Which ESG ratings were analyzed?
Nine sustainability ratings from seven leading rating agencies were analyzed: Refinitiv ESG Score, Refinitiv ESG Controversies Score, ESG Book ESG Score, ISS Quality Score, Sustainalytics Controversy Rating, S&P Global ESG Score, Sustainalytics ESG Risk Rating, Bloomberg ESG Score, and MSCI ESG Rating. In addition, four sub scores - Refinitiv Human Rights Score, Refinitiv Social Pillar Score, Refinitiv Environmental Pillar Score, and Refinitiv Governance Pillar Score - of Refinitiv´s ESG Score were analyzed to explore the drivers of the rating.
Which differences exist between those ESG ratings?
The ESG ratings market is largely unregulated and lacks comprehensive supervisory or regulatory frameworks. Thus, each ESG rating provider uses its own definitions and methods. However, three important methodological approaches can be differentiated: (1) rate the sustainability controversies of a company, (2) rate the sustainability management system of a company, and (3) rate the financial sustainability risks of a company. Besides that, it is crucial for ESG ratings if a company receives absolute scores or if it is rated relative to its peer industry (in this case how it performs compared to other defense companies). Currently, most ESG ratings measure financially relevant sustainability risks relative to peer industries. The analysis showed that this common approach leads to better ESG scores for defense companies that export arms to war zones.
What exactly has been analyzed?
For each sustainability rating we analyzed averages scores, correlations, and regressions. First, for each ESG rating the average score of companies that export weapons to war zones has been compared to the average score of defense companies that do not export arms to war zones. Second, the correlation between a company´s score and its total number of arms deliveries to war zones as well as the correlation between a company´s score and the number of different war zones it supplied have been calculated. Third, simple linear regressions and multiple linear regressions have been run to examine the effect of a company´s involvement in arms deliveries to war zones on its ESG ratings. Different multiple linear regressions were used to control possible confounding factors.
Companies that export arms to war zones have better ESG ratings than other defense firms?
Yes. Ratings such as Refinitiv ESG Score, MSCI ESG Rating, Bloomberg ESG Score, and S&P Global ESG Score that measure financially relevant ESG risks relative to peer industries, which is the most widely used approach, tend to provide better scores to companies with a more controversial weapon export track record. First, these ratings give better average ESG scores to companies that export arms to war zones than to defense companies that do not. Second, within the group of companies with controversial arms exports, a higher involvement in arms exports to war zones is associated with better ESG scores. Only the two ratings that are absolute and measure ESG controversies – Refinitiv ESG Controversies Score, Sustainalytics Controversy Rating – tend to assign worse scores to defense companies with more controversial weapon export practices.
Does a company improve its ESG score by exporting more weapons to war zones?
No. In fact, companies that export weapons to war zones tend to receive better ESG scores than companies that do not. Moreover, within the companies that export weapons to war zones, those with more exports to more different war zones tend to receive better ESG scores than those with fewer exports to fewer war zones. For most sustainability ratings there is a positive correlation between a company´s score and its arms exports to war zones. However, it is not possible to conclude a causal relationship since ESG ratings are determined by different factors. This analysis only controlled for two factors with a proven influence on ESG scores, a company´s market capitalization and its country of incorporation. When controlling for these two factors, the positive effect of arms exports to war zones on ESG ratings is still significant. Nonetheless, there still might be other confounding factors.
Do investors that buy ESG investment funds invest more in war-fueling arms companies than investors that buy conventional investment funds?
No. Indeed, defense companies that export weapons to war zones tend to get better ESG ratings than other companies. And ESG investment funds are usually based on these ESG ratings. However, ESG investment funds often have a lower exposure to the defense industry than conventional investment funds due to exclusionary investing strategies and because the defense industry is rated as high ESG risk compared to other sectors. On the other hand, ESG investors that use common ESG ratings for a best-in-class investment approach without sector exclusions, increase their exposure to arms deliveries to war zones.
What is the problem?
Most retail investors expect ESG investment products to lower their exposure to controversial companies - companies with products and business practices that harm environment and society - , while in fact they are primarily designed to lower their exposure to financially relevant ESG risks. This misunderstanding frequently leads to ESG washing and greenwashing allegations when retail investors discover that their ESG funds invest in fossil companies that still expand fossil production and in defense companies that export weapons to armies involved in war crimes and human rights violations. The widespread unawareness of the differences across ESG ratings and ESG investment products leads to the situation that retail investors often invest in companies which they do not want in their portfolios. Rating agencies, index providers, banks, asset managers, and investment funds should make these differences very clear to protect consumers. However, the finance industry often is not interested in solving these misunderstandings, prefers to present itself as extremely sustainable, and tries to hide controversial issues.
ESG ratings of defense companies and arms exports to war zones
What is this analysis about?
This is a summary of Facing Finance e.V.´s investigation on ESG ratings of defense companies and arms exports to war zones. It analyzes the sustainability ratings of companies involved in arms exports to war zones using data from Facing Finance e.V.’s ExitArms database as it is the only publicly available, global database on companies that supply arms to warring states. First, 13 sustainability ratings of ExitArms companies from seven leading ESG data providers will be analyzed: Bloomberg, ESG Book, ISS, S&P Global, MSCI, Refinitiv, and Sustainalytics. Thereby, for each sustainability rating it will be examined whether the average score of ExitArms companies differs compared to Non-ExitArms companies and whether these differences are in line with the methodology of the rating. Thus, the first research question is whether sustainability ratings show a difference between companies that export arms to war zones and companies that do not.
Second, within the group of ExitArms companies for each sustainability rating it will be analyzed if there is any relation between a company’s score and its degree of involvement in arms exports to war zones. Thus, for each sustainability rating a correlation and regression analysis examines the second research question: Do companies that deliver more weapons to more war zones tend to receive different scores than companies with fewer exports to fewer war zones? This question is currently relevant since some investors that used to exclude the defense industry due to sustainability concerns are in the process of rethinking their point of view as a result of Russia´s war of aggression against Ukraine. Since these investors usually incorporate ESG ratings into their investment decisions it is likely that differences across ESG scores will influence their investments in defense companies. In this process, it is presumed that for many ESG investors that consider investing in the defense sector it is decisive where the respective weapons end and by whom/how they are used, e.g. if they could fuel wars and contribute to human rights violations.
Of the total of approximately 700 ExitArms companies, sustainability ratings are available for 87 companies, so only these companies are further assessed in this investigation. Some of these ExitArms companies are not allocated to the Aerospace & Defense sector by the rating agencies classification frameworks, even companies that make most of their revenue with armament. The industry classification of companies that cannot be clearly assigned to one sector is highly relevant since some sustainability risks could be omitted in the case of companies that face more than the typical ESG industry risks as they operate in several sectors. In fact, it has been found that how data providers define companies’ peer industry groups is crucial in determining ratings.
Nine ratings, the Refinitiv ESG Score, Refinitiv ESG Controversies Score, ESG Book ESG Score, ISS Quality Score, Sustainalytics Controversy Rating, S&P Global ESG Score, Sustainalytics ESG Risk Rating, Bloomberg ESG Score, and MSCI ESG Rating were selected from seven leading ESG data providers. Besides these sustainability ratings, the sub scores Refinitiv Human Rights Score, Refinitiv Social Pillar Score, Refinitiv Environmental Pillar Score, and Refinitiv Governance Pillar Score are analyzed as well. The data provider from which most ratings are analyzed is Refinitiv as its ratings cover the largest number of ExitArms companies. Moreover, analyzing the different sub scores that together make up the Refinitiv ESG Score helps to explore the drivers of the rating.
The ESG ratings market is largely unregulated and lacks comprehensive supervisory or regulatory frameworks for ESG ratings providers. Different ESG ratings use different data sources, data collection methods, data gap-filling techniques, approaches to materiality, scoring systems, weighting methods, and objectives. Therefore, the resulting company scores of these ESG ratings differ substantially and the correlation between ESG ratings is low. The 13 analyzed sustainability ratings can be allocated to three different approaches: (1) rate the sustainability controversies of a company, (2) rate the sustainability management system of a company, and (3) rate the financial sustainability risks of a company. Besides that it is relevant if a rating is absolute or relative to peer groups because ratings of relative assessments depend on the performance of the peer group itself, in this case the performance of the defense industry. Most ESG ratings such as Refinitiv ESG Score, S&P Global ESG Score, Bloomberg ESG Score, and MSCI ESG Ratinge measure financially relevant sustainability risks (approach 3) relative to peer industries. Very few ratings such as Sustainalytics Controversy Rating and Refinitiv ESG Controversies Score are absolute and measure sustainability controversies (approach 1). Finally, some ratings combine different methodological approaches: ESG Book ESG Score (approach 3, but absolute), ISS Quality Score (approach 2, relative to peer countries), Sustainalytics ESG Risk Rating (absolute, approaches 2 and 3).
Some data concerns arise from the list of ExitArms companies and their ESG ratings. First, considerable gaps might exist in the ExitArms database and it is likely that these gaps are not randomly distributed across all types of companies. For example, Chinese and Middle Eastern defense companies tend to be very non-transparent. Consequently, companies headquartered in China, or the Middle East are presumably less likely to be included in the ExitArms database (ExitArms 2023). To handle this problem, the companies have been split into different groups according to their headquarters, which allows to control jurisdictional specific effects. Second, many ExitArms companies are either state-owned, Russian or owned by private businessmen and for all these company types most ESG ratings are unavailable (Bloomberg 2023, Refinitiv 2023). This results in a considerable difference between the overall structure of the approximately 700 ExitArms companies - many small firms, private or state-owned, often headquartered in Russia, China, Middle East - and the structure of the 87 ExitArms companies for which ESG ratings are available – large and listed firms, often headquartered in North America and Western Europe. Thus, it has been checked whether the structure of the 87 analyzed ExitArms companies differs compared to the overall market. It has been controlled for two factors that might be problematic issues, the company size and headquarters, since past studies found that larger companies tend to receive better ESG scores and companies with headquarter in countries with strongly developed financial markets such as North America and Western Europe generally get better ESG scores. It turns out that the average market capitalization of ExitArms firms is a bit higher than the average market capitalization of companies of the overall industrials sector and that the proportion of North American/Western European companies within the analyzed ExitArms firms is the same as their proportion within Non-ExitArms peer industries. Thus, the ExitArms firms and their Non-ExitArms peer groups are comparable.
Ratings differences between ExitArms firms and Non-ExitArms firms
The only two ratings where defense companies that do not export weapons to war zones have better average scores than companies that export arms to waring states are Refinitiv’s ESG Controversies Score and Sustainalytics Controversy Rating. The only two ratings without a significant difference between the average ESG scores of companies that export weapons to war zones and those that do not are Sustainalytics ESG Risk Rating and ESG Book’s ESG Score. These are – besides the two controversies ratings – the only analyzed ratings which are absolute and not relative to peer group. most analyzed ratings - ISS Quality Score, S&P Global ESG Score, Bloomberg ESG Score, MSCI ESG Rating, and Refinitiv ESG Score - assign better average scores to companies that export arms to waring states than to companies that do not. For all ratings that are relative to peer groups, an outperformance of defense companies with controversial export practices is found. Looking at Refinitiv´s sub scores, it is remarkable that all pillars show an outperformance of ExitArms firms and ExitArms companies on average also have better Human Rights Scores and Social Pillar Scores – the scores where arms exports to war zones might play a role.
Analyzing the ExitArms companies with HQ in North America and Western Europe separately from ExitArms companies with HQ in other regions, shows that for most ratings and sub scores - MSCI ESG Rating, Bloomberg ESG Score, Sustainalytics ESG Risk Rating, Refinitiv G Pillar Score, Refinitiv S Pillar Score, Refinitiv Human Rights Score, Refinitiv ESG Score -, ExitArms companies with HQ in North America and Western Europe have better average scores. The two Controversies Scores are the only ratings that tend to assign better scores to ExitArms companies based outside of North America and Western Europe and are also the only ratings that assign worse scores to ExitArms firms than to their Non-ExitArms peers.
Ratings differences within ExitArms firms
Besides the comparison of sustainability ratings between ExitArms and Non-ExitArms companies, the ratings differences within the group of ExitArms firms have been analyzed as well. The second research question is if there is a relationship between companies ESG scores and their degree of involvement in arms deliveries to waring states. The degree of involvement is measured by two different criteria. The first criterion is the total number of arms deliveries to war zones by a certain company and the second criteria is the number of different waring states that received weapons from the respective company. Unsurprisingly, the correlation between these two criteria is very high (0.884). First, for each of the 13 ratings and sub scores, the correlation between the scores of ExitArms companies and their degree of involvement in exporting weapons to war zones is analyzed. Second, for each rating a simple linear regression (SLR) is run on the second criterion - the number of different waring states that a company supplied. However, it is doubtful whether the SLR assumptions hold, since an omitted variable could drive both a company’s sustainability rating and the number of different warring states it supplied. Thus, third, for each rating an MLR (multiple linear regression) is fitted on the second criterion, whereby the company’s market capitalization and its HQ location are included as control variables. Past studies have shown that companies based in strongly developed financial markets tend to receive better ESG scores, and that companies with larger resources regularly achieve better ESG scores.
While a company’s market capitalization turns out to be not statistically significant, the HQ location is statistically significant at the 1% significance level for all 13 ratings and sub scores. This shows that jurisdiction is crucial in determining ratings. Therefore, the MLR on average explains 65.8% of the variation in the sustainability ratings, indicating that the number of supplied war zones in combination with the HQ location explain a company’s ESG score pretty well.
Besides the two ratings following approach 1 – Sustainalytics Controversy Rating and Refinitiv ESG Controversies Score – there is only one other rating where higher involvement in arms deliveries to war zones is correlated with worse scores: Sustainalytics ESG Risk Rating. This negative effect of the number of warring states that a company supplied on its Sustainalytics ESG Risk Rating and its Sustainalytics Controversy Rating is confirmed by the SLR (at the 1% significance level) and the MLR (at the 5% significance level).
On the other hand, all ratings that are relative to peer industries and follow approach 3 - Bloomberg ESG Score, MSCI ESG Rating, S&P Global ESG Score, and Refinitiv ESG Score - have a positive correlation between a company’s ESG performance and its degree of involvement in arms deliveries to waring states. The SLR confirms a significant positive effect (at the 1% significance level) of the number of war zones that a company supplied on its ESG score for these ratings. All Refinitiv sub scores, including the Human Rights Score, are positively correlated with the degree of involvement in arms deliveries to waring states. This shows that the good ESG performance of defense companies responsible for many weapon deliveries to different war zones worldwide is not only based on their good environmental scores, but also on their good governance and social scores.
Overall, the outperformance of ExitArms firms for most sustainability ratings cannot be entirely explained by confounding factors such as market capitalization or HQ location. The jurisdiction actually has a strong influence on a company’s score and partly explains the good ESG performance of ExitArms firms. However, the MLR which includes the HQ location as control variable still shows a significant effect of a company’s degree of involvement in arms exports to war zones on most ESG scores measuring financial ESG risks (approach 3), whereby higher involvement is associated with better scores. Nonetheless, a causal relationship between a company’s arms exports to war zones and its sustainability ratings cannot be proven since other omitted confounding factors cannot be ruled out.
Implications for ESG investors
The findings indicate a huge difference between defense companies with good common ESG ratings and defense companies with good sustainability controversies ratings. On average, companies heavily involved in arms exports to war zones tend to have better ESG ratings with approaches 2/3, while companies that do not – or less - export arms to war zones tend to have better ESG controversies ratings. As a consequence, ESG investors using common ESG ratings for a best-in class investment approach without sector exclusions, would increase their exposure to arms deliveries to war zones. It should be clear for all users of ESG ratings that most ratings assess financially relevant sustainability risks, rather than sustainability impacts of a company’s business. Currently, retail investors often believe ESG investment products to lower their exposure to ESG controversies while in fact they are primarily designed to lower their exposure to financial ESG risks, which leads to a gap between the expectations of retail investors about ESG products and their reality. This misunderstanding is one of the reasons for the current discussions around greenwashing and ESG washing.
If the differences between ESG ratings were clear, they could serve varying users’ needs. For investors that want to align their portfolio with their values and not support controversial companies due to ethical considerations, sustainability controversies scores (approach 1) and negative screening seem to be the most appropriate approach. While for investors that want to improve their risk-return profile by reducing financial sustainability risks, common ESG ratings measuring financial ESG risk (approach 3) and ESG integration strategies seem suitable. The problem is that currently the different ESG ratings and products with lacking simplicity and confusion in terminology cause misunderstandings, create a huge discrepancy between the number of retail investors interested in sustainable investment and those actually investing sustainably, and frequently lead retail investors to invest in companies that they do not want in their portfolios.
Picture: 116816412 © Nitsuki | Dreamstime.com
 The ExitArms database covers almost 700 companies that have been involved in arms exports to waring states in recent years. In the following, it is referred to these companies simply as “ExitArms companies”.
 Ainger & Arons 2022, Hepher et al. 2022
 All ESG ratings data has been extracted in March 2023 (Bloomberg 2023, Refinitiv 2023).
 For example, the Spanish defense company Indra Sistemas SA is part of ExitArms and makes most of its revenue with armament but is allocated to the IT sector by Refinitiv and ESG Book (Indra Sistemas SA 2023). Therefore, ESG ratings based on industry-relative performance compare Indra Sistemas SA with the IT sector, which generally has a higher ESG performance than the defense sector, thereby affecting the company’s ESG rating.
 Kotsantonis & Serafeim 2019
 IOSCO 2021
 IOSCO 2021, Kotsantonis & Serafeim 2019, Berg et al. 2023
 Chatterji et al. 2016, Capizzi et al. 2021, Ducsai & Mayer 2023, Berg et al. 2022
 Kotsantonis & Serafeim 2019
 Bloomberg 2023, ESG Book 2022, MSCI ESG Research LLC 2022, Refinitiv 2022, S&P 2022
 Refinitiv 2022, Sustainalytics 2021a
 ESG Book 2022, ISS ESG 2022, Sustainalytics 2021b
 There are 65 Russian defense companies in ExitArms (ExitArms 2023). However, since the beginning of the Ukraine War, Russian companies are not rated anymore by the ESG data providers used in this analysis.
 Doyle 2018, Drempetic et al. 2020, Liang & Renneboog 2020
 Azevedo et al. 2023
 Refinitiv 2023
 To ensure that linear regression models can be used, it has been tested for heteroscedasticity, normal distribution of residuals, autocorrelation, and multicollinearity. The only problematic issue found are indications of multicollinearity. This could be handled by removing the variable market capitalization and running the regression only on the two variables HQ location and number of different supplied war zones. Thereby, the multicollinearity issue disappears and the regression fit does not change significantly (R-squared remains almost equal) since it turned out that HQ location and number of supplied war zones are the determining factors, while market capitalization has no significant effect.
 Azevedo et al. 2023, Doyle 2018, Drempetic et al. 2020, Liang & Renneboog 2020, Mackenzie et al. 2013, Maignan & Ralston 2002
 It is the only ESG rating without approach 1 that shows better scores for ExitArms companies exporting less weapons to less waring states. However, this correlation is substantially lower than for the Refinitiv ESG Controversies Score and the Sustainalytics Controversy Rating.
 For Refinitiv’s ESG Controversies Score the regression analysis seems to contradict the correlation since it shows a positive effect suggesting that an increasing number of supplied war zones is associated with better scores. This is explained by the non-linear relationship between Refinitiv’s ESG Controversies Score and the number of war zones that a company supplied. The nonlinear regression of Refinitiv’s ESG Controversies Score on the number of supplied war zones indicates that the score decreases as the number of supplied war zones increases, which is in line with the correlation analysis suggesting that higher involvement in arms deliveries to war zones is associated with worse scores.
 This is not in line with the expectations of most sustainability-focused retail investors, which supposedly expect social scores to be poor for companies that deliver weapons to regimes involved in wars and human rights violations.
 Generally, ESG funds tend to have lower exposure to the defense industry due to exclusionary investing strategies and because the defense industry is rated as high ESG risk compared to other sectors (Fernand 2020, Jones & Templeman 2022).
 FINRA Investor Education Foundation 2022, Verbraucherzentrale Bremen 2017
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 Amel-Zadeh & Serafeim 2018, SustainAbility 2020
 FINRA Investor Education Foundation 2022, Dumrose et al. 2023
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