The tariff-flip-flop-induced market turmoil of recent weeks has pushed other items off the agenda that were critical only a month ago.
A quick rewind to March: with the US administration shifting the responsibility to Europe for supporting Ukraine, policymakers started ratcheting up their hawkish rhetoric and defence stocks began to soar. European Commission President Ursula von der Leyen described it as “the most momentous and dangerous of times”. In response, the European Union (EU) unveiled its €800 billion ReArm Europe Plan, comprising €650 billion in fiscal space and €150 billion in borrowing, to bolster defence capabilities and ensure strategic autonomy.
It also reignited the three-year debate about the role of environmental, social, and governance (ESG) criteria in defence investments, this time in earnest.
At the heart of the debate lies the question of whether Europe’s ESG frameworks, which have long excluded defence stocks on the basis that they are “unethical”, should be recalibrated to reflect their role in ensuring security and supporting sustainable growth. Many defence companies remain structurally excluded from many sustainable portfolios due to regulations embedded in ESG norms, such as exclusion lists and negative ratings.
Policymakers are increasingly arguing that these frameworks fail to account for the growing geopolitical pressures facing Europe, where security is now seen as essential to economic resilience.
Figure 1. Defence spending as percentage of GDP (1960 -2024)
Source: World Bank Group, as at 31 December 2024.
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Misalignment between defence and ESG
Funds regulated under the EU's Sustainable Finance Disclosure Regulation (SFDR), including Article 8 and Article 9 funds, which dominate Europe’s sustainable finance landscape, are significantly underweight aerospace and defence stocks. Article 8 funds are 65% underweight, while Article 9 funds exceed 90%. Norms built over years of ESG investing will not change overnight.
Yet the potential for inflows is substantial. Were Article 8 and 9 funds to move to benchmark weight in aerospace and defence in the STOXX Europe 600, it would drive almost US$90 billion in inflows.1 Despite this, sustainable investors remain hesitant, even as defence equities outperform broader indices like the STOXX Europe 600.
Pushback against ESG exclusions
More than 100 UK Labour Members of Parliament (MPs) recently urged banks and fund managers to both support Ukraine and the defence industry. While recognising the importance of ESG investing, the MPs wrote, “…we must rethink ESG mechanisms that often wrongly exclude all defence investments as ‘unethical’.’’ HM Treasury and the Financial Conduct Authority have echoed this sentiment, emphasising that sustainable investing can complement defence funding.
The European Investment Bank – once dubbed the EU’s climate bank – has rewritten its mandate to include lending to defence companies. Political pressure is mounting on influential investors, such as Norges Bank, to revise exclusion lists widely adopted across Scandinavia.
A shift in asset flows
The performance of European defence stocks suggests investors are already paying attention. The Goldman EU defence basket has consistently outperformed the STOXX Europe 600 since 2022. Yet, the path forward requires more than strong returns.
Figure 2: Defence stocks started to soar
Source: Bloomberg and Goldman Sachs, as at 3 April 2025.
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In short, the policy imperative to link defence and ESG is pretty clear, which means that EU and UK politicians and policymakers will use every mechanism available to pressure private sector investment into financing the defence and dual-use sectors.
Hence, policymakers will likely make the case for sustainable defence in several ways. We expect a lot more suasion on investors, such as the letter from UK MPs, as well as institutional changes.
Regulators could reassess frameworks like the EU taxonomy to potentially include defence. And we may see the issuance of World War One and World War Two-style patriotism and war bonds to support investment into the defence sector.
1. Source: Goldman Sachs.
All data sourced from Bloomberg unless otherwise stated.
With contributions from Jason Mitchell, Head of Responsible Investment Research at Man Group.
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