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The Defense Industry: an Unintended Victim of Financial Regulation 

Analysis - 12 April 2022

If the Russian invasion of Ukraine has taught us one thing, it’s that Europe’s security environment has changed profoundly. In a time when the EU’s ability to achieve strategic autonomy is anything but certain, this three-part series, Financing Defense in the 21st Century, examines the importance of the defense industry for Europe and considers ways to guarantee its resilience. In this second article, Nicolas Bavarez considers the link between financial regulation and investment in the defense sector.

Building on the momentum of the Paris Agreement, the EU initiated a sustainable finance agenda in 2016. The Union set ambitious goals: it seeks to make sustainable finance the norm in Europe, and strives for Europe to become the global leader in this domain. In line with an action plan - for which an update is expected soon - it has launched a series of legislative initiatives. These intend to achieve three main objectives:

  • The first aim is to redirect capital flows. To this end, the Commission worked with a group of technical experts to develop a taxonomy of sustainable activities, which was adopted in June 2020. In July 2021, the Commission proposed an EU Green Bond Standard. It is currently working on the regulation of "climate transition" or ESG benchmarks - adopted in December 2019 - as well as labels for investment products that claim to be environmentally responsible. In addition, the Union has ensured that its own investment plans, in particular Invest EU and the Green Deal, are consistent with these standards.
  • The second aim is to make sustainability a widespread practice in risk management. This means ensuring that ESG criteria are taken into account by credit rating agencies (the European Securities and Market Authority published guidelines in July 2019). The Commission has also proposed to reinforce reporting on sustainability issues by asset managers and institutional investors. The Corporate Sustainability Reporting Directive (CSRD), adopted in March 2021, requires each investor to report on its ESG policies and their implementation. Finally, the Commission is considering changes to the prudential frameworks of banks and insurance companies by integrating objectives related to the ecological transition.
  • The third aim is to reinforce and overhaul the Non-Financial Reporting Directive (NRD). Two new structures are set to be created: a European standard-setting body and an International Sustainability Standards Board. The latter would operate under the auspices of the International Financial Reporting Standards Foundation. Regulatory initiatives on due diligence and the responsibility of boards of directors are also under discussion.

Sustainable development issues are often treated in isolation, with measures adopted in response to social demands following major events, such as the Rana Plaza disaster in Bangladesh in 2013. In this regard, the European Commission and Parliament may be commended for aiming to create a coherent, overarching framework to address sustainable development issues. Nevertheless, many of the EU’s intentions remain vague, illustrated by the particular case of defense industry financing.

The demand for greater "sustainability" by citizens and consumers can lead to erroneous and penalizing financial decisions.

"Making sustainable finance the norm" can be achieved by seeking greater "awareness" in the financial sector. Indeed, ignoring climate change, the transition to a carbon-neutral economy and the demand for greater "sustainability" by citizens and consumers can lead to erroneous and penalizing financial decisions. By shedding light on these blind spots, public authorities can minimize risk. In addition, by standardizing financial products and instruments that are claimed to be "responsible", they can limit greenwashing.

But "making sustainable finance the norm" can also mean imposing certain practices based on convictions. While this is legitimate in some domains - disarmament, for example - it seems excessive and dangerous to elevate these practices to the level of absolute principles. The EU’s initiatives have enforced a range of standards. Today, we have reached a decisive turning point to identify which European regulations are going too far. This comes with the risk of significant and unintended damage to some sectors, including defense.

 Beyond regulatory initiatives, this issue needs to be addressed because of the rapidly evolving practices of financial institutions - for the sake of internal coherence as well as due to the pressure of NGOs and certain stakeholders.

Within the framework of financial institutions, imprecise intentions can lead to dangerous decisions. On the one hand, we can hardly criticize decisions made by legitimate institutions themselves. On the other hand, it is important that these decisions are based on a clear strategy, well-defined scope and complete assessment of the consequences. If it appears that the widespread enforcement of new practices is driven by emotional decision-making rather than a coherent decarbonization strategy, we might want to question the relevance of initiatives.

Investments in sustainability will never represent more than a minority share of the total level of financing in our economies.

Another source of confusion is the scale of sustainability investments. The reality is that investments in sustainability will never represent more than a minority share of the total level of financing in our economies. The EU taxonomy provides a good example. According to first estimates, the taxonomy covers about 5% of the financing currently provided by European financial institutions. This figure must be adjusted to reflect the climate transition’s investment needs, which are higher - around 10% of total investment. While these investments must clearly grow, they will not overshadow other essential financing. The goal should not be to funnel all investments into one green sector, as this would run the risk of greenwashing, and creating a gigantic speculative bubble. On the contrary, the priority should be to decarbonize the entire economy, including the sectors that have to implement the most changes.

The defense industry should be part of the crucial evolution of standards related to governance, the fight against corruption, equality and climate change. It cannot be excluded from these mechanisms based on ideological rather than economic and legal reasons. Legislators, regulatory authorities and the financial governance bodies - investors, investment funds, banks and insurance companies - need to defend themselves from militant pressure regarding the shape and application of these necessary changes. They need to ensure that a coherent strategy prevails, in order for a new economic model to emerge - one that reconciles sustainability, competitiveness and security.



Copyright: Eliot BLONDET / POOL / AFP


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