Morningstar’s assessment of a wide portfolio of defence companies shows that 68% of the businesses surveyed are rated as having a ‘medium’ ESG risk, whereas only 40% of all other industries are rated as medium risk. Furthermore, 34% of defence companies have a ‘high’ ESG risk, compared to 20% of all other industries. But the factors contributing to this higher-than-average ESG risk rating for defence companies are not actually defence-specific: the defence industry produces more carbon-intensive products and emits more greenhouse gases than the all-industry average. Moreover, the defence industry works closely with governments and depends on them as clients, potentially resulting in compliance risks such as corruption, price fixing and circumvention of export controls. The defence industry is also more likely to be the victim of hostile state-inspired cyberattacks, implying higher risks to data privacy and cybersecurity. Still, while defence’s risk ratings in these categories are higher than the all-industry average, the type of risks the industry is assessed against is not specific to the defence sector.
One defence-specific risk category affecting defence companies’ ESG ratings is their product offerings. Sustainable-branded funds often exclude companies involved with ‘controversial weapons’. However, these products differ across ratings agencies, investment funds and national regulatory regimes. Most often, ‘controversial weapons’ are defined as anti-personnel mines, cluster bombs and other weapons banned under customary international law or treaties such as the Chemical Weapons Convention, the Biological Weapons Convention and the Convention on Certain Conventional Weapons. The UK has signed and ratified these conventions, and almost no European defence companies are involved in the development or production of cluster bombs, anti-personnel mines or chemical and biological weapons. Some investors also take into account the development of nuclear weapons, while still fewer include the civilian firearms sector, which can significantly broaden the list of prohibited investments.
Definitions and Existing Regulatory Frameworks
Sustainable-branded funds based within European regulatory regimes face a set of EU and UK rules on reporting and branding; these regulate the amount of reporting by publicly traded companies and the investment funds that invest in them that facilitate accurate assessment of their equity’s ESG-related risks. These risks can then be reflected in ESG ratings that funds can use to decide if they want to invest in the companies’ stock. In its sustainable finance disclosure regulation (SFDR), the EU distinguishes between various levels of reporting, ranging from risks (Article 6) and negative impacts (Article 7) to investments that actively promote environmental and sustainable characteristics (Article 8) and investments with a sustainability objective (Article 9). The UK’s Financial Conduct Authority (FCA) has its own framework, the Sustainability Disclosure Requirements (SDR). Fund managers are required to disclose their fund’s alignment with these reporting standards when they market their funds as ‘sustainable’. Also, the EU has published a taxonomy of what it considers to be ‘environmentally sustainable’ activities, which in turn provides the basis for public companies’ reporting on these activities.
What bearing do the EU and the UK’s regulatory frameworks have on defence-related activities? As a matter of fact, only a small number of elements of reporting standards and taxonomies mentions the defence sector explicitly. The EU’s reporting regime under the SFDR does not encompass mandatory banning of businesses that handle defence-related products, and the European Commission has recently released a statement clarifying this policy. Similarly, the FCA announced recently that there were no regulatory reasons for excluding defence businesses from sustainable-branded funds under the SDR.
However, the EU Green Taxonomy, a regulation passed in 2020 that defines environmentally sustainable behaviours for corporations, does require companies operating in the EU to comply with UN Guiding Principles on Business and Human Rights and International Labour Organisation principles. This includes the application of a ‘do no significant harm’ principle. Since the language regulating this principle is relatively ambiguous, fund managers have a significant degree of agency in deciding on a company’s alignment with these principles. Mostly, it is applied in the reporting of companies’ operations and ensuring that staff are properly cared for and that modern slavery is not part of their supply chains.
Funds see the exclusion of ‘controversial weapons’ as an application of the ‘do-no-significant-harm’ principle. Some fund managers, albeit not a wide group, claim that most defence-related products – or any ‘offensive’ technology – are inherently incompatible with human rights standards as defined in the EU Green Taxonomy and they therefore implement broad exclusions of defence holdings in their funds. The ambiguity in regulatory language and the resulting margin for interpretation explain the prevailing misconception that ESG standards preclude investment in defence. This misconception is exacerbated by those funds that may have extremely strict exclusionary filters for the allocation of their investments, but market themselves as sustainable in line with European Securities and Markets Authorities naming rules (even though this is not mandated by these rules).
In short, ESG reporting and labelling standards do not preclude sustainable funds from investing in defence, but certain sustainable funds may deliberately exclude defence owing to interpretation of regulations, creating confusion over whether this is mandated by ESG rules or whether it is voluntary practice (for example, in response to clients’ preferences).
There are other sources for confusion, too. For instance, stricter disclosure and labelling rules, such as the EU’s SFDR Article 9, require companies to affirm that environmental and social sustainability is at the heart of a business case. These sustainable goals can relate to environmental and social outcomes, broadly defined, with objectives including affordable housing, improved health or community development, in addition to environmental protection. While some may see the negative social consequences of when defence products are being used, defence companies argue that their work should be considered as having a significant positive social impact, since they equip the state with the means to protect its citizens and help secure a stable environment in which communities and economies can prosper.
In response to the confusion over defence’s place in its sustainability regulations, the EU has recently clarified that its disclosure and labelling regime, the SFDR, does not prevent ESG funds or any other type of fund from investing in defence. However, investors previously faced the prospect of possible regulatory restrictions. Several years ago, the European Commission Platform on Sustainable Finance considered early proposals for a taxonomy that defines socially sustainable activities that initially categorised defence-related businesses as socially unsustainable. It is likely that these past considerations of potential regulatory tightening had an impact at the time on some fund managers’ appetite to include defence businesses in their portfolios. Furthermore, investment allocations can be slow to reverse.
Some defence companies exacerbate the problem of ESG being blamed as the reason for their lack of access to investment; representatives interviewed for this paper claimed that ‘ESG’, loosely defined and used, is responsible for their difficulties in accessing basic financial services. Putting the blame on ‘ESG’ is often unsubstantiated, as financial regulators have not imposed such exclusions.
The regulatory outlook is now beginning to change. In the context of the research for this paper, industry experts confirmed they are less concerned over the potential tightening of defence-related ESG exclusions. This is in part due to changing public opinion and increasing awareness of the defence industry’s role in ensuring national security in a destabilised geopolitical context. Consequently, the tendency among some investors to pre-emptively over-comply and exclude defence investments is gradually being reversed. Indeed, funds that adhere to EU SFDR Article 8 reporting requirements have increased their exposure to defence equities, and now also include companies that rely on defence as their main business. Thus, market practice continues to evolve and shift over time in response to regulatory and industry-wide developments.
Defence Exclusions not Driven by Regulation
While there are little to no regulatory reasons to exclude defence companies from ESG-branded funds, some investors still implement broad, sector-wide exclusions. Reasons for these exclusions are numerous, but first and foremost, fund managers want to offer their customers the option to not invest in businesses with which they take issue. For investors themselves, there can also be an incentive to exclude defence businesses due to the volatile reputational risks mentioned previously. One notable example is that while the sector has been praised for its support of Ukraine in the war against Russia, it has also been subject to criticism when supplying government-authorised exports to Israel.
These exclusions are therefore not motivated by compliance with ESG standards, but will instead often fall under ‘ethical’ investments. But they can often be marketed as ‘ESG’ or ‘sustainable’ funds, which has contributed to the widespread misconception that ESG standards are to blame for the lack of investment in defence and for the industry’s difficulty in accessing financial services. This misconception is reinforced by the fact that ‘ethical’ investment funds often follow ESG regulatory standards in their allocation of equities. For instance, according to the FundEcoMarket database, as of 7 August 2025, out of 114 SDR-labelled funds surveyed, 18 excluded all businesses with military contracts and 86 ‘avoid[ed]’ armament manufacturers. Neither of these exclusions is mandated by regulations but results from a voluntary avoidance of any exposure to defence-related equity. The same sort of voluntary avoidance can apply to other sectors, such as gambling, pornography and tobacco. Thus, these funds can legitimately brand themselves as ‘ESG’ or ‘sustainable’, while also implementing additional voluntary standards that can exclude entire sectors. Consequently, it is necessary to inform the public and investors about ESG standards’ tolerance for defence investments, and to distinguish broader ESG funds from the narrower pool of ‘ethical’ funds, which can operate with additional, voluntary exclusions.
Following the global rally in defence industry equity in recent months, some ethical investment funds have loosened their product-specific exclusions to allow certain investments in defence. The new exclusions that some funds have been using can be confusing. One notable example is the pledge that certain investors have made to only invest in companies that research and develop ‘defensive weapons’, or, in other words, technologies that deliver their function but with decreased lethality. These new approaches can be poorly defined, and funds with such investment strategies may be branding themselves as ‘ESG’, thereby falsely suggesting that their policies are guided by ESG disclosure and labelling regimes. It may be necessary for the industry to consider new ways to more clearly clarify their approach to common ESG-based exclusions, such as ‘controversial weapons’, to help distinguish more mainstream ESG funds from ethical funds and prevent unintended outflows of investments from those investors who do wish to invest in defence.
Ultimately, ESG-based and ethical exclusions of the defence sector are only two factors among the many metrics that fund managers consider when evaluating investments in defence equities. Performance is perhaps the most crucial metric. Defence companies have delivered relatively reliable but unexciting returns over the past decades, until demand surged recently. For a long time, company valuations remained stable and dividends remained reliable, but defence companies indicated little growth potential.
Additional characteristics can make the defence sector unattractive for certain investors: for one, national defence markets are dominated by a single buyer – the state – and companies are accordingly dependent on its political appetite for defence procurement. National regulations can also limit defence companies’ profit margins. Further, government contracts can take years from planning to execution, and defence ministries often challenge the quality of the products delivered or the timeline of their delivery. In addition, government payments can be delayed, and legal risks in the market are high.
Notwithstanding these obstacles, equities in the defence sector have begun to rally over the last three to five years, and can now deliver serious growth for investors. During that time, more sustainable-branded funds have invested in defence or significantly increased their exposure to defence. Morningstar reported recently that actively managed, sustainable-branded European equity funds have now on average tripled their exposure to defence and aerospace equities since 2021.
