Are ads on children's social networking sites harmless child's play or virtual insanity?

As social networking spreads to users as young as five, makers of toys and TV shows are making the most of new opportunities to reach children online. But with more than 100 youth-focused virtual worlds now either up and running or about to launch – over half of which are aimed at under-sevens, according to one estimate – regulators and parents are struggling to keep up.

It was the £350m sale of children's social networking site Club Penguin to Disney last August that confirmed to many the commercial potential of targeting children online. "Before then, many still questioned how much time kids would be willing to spend online, what they would most like to do when they were there, and what they would be prepared to pay," says Michael Smith, CEO of the London-based online social games creator Mind Candy. "Club Penguin's sale, however, opened eyes – and doors."

Club Penguin is a virtual online world for six- to 14-year-olds in which children use cartoon penguins to waddle around a snow-covered virtual world, play games and interact with one another. It is advertising-free and free to use, although for £4 a month users can buy additional premium content – a model that Mind Candy now hopes to emulate with its new offering, Moshi Monsters.

"Moshi Monsters gives children the chance to look after their own virtual pet," Smith explains. "Sophisticated animation allows for emotional engagement in quite a deep way. It also includes a safe social network for children to use to show off their pets, and an educational element – the Monsters love puzzles, and users are encouraged to play at least one a day."

Moshi Monsters, which launched in April, is currently free although a monthly subscription for premium content will soon be introduced along with a range of plush toys and puzzles due out for Christmas.

"Children's online safety has been a major consideration," Smith adds. "But so too has our commercial model. You have to tread a fine line between developing a business and safeguarding children's interests given concern about advertising to children online, but with growing interest in developing online immersive experiences for children there is also a risk some will be lured by the commercial potential."

A number of different commercial models are emerging amongst child-focused virtual worlds, the most controversial of which involves paid-for advertising. One of the biggest players is Neopets, bought by media giant Viacom for $160m in 2005, which features "immersive advertising" – ads integrated into content rather than placed alongside it – by third party brands including McDonald's.

Another children's site to carry advertising is Webkinz, a virtual world that children enter by using secret codes embedded in cuddly toys – costing around £9.99. The codes are then keyed in online. Once inside, they can chat with friends and play games to earn points that translate into a virtual currency called KinzCash for virtual shopping.

Concerns were voiced both by parents and consumer groups when both these sites – run from the US and Canada, respectively – introduced third party advertising. The hybrid reality-virtual model now being adopted by a growing number of toy companies – Bratz dolls, for example, now come with a USB "key" allowing a child to access a Bratz virtual world online – raises another issue. While sites like Hasbro's Littlest Pet Shop carry no advertising and do not require a subscription, the purchase of additional cuddly toys is required if children are to assemble a virtual collection of toys and accessories online.

All of which throws up concerns for parents. For it's not just a question of brand targeting advertising at their children online. Another issue is the creeping commercialisation of children's online experience. Then there's the tactic used by some sites of actively rewarding children with virtual cash the longer they stay online to play.

"It's an area we are monitoring closely," says Will Gardner, deputy chief executive of Childnet International, which campaigns for children's safety on the internet. "Interacting online can be an incredibly creative and rewarding experience for a child, but the underlying commercial tone of many sites is an inescapable concern."

The Advertising Standards Authority is tasked with dealing with complaints from the public about online advertising. The organisation's current remit, however, only covers paid-for advertising such as banner or pop-up ads – despite the fact that most of the complaints it receives concern what companies say and do on their own websites.

"While a paid-for advertising message in a virtual world would fall under our remit, the commercial content of a site owned and paid for by that company does not," ASA spokesman Matt Wilson explains. "Given public concerns about online advertising generally and advertising to children specifically, it's a regulatory gap we are now working hard to address."

Those involved in developing children's virtual worlds are quick to emphasise their efforts to make their sites a totally safe environment. The appropriate extent to which they should be commercialised is less clear-cut.

At LEGO, for example, its yet-to-launch virtual world LEGO Universe is simply "another way to play LEGO rather than a marketing vehicle for the brand", insists Mark Hansen, director of LEGO Digital Play Studio. The question for many parents, however, is: just how do you distinguish between the two?

For BBC Children's controller Richard Deverell – who has recently overseen the launch of two non-commercial, virtual spaces for six- to 12-year-olds: Adventure Rock and MyCCBC – the question is erroneous.

"Any organisation seeking to engage people with a brand today needs a credible, intelligent web presence," he says. "It's become an essential, non-negotiable part of the mix – and for children, too. Is that commercially exploitative? Well I'm not sure how it's any different to what Disney has been doing for 80 years."

It's not in commercial organisations' interest to alienate children or their parents by being commercially exploitative online, Deverell believes. Besides, children can benefit considerably from the control, creativity and social interaction online virtual worlds provide.

"The key challenge is to provide legitimate reassurance to parents that the sites their children use adhere to strict codes and standards," he claims. "The simplistic argument is that children should be outside playing cricket or climbing trees. The reality is they do just that as well as other things like watching TV and playing online, so long as the content that they consume is safe, good quality and age appropriate."