Profiting from war: Europe’s pension funds mull investing in defence

PensionDanmark’s decision to invest in naval patrol ships flags a new source of complexity bearing down on ESG and sustainability-minded European pension funds. Many cap investment in the defence sector and exclude defence stocks because they fall foul of ESG filters, but as war drags on in Europe, the continent’s institutional investors will increasingly have to review the ethics of investing in defence.

PensionDanmark’s decision has been many years in the making and isn’t new territory for the $49 billion labour market fund. It is already an experienced investor in ships and the multifunctional patrol vessels, still in the design phase, will sit in its sizeable infrastructure allocation alongside flagship green investments like its stake in ten wind energy projects on islands around the world.

PensionDanmark is providing the finance to a newly formed consortium, Danske Patruljeskibe K/S, comprising defence group Terma and ship designers Odense Maritime Technology (OMT.) The trio’s first customer is the Danish Ministry of Defense Acquisition and Logistics Organization (DALO). Once this order has rolled off the production line, they hope to begin building military vessels for other country’s navies too.

“The risk primarily lies in the fact that it is a new type of ship that we are developing together with our experienced partners Terma and OMT,” says a spokesperson for PensionDanmark from the fund’s Copenhagen offices.

“PensionDanmark’s investment policy, including our principles for responsible investing, is discussed and approved every year by the board and has broad support. There has been a shift in the general perception of defence investments after Russia’s invasion of Ukraine.”

The fund has been first out of the gate amongst European peers to identify opportunity in geopolitical risk and the ongoing war in Europe. Most other European pension funds are only just beginning to have a complex and soul-searching conversation on the ethics of investing in defence with their stakeholders and society.

But pressure is building. Like the former Dutch Minister for Defence Kajsa Ollongren urging the country’s pension funds to invest more in the sector earlier this year. Her comments followed 2022 calls from a majority in the Netherland’s House of Representatives on pension funds to invest more in defence groups due to the war in Ukraine.

In the UK, the Investment Association, a trade body for investment managers and pension schemes, is also on the case, recently writing that “investing in good, high-quality, well run defence companies is compatible with ESG considerations.”

Meanwhile defence firms, confident that by the EU’s taxonomy won’t impose restrictions on financing their sector, are upping the ante and lobbying hard to get into pension funds’ portfolios.

“The geopolitical backdrop is changing, and different nations are in different positions,” reflects Richard Tomlinson, CIO of the United Kingdom’s £26.3 billion Local Pensions Partnership Investments, LPPI. “Understandably, there is more political support for this kind of thing in the Nordics than in the UK, given geographical proximity to Russia. That said, it’s not inconceivable to think that the UK government could do the same and actively encourage pension funds to invest more in the military in the future.”

For now, any conversation about defence at LPPI remain confined to navigating geopolitical risk in the portfolio. The investment team, alive to growing geopolitical risk for a while, have run “wargaming” workshops to plan for different scenarios and how they might respond in each. These have included an escalation in the conflict in Ukraine or rising tension between China and Taiwan.

Investing through an impact lens

One way pension funds could approach their traditional reluctance to invest in defence is by looking through an impact lens. In this context, investment in some defence assets could even sit in the social infrastructure bucket, reflects Tomlinson. “Viewed through this lens, it’s not that big a leap to go from investing in hospitals and social housing to ensuring the sustainability of liberal democracy via supporting critical defence infrastructure.”

PensionDanmark certainly has no qualms about investing in companies that contribute to “the defence of Denmark and NATO allies” so long as these companies aren’t involved in controversial weapon production and respect treaties prohibiting chemical weapons, cluster munitions and anti-personal mines.

The vessels will strengthen the capabilities of the Danish navy in domestic waters and prepare the fleet for future complexities at sea, extols the fund. “We believe our investment will make a significant contribution to society in supporting the future-proofing of Denmark’s navy and thus national security.”

But like many ESG and impact investments, investing in defence scores well in one area, preserving liberal democracy and national security, but less so in others, for example, climate. War ships and planes kick out huge amounts of emissions that will be difficult to square with net zero ambitions.

For some investors, the obvious starting point is clear government guidance. Daan Spaargaren, senior responsible investment strategist at PME says the Dutch pension fund for 1500 employers in the metal and high-tech sector that serves 630,000 beneficiaries, is willing to discuss the issues at stake. But he also wants policy guidance on which areas of the defence industry needs most investment, and where pension funds should funnel capital.

Moreover, he believes it is incumbent on the government to procure from these defence companies.  “If governments want investors to support a national defence industry, then the government should guarantee procurement so these companies can invest and expand.”

Spaargaren is aware of the potential returns in the sector where PME already invests, mostly in listed defence stocks and bonds. “The defence sector is flourishing and returns high,” he says in a nod to how the rearmament of Europe, as well as wider military spending among the US and its Asia-Pacific allies, is an increasingly important macro theme.

UK pension funds wrestling with the issue should reflect that in some respects they could already be active investors in the sector, suggests Tomlinson. At one end of the spectrum, some UK pension funds may be investors in military housing group Annington Homes via private equity group Terra Firma, for example. Further up the scale, others will hold stakes in BAE Systems which supports the UK’s strategic nuclear deterrent Trident.

Investing in more conventional, listed defence stocks to financing a country’s critical defence capabilities should be seen on a spectrum but the leap may not be that big.

Many pension funds also have existing investments in dual use technologies such as AI, facial recognition and secure communications, he continues. These technologies, with both military and civilian applications, also sit on the spectrum.

The recent spike in ransomware attacks on UK NHS hospitals has highlighted the critical role of this kind of technology in fighting cyber attacks. It offers another example that makes it possible to trace a line between UK pension fund investment in cyber security today – to financing war ships PensionDanmark-style tomorrow. “At what point does social infrastructure that enables our national institutions to combat cyber risks and broader asymmetric warfare extend to funding warships?” he asks.

As the debate grows in the Netherlands, Spaargaren notes that a few pension funds are seeking to loosen exclusion policies and invest in nuclear. He says PME has no desire to unpick its own policies, and questions if funnelling more capital into nuclear would actually support the Netherlands defence strategy anyway.

Moreover, he believes that investing in nuclear and any other controversial weapon would cross a line for PME beneficiaries, where some are already uncomfortable investing in defence.

“Investing in military capability will come down to an investor’s investment beliefs and their stakeholder group,” concludes Tomlinson. “Some investors will have clear fiduciary responsibility to principles that preclude this type of investment and will be very clear about what they can and can’t do. Others may be more able to align with government policy, if one emerged.”

In the meantime, governments’ attempt to convince Europe’s pension funds that the defence sector is green and sustainable has only just begun.