Even as some investors shift their environmental, social and governance (ESG) views on energy and defense stocks amid Russia’s invasion of Ukraine, we think it’s sensible to stick to core ESG principles in identifying responsible companies. In this case, it means firms that can contribute to the West’s quest for energy independence and military deterrence.
Russia’s invasion of Ukraine will have lasting implications for investors in many areas. For example, energy independence is now seen as an essential goal for the US and Europe. And defense spending in the West is likely to grow to ensure that countries are adequately prepared to cope with potential threats.
These changes have challenged prevailing norms for some investors focused on ESG issues, as they evolve their attitudes to recognize the necessity and value these industries create, along with their negatives. Indeed, S&P 500 energy stocks surged by 42.3% in the first quarter through March 25, while the S&P 500 Aerospace & Defense industry group rallied 13.5% over the same period.
Energy Security in the Spotlight
The Russia-Ukraine war amounts to a monumental shift in the world order, challenging the trend toward globalization over at least four decades. Some political pundits say Russian president Vladimir Putin chose to attack Ukraine now due to high oil and gas prices, which put Russia in a position of economic strength vis–à–vis the West. It’s also been said that the decarbonization push helped boost energy prices, by deterring investment in fossil fuel production. Whether or not that’s true, it’s now painfully clear that countries and regions need adequate access to traditional sources of energy while they plot the course for a green energy future.
Now, gas prices at the pump have soared in the US. Natural gas prices in Europe, which relied on Russian supply, have also jumped. Energy prices have fluctuated wildly, driven up by war news and falling back when headlines project hopes for a ceasefire. Whatever happens, it’s now clear that energy self-sufficiency is vital for the US and will require oil and gas during the transition to renewables as well as more investment in low-carbon energy sources in the coming years.
Investors taking a long-term view should look for energy companies with robust businesses and responsible behavior. We believe high-quality energy groups that can generate solid profit margins with oil prices at much lower levels than today are well positioned to benefit in the current environment but can still thrive if the current crisis is resolved and prices fall back.
Many energy companies are making efforts to meet best-practice sustainability standards. Select energy producers and utilities that are investing in renewables can offer transition opportunities, helping to meet the short-term need for oil and gas as well as rising demand for wind and solar energy. Active investors should engage with energy groups to ensure they manage the energy transition appropriately, improve disclosures and reduce carbon emissions from activities generated by their operations.
Defense as a Necessity for Democratic Society
It’s easy to understand why the defense industry was avoided by many investors in a world attuned to ESG issues. Defense companies make products that kill people, which are often sold to bad actors.
Now, as Ukrainian president Volodymyr Zelensky seeks weapons support from the West, defense contractors are playing a crucial role for defending democracy—a basic ESG human rights goal. However, defense spending is close to the lowest level as a percentage of GDP over the last 40 years, at 3.7% of GDP for the US and 2.4% globally, according to the World Bank.
Putin has pushed us back in time to a world where peace was not a given. The unprovoked war has made many governments aware of the limits of soft power—and the need for military might to safeguard our values and societies.
Nothing symbolizes the shift in sentiment more than Germany’s pledge to double its defense budget to €100 billion this year—a huge change for a country that has strictly limited defense spending since World War II. And Germany’s recent decision to order 35 F-35 fighter jets from Lockheed Martin is just the beginning. These moves show how the Russia-Ukraine war on the doorstep of Western Europe is changing public opinion toward the defense industry.
Shares of defense companies tend to hold up relatively well in downturns; they’re likely to be resilient in a recession because of the acyclic nature of defense spending. Investors taking a fresh look at the industry should verify that companies aren’t manufacturing controversial weapons such as cluster munitions or chemical and biological weapons. Business ethics are another important ESG area of focus in an industry where companies have historically violated corruption and anti-bribery laws. Companies should have robust processes to prevent illegal sales and minimize the abuse of their products.
Rethinking ESG Issues: Three Points to Ponder
Changing attitudes toward these industries highlight three important issues related to the integration of ESG in investment processes.
1. Don’t forget the ‘S’ in ESG: Investors often give priority to environmental issues, but social issues are also part of the ESG equation. Skyrocketing energy prices are a tax on consumers that can hurt lower-income households disproportionately. And safeguarding democracy is an imperative for every society that values freedom.
2. ESG issues evolve; ESG integration should remain a pillar: While some investors may be rethinking their stance on energy and defense given recent developments, we believe ESG integration should remain a consistent, thorough framework that considers the complex nuances of ESG issues.
3. Exclusion precludes engagement: Excluding entire sectors and industries from portfolios precludes active managers from engaging with these issuers to encourage more responsible business practices. Investors should understand the limitations of labeling an entire sector or industry “good” or “bad.”
By keeping these three principles in mind, we believe investors can deploy a much more thoughtful approach toward integrating ESG research in portfolios. The recent impetus for energy and defense stocks is likely to persist as the world adjusts to changes provoked by the Russia-Ukraine war.
We believe investors should focus on energy and defense companies that have attractive valuations, strong cash flows, capital return and business advantages, while using ESG research to identify businesses that behave more responsibly than their peers. And given the turbulence in equity markets, we strongly believe that a flexible investing approach is vital in adapting to changing market conditions.