ESG and Defence in the UK and EU – navigating the politics and legal requirements to include defence projects in sustainable investment funds

Increasing global security concerns (coupled with changes on the global political scene) have led governments to increase their budgets for defence spending. In this briefing we consider how compatible defence sector investments are with sustainability-related rules and regulations, such as the EU Sustainability Finance Disclosure Regulation and the UK Sustainability Disclosure Requirements amidst a clear drive in the EU and UK to promote private sector investment in defence.

“Europe faces an acute and growing threat. The only way we can ensure peace is to have the readiness to deter those who would do us harm.”¹ And so begins the EU’s White Paper for European Defence – Readiness 2030 (the Defence White Paper).

Increasing global security concerns (coupled with changes on the global political scene) have led EU member states and the UK government to increase their budgets for defence spending. This means finding more money for defence from public budgets which are already stretched and leaning on the private sector to facilitate more investment in defence companies and encouraging the inclusion of defence companies in investment portfolios.

But defence no longer means just ammunition, weapons and military equipment, it covers a wide range of innovative products. The arms race is being fought on new fronts, defending from “global hybrid threats including cyber-attacks, sabotage, electronic interference in global navigation and satellite systems, disinformation campaigns and political and industrial espionage, as well as weaponisation of migration”¹. The Defence White Paper identified “critical and foundational technologies like AI, quantum, biotech, robotics, and hypersonic [as] key inputs for both long term economic growth, and military pre-eminence.” And recently, the NATO Innovation Fund invested in the world’s first full-length single-molecule protein sequencer because defence is “no longer confined to the traditional battlefield; it encompasses supply chain resilience, energy security, and vitally, preparedness against disease and biological threats…biosecurity capabilities play a central role in national security and global defence strategy”.²

Against this background of many differing projects which fall under the defence umbrella together, many with dual use in the civilian sphere, we take a look at whether defence investments can ever also be considered compatible with ESG³labelled investments.

Reconciling sustainability and defence

Recently, there has been a lot of discussion about whether defence investments are eligible sustainable investments or whether such investments inherently contradict sustainability requirements or indeed a firm’s own ESG policies. Below we consider the answer with reference to EU and UK law and the issues organisations are dealing with.

The EU Commission and the UK government have clarified that just because an investment is in the defence sector it is not precluded from also being sustainable

Both the UK and EU Commission have confirmed that investments in the defence sector are not considered incompatible with sustainability-related rules and regulations.

On 11 March 2025, the FCA published a statement clarifying its position on sustainability regulations and UK defence, stating that “There is nothing in our rules, including those related to sustainability, that prevents investment or finance for defence companies.” It stated that financial institutions do not have to treat the defence sector differently to other sectors.

The EU clarified in the Defence White Paper in March 2025 that the “EU’s Sustainable Finance Disclosure Regulation (SFDR) does not prevent financing of the defence sector”. Though it stated that further clarifications on the relationship between defence and sustainability goals would be beneficial in the context of the SFDR review.

But entities and funds are also constrained by their own investment policies and choices as to the types of businesses they wish to support and their appetite for risk. Some investors have excluded defence investments entirely from their funds or at entity level, others have restricted investment in line with their approach to complying with regulation. This has led to a variety of results and some funds will continue to be unable to invest in some or all defence activities by choice (either their own ethical views or those of their clients) regardless of clarifications in law.

Excluding controversial weapons

Some of the variation from fund to fund is a consequence of the definition of “controversial weapons” that is included in Delegated Regulation (EU) 2020/1818 (which establishes minimum standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks). It refers to “controversial weapons as referred to in international treaties and conventions, United Nations principles and, where applicable, national legislation”.⁴ This has led to interpretation as to which weapons should be excluded (and clearly also depends on national legislation), many allow for military weapons but not ‘controversial weapons’ and some funds allow nuclear weapons if their manufacture or end-use is by countries covered by the 1968 Treaty on Non-Proliferation of Nuclear Weapons (which all member states are⁵). Whilst others, restrict all nuclear weapons.⁶

As part of the Defence Readiness Omnibus, the Commission has proposed an amendment to the Delegated Regulation to refer to “prohibited weapons” with a list of relevant treaties/conventions listed to ensure that sustainable finance legislation does not unnecessarily hinder defence investment. This Delegated Regulation (with the rest of the Defence Readiness Omnibus) has not yet been adopted and is subject to the normal legislative procedure of the EU. When in force, there will be a six months grandfathering period for benchmarks which have already been authorised before the amendment enters into force.

We note that the original “controversial weapons” definition is also reflected in the UK law⁷ and that a change in the EU law would lead to divergence in legislation, with the UK legislation continuing to be more restrictive (unless the UK implements a similar amendment).

SFDR – can Article 9 funds ever invest in defence?

The European Commission has clearly stated that defence-related investments can be compatible with the SFDR. As long as a defence investment meets the following three tests: (i) contributes to an environmental or social objective; (ii) Does No Significant Harm (DNSH) to any other environmental or social objectives (by reference to fourteen mandatory and any additional principal adverse sustainability indicators) and (iii) follows good governance practices, then they are ‘sustainable investments’ for the purpose of the SFDR.

Earlier this month, Morningstar reported on the increase in aerospace and defence (A&D) investing in Europe. They noted that exposure to A&D investments in ESG European equity funds had increased by a factor of 2.7 since the invasion of Ukraine in 2022. This trend continued when the European “ReArm Europe” plan was announced. Morningstar data found that around “43% of ESG European equity funds now hold some A&D exposure, narrowing the gap to non-ESG funds, which have an exposure of 56%” according to Morningstar data⁸. This includes funds disclosing under Article 8 SFDR which promote environmental or social characteristics and Article 9 SFDR which have a sustainability objective, including funds with climate, impact, and social mandates.⁴

It is easy to understand why – there is profit to be made in these investments and sentiment is changing towards the defence sector. But there are still reputational issues with including defence activities in funds disclosing under Article 9 – and this is something which needs to be managed carefully but is not insurmountable. Responsible Investor reported that a handful of funds hold large defence companies and “French asset managers and passive funds make up the majority of Article 9 funds holding large European defence companies”⁶ Sometimes a policy change is required at the highest level within an organisation, while sometimes a change in the investment policy of the fund itself is sufficient.

The Defence Readiness Omnibus

The Draft Commission Notice on the application of the sustainable finance framework and the Corporate Sustainability Due Diligence Directive to the defence sector (the Draft Notice) sets out a number of clarifications including:

• SFDR: when considering the DNSH test, the principal adverse impact (PAI) indicators which might call for further explanation in the context of defence investment would be PAI 10 ‘Violations of UN Global Compact principles and OECD Guidelines for Multinational Enterprises’, PAI 11 ‘Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises’ and PAI indicator 14 ‘Exposure to controversial weapons’. The Draft Notice gives further detail.
• EU Taxonomy: the Draft Notice refers to economic activities substantially contributing to one of the six environmental objectives and doing no significant harm to any of the other objectives as well as meeting the minimum safeguards and complying with the technical screening criteria. The Commission encourages operators to factor in due diligence arrangements to ensure that these are fully met.
• CSRD: The European Sustainability Reporting Standards (ESRS) introduced under the Corporate Sustainability Reporting Directive (CSRD) have two key provisions which are relevant to the defence industry:
  • General Requirements (ESRS 1, para 105) allows disclosure of classified or sensitive information to be withheld, even if deemed material. It is noted that the defence industry is more likely than other industries to make use of this and that this should influence the interactions of assurance providers with this companies on the use of this provision.
  • Consumers and End Users (ESRS S4) clarifies that any unlawful use or misuse of a company’s products or services by consumers and end-users is outside the scope of reporting.
• Contribution to social sustainability: the Draft Notice “recognises the defence industry as a crucial contributor to the resilience and security of the Union, and therefore to peace and social sustainability”. It concludes that “financial market participants may determine that defence investments safeguarding peace and security contribute to social objectives based on a careful case-by-case assessment as long as the other tests under SFDR are met. But there is no presumption that this would be the case.

A Last Thought

Defence investments are not necessarily incompatible with sustainability requirements. But financial institutions, funds and insurers will need to decide on their strategic approach and take action to ensure that their policies and documentation are not misleading. They will also need to consider the direction of travel as some laws are still evolving. And the need for more investment in defence coupled with the attractive economic returns on many defence investments will drive many ESG funds to include defence activities where the relevant sustainable criteria can support this on a case by case basis.

However, potential reputational issues associated with classifying defence investments as sustainable must be mitigated with adequate due diligence processes being implemented and very clear disclosure for investors of the factors considered and the reasoning for the decision.

Enhanced transparency and disclosure requirements come with the territory for ESG and sustainable investments, and national security and confidentiality concerns may prevent some defence investments from being able to meet disclosure requirements, such as those in the SFDR or in the UK Sustainable Disclosure Requirements.

In June 2025, the International Capital Market Association (ICMA) published an updated Guidance Handbook which included a question as to whether defence projects could ever be considered eligible under the ICMA Principles. FAQ 2.1.15 stated that “the evaluation of sustainability characteristics is not inherently incompatible with investment in defence projects or companies” but it noted that it expected investors in green, social and sustainability bonds may exclude such projects “due to issues with traceability, the ultimate destination and application of products, as well as restrictions under national and international legislation”

Much therefore rests on investor preferences which will vary across sectors and geographies. But based on the current direction of travel the share of defence projects in sustainable investments appears set to rise.

As with any evolving area of investment, however, care will be needed. Investments in defence and related industries involve multiple additional risks and regulatory hurdles which are specific to those markets and which need to be considered alongside the potential opportunities. Hogan Lovells specialists are well-versed in managing these specific risks and opportunities.

References

1. White Paper for European Defence – Readiness 2030, accessed 22 July 2025.
2. NATO Innovation Fund leads $35 Million Series A in Portal Biotech alongside Earlybird to deliver world's first full-length single-molecule protein sequencer, Nato Innovation Fund, 30 June 2025, accessed 22 July 2025.
3. In this briefing we use ESG and sustainability interchangeably in connection with the naming and labelling of investments and funds.
4. Commission Delegated Regulation (EU) 2020/1818 supplementing Regulation (EU) 2016/1011 of the European Parliament and of the Council as regards minimum standards for EU Climate Transition Benchmarks and EU Paris-aligned Benchmarks
5. Draft Commission Notice on the application of the sustainable finance framework and the Corporate Sustainability Due Diligence Directive to the defence sector
6. We note that Italy prohibits the financing of companies involved, directly or indirectly, in the production or sale of anti-personnel mines and cluster munitions though its application has been limited to SFDR Art 8 and 9 funds in practice. Source: Minerva Analytics, Minerva Briefing Beyond the Headlines: Is ESG the Problem?, Anastasiia Semenova MSc, ed. Sarah Wilson FRSA and Jack Grogan-Fenn MA, July 2025, accessed 21 July 2025.
7. UK position on sustainability regulations and UK defence, 11 March 2025, last accessed 22 July 2025.
8. How ESG Funds Learned to Love Weapons, Antje Schiffler, Morningstar, 15 July 2025, accessed 22 July 2025.

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