as socially harmful. Lobbyists feared this would lead to widespread fund exclusions.

As Germany, Sweden and others announced higher defense spending since the war in Ukraine, analysts rushed to improve their forecasts and stock prices soared.

Calling ESG concerns “wrong and morally weak,” Agency Partners said in a note that the EU taxonomy debate had clouded the investability and valuations of defense stocks.

And French warplane maker Dassault Aviation (AM.PA) has tackled a “schizophrenic” situation that has seen European defense spending rise only for US rivals to benefit as European suppliers were harmed by the EU taxonomy campaign.

“Taxonomy is not an effective weapon against current threats,” CEO Eric Trappier, who also represents the French defense industry, told reporters. “It’s a weapon being used against us, the defense industry, and the proof is that…its smaller suppliers are starting to have problems with their banks.”

TO DEFEND ONESELF

The defense industry’s fight is far from over, however.

Including defense in the EU’s social taxonomy “would go against the ‘Do no significant harm’ principle,” said Hortense Bioy, director of sustainability research at Morningstar.

EU technical advisers are also backing a 5% revenue threshold to exclude defense firms from the bloc’s planned “EU Ecolabel”, which is designed to help consumers identify more environmentally friendly and socially good products.

A spokesperson said the Commission would “consider carefully all implications of these exclusions for defence-related activities”, but stressed that no final decision had been made.

For a fragmented industry that may struggle to compete with rivals in the United States where ESG concerns are less common, winning the hearts and minds of investors is crucial.

“Even if some banks and investors are going back to defence, that doesn’t mean they are all back,” said Jan Pie, secretary general of European defense industry lobby ASD, saying that at more In the long term, defense needed more reliable donors.

“It shouldn’t be public opinion that decides whether or not to fund the defense industry.”

Reporting by Simon Jessop, Tommy Wilkes and Tim Hepher; Editing by Susan Fenton

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