No guns, no betting and no smoking

The battle is on to establish a benchmark for 'green' investments. Leo Lewis looks at the challenge facing the ethics boys

A green war is about to be waged in the City. As more and more funds strive to be "socially responsible", Dow Jones is to fire a salvo across the bows of FTSE International in the battle for creating an industry standard benchmark. This comes at a time when the third big player in the index market – MSCI – is poised to join the fray.

The market they are vying for is big and fast-growing. In May, State Street Global Investors was awarded one of the largest socially responsible mandates ever – to run the €320m (£200m) Swiss Federal Social Security Fund. Socially responsible investment (SRI) has doubled in size over the past three years, and in the UK alone, estimates for total "ethically screened" funds stand at £4bn. Realising that this is a major growth area, the other major index maker, Morgan Stanley Capital International (MSCI), is already well into preparations for launching its own series to compete with the other two.

The concept of ethical investment originated almost a decade ago in the US, where funds belonging to churches and other religious groups informed their fund managers that there were certain companies they would prefer not to be invested in. Firearms, tobacco and anything gambling-related were early victims of the drive to build "moral" portfolios.

But as the idea – and huge levels of investment – spread across the globe, the index makers realised that there was scope for the concept to become a great deal more sophisticated. Tomorrow sees the launch of the latest European-based product in the Dow Jones STOXX Sustainability index series, and another attempt to define "socially responsible" for the benefit of investors.

For its part, FTSE International is already there. At the end of July this year the group unveiled its FTSE4Good range of seven indices tracking UK, European and global stocks. So far, however, only Close Brothers and UBS Warburg have launched investment products linked to the 4Good range and none of the established SRI funds – run by the likes of Friends Ivory & Sime and Jupiter – have adopted it as a benchmark to measure their own performance.

The principal problem the index makers face is what criteria to adopt if they want to encourage the funds to start using their indices as a benchmark, and how to differentiate themselves from their rivals. The approaches break down into two types. There is the ethical test, which operates as a negative screening process and dismisses companies that fail to comply with a particular set of standards. And there is the sustainability test, which poses questions about companies and selects the most impressive. The former approach has an American feel to it, while the latter tends to be more European.

The FTSE4Good range assesses companies by using three criteria: social issues, human rights and environmental sustainability. All three use a best-practice framework and, via a questionnaire, judge companies against it. Members of the UK version of the 4Good series include BP, Shell, BSkyB, Unilever and Marks & Spencer. The Global product includes Microsoft, Honda and Merck.

The difficulty is that while the index makers are only supplying an investment tool, it is clearly in their interests for the indices to perform favourably against the mainstream benchmarks. For its Sustainability series, which was the first to be set up in 1999, Dow Jones has taken a different approach. It also uses a questionnaire to judge companies' compliance with its criteria, but weights those criteria according to importance. Although "environmental performance" and "environmental charters" score highly, at the top of the list are "strategic planning" and "risk & crisis management".

"Within the SRI sphere, investors are getting more sophisticated as the level of investment goes up," says Dow Jones spokesman Scott Stark. "There has to be a set of standard, well-understood criteria. On that basis, what you are seeing is a definite move to the sustainability side, away from the straight ethical criteria that used to be applied, but didn't work so well." The European index will include the likes of BT and Granada from the UK.

MSCI, the index maker that first used the now standard "free float" criteria for its products, is happy to watch its two rivals scrap it out before launching its own range. "While growth has been impressive in the SRI field, it is still very immature. We are wary of diving into this with a product that has not been properly thought out," says a spokesman.