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Ethical investment has grown enormously in recent years and is now central to many charities' policies - but some large ones believe it will damage their financial returns. David Ainsworth examines the state of play

Just over 20 years ago, the Bishop of Oxford launched a court case against the Church Commissioners, the investment arm of the Church of England, saying that he felt a charity had a duty not only to maximise financial returns when investing, but also to take ethical considerations into account.

The bishop won his case and, consequently, the Charity Commission rewrote its guidance to make it clear that a charity could exclude from its portfolio any companies to which it had moral objections.

The Church Commissioners, which manages more than £5bn, took the bishop's views to heart and now has one of the strictest policies of that sort anywhere in the UK. It excludes companies that sell tobacco, alcohol, pornography and weapons.

Since that case, ethical investment has evolved considerably. Charities and other investors have moved on from simply excluding those companies they dislike, known as 'negative screening'. When investing in companies, many now take into account the quality of their environmental, social and governance policies, or seek out companies that align with their mission.

Some have used their powers as shareholders to lobby companies for change, while others have stepped outside the mainstream stockmarket to invest only in organisations that actively work for social good - a process known as 'social investment' or 'programme-related investment'.

However, the level of interest in ethical investment varies widely from charity to charity, says Richard Jenkins, policy officer at the Association of Charitable Foundations, who recently compiled a guide called The Governance and Financial Management of Endowed Charitable Foundations.

"We spoke to a lot of charities about this when we compiled the guide," he says. "We found an enormously diverse range of responses. Some charities weren't doing it at all. Others were extremely involved."

A survey in 2009 of 164 Charity Finance Group members by the group and Eiris, a not-for-profit organisation that conducts research into ethical investment, found that 60 per cent of organisations that invested more than £1m had some sort of ethical investment policy. Of those, a quarter went further that just negative screening.

Victoria Heath, head of business development at Eiris, says she believes the focus on ethical investment has increased in the three years since that survey was published. But some large charities still deliberately do not adopt the policy, she says, because they fear it will limit returns.

"For me, it's a no-brainer that you should invest in line with your mission because, if you don't, you're probably investing in someone whose actions run directly contrary to that mission," she says. "But some very big charities are not doing that. They say clearly on their websites that they invest to maximise return."

Heath says one common reason given by those that do not have ethical investment policies is that trustees still believe they have a legal duty to maximise returns, and that it is unlawful to exclude investments on moral grounds. Others believe that ethical investment will damage their returns.

Others, she says, shy away because the process of developing an ethical investment policy is seen as time-consuming and difficult. "But it's not illegal, and it won't negatively affect your returns," she says. "It's possible to develop a policy relatively simply."

Jenkins says that evidence gathered while compiling his guide suggested that ethical investment is moving up foundations' agendas. One reason for this, he says, is the publication of guidance that makes it clear that charities can invest ethically, notably the Charity Commission's investment guidance CC14, published last year. He says this gives charities "a really pragmatic and permissive power to invest in ways that are relevant to their beneficiaries".

The UN Principles for Responsible Investment, launched in 2006, have also highlighted the issue to all investors. "I think the financial crash also made a difference," says Jenkins. "I'm sure it's made people think about whether their money is really doing what they want."

Above and beyond that, he says, there is an increasing move among foundations towards 'whole-balance-sheet investing'. "Foundations are thinking about how they can use every penny at their disposal to achieve their objectives," he says. "But there's always a delicate balance between the extra good you can do with your investments and the good you can do with the extra investment return."

Helen Wildsmith, head of ethical and responsible investment at the fund manager CCLA, says that the move towards ethical investing appears to be one-way traffic. "I've never heard of anyone abandoning their ethical investment policy once they've got one," she says. "It only moves in one direction."

Wildsmith says all money managed in CCLA funds is subject to some form of ethical screening. "We have two policies," she says. "One of those excludes tobacco and weapons banned by international treaty; the other has much more extensive screening. The first excludes about 3 per cent of the market, the second about 10 per cent.

"But what we're also finding is that charities aren't interested in exclusions only. Our clients have told us they want us to be engaged investors, and to use their shares to vote on issues such as human rights and child labour. And if engagement doesn't work, they've told us to divest."

In one high-profile case, charities sold their shares in protest about poor conduct by the mining company Vedanta. A coalition of church investors, including CCLA, the Central Finance Board of the Methodist Church, the Joseph Rowntree Charitable Trust and the Church Commissioners, put pressure on the company over its plans to mine a sacred mountain in India, and eventually sold their shares in protest.

Edward Mason, secretary to the Church of England ethical investment advisory group, who took part in the divestment process, says that getting involved in ethical investment can look complicated at first, but "you shouldn't throw your hands in the air and do nothing".

He says: "There are plenty of organisations that can help. The guidance is very good. You can ask your fund manager what they can do for you. Managers respond to their clients. If enough clients ask them for something, they'll do it.

"The evidence isn't entirely clear that there's an active investment benefit, but it's pretty clear that there's no detriment. And it's a good investment process to take into account issues that could affect the stock in the long term."

Gemma Woodward, an investment manager at the fund management company Newton, says that taking account of environmental, social and governance issues - known as ESG for short - is simply good financial management, as well as having an ethical benefit. "Our belief is that ESG factors affect share price and you need to understand them," she says. "We think looking at ESG is integral to good investment processes, particularly over the long term."

Woodward says another reason to have an ethical investment framework is the wishes of supporters. "There's a clear indication that supporters feel charities should have ethical investment policies," she says.

"Once you've developed a policy, test it. Find out where your concerns are. Make sure it's really doing what you want it to. It can be quite a lot of work to set up, but it's not that hard to run."

- Read our interview with the head of Panahpur, James Perry

- See our article on the new guidance for charities on social investment

- Check out our case study about the Esmee Fairbairn Foundation's investment strategy