Arushi Agarwal from the European Sustainability Strategy team and
Aerospace & Defense Analyst Ross Law unpack what a reshaped
defense industry means for sustainability, ethics and long-term
investment strategy.
Read more insights from Morgan Stanley.
----- Transcript -----
Ross Law: Welcome to Thoughts on the Market. I'm
Ross Law from Morgan Stanley's European Aerospace and Defense
team.
Arushi Agarwal: And I'm Arushi Agarwal from the
European Sustainability Research Team.
Ross Law: Today, a topic that's rapidly defining
the boundaries of sustainable investing and technological
leadership – the use of AI in defense.
It's Tuesday, July 8th at 3pm in London.
At the recent NATO summit, member countries decided to boost
their core defense spending target from 2 percent to 3.5 percent
of GDP. This big jump is sure to spark a wave of innovation in
defense, particularly in AI and military technology. It's clear
that Europe is focusing on rearmament with AI playing a major
role.
In fact, AI is revolutionizing everything from unmanned systems
and cyber defense to simulation training and precision targeting.
It’s changing the game for how nations prepare for – and engage
in – conflict.
And with all these changes come serious challenges. Investors,
policy makers and technologists are facing some tough questions
that sit at the intersection of two of Morgan Stanley's four key
themes: The Multipolar World and Tech Diffusion.
So, Arushi, to set the stage, how is the concept
of sustainability evolving to include national security and
defense, particularly in Europe?
Arushi Agarwal: You know, Ross, it's fascinating
to see how much this space has evolved over the past year.
Geopolitical tensions have really pushed national security much
higher on the sustainability agenda. We're seeing a structural
shift in sentiment towards defense investments.
While historically defense companies were largely excluded by
sustainability funds, we're now seeing asset managers revisiting
these exclusions, especially around conventional and nuclear
weapons. Some are even launching thematic funds, specifically
focused on security and resilience.
However, in the absence of standard methodologies to assess
weapon related exposures, evaluate sector-specific ESG risks and
determine transparency, there is no clear consensus on what
sustainability focused managers can hold.
Greater policy focus has created the need to identify a long-term
approach to investing in this sector, one that is cognizant of
ethical issues. Investors are now increasingly asking whether
rapid technological integration might allow for a more
forward-looking, risk aware approach to investing in national
security.
Ross Law: So, it's no news that Europe has
historically underspent on defense. Now, the spending goal is
moving to 3.5 percent of GDP to try and catch up. Our estimates
suggest this could mean an additional $200 billion per year in
additional spend – with a focus on equipment over personnel, at
least for the time being. With this new focus, how is AI shaping
the European rearmament strategy?
Arushi Agarwal: Well, AI appears to be at the
core of EU’s 800 billion euro rearmament plan. The commission has
been quite clear that escalating tensions have not only led to a
new arms race but also provoked a global technological race.
Now to think about it, AI, quantum, biotech, robotics, and
hypersonic are key inputs not only for long-term economic growth,
but also for military pre-eminence.
In our base case, we estimate that total NATO military spend into
AI applications will potentially more than double to $112 billion
by 2030. This is at a 4 percent AI investment allocation rate. If
this allocation rate increases to 10 percent as anticipated by
European deep tech firms, then NATOs AI military spend could grow
sixfold to $306 billion by 2030 in our bull case.
So, Ross, you were at the Paris Air Show recently where companies
demonstrated their latest product capabilities. Which AI
applications are leading the way in defense right now?
Ross Law: Yeah, it was really quite eye-opening.
We've identified nine key AI applications, reshaping defense, and
our Application Readiness Radar shows that Cybersecurity followed
by Unmanned Systems exhibit the highest level of preparedness
from a public and private investment perspective.
Cybersecurity is a major priority due to increased proliferation
of cyber attacks and disinformation campaigns, and this
technology can be used for both defensive and offensive measures.
Unmanned systems are also really taking off, no pun intended,
mainly driven by the rise in drone warfare that's reshaping the
battlefield in Ukraine.
At the Paris Airshow, we saw demonstrations of “Wingman” crewed
and uncrewed aircraft. There have also been several public and
private partnerships in this area within our coverage. Another
area gaining traction is simulation and war gaming. As defense
spending increases and potentially leads to more military
personnel, we see this theme in high demand in the coming years.
Arushi Agarwal: And how are European Aerospace
and Defense companies positioning themselves in terms of AI
readiness?
Ross Law: Well, they're really making
significant advancements. We've assessed AI technology readiness
for our A&D companies across six different verticals: the
number of applications; dual-use capabilities; AI pricing power;
responsible AI policy; and partnerships on both external and
internal product categories.
What's really interesting is that European A&D companies have
higher pricing power relative to the U.S. counterparts, and a
higher percentage are both enablers and adopters of AI. To
accelerate AI integration, these companies are increasingly
partnering with government research arms, leading software firms,
as well as peers and private players.
Arushi Agarwal: And some of these same
technologies can also be used for civilian purposes. Could you
share some examples with us?
Ross Law: The dual use potential is really
significant. Various companies in our coverage are using their AI
capabilities for civilian applications across multiple domains.
For example, geospatial capabilities can also be used for
wildfire management and tracking deforestation. Machine learning
can be used for maritime shipping and port surveillance.
But switching gears slightly, if we talk about the regulatory
developments that are emerging in Europe to address defense
modernization, what does this mean, Arushi, for society, the
industry and investors?
Arushi Agarwal: There's quite a lot happening on
the regulatory front. The European Commission is working on a
defense omnibus simplification proposal aimed at speeding up
defense investments in the EU. It's planning to publish a
guidance notice on how defense investment will fit within the
sustainable finance framework. It’s also making changes to its
sustainability reporting directive. If warranted, the commission
will make additional adjustments to reflect the needs of the
defense industry in its sustainability reporting obligations.
The Sustainable Fund Reform is another important development.
While the sustainability fund regulation doesn't prohibit
investment into the defense sector, the commission is seeking to
provide clarification on how defense investment goals sit within
a sustainability framework.
Additionally at the European Security Summit in June, the
European Defense Commissioner indicated that a roadmap focusing
on the modernization of European defense will be published in
autumn. This will have a special focus on AI and quantum
technologies. For investors, whilst exclusions easing has started
to take place, pickup in individual positioning has been slow. As
investors ramp up on the sector, we believe these regulatory
developments can serve as catalysts, providing clear demand and
trend signals for the sector.
Ross Law: So finally, in this context, how can
companies and investors navigate these ethical considerations
responsibly?
Arushi Agarwal: So, in the note we highlight
that AI risk management requires the ability to tackle two types
of challenges. First, technical challenges, which can be
mitigated by embedding boundaries and success criteria directly
into the design of the AI model. For example, training AI systems
to refuse harmful requests.
Second challenges are more open-ended and ambiguous set of
challenges that relate to coordinating non-proliferation among
countries and preventing misuse by bad actors. This set of
challenges requires continuous interstate dialogue and
cooperation rather than purely technical fixes.
From an investor perspective, closer corporate engagement will be
key to navigating these debates. Ensuring firms have clear
documentation of their algorithms and decision-making processes,
human in the loop systems, transparency around data sets used to
train the AI models are some of the engagement points we mention
in our note.
Ultimately, I think the key is balance. On the one hand, we have
to recognize the legitimate security needs that defense
technologies address. And on the other hand, there's the need to
ensure appropriate safeguards and oversight.
Ross Law: Arushi, thanks for taking the time to
talk.
Arushi Agarwal: It was great speaking with you,
Ross,
Ross Law: And thank you all for listening. If
you enjoy Thoughts on the Market, please leave us a review
wherever you listen and share the podcast with a friend or
colleague today.
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