Chris Bunting looks at ethical issues arising from institutional investments

If you see a chain smoker coughing their lungs out on the street, rub your hands in glee. If you read a newspaper report about the latest contract won by a British arms exporter to sell aircraft to a third-world dictatorship, shout for joy. If you hear about the oil industry displacing peasants to build its huge pipelines while the planet boils in its carbon dioxide juices, put a skip in your step and whistle a happy tune because all is right with your world.

Every year, UK academics make millions from the arms trade, tobacco companies, oil companies and other ethically controversial enterprises. The scale of the investment is huge. The Universities Superannuation Scheme, Britain's third biggest occupational pension scheme, has 170,000 members and a fund of Pounds 18 billion. It holds more than 8 million shares in BAE Systems, Britain's biggest arms manufacturer, and significant holdings in Britain's five other big arms makers. It invests heavily in companies accused of involvement in child labour, the tobacco industry, alcohol manufacture, animal testing and environmental damage.

And yet, in 1999, the USS was lauded for leading the pensions industry in its ethical investment policies. It was among the first university pension funds to commit themselves to implementing socially responsible policies and, for the past five years, has employed a team of three advisers to implement a strategy of "active investment", encouraging responsible behaviour among the companies it invests in.

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Indeed, Meredith Alexander, coordinator of the Ethics for USS campaign at the pressure group People and Planet, concedes that the USS is still an example of relatively good practice in the industry. "It is among the better ones. We certainly would not refer to the USS as having an ethical investment policy, but it does consider these issues - which is more than many funds do."

The essence of the USS approach is a policy of "engagement". Despite pressure from groups such as People and Planet, it refuses to implement "screening" of its investments - the pension industry's jargon for a policy of refusing to invest in certain business sectors because their activities are unethical. Instead, it invests in all companies offering a good return on its investment but, once inside the company, will use its influence to encourage more socially responsible practice.

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Raj Thamotheram, senior adviser for responsible investment at the USS, explains how holding shares in major arms dealers is consistent with a broadly ethical approach to investment. "We made clear when we moved towards our engagement policy that it wasn't a back door to screening, but that our intention was to move towards becoming a responsible investor," he says.

The scheme's legal advisers have stated that limiting investment opportunities on moral grounds would be vulnerable to challenges in the courts, Thamotheram says. The fund's legal responsibility is to maximise its returns. To limit this work because of moral judgements, which many of its members might dissent from, would be hazardous.

"Our membership includes people who are employed by the defence industry and those who are particularly antagonistic towards it. We are working on behalf of universities that have tobacco-funded institutes and those that host cancer research laboratories that campaign against smoking. It is probably impossible to aggregate those viewpoints into an ethical policy," he says.

Instead, the fund's engagement policy is justified in terms of long-term profitability. "The question is: are funds like us just trading stock or are the owners of companies responsible for encouraging good governance in companies? We take the latter view and it is a view that is really mainstream among fund trustees now. We believe that companies that are better run and meeting social norms are likely to be better performing in the long term," he says.

The misanthropic senior common room denizen who strongly believes that social irresponsibility is to be admired in the business sector is not ignored because the fund's directors disagree with his ethical judgement but because they do not believe it is a sensible basis for an investment strategy. "We are not seeking to reflect the views of our membership because this is not a membership organisation in that sense. Our objective is to invest well. If we make a judgement about climate change, for instance, we are making it because we think it may affect our investments," Thamotheram says.

He argues that the refusal to "screen" does not result in a toothless policy. Two years ago, the USS took a leading role in setting up the Institutional Investors Group on Climate Change, a group of major funds that aims to encourage the "companies and markets in which we invest to address any material risks and opportunities to their businesses associated with climate change and a shift to a lower carbon economy". The USS has also set up the Pharmaceutical Shareowners Group, a similar organisation aimed at encouraging major pharmaceutical companies to respond to public health crises (including the Aids epidemic) in third-world countries.

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"You have to have an escalation strategy when engaging with companies, but that does not mean necessarily disinvesting if they don't totally agree with you. I would argue that being there in the long term and consistently making your views known can have a significant influence when you are a major investor. One of the things we tell the people in these companies is that we are going to be owning these companies for much longer than they are on the board," Thamotheram says. "We can have arguments about whether our fund is 1 per cent ethically pure or 99 per cent ethically pure.

Perhaps you can make yourself ethically purer by not holding any investments in the companies involved in these areas, but how do you change things?

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"From the broadly ethical point of view, if we screened out, say, tobacco companies, that may mean we will be making a general statement about tobacco, but would we have any influence over how this industry operates, for instance, over under-age smoking, tobacco smuggling, third-party sales? Perhaps not."

Amanda Sandford, research manager at the anti-smoking group Ash, has no truck with such arguments. She says engagement fails to address the fundamental problem that some companies do bad things as part of their core business. "The whole point of the tobacco companies is to make money from a product that kills people. It is nonsense to 'engage' with them. In the end, an ethical policy for them is to put a thick layer of cosmetics over a fundamentally unethical product," she says.

"British American Tobacco issued a corporate responsibility document not so long ago. They said they were opposed to child labour. They said they were doing wonderful things with the environment. They said they were building hospitals. There is one thing they didn't say anything about: selling tobacco, which kills people. These companies need to be screened out."

A screening policy would not necessarily come at the expense of investment income, says Roger Morton, a trustee of the Joseph Rowntree Charitable Trust, which has disinvested from companies on ethical grounds. "That is the commonly assumed view, but looking at our own investments, which have excluded companies on ethical grounds, we have seen performance in line with the all-share index over quite a long period, 1978 to 2002. Allowing for the fact that we incur dealing expenses and the all-share index does not, I think we can say we have performed significantly better than the all-share index. So this excuse, that a move to screening might be illegal (and damage returns), is not necessarily right."

Morton also believes that it might be easier to reach an ethical consensus among members of the USS than Thamotheram thinks. "Very little research has been done into the actual opinions of the wider public, and perhaps it should be done. But I would make the observation that when you interview ethical investors, you find that there is a consensus on the major exclusions - arms, tobacco, gambling, pornography - backed by more than 90 per cent of respondents.

"Admittedly, these are ethical investors and not the general public, but I think you will find that, although there is a wide range of views on the detail of how these activities should be regarded, there is a broader consensus that personally profiting from them is distasteful," he says.

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But for Lord Harris of High Cross, founder of the Institute of Economic Affairs and a proud smoker, such talk is a misrepresentation of the diversity of views among academics. "The truth is that British American Tobacco, for instance, has been an amazing investment over the years: a blue-chip investment. As an economist, I really take the view that a pension scheme's requirement is to achieve the best return for the future pensioner. They should decide whether BAT is a good investment or not. It seems preposterous for a small group of people to promote their own ethical foibles over the ethical preferences of others. It is arrogant."