European Defense: A Vital Industry at Risk

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Senior Fellow - Defense

The last decade has witnessed a sharp deterioration of Europe’s security environment. Within this context, the war in Ukraine has served as a potent reminder of the urgency to invest in the continent’s defense. In this first article of the series Financing Defense in the 21^st Century, Nicolas Baverez discusses the specific aspects of the defense industry, a vital yet threatened component of European sovereignty.

Since the 2010s, democracies, and France and Europe in particular, have seen a rapid deterioration of their security environment, resulting from the combined pressures of jihadism and autocracies’ ambitions for power. Russia’s invasion of Ukraine and Vladimir Putin’s subsequent nuclear threats have dramatically heightened these security risks. This new war at the heart of Europe, which is mobilizing all the resources inherent to a hybrid conflict, is highlighting the continent’s vulnerability.

Because of its magnitude, brutality and duplicity, Russia’s aggression in Ukraine came as a major shock for Europe and Europeans, most of whom had neither anticipated nor prepared for a war. It has roused Germany from its commercial complacency towards Moscow, prompting Berlin to invest €100 billion in its armed forces and increase its defense spending to 2% of GDP. It has forced the European Union to step up as a power: the bloc has approved sanctions against Russia that are unprecedented in both scope and speed; it plans to deliver €450 million in military equipment to Ukraine; and it has banned RT and Sputnik, vehicles of Russian propaganda, from its territory.

Europe is embarking on a path of rearmament, which implies a modernization of both its military forces and defense industry.

Europe is embarking on a path of rearmament, which implies a modernization of both its military forces and defense industry. The latter, however, is currently being torn apart by contradictory demands that are compromising its mobilization. On the one hand, the Union has launched a €7 billion defense fund to help finance investments and innovation. On the other hand, the movement toward sustainable finance is raising concern in the industry that finances will dry up, which would limit its ability to develop, innovate, export and attract talent.

The Ukrainian tragedy is forcing Europe to speed up the resolution of this inconsistency. It goes without saying that the defense industry must fully comply with standards related to governance, the fight against corruption, the energy transition and gender equality. At the same time, however, it is vital to ensure that it is not sidelined from market financing, due to a poorly controlled regulatory agenda or pressures from certain parts of civil society. There can be no sustainable development without security, which remains the primary condition for freedom.

In this series of three articles, Institut Montaigne will revisit the importance of Europe’s defense industry, and the risks it might face from the sustainable finance agenda. We will also formulate proposals to ensure that, faced with the need to strengthen its defense, Europe maintains an industrial base that guarantees its strategic autonomy.

A crucial industry with unique features

The defense industry has specific dimensions that are important to address. It is firmly embedded in the sphere of sovereignty, which means that the state plays a crucial role in the development of projects, export orders and authorizations, and sometimes even in company capital. As such, it depends directly on political will. This reality extends to the industry’s financing, either in the form of shareholders - as is demonstrated by the provisions on investment control - or in the (largely sovereign) form of taking risks.

In defense, business life cycles are long, ranging anywhere from 10 to 25 years, which implies two strong constraints. On the one hand, there is the "non-obsolescence" requirement, which reinforces the second requirement, of design performance: because the equipment must last, it is imperative that it uses technologies that are both innovative and robust. In other words, the defense industry must be at the forefront of innovation.

This also makes it an important player in technology used for civilian purposes, which explains the prevalence of companies in the "dual-use" category (developing products for both military and civilian applications) in the defense industrial and technological base.

The defense industry must be at the forefront of innovation.

At the same time, these long lifecycles and the importance of innovation contribute to the sector’s financing constraints. Industry players must be able to rely on sufficient equity capital, debt maturities that are consistent with the length of the development cycle and, for subcontractors in particular, financing that understands the nature of the programs and the ordering institutions.

The European defense industry is a key economic pillar, representing annual revenues of €100 billion and around 1.4 million direct and indirect jobs. Beyond these numbers, many of Europe’s flagship industrial companies have developed dual activities - both civilian and military - with obvious synergies between the two, particularly in research and development. France holds a leading position, with €15 billion in revenues for an industrial and technological base that counts ten major corporate groups, over 4,000 companies, and more than 200,000 highly technical jobs. Defense is a vehicle for France’s strategic autonomy, especially because it provides and deploys nuclear deterrence.

Paradoxically, the financing of the European defense industry has encountered increasing obstacles over the last few years, even as the continent faces growing threats to its security. The progressive tightening of funds can take many forms: shrinking liquidity; the delisting of public companies; diminishing access to equity and debt finance; complications and growing costs in export financing; refusals by historical banking partners to contribute to the cession of family businesses.

The gradual closure of the defense industry’s financing tap affects both large firms and SMEs, companies working solely for defense markets and those with dual activities. This phenomenon can be witnessed across Europe, including the United Kingdom. It involves all financial players, from banks to markets and investment funds.

There is a risk that this trend is getting out of hand, as Europe strives to make sustainable finance the new norm - without having clearly defined what this entails.

While the cause of this trend is partly economic, it is also regulatory. Even more so than other sectors, the defense industry has been targeted by reinforced compliance regimes. These provisions can be contradictory, notably between the European Union and the United States, where export controls are being used as weapons to wield sovereign power. Sanctions regimes have similarly multiplied, again through measures that might differ from one jurisdiction to another. Financial institutions have been forced to act with more caution - to the point of completely withdrawing from businesses deemed too sensitive - as a result of particularly severe and sometimes questionable sanctions.

There is a risk that this trend is getting out of hand, as Europe strives to make sustainable finance the new norm - without having clearly defined what this entails. At a time when everything must become "sustainable", and when the fight against greenwashing mandates regulatory control, the defense industry risks becoming a collateral victim of the sustainable finance agenda. More precisely, if institutions view all financed activities through the lens of sustainable development objectives and prefer a simplistic reading of SDG 16 (promoting peaceful and inclusive societies) over ancient wisdom (si vis pacem, para bellum), defense activities would be excluded on principle. In parallel, the draft directives on corporate sustainability due diligence, which would require companies to report on customers’ use of products, could prove incompatible with the sale of military equipment. It is worth recalling that the latter is already subject to specific controls - notably a general prohibition regime that demands prior authorization by states.

Because it remains a poorly understood and specialist domain, the field of defense is struggling to navigate national and European public debates - that is, until the day circumstances compel us to hold a wider debate on these issues. . For the same reasons, the industrial aspect of defense issues remains peripheral to our economic and regulatory reflections. This is a dangerous periphery which, if we are not careful, may lead to the defense industry’s eviction from market financing, due to inadequate regulation that would amplify the legal and reputational risks faced by financial actors. This breakdown would have major consequences. First, it would trigger a spiral of devaluation for companies in the sector. Second, it would jeopardize the development of major projects and innovations that cannot rely on public funds alone. Third, it would ruin the ability of the defense industry to attract the talent and intellect that it cannot survive without. Finally, it would heavily impact the competitiveness of European companies in comparison to their foreign counterparts. In a world where force is visibly wielded, it would condemn Europe to remaining an actor that is unable to guarantee its own security and control its own destiny.

Copyright: INDRANIL MUKHERJEE / AFP

01/07/2022

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European Defense: A Vital Industry at Risk

A crucial industry with unique features