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Defending the defensible: is the defence sector sustainable?

Guirec Thouement, October 2022

Defending the defensible: is the defence sector sustainable? October 2022 Ukraine’s legitimate right to defend itself against Russian armed forces demonstrates the importance of an effective and well-funded military. Recent events have sparked questions about the role of defence companies in sustainable investment portfolios and the long-standing exclusions applied to these investments. Is there room for a more nuanced view of the sector, particularly as it evolves and defence spending rises? Guirec Thouement Sustainability Key takeaways Analyst – War in Europe has drawn attention to the relevance of the aerospace & defence (A&D) sector in portfolios, where typically these stocks have been totally or partially excluded – Allianz Global Investors’ approach is to exclude controversial weapons across all portfolios, but an additional restriction of a 10% threshold of investee revenues generated from weapons, military equipment and services is applied to sustainable portfolios – With perceptions of defence changing in the light of recent events, and spending set to rise, some investors are asking whether a more nuanced approach to the sector is possible – Engagement with defence companies could form part of an alternative approach, but may not be a definitive answer The Ukraine war has brought a significant focus Typically, defence stocks have been subject to on the aerospace and defence (A&D) sector and whole or partial exclusion from portfolios for contributed to record outperformance by the investors with sustainability preferences. Now as 1 sector this year. In February 2022 – the month in the war in Ukraine continues there are questions which Russian forces renewed Ukraine hostilities around the positioning of the sector. Meanwhile –the EU Commission published its Final Report heightened concerns over national and regional on Social Taxonomy, which sets out to define security and the “legitimate” use of military what constitutes a “social investment”. This equipment are sparking a review of the use of document notably omitted a previous description exclusions and whether other approaches could of the defence industry as “socially harmful”. be appropriate. Value. Shared.

Defending the defensible: is the defence sector sustainable? Excluding defence stocks The primary reason for excluding A&D companies Did you know? is that their involvement in so-called controversial – Exclusions on armaments are not a new develop- weapons makes them inconsistent with sustainable ment: In 1096, Pope Urban II banned the use of portfolios. Although there is no single definition of this crossbows against Christians, and the Second term – and views on what constitutes “controversial” Lateran Council extended this ban to archers in 1139. vary – such weapons are broadly forbidden via – Today, some weapons deemed “controversial” are national or international laws. Moreover, exclusions either fully or partially forbidden under international exist for specific groups of weapons: agreements or local laws, although the latter can – Most European countries forbid investments vary by country. In addition to local and international in companies that produce landmines, cluster laws, there can be further investment constraints munitions, and chemical or biological weapons. relating to specific investor distribution standards or local regulations. – However, some investors extend this ban to include companies involved in nuclear weapons, depleted uranium weapons, and white phosphorus – given the Our approach to exclusions challenges of controlling the impact of these The AllianzGI exclusions policy includes firm-wide exclusions weapons, especially on civilians, whatever their and additional exclusions for sustainable-labelled funds. The intended use. firm-wide exclusions centre on long-standing international – The final area of exclusions covers companies that protocols and agreements and its application covers produce military equipment and services. This term development, production, use, maintenance, offering for can be relatively broad but covers weapons, arms, sale, distribution, import/export, storage and transportation military supplies and equipment that may be used of the types of weapons listed on the left within Exhibit 1. For for military purposes. These exclusions depend on sustainable-labelled funds there is an additional exclusions investment standards of individual countries, and threshold for some weapons and a threshold for some military approaches can differ. equipment, also shown in Exhibit 1. Exhibit 1: Allianz Global Investors – exclusions overview Firm-wide exclusions Sustainable minimum exclusions This set of exclusions is applied to all This set of exclusions is applied to our SRI Best-in-Class, Climate Enaement 1 AllianzGI mutual funds ith utcome and SG-alined inestment cateories Weapons Coal Weapons Coal International Tobacco Companies involved Companies that Companies involved Companies that standards/norms Companies involved in controversial derive more than in controversial derive more than Companies having in the production of weapons (cluster  of their weapons (cluster  of their a severe violation to­acco. munition, anti- revenue from munition, anti- revenue from of international Companies involved personnel mines, thermal coal personnel mines, thermal coal standards and or in the distri­ution of biological, chemical, etraction. biological, chemical, extraction. international to­acco in ecess of depleted uranium Companies where depleted uranium, tilit companies regulations † of their revenues. weapons, nuclear more than  of white phosphorus that generate (including the ­N weapons outside weapons, nuclear ‚ their electricit more than 2 €lobal Compact 2 of NPT ). production is weapons inside Œ of their revenues and the ƒ„C… 2 † outside of NPT ).  €uidelines , and based on coal. from coal . ­N €uiding Companies that Principles for derive more than ‡usiness and  of revenues Š ‹ from weapons, ˆuman ‰ights ) . military equipment and service. Source: Allianz Global Investors, 2022. This is for illustrative purposes only. Exclusions apply to direct investments. Specific revenue thresholds apply, for further details visit Sustainable minimum exclusions: for sovereign issuers, an insufficient Freedom House Index score is considered unless otherwise stated in the individual investment restrictions. 1. Applicable as of December 2021, where AllianzGI is acting as the management company. For institutional funds and mandates, it is subject to the consent of the respective clients. 2. Non-Proliferation Treaty, for further details visit Treaty on the Non-Proliferation of Nuclear Weapons (NPT) – UNODA 3. Please note firm-wide exclusion coal criteria on power generation (exclude companies where more than 30% of their electricity production is based on coal) will be additionally applied for sustainable funds as criteria are not the same. 4. More information can be found at 5. More information can be found at corporate/mne//. 6. More information can be found at GuidingPrinciplesBusinessHR_EN.pdf ( 7. For certain cases, flagged issuers shall be on a watch list. These companies will appear on this watch list when there is our belief that engagement may lead to improvements or when the company is assessed to take remedial actions. Companies on the watch list remain investible unless we believe that our engagement or the remedial actions of the company does not lead to the desired remedy of the severe controversy. 2

Defending the defensible: is the defence sector sustainable? There are other reasons why weapons may be excluded, even if they are not explicitly banned under international Did you know? agreements. Examples of such exclusions include country- – The theory of just war from the Latin “bellum specific commitments to nuclear disarmament; white 7 justum”, has existed since ancient times. phosphorus which has lawful and unlawful uses; and However, the description by Greek historian depleted uranium weapons for which no international Appian of the means used by the Romans to be agreement exists. able to claim that they were on the “just” side of Our final exclusion addresses companies generating the Third Punic War show that in 149 BCE just more than 10% of revenues from weapons and military wars were already difficult to define. equipment and services. By excluding these companies, we aim to avoid the active financing of military acts of aggression and conflict. International law recognises the right for a state to defend itself, but there is no legal Military equipment is the main reason for companies consensus on the concept of “legitimate war”. In addition, being excluded – see Exhibit 2. The application of our 10% by setting a threshold of 10% of revenues, we aim to revenues threshold ensures that we minimise exposure avoid excluding companies whose core business is not to military equipment through other sectors outside of military in nature. industrials – as shown in Exhibit 3. Exhibit 2: AllianzGI exclusions applied to the A&D sector* by weapon type Nuclear weapons (outside NPT) ines epleted uranium hite phosphorus Cluster munitions Weapon typeNuclear weapons (inside  outside NPT) ilitar euipment excluded 0 50 100 150 200 250 300 Companies in the A&D sector (Companies can be excluded for more than one criteria) *Based on the Bloomberg Industry Classification System Source: Allianz Global Investors internal data Exhibit 3: AllianzGI’s 10% threshold minimises investor exposure to weapons Companies by sector* flagged by AllianzGI’s exclusion policy for military equipment but non-excluded (itin  tresold Go‚ernment ƒi‚ersified …tilities †nergy Consumer‡ ˆon-cyclical Industrial (A‰ƒ Šinancial ‹asic Œaterials Companies by sectorCommunications Žecnology Consumer‡ Cyclical Industrial (ˆon-A‰ƒ      ­ ­  € Companies in the A&D sector *Bloomberg Industry Classification System Source: Allianz Global Investors internal data 3

Defending the defensible: is the defence sector sustainable? Geopolitical instability and security concerns will boost particularly in Europe. While total defence expenditure defence spending for European countries continued to rise for a sixth How investors think about defence will likely change as year running – reaching EUR 198 billion in 2020 – this definitions of geopolitical conflict and war doctrine evolve. figure was equivalent to only 1.5% of the GDP of the 26 The need to increase financial resources to national European Defence Agency (EDA) member states.2 By security has risen up the agenda for governments, comparison, US defence expenditure dwarfs that of every 3 following the onset of war after a long period of peace other EDA member as highlighted in Exhibit 4. in Europe. The EU Commission’s change of approach to As conflict and defence evolve, the question is whether defence in its report on social taxonomy is another factor investments in the sector can influence the direction of for European investors. capital towards a more resilient defence infrastructure, How defence budgets are spent is also evolving. For and away from more controversial activities. example, prior to the Ukraine crisis, the UK had decided However, the rise in military expenditure among to redirect spend from defence personnel to focus more European countries shown in Exhibit 5 might spark new on cybersecurity and aerospace, while in the midst of the controversies by supporting innovative technologies, conflict, Germany pledged to invest EUR 100 billion to such as drones and autonomous weapons, which raise modernise its military. new ethical questions about their use and impact. But Defence budgets are expected to rise steadily in the these questions may take years to resolve, and a new coming years following a long period of underfunding, international agreement could be required. Exhibit 4: Top 10 countries by defence spending show their changing focus 16 14 12 United States of America 10 United Kingdom Saudi Arabia 8 Russia Korea Sout 6 aan USD billions4 ndia erman 2 ­rance €ina 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Year Source: Information from the Stockholm International Peace Research Institute (SIPRI), Exhibit 5: Expected change in defence spending for selected European countries Target 2023 Target 2026 Target 2028 Target before 2030 Target 2030 3.5 3.0 2.5 2.0 1.5 1.0 Percentage of GDP0.5 0.0 Poland Romania Germany taly eden pain nited elgium ingdom % of GDP spending on defence previously % of GDP spending expected Source: Allianz Global Investors internal research 4

Defending the defensible: is the defence sector sustainable? The role of engagement in A&D Did you know? As a potential alternative to excluding companies from – Despite an annual military budget target of 2% portfolios, active investors have the option to exert their of GDP agreed by NATO alliance members in influence through engagement. The challenge is that 2006, only eight out of the 30 member nations are military companies and industries typically exist because of believed to be reaching this target.4 a Sovereign state’s interest to ensure, at least partially, the independence of its armed forces. Furthermore, there are significant development costs and At AllianzGI, our current exclusions policy implicitly avoids exports are often needed to make these projects economic. controversies related to new defence systems (due to This adds a layer of complexity to how and with which our 10% threshold). New weapons are costly to develop, companies the necessary engagement can be achieved. and significant barriers to entry exist in the A&D sector. Exports are most likely to go to regions aligned with the Companies developing new and potentially controversial interests of the location of the company, which means weapons would likely fall within our existing exclusions. engagement is not always possible. Despite these challenges, there is a role for engagement. Military transformed: the focus of future It can be used to encourage improved disclosures on defence spending the types of A&D activities undertaken and evidence of governance over the supply chain of military equipment, – The increase in defence spending will help including formal assessments or audits of internal prepare European armies for the possibility of processes and related disclosures. This focus is important high-intensity warfare. Spending will need to be in a sector that can be exposed to bribery, corruption, and directed to develop current capacity, replenish high political influence. stockpiles, modernise old Soviet era equipment for eastern countries and develop air and missile The future of defence defence systems. Air forces will need to be Looking to the future, an important question to ask is: are modernised and expanded, and new warships the weapons used by an aggressor and a defender viewed launched. For instance, France is already working in the same way? This analysis of investing in the A&D on its new aircraft carrier. sector highlights that there is no clear distinction between – The EU Commission established a Defence Joint “good” and “bad” weapons or those with a positive or Procurement Task Force to rapidly fill the gap negative impact. Ultimately, funding defensive weapons in military equipment for EU countries by group means funding offensive weapons and vice versa. ordering of critical equipment. Our approach seeks to avoid using assets invested in sustainable strategies to finance products and services related to conflict. Through both a specific 10% revenues Our analysis of publicly listed companies involved in the threshold and active engagement, our aim is to align development of weapons that typically raise such ethical with the UN Sustainable Development Goal 16 that concerns suggests that these activities would exceed our upholds peace, justice and strong institutions, and seeks to 10% revenues threshold. “significantly reduce all forms of violence and related death rates everywhere”. As the discussion around conflict and defence continues to evolve, we are committed to playing an active role in this debate. 1., Defence stocks beat global market on expectations of higher spending, April 2022 2. 3.Forbes, Where NATO defense expenditure stands in 2022, June 2022 4. 5. 5

Defending the defensible: is the defence sector sustainable? Appendix 1: International Agreements on related weapons Year Name Weapon Action 1968 Treaty on the Non-Proliferation of nuclear weapons Nuclear weapons No new Nuclear Power, disarmaments in the future (no date) for the other 1972 The Convention on the Prohibition of the Development, Biological Weapons Prohibit Production and Stockpiling of Bacteriological (Biological) and Toxin Weapons and on their Destruction 1981 The Protocol (III) on Prohibitions or Restrictions on the use of Incendiary weapons Restrict some usage Incendiary Weapons (of which WP if used as ammunition) 1993 The Convention on the Prohibition of the Development, Chemical Weapons Prohibit Production, Stockpiling and Use of Chemical Weapons and on their Destruction 1997 The Convention on the Prohibition of the Use, Stockpiling, Landmine Prohibit Production and Transfer of Anti-Personnel Mines and on their Destruction (Convention of Ottawa) 2008 The Convention on Cluster Munitions Cluster munitions Prohibit N/A N/A Depleted Uranium Can be prohibited under some local laws, either offensive or defensive usage Source: UN5,, Allianz Global Investors Research Investing involves risk. 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