Defence stocks lined up to offer lifeline to ESG as investors fade away

Investors have used the war in Ukraine to justify buying shares in weapons manufacturers that were once taboo. Getty Images

Spoiler alert. The new series of Industry, the BBC’s highly watchable City drama, contains an excoriating analysis of everything that is wrong with ESG. Anyone watching will be left in no doubt that, according to this well-researched show, the hold those three initials held over the financial world is well and truly over.

The grip of Environmental, Social and Governance (ESG) has weakened in the real world, too. Less entertaining confirmation, but just as dramatic, was the decision of BP to pull back on net-zero targets. Not so long ago, the British oil major was known as “Beyond Petroleum’ for its pursuit of green standards. Not any more.

Far from abandoning curbs on fossil fuel production, BP is now targeting new investments in the Middle East and Mexico. Further evidence of the retreat of ESG came with reaction to the BP announcement. Once, where there would have been shock among environmental campaigners, there was little surprise.

For some time, the investment community has been pushing in one direction, which is the trumping of profit over protection of the planet. The fiduciary duty of directors has seen the requirement to generate returns become the imperative. In the face of global inflation, supply chain issues, cost-of-living crisis and post-pandemic blues – not to mention wars – the climate threat is one on a spectrum of risk. The mood at next month’s COP climate change talks in Baku, Azerbaijan is likely to be much darker than last year.

The loosening of ESG is heralding something of a shake-up in investing and fund appraising. There is a sense of those charged with making money from equities having got the bit between their teeth and being determined not to stop.

What’s in their sights is defence stocks. For years, no self-respecting portfolio manager would dare add a weapons manufacturer to the line-up, there was not a chance of military hardware and ordnance passing muster with the ESG police. To do so would invite protest – they would think of those brave souls who walked past demonstrators at arms fairs and shudder.

Companies that enjoyed audiences with world leaders, that would be feted by defence ministries, became used to a very different reaction where the markets were concerned. They were locked out, unable to attract the most blue-chip pension funds to their share registers. They were regarded as vice stocks, unethical, down with the likes of tobacco and gambling.

Apart from those wearing uniform, no one else wanted to know them. The media and elected, image-savvy politicians, they thought carefully before accepting an invitation to attend a dinner or a session at Davos with the head of a military supplier. Of course, the weapons firms lobbied hard but progress was slow. In polite company, to say you worked for a defence contractor would normally be prefaced by a shame-faced apology.

What changed was Ukraine. Russia’s invasion suddenly made it acceptable and within the parameters of ESG to discuss the supply of missiles, tanks and security systems to the beleaguered, smaller country. Moral outrage at Ukraine’s plight replaced misgivings about the trade.

For many in the West, including those on the left, it was a black and white issue: Ukraine must be helped. As the conflict has dragged on and some have called for Ukraine to sue for peace, that view has prevailed. Seemingly, within ESG, it’s OK to supply products of death to the oppressed defender.

With that shift and acceptance that military hardware is all right really, has come a broadening out: if it’s allowable to arm Ukraine is it not permissible to hold shares in the producers? If Ukraine is, then, surely, so must other conflicts be similarly tolerated?

To reinforce that case, shares of defence makers have risen – they remain a bright spot on the market indices. But, while the fighting in Ukraine and now Russia itself continues to rage, another conflagration has provoked renewed disquiet.

Defence and Security Equipment International fair - in pictures

That’s the war between Hamas and Hezbollah and Israel. The daily sight of flattened buildings, dead and injured civilians, and displaced residents has exacted a toll in global financial centres. Whatever the ins and outs of the hostilities, the result has been a re-examination of the embracing of shares in those companies that assist in the arming of Israel.

Some would like to have it both ways: approving the equipping of Ukraine while disavowing shipments to Israel. Presumably, those who march under the Palestinian flag would hail it as perfectly respectable, if not admirable, to send the same to Hamas and Hezbollah.

This, though, is to invite chaos – the setting of an arbiter to determine if investing in a share that is likely to prosper and provide a decent profit for your fund that can be disputed. So, you only buy stocks in arms producers who deal with defenders, do you? Good luck with that. You forget that one person’s violated territory is another’s justifiable target.

What is unfolding is the realisation that ESG is unworkable. To reframe that, it’s unworkable within the confines of a system that mandates investment managers to produce the best possible returns. It was thought that by applying the strictures of ESG, the framework of a social conscience could be brought to bear. It’s an artifice, it does not reflect the real world. It does not and cannot function properly and efficiently.

It’s too broad, too condemning and difficult to apply in all circumstances. When the markets are racing ahead, ESG is fine – profits continue to flow. When they tighten, ESG quickly proves a hindrance. The loser is the saver, the pensioner. They may be prepared to accept lower returns if they’re the result of investment decisions based on doing good. Some might, but equally, others may not.

We’ve had Corporate Social Responsibility, then CSR was succeeded by ESG, which, riding on the backs of the woke and climate change movements became fiercer and enveloping. Another framework is required or perhaps not one at all. We could have markets that are entirely free, where individual investors can make their own choices. Sometimes, let it be said, the old practices are the best.