In the final days of 2025, the European Commission published a notice clarifying how the EU sustainable finance framework, alongside the Corporate Sustainability Due Diligence Directive, should be applied to the defence sector.
While the document does not amend existing legislation, it sends a clear message to the market: the practical application of SFDR, particularly around Principal Adverse Impact (PAI) assessments, has become overly simplistic and risks drifting away from its original intent.
Zeidler Group, which offers support for investment funds law, recently delved into what the clarification means for SFDR and PAI assessments.
Central to the Commission’s position is a rejection of automatic conclusions. Exposure to defence companies, in itself, does not constitute an adverse impact under SFDR. The framework is designed to identify actual or potential negative impacts on environmental and social factors, not to categorise entire sectors as inherently harmful. Over time, however, many ESG and sustainability processes have treated defence exposure as a proxy for harm, substituting evidence-based analysis with sectoral labelling, it said.
Importantly, the clarification does not weaken the PAI regime, Zeidler said. Defence companies remain fully within scope of all relevant indicators, including those covering human rights, controversial weapons, governance failures and environmental harm. Where a company is involved in prohibited weapons, or where credible evidence links it to serious breaches of international humanitarian or human rights law, negative PAI exposure remains unavoidable. The distinction the Commission draws is that these conclusions must be reached through analysis, not assumption.
In practice, this shifts the focus towards attribution and foreseeability. SFDR does not ask investment managers to pass judgement on geopolitical conflicts or to determine whether military actions are offensive or defensive. Instead, it requires an assessment of whether a company’s activities are credibly linked to adverse impacts, whether those impacts were foreseeable, and whether reasonable steps were taken to mitigate them. Compliance with export controls, lawful sales practices and robust due diligence processes all remain relevant factors. Conversely, repeated allegations, patterns of civilian harm or continued supply in the face of credible warning signals can materially alter a PAI assessment.
For Article 8 and Article 9 products, the implications are more demanding rather than more permissive. Defence exposure is not prohibited, but it must be consistent with the product’s stated sustainability characteristics or objectives, and with how PAIs are applied across the wider portfolio. Misalignment between policies, disclosures and actual investment decisions is likely to attract scrutiny, particularly where exclusions appear arbitrary or unsupported by impact analysis.
More broadly, the notice reflects growing regulatory discomfort with sustainability frameworks that operate on autopilot. Mechanical ESG downgrades and blanket exclusions may feel low-risk, but they sit uneasily with an impact-based regulatory regime and with wider EU policy goals. Good governance under SFDR increasingly means being able to articulate, clearly and defensibly, why a specific defence exposure does or does not give rise to adverse impacts.
Seen through this lens, the Commission’s notice is less about shielding defence from sustainability standards and more about ensuring those standards remain credible when tested by geopolitical reality, Zeidler said. For investment managers, the challenge is to apply SFDR and PAI discipline with nuance, context and transparency, recognising the consequences of both action and inaction.
For more insights, read the full story here.
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