* Central bank should decide on which firms to avoid-report
* Critics says this will weaken ethical stance of fund
* The central bank runs the sovereign wealth fund
* Report calls for research on ethical impact on returns
By Gwladys Fouche and Joachim Dagenborg
OSLO, Nov 11 (Reuters) - The ethics panel that decides which firms Norway's $800-billion wealth fund should avoid should lose its independence and become part of the central bank, a report said, a shift critics said would undermine the fund's ethical strategy.
The report by a government-appointed commission also called for more research on the performance of ethical investments, saying a lack of such studies made it difficult to assess how the fund's stance compared with other strategies.
The fund, which is run by the central bank, is the world's richest sovereign wealth fund and holds about 1.25 percent of all global equities. Its decisions are closely followed by international investors.
Its exit from its investment in Walmart, the world's largest retailer, in 2006 for alleged breach of human rights and labour rights led to other funds doing the same, including Sweden's four national pension funds and the Netherlands' PGGM pension fund. Walmart declined to comment on the decision at the time.
The fund is not allowed to invest in some industries - tobacco, nuclear arms, anti-personnel landmines and cluster bombs. Nor can it invest in companies involved in serious or systematic human rights violation.
The commission said making the independent panel, the council on ethics, part of the central bank would speed up decisions on exclusions and ensure more consistency - the fund has its own ethical strategy, separate from the panel's, which covers different areas of concern.
Oeystein Doerum, chief economist at Oslo-based bank DNB Markets, said such a reform could lead to fewer companies being excluded on ethical grounds.
"The more independent the council on ethics is, the better," Doerum told Reuters. "In other words, it should not be made into a section of the Norwegian central bank.
"If anything, a less independent ethics council could lead to more conservatism - i.e. fewer exclusions."
The fund, which invests in about 7,500 companies, has excluded about 60 firms so far, including Lockheed Martin , Boeing or Philip Morris.
Currently the five-strong council on ethics decides which companies should be excluded, subject to approval from the ministry of finance. The approval process can often take several months.
The commission said if the panel became part of the central bank, it would not require the approval of the ministry, thereby speeding up the exclusion process.
It said it would also bring it into line with the fund's own separate ethical strategy which it pushes with the companies it invests in, including issues such as the equal treatment of shareholders, board accountability, climate change, water management and children's rights.
Non-governmental organisations roundly criticised the commission's proposal.
"There needs to be a strong and independent player who performs the screening of a company and comes with a recommendation about the impact it should have on an investment," Beate Ekeloeve-Syldal of Amnesty International told Reuters.
"If the independent investigation of serious conditions in a company is left to the fund ... I think it will undermine the oil fund's credibility when it comes to ethical guidelines."
Svend Soeyland of environmental group Bellona said: "This will make it more difficult for NGOs to make complaints about specific companies. There would be less openness and what we can do would be less."
The commission said it was difficult to assess whether the Norwegian fund, whose wealth stems from taxes on Norway's offshore oil industry, would have made more money if it did not have an ethical stance.
Many sovereign wealth funds do not disclose their results, like the Norwegian one does every quarter, nor do they have an ethical profile.
And the pension funds that do have an ethical dimension, such as those in Canada, New Zealand or the Netherlands, have different ethical guidelines than the Norwegian fund, or are much smaller in size.
Some academic research on so-called sin stocks - shares in industries such as gambling, tobacco and liquor - suggest they return more money than ethical stocks on a risk-adjusted basis.
But if they constitute only a small part of a fund's portfolio, then they do not affect overall performance.
"The Norwegian fund is so big and is growing bigger and bigger. Small investments will not make a big difference on the return of this fund," said commission member Laura Starks, a professor of finance at the University of Texas at Austin.
"It is like a giant ship. It is more affected by the fluctuations of the world economy," she told Reuters.
She and her fellow members called on the fund to finance independent research on the impact of responsible investment practices on portfolio value.
The finance ministry will decide whether to accept the commission's recommendations and will publish a review of the fund in spring next year.