Britain's defence industry is still being held back by “bonkers” ESG rules despite hopes that Russia’s invasion of Ukraine would prompt a rethink among investors.
Kevin Craven, chief executive of ADS Group, the trade body for aerospace and defence companies in the UK, said professional investors were still shunning companies in his industry despite the outbreak of war in Europe underlining the importance of defence.
Mr Craven called on the Government to step in and encourage investors to back defence companies, which have been shunned by fund managers in recent years.
So-called ethical, social and governance (ESG) rules require investors to avoid defence stocks if they want to carry an ESG label, which has become highly sought after in recent years. ESG rules govern billions of pounds worth of British pension investments and savings, and lump defence shares in with cigarette pedlars, animal testing companies and oil firms.
European investors use similar rules but ESG has proved less of a hindrance to arms makers in the US.
The rules risk giving an edge to China and Russia, which have nationalised defence industries and do not need to persuade investors that they should be supported, Mr Craven said.
“The fundamental argument must be that a government's first duty to citizens is to protect them, and it must have the means to do so,” he said.
“For investment funds and professionals to make the decision to exclude the means by which you can do so seems to me to be totally bonkers.”
Russia’s attack on Ukraine has put defence companies and spending in the spotlight. Boris Johnson last week announced that UK defence spending will rise to 2.5pc by the end of the decade, labelling the additional investment the “cost of freedom”.
Ultimately, however, the investment industry will need to back Britain’s defence sector for it to be a success, Mr Craven said. He urged politicians to encourage investors to think again about how they classify defence stocks under ESG rules.
“Will it stop of its own volition as a result of Ukraine? I don't think so; I think it will take active engagement by both our sector and by politicians, and ultimately by investment professionals to say defence is an important part of society,” he added.
The withdrawal of UK fund managers has kept prices low and attracted bargain-hunting US investors. US-based investors now own almost twice the share value of UK money managers, Telegraph analysis revealed last month.
A decade ago, shipbuilder Babcock was 58pc owned by British investment houses, but now that figure has slipped to 37pc. Rolls-Royce has fallen from 37pc British ownership to 7pc and defence contractor BAE is down from 38pc to 26pc.
US investors now own 54pc of BAE, 71pc of Rolls and 49pc of Babcock.
While US buyers are seen as benign owners, the cheapness of defence shares makes it comparably more expensive for them to raise fresh funds if they experience trouble or wish to expand or make purchases themselves.
Private equity companies have also been buying up British defence businesses, stoking fears that British industry is being sold off on the cheap. Submarine sonar supplier Ultra is to be bought by US private equity house Advent International, the same company that bought air-to-air refueller Cobham in 2019.
The UK sector does have some opportunities to seize, however, said Mr Craven. New Nato members such as Finland and Sweden will need to upgrade their equipment and existing members like Germany, which has said it intends to swell its defence budget, could be potential customers to the UK.
A new US focus on the Pacific and China as a threat could also persuade new Nato members to buy British, or at least from European arms makers, as could worries about supply chains, which even in defence are suffering from parts shortages and volatile raw material prices.
“You can point to Germany, Denmark, Finland, Spain, a number of European countries who are increasing by very large percentages, their spending on defence and that will play out in terms of increased demands,” he said. “Given the US pivot towards the Pacific, there is clearly an opportunity for European-based manufacturers to step up.”