ESG, SFDR, and Defence Investment: Greater Investor Choice

In our previous alert, “European Defence’s Shifting Financial and Regulatory Landscape,” we noted that the consensus which largely excluded defence from responsible investment has now changed. In the European Union, the main driver for this was the Commission’s publication in June 2025 of its Defence Readiness Omnibus package (the “Package”) together with a Commission Notice (published in the Official Journal of the EU on 30 December 2025) on the application of the EU sustainable finance framework to defence investments. This has sought explicitly to reframe defence investment as ESG-compatible, with a clear statement that the Sustainable Finance Disclosure Regulation (SFDR) is not to be interpreted to exclude defence-related activities.

The recent publication of amendments to EU Climate Transition Benchmarks and EU Paris-Aligned Benchmarks Regulation 2020 (“Benchmark Regulation”) has given effect to the Commission’s commitment above. Moreover, Invest Europe recently published model limited partnership agreement (LPA) language for defence (the “Model Language”). Finally, the proposed changes to the SFDR or “SFDR2” are expected to address the defence exclusions, as we noted in our alert, “What does the final draft of the SFDR2 mean for Private Fund Managers?”

In light of these new developments, we continue the discussion on ESG and defence investment from our previous alert, focusing on the SFDR and further discussing the question of the SFDR classification and treatment of defence investments. We also discuss in more detail whether defence-related investments can qualify as “sustainable investments” for the purpose of pre-contractual disclosure under Article 9 or are limited to pre-contractual disclosure under Article 8 as investments that promote environmental or social characteristics.

While the UK Treasury and Financial Conduct Authority have made statements that defence investment is not inconsistent with ESG and sustainable investing — and, for example, the Canadian Securities Administrators have said that ESG disclosure rules do not exclude sectors — the EU statements and measures on ESG and defence investment remain the most substantial.

A Prohibition on Defence Investments Under the SFDR?

Starting with the basics: the SFDR is a disclosure regime rather than a product eligibility regime. Neither the SFDR nor the regulatory technical standards (RTS) that supplement the SFDR contain an express prohibition on investments in defence companies or defence-related activities.

Why the Historic Challenges for Disclosure of Defence Investments Under the SFDR?

Despite the absence of an express prohibition, challenges arose from the requirements under Article 7 that the principal adverse impacts (PAIs) for financial products, such as funds, be identified in the pre-contractual disclosure for those products. (Similar requirements apply to the disclosure of PAIs for entities, such as the managers.) In this respect, and tracking the language in the Benchmark Regulation, the PAI indicators in the RTS included exposure to companies involved in “controversial weapons (anti-personnel mines, cluster munitions, chemical weapons, and biological weapons).”

Further, the concept of “sustainable investment,” possible under Article 8 and required under Article 9, has created issues because a manager must demonstrate that investments satisfy the substantive requirements of the sustainable investment definition in Article 2(17), including that the investment:

• contributes to an environmental or social objective
• does not significantly harm any environmental or social objective

Demonstrating that defence-related activities contribute to a recognised environmental or social objective was difficult because the SFDR provides limited guidance on the meaning of a “social objective.” It was not clear that activities such as the manufacture of military equipment, weapons systems, or defence technologies could satisfy the positive contribution requirement in Article 2(17).

Showing that defence-related activities do not significantly harm any environmental or social objective was also difficult. Although the inclusion of “controversial weapons” in the PAI indicators in the RTS, as noted above, did not create automatic exclusions, they created doubt about whether defence investments could ever be sustainable investments.

Finally, the approach of ESG rating agencies, index providers, and institutional investors, many of whom historically applied broad defence exclusions irrespective of the underlying legal requirements of the SFDR, added to the uncertainties above.

How Did the Commission Clarification of the Application of Sustainable Finance Rules to Defence Change the Position?

On 17 June 2025, the European Commission published its Defence Readiness Omnibus package together with a Commission Notice concerning the application of the EU sustainable finance framework to defence investments. The Commission Notice was subsequently published in the Official Journal of the EU on 30 December 2025.

The Commission expressly recognised that sustainable finance legislation should not be interpreted in a manner that creates unjustified obstacles to investment in the defence sector. Importantly, the Commission confirmed that the SFDR is sector-neutral and does not require the exclusion of defence companies from sustainable investment products.

What About the Role of PAI Indicators?

The Commission has clarified that PAI indicators are intended to facilitate transparency and informed decision-making rather than to create mandatory investment restrictions. Therefore, the presence of adverse impacts associated with defence-related activities does not require divestment or exclusion. This underlines the view that the SFDR is a disclosure rather than a sector-based exclusion regime.

Is There a Role for Defence as Potentially Supporting Social Sustainability Objectives?

A notable aspect of the Commission’s guidance was its recognition that defence-related activities may contribute to broader social sustainability objectives. The Commission emphasised the importance of security, societal resilience, and the protection of democratic institutions, thereby recognising that certain defence activities may generate positive societal outcomes capable of being considered within a sustainability framework.

What About the Narrowing of Weapons-Based Exclusions?

Under the Package, the term “controversial weapons” in the Benchmarks Regulation, noted above, was replaced with the term “prohibited weapons” in the Annex to the Regulation.

Prohibited weapons are now limited to:

• anti-personnel mines
• cluster munitions
• biological weapons
• chemical weapons

The use, possession, development, transfer, manufacture, and stockpiling of prohibited weapons is expressly prohibited by the international arms conventions to which most EU member states are parties.

Do the Changes to the Benchmark Regulation Have an Impact on the ESMA Fund Naming Guidelines?

Yes. We discussed the ESMA Guidelines (the “Guidelines”) on funds’ names using ESG- or sustainability-related terms in our previous alert, “ESG and EU Fund Names: ESMA’s Final Guidelines.” The Guidelines remain an important consideration for managers seeking to promote and market funds with ESG-related names that make defence investments.

The Guidelines do not impose a blanket prohibition on defence investments. They do, however, establish specific exclusion requirements for funds using terms such as “ESG,” “sustainable,” “green,” and “impact” in their names (“Fund Names”). This has had the effect of imposing requirements on managers — for example, for at least 80% of the fund’s assets under management to be invested in assets of a type captured under the relevant Fund Name.

Importantly, managers using a Fund Name are prohibited from making investments that are excluded under the Benchmark Regulation. Noting the changes from “controversial weapons” to activities connected with “prohibited weapons” above, the exclusions under the Guidelines will now be more accommodating, in line with the changes to the Benchmark Regulation — albeit that the Guidelines will continue to impose a more exacting standard in the form of a higher minimum amount of ESG investment connected with the Fund Name in question than is the case under the SFDR for funds that do not use a Fund Name.

Are There Related Standards That Might Give Investors Greater Certainty on Prohibited Weapons?

Yes. The Model Language is helpful, and managers could include (where not otherwise included in the Guidelines) prohibitions on cluster munitions under the 2008 Convention on Cluster Munitions, anti-personnel mines under the 1997 Anti-Personnel Landmine Convention, biological weapons under the 1975 Biological Weapons Convention, and chemical weapons under the 1997 Chemical Weapons Convention.

What About the Permitted Investments?

Again, the Model Language is helpful, and a manager could identify permitted investments as investments in conventional defence technologies; military equipment and dual-use goods; or enabling technologies, such as cyber — as well as investments in activities connected with the destruction of prohibited weapons and protection against their effects.

Managers may want to qualify these further by reference to jurisdiction of the investment and governance processes connected with the investment to ensure, for example, compliance with export control requirements and, as appropriate, enhanced human rights standards.

Is There a Working Definition of “Dual-Use” Goods That Can Assist Managers?

Yes. EU Regulation 2021/821 on the control of the export of dual-use items (“Dual-Use Regulation”) is useful for giving greater certainty both on prohibited weapons and on permitted weapons, noting that dual-use goods are identified in the Model Language. Managers will, however, need to adapt or qualify the definition in the Dual-Use Regulation when using it to identify permitted investments, as the Dual-Use Regulation is aimed at limiting activities connected with dual-use items. The Dual-Use Regulation defines dual-use items as items, including software and technology, which can be used for both civil and military purposes. It includes items which can be used for the design, development, production, or use of weapons or their means of delivery.

Do the Changes Address the Article 8 vs Article 9 Question?

Although there was a general scepticism about defence and ESG and, therefore, the compatibility of any defence-related investments with the SFDR, the distinction between disclosure under Article 8 and Article 9 was important.

For a manager to make disclosures under Article 8, all that the fund must do is promote environmental and/or social characteristics, provided that investee companies follow good governance practices.

By contrast, Article 9 requires the fund to invest predominantly in assets that qualify as “sustainable investments” within the meaning of Article 2(17) SFDR. The fund’s manager must therefore show that an investment: contributes to an environmental or social objective; does not significantly harm any environmental or social objective; and is made in a company that follows good governance practices.

It seems clear that the Commission’s confirmation that the SFDR is sector-neutral and does not require the exclusion of defence companies from sustainable investment products will bring those investments within a strategy that is disclosed under Article 8 — that is, where the fund in question promotes environmental and social characteristics. There is also a good argument that this includes a fund that promotes environmental and social characteristics and one where the fund’s manager makes sustainable investments — an opposite conclusion would be at odds with the Commission’s statement which refers expressly to sustainable investment.

The position under Article 9 is less clear. “Sustainable investment” is defined, as noted above, by reference to Article 2(17) with defined requirements, including the requirement that the investment not significantly harm any environmental or social objective. An Article 9 fund, in showing that substantially all of its holdings meet the Article 2(17) test, has to meet a materially higher bar for a defence-concentrated strategy than for a diversified Article 8 fund with partial defence exposure. The fact that the Commission has suggested, if not indicated, that defence of a country can be a social objective is helpful, as are the revisions to the Benchmark Regulation exclusions.

However, what about harm to some other objective, such as the protection of the environment, which the use of weapons could undermine? The changes do not provide an easy answer to this, and managers may remain reluctant to classify a fund that makes defence-related investments under Article 9.

Will SFDR2 (Further) Change the Position?

Among the proposals under consideration are reforms that would replace the existing Article 8 and Article 9 architecture with a more detailed product categorisation regime.

Specifically, SFDR will include, in addition to other new categories:

• Article 8 “ESG basics:” products that integrate sustainability factors in investment strategy beyond the consideration of sustainability risks can be disclosed
• Article 9 “sustainable:” products that invest in sustainable undertakings, sustainable economic activities, or other sustainable assets or that contribute to sustainability

The other categories are discussed in our alert, “What does the final draft of the SFDR2 mean for Private Fund Managers?”

For managers promoting defence-focused investment strategies, the new categories may prove helpful and provide greater flexibility, reducing reliance on the current Article 2(17) sustainable investment concept. For the reasons noted above, this could be helpful in placing defence investments within a more ESG-focused SFDR classification. The SFDR2 changes are still not final, with more negotiation to come. Once final, there should be time to assess and address the impact of the changes because, on the current legislative timetable, they are unlikely to take effect before Q3 2028. Moreover, speculation remains as to whether the SFDR will continue to apply to financial products marketed to professional investors after the SFDR takes effect.

Do the Changes Herald a Definite Move for ESG Investors to Defence Investments?

It would be a brave commentator who concludes that the changes and general shift of the consensus which largely excluded defence from responsible investment will result in a rush by ESG investors towards defence. Current market practice bears this out with the trade press, suggesting that despite the Commission’s clarification, actively managed Article 9 funds have added little defence exposure. Instead, defence is currently concentrated among French and passive, index-tracking strategies. One can safely say that the SFDR and related measures are designed to facilitate and encourage ESG investment. Ultimately, however, the move towards ESG defence investing will be driven by the ability of managers to structure investments that are inviting to ESG investors and the appetite of those investors to take up the invitation.