Are defence stocks now ESG?
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I have been invited to a seminar titled “How does ESG continue to evolve?” I don’t need to go. I already know the answer.
It will continue to evolve until one way or another it encompasses everything. Then, like everything that has tried to be all things to all men before, it will mean nothing.
I’ve written here before about the idiocy of exclusionary investment — refusing to invest in fossil fuels and mining because they are dirty but also relying on both to drive the global economy and the energy transition for example.
ESG investors (people following environmental, social and governance criteria) tend to focus so much on the environment that they forget the social — the wellbeing of our communities and the maintenance of our living standards.
The past week has made that point pretty clearly — we are seeing the results of structural under-investment in efficient energy in oil and gas prices — there is talk of the average UK household energy bill hitting a terrifying £3,000. We have also seen it in share prices and in the way people want to invest.
In Europe in February, notes Deutsche Bank Research, companies with “lower ESG ratings . . . fared better”. And carbon prices? No one was much interested — as gas soared, carbon saw “high single-digit declines”.
At the same time, ESG ETF flows weakened and investors turned to “more diversified instruments”.
As I think you would expect, those who thought investors would be happy to lose money for their principles might have another think. Prepare to hear less about green transition and more about energy security.
So what do you do if you run an ESG fund? You think about how things that are going up could perhaps be reclassified from a bit iffy to completely fine.
Take defence. This has long been a no-no for full-on ESG funds. It’s also been a bit of a no for most funds with a bit of an ESG overlay.
After all, jets and tanks have something of a significant carbon footprint — and anything designed to frighten and kill is surely impossible to classify as a good thing.
But it isn’t so simple. Sure, if you are only selling goods to nasty dictators it’s hard to see how you could fit under E, S or G. And we wouldn’t want to buy your shares anyway, as we would worry about the G issues in your client base meaning you’d never get paid.
War is nasty, the weapons that facilitate war are nasty and buyers of those weapons aren’t always particularly steady clients. But if you supply weapons to the invaded underdog in an unprovoked fight, or to the countries backing said underdog to pass along, could we not file your activity under S as a social good? Surely.
As the Latvian deputy prime minister said this year: “Is national defence not ethical?”
The problem? Most defence companies serve both the dictators and the underdogs — and so end up in the “too hard” bucket for a lot of managers.
The sector stayed cheap — and by the end of last year European defence stocks in particular were trading at a pretty hefty discount to the MSCI index of global shares as a whole.
This dynamic has changed. One example. Sweden’s Skandinaviska Enskilda Banken. A year ago it decided that none of the funds it runs would be allowed to touch defence stocks.
This week it changed its mind, as the Wall Street Journal reported. Now six of its 100 funds can — although they will perhaps have missed the 30 per cent rise in Saab in the past five days. Saab makes fighter jets.
You could say, it’s only six. But you could also say the principle is dead, now we are just arguing about quantum.
A few months ago there was no way that when the EU got around to completing its social taxonomy criteria for sustainable finance, defence would have had a hope of being considered aligned with its aims. That it makes a “substantial ESG contribution” or does “no significant harm” for example.
Today it’s almost a certainty. Here are analysts from Citi on the matter: “Defence is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace stability and other social goods.” If something is obviously vital to maintaining peace how can it also cause social harm?
You can also go vague. This is generally a killer strategy in the ESG space. A press release for a new fund just crossed my desk. It’s got all the buzzwords in its name — the Climate Transition Equity fund. Check the double meaning in equity . . . very good.
And it focuses neatly on the idea that you can divide good firms into mitigators and enablers. The former work to reduce their own emissions and the latter “provide products and services that support other companies and activities on their decarbonisation path”.
Those launching this fund mean well, I assume, and it is perfectly clear that at launch they have in mind producers of renewable energy and carbon capture technology when they talk about enablers.
But if a wind turbine manufacturer is an enabler surely so too are the producers of rare earth metals and (whisper it quietly) coal miners (steelmaking mostly needs coal). See how easy it is to shuffle the goalposts out a little should you be so minded? And how easy it is for close-to-pariah stocks to move to hero status in times of crisis?
The key point here is that the idea that anyone — yes, even the EU — can provide a static ESG framework that both excludes some sectors or companies and works is dead.
It can’t. There is good in most listed companies (that’s how they got listed in the first place). Pretty much the only sector you can argue has no upside of any kind is tobacco, although that might not be what those living off the dividends will say.
So if you want to invest sustainably for the long term in companies that offer something to society you don’t actually need an ESG fund manager.
In fact, you probably don’t want an ESG fund manager. They’ll either be too inflexible or too concerned about how to communicate their unexpected flexibility. You also don’t want to be in passive investments to the extent you have been in the past — as Research Affilliates’ Vitali Kalesnik points out, in a world in which we have just been reminded that G can stand for governance at a state as well as a corporate level, you don’t want a little bit of everything — most global portfolios will have a had a small weighting to Russian equities.
You just want an unconstrained, active, focused, and thoughtful fund manager — possibly one who recognises that his clients want to be good to the planet and to the people on it, but who also remembers the 1970s and buys you a hefty position in real assets to be getting on with.