Sustainability And Security: Investing In Defence

The publication of the EU's Defence Readiness Omnibus in June 2025 marks a significant shift in position by the European Commission towards defence funding, as part of a wider rearmament strategy in Europe. The EU wants to help Member States secure "effective and fast deployment of ... necessary large investments" in the defence sector. It notes that the effect of the regulatory landscape facing defence companies – both rules specific to the defence industry and the application of non-defence-specific legislation – may hinder these investments, posing regulatory and administrative burdens which would prevent the rapid ramping up of the production capacity needed to credibly deter and ultimately respond to conflict. The Defence Readiness Omnibus sets out a multi-pronged approach to simplifying and expediting investments into the sector.

As highlighted in our earlier briefing, it is not only direct investments in defence which stand to benefit from the EU's repositioning. Adjacent industries such as technology, chemicals and industrial parts can also expect a surge in demand, though producers of these products which have a "dual use" may continue to find it difficult to navigate export control restrictions. Though the Commission says that it will apply the simplification measures to dual-use technologies and materials "where relevant", it is not yet clear how comprehensively this will be done.

One issue with an EU-level strategy on defence is that a number of aspects of defence remain under the competence of Member States, which has resulted in a somewhat de-harmonised picture to date. Via the Defence Readiness Omnibus, the EU is extending as far as it is able – into licensing, permitting and import duties – though ultimately Member States retain competence over these areas and appetite to implement the measures "encouraged" by the Commission is not guaranteed to be uniform. Countries in the east of the bloc are likely to be quickest to respond, given that the threat of Russian aggression is closer to home.

The streamlining measures laid down in the Omnibus are primarily aimed at enhancing national security in a precarious geopolitical climate, but are expected to further boost the prospects of a sector which has seen outsized growth in recent times. According to Private Equity International, the STOXX Europe Total Market Aerospace & Defence benchmark grew 53% in 2025 compared with 8.3% for the EUROSTOXX 50. Babcock International's share price more than doubled in 2025, while Germany's biggest arms company, Rheinmetall, grew by 158% this year. European investments in defence are growing rapidly, but remain dwarfed by US investments. Accelerating European investments would therefore hit another of the EU's top priorities: competitiveness.

A key question is whether the more-than-half of funds subject to the EU's Sustainable Finance Disclosure Regulation ("SFDR") that have opted in to Article 8 or Article 9 are able to feed their capital into the defence sector (and indeed, the perhaps more important question of how their investors will react if they do). While it is hard to argue with the premise that "there is no sustainability without security", there is a natural tension between sustainable investment and investments linked to weapons. The Commission may have a challenge to shift some (particularly retail) investor and public perspectives, although there are signs that investment in the sector from "sustainable" fund categories is growing. It is against that backdrop that the Commission issued a notice as part of the Defence Readiness Omnibus package, explaining the interaction between sustainable finance frameworks and defence investments, aimed at providing comfort for investors.

In this briefing, we outline some of the key proposals in the Defence Readiness Omnibus, before examining the impact on sustainable finance and sustainability considerations of this pivot towards defence funding.

1 Defence Readiness Omnibus

1. Procurement

In advance of a full revision of the Defence and Sensitive Procurement Directive, expected in 2026, the Omnibus proposes various simplifications of defence procurement processes – a critical element in assessing the viability of defence investments, given that EU Member States' defence expenditure in 2024 totalled EUR 343 billion. Procurement processes can be administratively burdensome and long, with average time periods being varied across jurisdictions and types of procurement, but very often being measured in years rather than months, and the duration of the bidding process sometimes exceeding the contract term. Proposed measures include:

• increasing the thresholds for application of the Directive to EUR 900,000 for supply and service contracts, thereby exempting large numbers of smaller contracts from scope;
• permitting Member States to conduct common procurement without adhering to the usual formality of a published procurement procedure; and
• allowing framework agreements with an extended duration of up to 10 years.

2. Intra-EU transfers of defence products

The Omnibus takes various steps to simplify inter-Member State transfers of defence projects, namely:

• within the EU competencies, simplifying transfers to the armed forces, within supply chains and within EU-funded projects;
• encouraging Member States to broaden the use of General Transfer Licences, and to exempt further categories of transfers from the obligation of prior authorisation; and
• simplifying reporting obligations for intangible technology transfers.

3. European Defence Fund

The Omnibus aims to reform the award process for the European Defence Fund (EDF), in order to simplify its procedures and reduce administrative burdens, making investment into defence R&D more attractive. The reforms therefore propose to:

• clarify and simplify criteria for evaluating proposals, to enable faster and more agile awards;
• expedite evaluation, contracting and issuance of payments; and
• allow testing carried out in Ukraine to be eligible for EDF funding.

4. Existing non-defence-specific legislation

The Omnibus proposes a number of amendments to non-defence-specific legislation which currently may act to delay or complicate the execution of defence-related projects. These include:

• encouraging Member States to establish fast-track and priority-rated national permitting processes with a single point of contact;
• extending the defence exemption within the REACH chemicals framework to ensure its suitability for defence readiness, and encouraging Member States to employ it in full; and
• encouraging the suspension of import duties on certain equipment imported by or on behalf of military defence authorities from third countries (including the UK), with possible extension of the suspension of tariffs for related industrial, raw materials, semi-finished goods and components;
• clarifying that general exemptions and derogations within legislation that refer to "overriding public interest", "public safety" or "crisis" include defence readiness activities and defence investments.

In fact, from an ESG perspective, the expansion of some of these exemptions might limit the attractiveness of certain new industrial or defence investments. In particular, the Commission emphasises the ability to use exemptions relating to overriding public interest, public safety or crisis as a method for defence readiness activities to circumvent protracted environmental impact assessments and regulation, noting that the existing framework was "adopted in peace time" and "must now cater" for expedited procedures tailored to the defence need. As such, defence-focused projects with a negative local environmental impact are more likely to be permitted. While Article 8 and 9 funds might now have a degree of clarity from the Commission as to the compatibility of defence investments with their social or environmental objectives (see below), the risk of environmental harm posed by investments utilising this newly loosened permit system might make some investments more challenging for sustainable funds relying on environmental objectives.

Though not subject to a specific amendment proposal, the Commission also notes the need to ensure that employment laws are sufficiently agile to respond to the urgent needs of defence companies. Member States are invited to clarify in their own laws that derogations can be made to provisions deriving from the Working Time Directive where there are surges in activity. Further changes to the Directive could be proposed with clearer exemptions for the defence sector. Similarly, the competition law regime may need to be adapted for a more agile and effective defence sector, both in terms of merger controls and collaboration between competitors.

2 Impact on dual-use products

While investments in the arms sector are easy to identify and for firms to take a position on, investments into companies that make dual-use products are more complex. There is a necessary distinction between defence-adjacent industries – metals manufacturing, transport or communications for example – and those concerned with dual-use products. Each is likely to benefit from an increase in defence-sector investment, but dual-use products (which can be put to either a civilian or a military use) face the additional hurdle of navigating export controls, either via licensing or export prohibitions to certain countries. Advanced technologies including AI are also potentially subject to this complex regulatory environment. Dual-use products can be a gentle entry point to defence investment for those investors not quite ready to let go of their weapons exclusions or looking to hedge the exit risk from a defence-only investment.

The Commission aims to open up various existing R&D grant and support schemes to dual-use technologies, including the European Innovation Council (EIC) Accelerator, STEP and Scaleup Europe Fund. These funds aim primarily to provide grants and support for startups and SMEs producing new products, and particularly new technology. An expansion of these schemes to boost R&D in dual-use technologies may make private sector investment somewhat more attractive, but it seems that the Commission could have addressed more directly the position of dual-use focused companies.

AI technologies, robotics and other deep-tech have attracted a significant proportion of defence-related investments over the last five years. These products, which may be dual-use but could also have uniquely military application, can face difficult moral arguments; while autonomous unmanned vehicles and software which allows precise targeting could reduce the likelihood of loss of human (civilian) life, the opposite argument is that the lack of meaningful human control prevents the application of international legal standards and raises ethical questions around accountability in war. Investments in these companies attract headlines, and not necessarily positive ones. Helsing, an AI company which pivoted to defence technology, attracted a EUR600m investment from the founder of Spotify, but Spotify subscribers and even musicians objected and boycotted the platform as a result. While investor portfolios are unlikely to face the same level of scrutiny, the incident highlights the emotive nature of defence investments. This example also underlines the fact that not all defence investments are created equal, and Helsing is squarely within one of the more controversial aspects of defence equipment. However, with a shifting perception of the importance of national security, even consumer views on funding of the defence sector are likely to see some softening.

3 Defence in an ESG context

In view of the fact that, as of June 2025, EUR 6.4 trillion of assets were in "green" funds classified as Article 8 or Article 9 under SFDR, it was important for the Commission to clarify how far these funds are compatible with the defence sector investments which it wishes to see prioritised. According to Morningstar, European equity-focused Article 8 funds have increased their exposure to the aerospace and defence sector over the last three years, with 19% of Article 8 funds having more than 5% exposure. By contrast, only around 5% of similar Article 9 funds have more than 5% exposure to aerospace and defence.

It is a common perception that the increasingly widespread coverage of ESG funds limits investment in defence. ESG rating agencies typically categorise defence companies as high or less frequently medium risk, with few benefiting from a "low" risk rating, though many non-defence companies also rank as "medium", and the sophistication of the rating's methodology will impact the outcome.

Some evidence suggests that the impact of ESG regulations on defence funding is limited, with the defence market's issues instead stemming from "ethical" fund exclusions, fear of reputational risks, and a perceived lack of growth potential due to a complex range of factors, including procurement and many of the other issues to be tackled in the Defence Readiness Omnibus.

In the UK, the Financial Conduct Authority very clearly stated that there is nothing in the FCA rules, including those that relate to sustainability, that prevents investment in or financing for defence companies, even by labelled funds under the Sustainable Disclosure Requirements ("SDR") regime. As part of the Defence Readiness Omnibus package, the Commission issued a notice on the application of the EU's sustainable finance framework to the defence sector, in which it addresses some of the potential compatibility issues.

In the following paragraphs we review the potential obstacles created by the SFDR and, where applicable, the European Commission's views on them.

1. Article 8 "light green" funds

Funds categorised as Article 8 under the EU's SFDR must specify their environmental and / or social characteristics. As long as they have not framed these in a way that restricts their ability to invest in defence investments – and have not committed to invest a minimum proportion of their fund into "sustainable investments" (see below) – there is no regulatory reason for those funds to avoid making defence investments. Provided the investments are consistent with the ESG characteristics that the fund manager has decided to promote, and any exclusions based on investor commitments, defence-related investments are certainly possible.

Whether the pursuit of defence investments could in and of itself be a social characteristic for an Article 8 fund is not wholly clear from the Commission's commentary. It notes the defence industry as "a crucial contributor to the resilience and security of the Union, and therefore to peace and social sustainability". On this basis, it seems possible to formulate a social characteristic based on the pursuit of peace and stability by means of defence investments (with appropriate exclusions, such as for controversial weapons, as discussed below).

The only other significant requirement for Article 8 funds is to establish that investee companies have "good governance". The four relevant heads – sound management structures, employee relations, remuneration of staff and tax compliance – raise no particular concerns in the defence sector, meaning that such investments can be assessed against the fund manager's usual policy.

2. "Sustainable investments" - Article 8+ "mid-green" and Article 9 "dark green" funds

The regulatory issues are more complicated, though, for those Article 8 funds which have committed to invest a minimum proportion of the fund in "sustainable investments" (often called Article 8+, or mid-green), and for Article 9 (or dark green) funds, which can only make "sustainable investments". To qualify as a "sustainable investment", the investee must pass a dual test: it must (i) contribute to a social and/or environmental objective and (ii) not do "significant harm" to any other social or environmental objective (the "DNSH test"). Within certain limits, the SFDR allows investors to write (and disclose) their own assessment rules for both limbs of this test.

In relation to the first limb, the Commission's commentary regarding defence's contribution to peace and social stability is helpful. The Commission also notes that the SFDR does not set out a closed list of sectors or economic activities that contribute to environmental or social objectives. It positively discourages operators from treating defence as a "de facto non-contributing sector" in terms of social sustainability, meaning that appropriate defence investments can meet the first limb of a firm's "sustainable investment" test if the firm decides that they should. There is nothing in the SFDR itself that would contradict that interpretation and there is, therefore, no reason for firms not to follow the Commission's interpretative guidance.

The Commission Notice also addresses the various elements of the DNSH test which could, potentially, be an issue for a defence investment. As a reminder, according to the Level 2 Delegated Regulation, firms must disclose, firstly, how the principal adverse impact indicators ("PAIs") have been taken into account, and secondly, whether the investment aligns with the OECD Guidelines for Multinational Enterprises ("OECD Guidelines") and the UN Guiding Principles on Business and Human Rights ("UNGPs"). While there is no immediate regulatory consequence to a lack of alignment, or exposure to a principal adverse impact, managers will not be keen to risk a fund's Article 8+ or 9 status being questioned by regulators or investors.

2.1 Principal Adverse Impact indicators

PAI 14 requires an assessment of whether the investee is involved in the manufacture or selling of controversial weapons, namely anti-personnel mines, cluster munitions, chemical and biological weapons. It seems to follow that an investee company that is so involved would not pass the test, excluding it from categorisation as a "sustainable investment". In that case, it would not be eligible for investment by an Article 9 fund, nor qualify as part of the "sustainable investment" allocation of an Article 8+ fund.

Unfortunately, it is not entirely clear what it means for an investee to be "involved in the manufacture or selling" (emphasis added) of controversial weapons, meaning that an investment in a company providing a technology or precursor chemical that could be used in controversial weapons will need serious consideration. SFDR is at heart a disclosure framework, and one would need to document carefully why a company linked to these controversial weapons, and therefore triggering a positive assessment under PAI 14, was nevertheless able to pass the fund manager's DNSH test. In undertaking the assessment, it seems clear that an investment in a chemical company with a limited or inadvertent exposure to chemical weapons is very different to an investment in a company with a significant business line manufacturing cluster munitions. An investor may decide that a company in the former category is capable of qualifying.

PAI 14 is not the only issue. PAIs 10 and 11 relate to violations of, and lack of processes and compliance mechanisms to monitor compliance with, the UN Global Compact and the OECD Guidelines for Multinational Enterprises. These international frameworks include sections on human rights and cross refer to the UNGPs. They require diligence to be conducted to ensure companies are not complicit in or directly linked to human rights abuses. It is also worth noting that even outside of the EU's sustainable finance framework, managers may have committed to the UNGPs in side letters, without necessarily considering at the time whether such a commitment would be compatible with future investments in defence.

The Commission addresses these PAIs in its notice. It "encourages operators to factor in due diligence requirements and measures put in place in order to comply with export control legislations ... as contributing to the fulfilment of the objectives of [the OECD Guidelines and UN Global Compact], and in turn to PAIs 10 and 11".

As we explain below, the Commission's suggestion to rely on export licence due diligence will be helpful, but will not always be a complete answer and asset managers should consider and document their own processes carefully.

PAIs are not only relevant for the DNSH assessment for Article 8+ and Article 9 fund managers, but also for any fund manager that has agreed to "consider" and report the PAIs under SFDR Article 4. This will include many Article 8 managers, even those who have not committed to a minimum proportion of "sustainable investments". Those firms will also need to assess an investee company's compliance with PAI 10, 11 and 14, including, therefore, the investee's approach to human rights due diligence.

2.2 OECD Guidelines, UNGPs and human rights

The second limb of the DNSH test requires an assessment of whether the investment is aligned with the international soft law frameworks on responsible business conduct. While the UNGPs have a specific focus on human rights, the OECD Guidelines cover a number of topics, including environment, employment and bribery and corruption, which may need attention in a defence-focused fund.

The first important point to note is that addressing human rights in the context of a defence investment does not generally require risks to be eliminated – that would be almost impossible. Instead, risks should be identified, assessed and (where possible) mitigated. This is not always an easy process, given that national security is often a legitimate driver of opaque supply chains.

A 2022 report by the UN Working Group on Business and Human Rights specifically considered the alignment of arms sector companies with the UNGPs (arms sector being broadly defined, including provision of professional services to the sector). Although it does not carry any legal weight, investors are likely to be interested in both the observations and recommendations to businesses in the report, which can help demonstrate alignment with the UNGPs.

The report notes the complex relationships between States and national arms companies, which may play a critical role in both the economy and security of the State. Furthermore, transparency and even judicial scrutiny over arms companies and licensing decisions are often avoided on foreign policy and national security grounds. It goes on to say that human rights due diligence is rarely required nor voluntarily conducted by arms companies, and there is a perception that compliance with export control requirements is a substitute for human rights due diligence, essentially outsourcing any consideration of potential human rights abuses to the State. Full human rights due diligence aligned with the UNGPs and the OECD Guidelines would require the investor to have a due diligence process to identify, prevent, mitigate and account for their impacts on human rights – not just those that they have directly caused, but also those to which they are linked via its business relationships. Prevention, mitigation and remediation of human rights impacts are all components of a UNGP-aligned approach.

The UN report does not fully align with the Commission's views expressed in the Notice. In particular, the Commission's position that due diligence requirements and export controls may assist an investor in satisfying itself that no significant harm is caused by the investment, in respect of PAIs 10 and 11, is not supported by the UN report, which suggests that companies should conduct human rights due diligence "in all cases, regardless of export licence decisions by States".

The UN Report, however, does not exclude any reliance on export control regimes which take account of human rights – and many do. For example, the UK's Strategic Export Licensing Criteria include "respect for human rights and fundamental freedoms in the country of final destination as well as respect by that country for international humanitarian law", though specific reasons for refusal of a licence relate only to internal repression and serious violations of international humanitarian law. In 2024, the UK Government refused only 39 standard individual export and trade control licence applications on the basis of this criterion (out of 611 refusals, and 15,456 total applications). Litigation has been brought in several jurisdictions challenging the validity of export licences on human rights grounds.

The conclusion of the report is that a permissive interpretation of the Arms Trade Treaty by States, a lack of transparency, and an absence of systematic due diligence combine to elevate the risk that arms may be used to commit human rights violations. It provides a list of recommendations to States, but also to businesses, which includes the implementation of enhanced human rights due diligence processes in situations of heightened risk, such as armed conflicts or internal upheaval.

The report's conclusions and recommendations suggest that it is challenging but not impossible to prove that an arms sector investment satisfies the requirements of the international standards on human rights, though this would likely require independent human rights due diligence.

3. Taxonomy alignment

The Commission applies a similar logic on alignment with international human rights due diligence regimes to the assessment of alignment with the EU Environmental Taxonomy. An entity claiming that it has economic activities aligned with the Taxonomy must additionally comply with "minimum safeguards", explained in Article 18 of the Taxonomy Regulation as procedures to ensure alignment with the OECD Guidelines and the UNGPs.

Taxonomy reporting is one requirement of SFDR reporting for an Article 8 or Article 9 fund, although many managers continue to report zero alignment. Some managers will use Taxonomy-alignment either as part of the environmental or social promoted characteristics of their Article 8 or 9 fund, or as a KPI to measure achievement of the investment strategy.

The European Parliament's draft report on Defence Readiness (notably, prepared by a rapporteur from the centre-right EPP) has even suggested that the Commission recognise defence investments within the Taxonomy (presumably, as eligible activities), as contributing to UN Sustainable Development Goal 16 on peace, justice and strong institutions; given that the Taxonomy focuses on significant contributions to environmental objectives, it is difficult to see how this social element could fit within the current framework.

4. EU fund naming guidelines

Certain funds will additionally need to ensure that they are not breaching ESMA's fund-naming guidelines ("Guidelines"). The guidelines provide that funds using any terms in their names relating to transition, social, governance, environmental, impact or sustainability must not invest in "companies involved in any activities related to controversial weapons" as per Article 12 of the Climate Transition and Paris-aligned Benchmarks Regulation.

As part of the Defence Omnibus package, the Commission is proposing to amend the Benchmarks Regulation, to change "controversial weapons" to "prohibited weapons"; "prohibited weapons" would mean "anti-personnel mines, cluster munitions, biological and chemical weapons" which are prohibited (and further defined) by international arms conventions referenced in the annex to the draft Regulation. This aligns with PAI 14, discussed above, which address exposure to "controversial weapons" and lists the same four categories of weapon types. ESMA had previously confirmed that the definition of "controversial weapons" in its Fund Naming Guidelines was aligned with the PAI definition, in the absence of any other indication from the Commission.

The proposed amendment will add a degree of legal certainty. However, for covered funds, investments in companies in adjacent industries will also need to be screened; for example, an industrial chemicals company may produce substances that fall under the legal definition of "toxic chemicals and their precursors" from the Chemical Weapons Convention.

Nuclear weapons were previously a grey area; the Commission's proposed clarification would exclude them from the definition of "prohibited weapons". Alignment with the UNGPs for the purposes of the DNSH test would need to be carefully assessed, given the likelihood of nuclear weapons to inflict indiscriminate civilian and environmental harm.

In addition to the restriction on prohibited weapons investments, the Guidelines limit the proportion of investments that can be made by funds using the relevant terms (as listed above) in companies or assets not aligning with the fund's environmental or social characteristics, or its sustainable investment objectives. A fund using these terms in its name must align at least 80% of its investments with its environmental/social characteristics or sustainable investment objectives. New funds with social characteristics directly linked to defence will easily be able to meet this threshold, whereas existing funds with unrelated characteristics or objectives must ensure that defence investments remain below 20% of total investments.

4 Conclusions

Defence investments require not only careful consideration but also an investment approach which is tailored, sensitive and proportionate. Due diligence may reveal matters which would be sufficient to disrupt other transactions, and should be put in the context of the investment as a whole. Defence sector companies can and in many cases do have regard to sustainability; more information on the approach of EU listed defence companies is flowing into the market this year thanks to the Corporate Sustainability Reporting Directive ("CSRD"), and many people-intensive defence businesses are expected to remain in its scope even after its current revision (though they may opt to withhold classified or sensitive information). The Commission notes in the Defence Readiness Omnibus that it may include further adjustments for the defence sector in its upcoming review of the CSRD reporting standards, though the body responsible for proposing the revised standard, EFRAG, notes that relief for the omission of confidential and sensitive information was not addressed in the revised standards given that it is under discussion in the "level 1" regulation revision.

The SFDR is also under review, with proposals expected from the Commission in November. It seems likely that the Commission will include further clarifications on the issues addressed in this note when it amends SFDR.

The Commission's multifaceted approach to encourage defence investments is ambitious and, once the legislative changes are made, likely to bring some welcome agility and certainty to enable those investments. Its explanation of the interaction with existing sustainable finance frameworks, on the other hand, is a little superficial. It ignores the fact that investors will need to work with certain provisions which are at present challenging to align with investments in a sector where sustainability is, understandably, not generally the highest priority, and the risk of negative impacts connected with the business are high. Rather than statements in a Notice, albeit persuasive and likely to provide comfort for investors leaning towards defence, a better solution might have been a targeted amendment to primary legislation to provide special treatment for defence investments. The European Parliament goes further, calling on financial actors to restrict their exclusions to only prohibited weapons (as per the new definition discussed above), and to publish their investment policies. The Parliament even proposes that access to "European financing" of those who adopt broader exclusions should be "reviewed on a case-by-case basis".

The political will is crystal clear: defence businesses should be investible by sustainable investment funds. But the political messaging and Commission confirmations, while comforting, do not obviate the need for investors to work through the regulatory requirements in a systematic way and to document how they have satisfied themselves that their investee companies comply. That may still mean that some potential defence-related investments are not eligible by investment by some funds.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.