Positioning the Japanese Defense Industry in ESG Framework

This op-ed by the head of Avascent’s Tokyo office, Toshi Nabeta, was originally published in Japanese in The Nikkei on June 15, 2022. 

The Russian invasion of Ukraine which triggered economic sanctions against Russia led by US and European nations, has resulted in the reassessment on the value offered from globalization as well as affected policymaking for economic security in various countries. ESG (Environmental, Social, and Governance) – a judging criterion broadly embraced for corporate management and decision-making for investors – is also affected, prompting debate on how it should be implemented in this new environment. In this column, I will focus on the ongoing debate around how the defense industry should be categorized within EU Taxonomy, and the potential implications for Japan.

EU Taxonomy is an EU-unique criterion published in April 2021, to help judge whether the economic activity conducted within the EU region is sustainable for the environment. If the sale of weapons accounts for more than 5% of the company’s turnover, that company will not be EU ecolabel certified. The EU Taxonomy also states that the arms industry itself could never become a socially sustainable industry.

Finland was the first to publicly express disagreement with this assumption. Finland has historically taken a policy of non-alignment, which states the defense industry is an essential foundation to defend the nation and also creates job opportunities. Because of the national goal to achieve a self-sufficient defense industry, Finland was unable to overlook the negative impact EU Taxonomy had in affecting financial institutions and institutional investors’ decisions on providing financial support or investment to the defense industry. It subsequently made an inquiry in the European Parliament requesting an explanation on what scientific ground this judgment was based on.

After the Ukraine invasion, a new tone emerged in Germany, praising the critical role played by the defense industry in achieving its goal to build a sustainable society, which is an important element of ESG. As a result, there is currently a lively debate on how the defense industry should be positioned.

Conversely in Japan, where the defense industry is struggling for survival, the focus of national level discussion regarding the defense industry remains at low level negotiations about improving low profits allowed under the current JMOD contract.

Japan will be renewing its National Security Strategy this year, and the Liberal Democratic Party has proposed to the administration that the new National Security Strategy state that “national government shall be held accountable for the sustainment and strengthening of the defense industry, not as an industrial policy, but as a national security policy.”

However, there is a disconnect with the current mindset of executives at defense related companies where proactive pursuit of defense business will create reputational risk and cause negative impact to the overall business performance of the company. There seems to be a lingering notion of passiveness, making people feel complacent and satisfied by only responding to the request made by JMOD.

As the security environment surrounding Japan is drastically changing, it is essential for Japan to initiate a national level discussion involving broad participants to discuss the role the defense industry must assume under this new security environment.