Withdrawing funding from courses that do not meet government policy objectives would be "dangerous" and could destabilise institutions, universities have warned.
The Higher Education Funding Council for England is consulting the sector on how teaching funds could be used to encourage universities to change their behaviour - from cutting dropout rates to recruiting more students in certain subjects.
One option would be to reduce funding to courses that are "not compatible with policy objectives" or are "of a lower priority", Hefce suggested in a consultation document published earlier this year. It gives the example of encouraging more flexible provision by cutting cash for three-year degrees.
But in its formal response, the 1994 Group of smaller research-intensive institutions warns that the idea holds "the inherent danger of the government picking the wrong short-term winner" and "destabilising" institutions and departments.
Labour's 10-year framework for higher education, Higher Ambitions, published last autumn, promised more competition between universities for funding, with money going to the institutions that best respond to "evolving economic challenges".
Diverting funds to courses that meet strategic-skills needs would mean taking money away from institutions "whose courses fail to meet high standards of quality or outcome", the framework states.
In its consultation document, Hefce proposes using a pot of funding, which would be known as the "strategic margin", to foster change.
Options would include allocating more student numbers to institutions that can demonstrate their ability to respond to a particular policy, with numbers recycled from elsewhere in the system; rewarding "quality provision"; or offering extra funds to universities that change to meet a particular policy objective.
The 1994 Group says it would support the use of a strategic margin only if the core grant was not reduced further in order to fund it.
"We are concerned that as a targeted, fluid and 'short-term' funding stream, the strategic margin could inject instability and uncertainty in funding," the group comments.
In its response to the consultation, Million+, which represents new universities, highlights similar concerns. In today's financial climate, it argues, most universities would have little option but to chase the funds, whether or not the objectives fitted their missions.
"If funding is fluid, temporary and is designed to change behaviour, what is the incentive when the funding is ceased?" it asks.
Million+ argues that it would be difficult to find appropriate measures for linking funding with quality, adding that it would be "entirely inappropriate" to couple quality with dropout rates, for example.
A recent report to Hefce examining teaching-funding methods globally suggests that England might emulate elements of Spain's system.
In Valencia, universities can access a "goal-orientated" pot of "a la carte" funding. In negotiation with the regional government, they pick 15 indicators from a "menu" of 31, covering teaching, research, lifelong learning, innovation, management and culture. Cash is linked to annual improvements in each agreed indicator.
The benefit of the model is that it funds improvement rather than existing excellence, says the report, Higher Education Teaching Funding Methods in Other Countries, written by consultancy Technopolis.
The study found few examples of contestable funding specifically linked to teaching and learning. One example, in Australia, "had problems since it resulted in funding being concentrated in already successful institutions rather than encouraging improvement," it says.
It identifies a shift in funding across Europe to mechanisms based on performance or "outputs", but acknowledges that this has to be carefully implemented because it can induce "perverse effects".
The Hefce consultation closes on 12 July.