Navigating Sustainability in Defense Investments: Commission Notice on SFDR, CSRD and CSDDD Compliance

Russia's war of aggression against Ukraine has made clear that to safeguard universal rights in the European Union (“EU”) and beyond, the EU must strengthen and further develop the capacity to defend itself. According to threat assessments by several EU intelligence services, Russia's capacity to produce military equipment has increased tremendously and it would have the military capabilities to test the unity of Western countries and the effectiveness of Article 5 of the North Atlantic Treaty within the next three to five years. This geopolitical reality has triggered a significant surge in demand for defense investments across Europe. 

At the same time, VC and PE fund managers structuring vehicles in the defense and defense-technology space have faced considerable legal uncertainty regarding the treatment of defense investments within the EU's existing ESG disclosure system (see our prior briefing on key legal considerations for defense tech and dual-use investments). Whilst the Joint White Paper for European Defense Readiness 2030 states that “the EU’s Sustainable Finance Disclosures Regulation (“SFDR”) does not prevent the financing of the defense sector”, the practical question of how to integrate defense investments into SFDR-compliant fund structures and align it with direct or indirect ESG-obligations resulting from the Corporate Sustainability Reporting Directive (“CSRD”) and Corporate Sustainability Due Diligence Directive (“CSDDD”), remained largely unanswered – until now.  

On December 30, 2025, the European Commission published a Commission Notice on the application of the sustainable finance framework and the Corporate Sustainability Due Diligence Directive to the defence sector (the “Notice”). The Notice seeks to clarify how the SFDR, CSRD, and CSDDD applies to the defense industry and, critically, to reduce the risk of undue discrimination against the sector in investment decisions, while recognising its potential contribution to social sustainability. 

This briefing analyses the Notice primarily from an SFDR perspective and outlines the key considerations for VC and PE fund managers when structuring funds in the defense-technology sector. 

Executive Summary 

• Legal Certainty for Sustainable Investments in Defense Sector: Financial market participants (“FMPs”) may conclude, based on a careful case-by-case assessment, that economic activities conducted by the EU defense industry to safeguard peace and security, provided they do not significantly harm any other sustainability objectives and that the company conducting the activity follows good governance practices, contribute to social objectives.
• Sector-Neutrality and Case-by-Case Assessment: The Commission recalls that the framework sets no limitations on the financing of any sector, including the defense sector, and encourages defense sector investments, like those in any other sectors, to be assessed on a case-by-case basis. 
• PAI Indicators Clarified: The Commission provides clear guidance on how to assess defense investments against PAI indicators  10,  11 and  14, with particular emphasis on export control compliance measures.  
• Role of Export Compliance and ICPs: Robust export control compliance and effective Internal Compliance Programmes (“ICPs”) are recognised as core governance and risk-management elements in the defense sector. They play a critical enabling role within the export control framework, as the granting of licences typically presupposes the existence of such compliance structures. In the context of SFDR, they are particularly relevant for DNSH analysis and the assessment of PAI indicators 10 and  11. 
• CSDDD Scope Clarification for Defense Companies: While the CSDDD applies to defense companies in principle, the Notice recalls a relevant scope limitation concerning downstream activities connected to authorised exports. This clarification is primarily relevant for determining the scope of due diligence obligations under the CSDDD. 
• Investments in Non-EU Defense Companies Remain Unclear: The Notice focuses primarily on the EU defense industry. The extent to which the guidance applies to investments in non-EU defense companies remains uncertain. 
  

1. Defense Investments under existing ESG Framework 

Amid growing geopolitical tensions and a shifting global security landscape, investment activity in the defense technology sector has accelerated significantly. However, this growth occurs within an increasingly complex regulatory environment.  

The Commission has repeatedly acknowledged the defense industry’s role in safeguarding the EU’s resilience, security and, by extension, peace and social sustainability. This recognition is reflected, inter alia, in the Proposal for a Regulation on establishing the Act in Support of Ammunition Production and the European defence industrial strategy. 

Until recently, however, these statements primarily signalled the EU’s strategic intent but did not provide fund managers with a usable “how-to” for applying the SFDR’s operative concepts to defense investments, in particular the classification as “sustainable investments” under Article 2 (17) SFDR, the DNSH analysis and the treatment of the relevant PAI indicators. As a result, they offered little practical value for fund managers structuring defense-focused products.

Against this backdrop, market practice under the current SFDR regime has been driven by legal caution rather than regulatory necessity. Defense funds have typically been structured either as Article 6 SFDR products, limited to minimum sustainability risk disclosures, or as Article 8 SFDR products promoting environmental or social characteristics primarily through exclusion policies rather than through sustainable investment objectives. This has resulted in structural shortcomings in investor disclosure. Sustainability-relevant aspects of defense investments have largely remained unarticulated, even where they are integral to the investment strategy. The Notice directly addresses this by providing a concrete and practical – albeit legally non-binding – framework. 

2. Defense as a Contribution to Social Sustainability under SFDR   

The central conceptual clarification of the Notice concerns the contribution of defense activities to social objectives within the meaning of Article 2 (17) SFDR. The Commission explicitly recognises that a resilient and competitive EU defense industry is critical to safeguarding peace and security and, to that extent, aligns with UN Sustainable Development Goal (“UN SDG”) 16 (“peace, justice and strong institutions”). On this basis, FMPs may conclude based on a careful case-by-case assessment, that economic activities conducted by the EU defense industry to safeguard peace and security, provided they do not significantly harm any other sustainability objectives and that the company conducting the activity follows good governance practices, contribute to social objectives.     

Importantly, the Notice avoids any automatic presumption. Defense activities are not deemed sustainable per se. Instead, the Notice applies the principle of sector neutrality: the SFDR does not impose sector-based financing prohibitions, sustainability disclosure obligations apply horizontally across all industries, and defense is assessed like any other sector on a case-by-case basis.  

3. DNSH and PAI Analysis for Defense Investments 

For defense investments to qualify as ‘sustainable investments’ under Article 2 (17) SFDR, they must contribute to an environmental or social objective while not significantly harming any other sustainability objectives (the “DNSH” principle). The Notice clarifies that, in the defense context, DNSH is primarily operationalised through the principal adverse impact (“PAI”) indicators.  

3.1. PAI Indicators 10 and 11: UN Global Compact and OECD Guidelines Compliance  

For FMPs investing in the defense industry, PAI indicators in Table 1 of Annex I of the Regulatory Technical Standards to the SFDR that may require particular explanation or contextualisation are PAI indicator 10 (“Violations of UN Global Compact principles and OECD Guidelines for Multinational Enterprises”), PAI indicator 11 (“Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for Multinational Enterprises”), and PAI indicator 14 (“Exposure to controversial weapons”). 

3.1.1. Export Control Compliance as DNSH Mitigation 

The Commission's most significant clarification concerns how export control compliance measures may be factored into the PAI assessment. The Notice encourages operators to factor in due diligence measures implemented to comply with export control legislation as contributing to the fulfilment of UN Global Compact Principles 1 and 2, principles 3 and 6 of Ch. IV of the OECD Guidelines for Multinational Enterprises, and in turn to PAIs 10 and 11. 

This is a crucial development. In the Commission’s view, robust export control compliance – typically a practical precondition for obtaining export licences in the defense sector – can be treated as probative evidence for PAI indicator 11 (the existence of processes and compliance mechanisms) and, to the extent it mitigates end-use and diversion risks, as relevant to the risk profile assessed under PAI indicator 10. In practice, ICPs operationalise export control obligations into verifiable governance controls, such as screening and escalation procedures, training, documentation, oversight and periodic review. 

However, export control compliance should be understood as one relevant governance and risk-mitigation element for PAI indicators 10 and 11 in the defense context, rather than as a standalone proxy for broader human rights and environmental due diligence or performance. It complements, rather than replaces, wider due diligence efforts, in particular where risks arise upstream in supply chains. 

To understand why export control compliance may be taken into account in DNSH assessments under the SFDR, it is necessary to recall the structure and operation of EU export control regimes in the defense sector. 

3.1.2. Export Control Framework Overview 

The export and intra-EU transfer of military and dual-use items is subject to comprehensive government oversight across the European Union, with exports requiring prior authorisation by national competent authorities. As part of the licensing process, competent authorities assess a range of risk factors, including the intended end use, the identity of the end user, the destination country and potential risks related to human rights, international humanitarian law and diversion. 

For military items, licensing decisions are taken under national regimes implementing the Council’s Common Position, which is legally binding on Member States and closely aligned with international obligations, including the Arms Trade Treaty. In particular, export authorisations must be denied where transfers would contravene UN arms embargoes or where authorities have knowledge that the items could be used to commit serious violations of international humanitarian law or other international crimes.  

EU and Member State export control regimes place significant emphasis on effective company-level compliance structures for both military and dual-use items. Whilst the Dual-Use-Regulation explicitly articulates these expectations for dual-use items at EU level, comparable requirements for military items arise under national licensing regimes. In both cases, the existence of adequate internal controls is a key element in the assessment of licence applications. 

These requirements are typically operationalised through ICPs, which translate export control obligations into concrete organisational and procedural measures, including clearly defined responsibilities, staff training and awareness, transaction screening and escalation mechanisms, documentation and internal monitoring. Export licences are therefore not merely formal approvals; they are commonly granted on the basis that such compliance structures are in place and functioning effectively. 

Export control regimes also place particular emphasis on end-use assurances and restrictions on re-export, supported by contractual clauses and, in certain cases, post-export verification. This reinforces the characterisation of export control as an ongoing risk-management framework rather than a one-off authorisation decision. 

Export control compliance and well-functioning ICPs constitute key elements of governance quality and risk management in the defense sector. In this context, their relevance for SFDR assessments, in particular with regard to DNSH analysis and PAI indicators 10 and 11, is explicitly recognised by the Notice. 

Start-ups and emerging defense-technology companies should be aware that export compliance obligations may arise earlier than expected – especially in cases involving cross-border collaboration, foreign investment, or international hiring. Notably, export control can also apply to software and intangible know-how (e.g., design files, source code, or manufacturing blueprints), not just physical goods. 

3.2. PAI Indicator 14: Controversial Weapons  

PAI indicator 14 – "share of investments in investee companies involved in the manufacture or selling of controversial weapons" – covers only the disclosure of exposure to four categories of controversial weapons: anti-personnel mines, cluster munitions, chemical weapons and biological weapons. These categories comprise weapons prohibited under international law binding the EU or banned by a majority of Member States, and are deemed to have a principal adverse impact. Conventional weapons systems, defense electronics, cyber defense, aerospace and most other defense technology activities fall outside the scope of this indicator. Notably, nuclear weapons are not covered by PAI indicator 14 under the SFDR framework. 

Accordingly, PAI indicator 14 functions as a narrowly defined, exclusion-based disclosure requirement rather than a comprehensive risk assessment tool for defense-related activities. It captures mere involvement in a limited set of internationally prohibited weapons, without addressing how defense activities are governed, controlled or safeguarded in practice. By contrast, PAI indicators 10 and 11 address conduct- and governance-related risks. In practice, the sustainability and DNSH assessment of most defense investments will therefore depend less on PAI indicator 14 and more on a case-by-case analysis under PAI indicators 10 and 11, reflecting the central role of governance, compliance and risk-management frameworks in the defense sector. 

4. Assessment and Outlook 

While defense investments were never subject to a sector-wide prohibition under SFDR, market practice lacked a credible methodology for assessing when such investments could qualify as sustainable. The Notice materially closes this gap. It confirms SFDR’s sector-neutral logic, recognises the potential social contribution of defense activities, and operationalises the DNSH requirement through a structured, case-by-case assessment focused on export-control compliance and narrowly circumscribed controversial weapons exclusions.

From a fund structuring perspective, this is consequential. Defense investments may be integrated as sustainable investments within Article 8 SFDR products, provided they contribute to social objectives, in particular UN SDG 16, comply with DNSH through appropriate PAI mitigation, and meet the good governance requirements. More fundamentally, the Notice establishes a defensible analytical basis for classifying certain defense investments as sustainable investments for the purposes of Article 9 SFDR. 

Beyond environmental and social concerns, investors should consider long-term risks related to governance, corruption, diversion, terrorism, and potential misuse of defense technologies. A comprehensive ESG assessment framework for defense investments must address these sector-specific risks alongside traditional sustainability metrics. 

The Notice nevertheless has clear limitations. It remains closely anchored to the current PAI-based DNSH architecture and provides little guidance for a regime in which PAIs play a reduced role, as envisaged under the Commission’s SFDR 2.0 proposal (see our prior briefing on SFDR 2.0). In addition, its scope is confined to the EU defense industry and does not address the treatment of non-EU defense investments, despite their potential relevance for EU security and resilience. 

That said, the Commission has set a meaningful marker. By articulating a coherent and operational assessment framework under the existing SFDR architecture, the Notice provides FMPs with a workable basis for integrating defense investments into SFDR-compliant products. In doing so, it materially reduces legal uncertainty and encourages sustainable investments in defense. This benefits the industry by attributing tangible value to sustainability characteristics and investors by improving transparency and comparability across financial products.