WHY IS THIS fund in vesting in arms com-panies and firms causing global warming?” Another day, and another activist is thundering at an annual general meeting trying to shame finance managers into adopting ethical criteria in their investment decisions.

The answer comes that the money – perhaps a pension fund, perhaps a local council’s reserves, or bank loans – is placed according to a policy of socially responsible investment, but no, they don’t ‘disinvest’. That is, the fund doesn’t exclude companies for ethical or environmental reasons. A more canny fund will add that they hold investments in irresponsible companies in order to influence them – a policy of engagement.

But does this argument hold water? And as importantly, what does it mean for the need to change corporations for the post-oil era? I recently joined the board of the London Pensions Fund Authority (LPFA), which invests £3.6 billion on behalf of London public servants. Here I’ve seen how an engagement policy works in practice. Do pension funds and other investment trusts really influence corporations?

One thing is not in doubt: the pension funds and other investment vehicles own the public corporations on behalf of millions of pensioners and unit trust holders. This should in theory give them some clout. They should be able to speak to, say, oil companies, and tell them to switch oil exploration spends into wind turbine development.

But while much is claimed, there are several fundamental obstacles to the funds having real influence. The first is a terrible, terrible irony. The funds are always trying to balance risk versus returns. Some investments are more risky than others and, to tempt investors to put their money into risky ventures, more attractive returns are paid than in safer investments. Funds are keen to chase the high returns, so they try to reduce the risk by spreading their investments.

Like nearly all funds, the LPFA refuses (so far) to exclude companies from the investment portfolio for ethical or environmental reasons. Instead the fund talks of its policy of engagement – even though it invests in hundreds of companies.

I recently sat in on a meeting to grill one of our fund managers on how they are engaging with the companies we invest in. What did I learn? First, that our own fund’s written policy of socially responsible investment has no impact or influence on the independent fund manager: they told us we hand the money over to them (with targets for the profits we want) and they invest according to ethical standards and environmental standards they choose.

Secondly, the supermarket which takes the environment most seriously in its working practices is… Tesco. (I kid you not.) Thirdly, climate change provides investment opportunities such as the profits to be expected from increased use of fertiliser (notwithstanding that oil is a main ingredient). And fourthly, the fund managers accepted an assurance from one of the world’s biggest mining companies (BHP Bilton) that its idea for opencast coal mining in the Indonesian rainforest is acceptable because the (notoriously corrupt) government there has designated the area “production forest” and not “protected forest”. So that’s all right, then.

To dig further, I sat in on a meeting our fund managers had with senior management at a leading store – one of the companies they invest (our money) in.

The topic was how the store ensured that people working for their suppliers in Asia were being paid decent wages. This meeting should have been important: in effect we were the owners of the company asking them to do something which they claim they want to do. Although the LPFA owns comparatively few shares, the investment managers (representing many funds) are one of the store’s bigger shareholders.

How is “engagement” working at this level? Our investment analysts accepted the store’s response that paying decent wages is “difficult”. We are told there is disagreement as to what amount is a decent wage: trade unions, NGOs and workers have different figures, though it’s agreed it should “meet basic needs with some discretionary income”. The store had pledged to pay a decent amount ten years ago (!) and say they are holding meetings with other Western shops which buy from these same suppliers, to set the rate. But until there is agreement, they tell us, they can’t pay the decent wage because they don’t know what it should be!

This meeting with the supermarket was what might be called pally. Everyone round the table agreed that paying 5p an hour is unacceptable. But they all (except me) also agreed that paying a decent amount is difficult to achieve.

The real reason it’s “difficult to achieve” is because it is these low wage rates which allow shops to sell clothes at low prices, gain the holy grail of competitive advantage, and thereby give comfort to the shareholders who want greater profits – i.e. pension funds.

Ironically for funds like ours, as companies gain more “competitive advantage” they drive out competitors by forcing them to close, or they merge with other companies – reducing the opportunity for pension funds to spread our risk.

The result is a triple whammy: funds still invest in companies acting in ways which many people find unacceptable. Their engagement with them is akin to being a supplicant rather than the owner. As shareholders, the funds encourage companies to grow ever bigger, and externalise their costs. This reduces the range of companies available to invest in. And funds invest in so many companies, that they can’t realistically influence them.

These are of course fundamental problems for our economy and our environment. How can pension funds ensure their investments are contributing to a sustainable society, rather than a destroying one? First, they need to exclude the very worst companies – the arms traders, the oil companies, those operating in countries with repressive regimes, those employing people at less than the amount needed to live on.

Secondly, they need to pump increasing proportions of money into companies working for environmental good: the wind technology firms, the ethical trading initiatives, the organic farms.

Thirdly, they need to rigorously talk to the ‘bad’ companies they invest in: the discussions should be trenchant and backed up with well researched data. The discussions should be in terms of an owner talking to the managers, and telling the managers they need to adopt the latest environmental and ethical thinking in the company’s day-to-day decisions.

Fourthly – and most radically – pension funds need to realise that it is very unlikely that corporations will continue to return the profits they’ve given over the last fifty years. So a pension fund looking to keep people in their old age in thirty years’ time needs to be more imaginative than simply trying to accrue profits. It would be better off using some of its funds to “future proof” its pensioners: for example, installing solar panels and insulating the homes of those still working would slash their fuel bills now – and when they retire they won’t need as much pension.

National Ethical Investment Week runs from 18th-24th May 2008. For more information visit www.neiw.org

Peter Lang was appointed a member of the board of the London Pension Funds Authority in the summer of 2007. He is the author of Ethical Investment: A Saver’s Guide and is London Representative for Resurgence.