20 April 2009 Richard Scarborough Royal Norwegian Embassy, Baku The measures of the Norwegian government aimed at the effective management of Government Pension Fund – Global during the world financial crisis. 20 April 2009 Richard Scarborough Royal Norwegian Embassy, Baku

Topics The petroleum sector and the Norwegian economy The Pension Fund and economic policy Governance Investment strategy Fund performance, in particular for 2008 Corrective measures Ethical guidelines

-Total petroleum production in Norway, mill. Sm3 o.e. Oil and gas extraction in Norway -Total petroleum production in Norway, mill. Sm3 o.e. But oil and gas are exhaustible resources. Up until now, and for a few more years, production will continue to rise, but then it will fall off. Slide: (Standard cubic metres oil equivalents) shows that production is expected to follow a bell-shaped pattern. cruce oil production has already peaked (dark blue) gas production will continue to rise for anoter 3-4 years Source: Norwegian Petroleum Directorate

The petroleum sector in relation to the Norwegian economy 25 % 38 % 24 % 51 % The petroleum sector’s The petroleum sector’s The petroleum sector’s The petroleum sector’s share of GDP share of state revenues share of total investments share of total exports Source: Statistics Norway, Ministry of Finance

Clarification 1: The Norwegian Government Pension Fund Global is a SWF, with the best of intentions for stakeholders and the financial market place Clarification 2: The Norwegian Government Pension Fund is not really a pension fund, but a petroleum fund Ekofisk was the first field that was discovered (1969) Production from Ekofisk began in 1971 In the following years a number of significant discoveries were made Today there are more than 50 fields in production In 2005 these fields produced 3 million barrels of oil per day (including NGL and condensate) and 85 billion standard cubic meters of gas per year Norway ranks as the world’s third largest oil exporter and the eight largest oil producer.

Common pitfalls in oil producing countries Lack of fiscal discipline Challenge: How to transform a windfall to a permanent income? Overheating instead of sustained higher growth Dutch disease Bad investments Large scale industry investments with high political prestige Public infrastructure projects with vague/low economic return Neglect of education Loss of focus in structural policy Main focus on how to grab a part of the oil revenues Productivity growth in non-oil activity suffers Labour supply falls Poor governance Resource wealth often associated with weak government institutions Rent-seeking activities Increased risk of corruption

Manpower is our most important resource National wealth per capita in Norway. 2006 the value of our petroleum resources account for only a small proportion of the national wealth in Norway. As you can see from the pie chart, human capital (or the value of labour) account for 85% of total wealth, while the value of the petroleum resources account only for 4% and the Fund 3%. A little reminder of what REALLY matters, which have, and ought to have, some implications for policies. Source: Ministry of Finance, NB08

In the long run productivity is the key to welfare Key findings in OECD’s Growth Study Stability-oriented macroeconomic policies (+) Flexible and competitive product markets (+) A high degree of exposure to foreign trade (+) Flexible labour markets (+) Education and training (+) High level of taxation (-) Spending on R&D (+)

Different types of funds Savings fund: Aim to build up wealth for future generations Fixed inflows. Discretionary outflows. Stabilization fund: Aim to reduce impact of volatile revenues Inflows/outflows contingent on whether revenues “high/low” BUT Money is fungible. Government borrowing means fund can be misleading (and lead to inefficient cash management) Rigid rules on inflows and outflows may become inappropriate Financing fund: Aim for both saving and stabilization role Integrated with state budget. Net inflow equals overall fiscal balance

The Fund mechanism – integrated with fiscal policy Revenues Return on fund investments Petroleum revenues Fund Transfer to finance non-oil budget deficit State Budget The Pension Fund is an integrated part of the government finances. - The income of the Fund consists of the net cash flow from petroleum activities (tax revenues + FTP) plus the return on the Fund’s assets. - The expenditure of the Fund is a transfer to the Fiscal budget to finance the non-oil budget deficit. - Thus, the Fund’s construction creates a direct link from the use of the Fund’s capital and the non-oil budget deficit (Some countries have let the revenues gone direct to the fund – not through the state budget first). - Increased government expenditure or lower tax incomes from mainland activities result in smaller allocations to the Fund i.e. net savings in the fund depends on what Government & Parliament decide to spend in the budget. - And this is the clue – it is the budget policy that decides how much we spend and how much we save. A PF is no substitute for sound fiscal policy. Government and Parliament must deliver sound fiscal policy. In the budget we decide how much to spend on health, education, roads, government salaries etc. (some gives hopefully increased return on capital and employment in the future). That which we do not spend, we save in the PF. The key to how much money is saved in the PF therefore depends on the outflow from the PF. The Government’s savings & expenditures policy guides the size of the outflows from the PF. Fund is only invested abroad in financial assets: risk diversification and good returns. Protects domestic economy (an efficient way of achieving capital outflow reflecting the current account surplus) Fiscal policy guideline (over time spend real return of the fund, estimated at 4%) Expenditures

Why a “Pension Fund”? Strong increase in pension expenditure is a challenge for public finances Pension expenditure and expected real return on the Fund as share of mainland GDP Calls for a cautious fiscal policy over the next decades The Pension Fund has a dual purpose long term saving short- and medium term stabilization Pensions But this is intended to illustrate an additional challenge for Norway. We expect future pension expenditure to grow rapidly, while petroleum revenues has peaked and will decrease in the future. This is a partial analysis, showing one income component and one expenditure component. It does not give a meaningful picture of the sustainability of fiscal policy. But it still illustrates that the compounded effect of rising pension expenditures and declining oil revenues over the next decades will be considerable, so there is also a need for a mechanism to soften this blow to public finances. This is the “second purpose” with the Petroleum fund. We will now discuss the more general need for separating the path of extraction of oil revenues from the path of increased consumption - the first purpose with the Petroleum fund. Expected real return of the Fund Source: Statistics Norway, Ministry of Finance

Pension Fund - Global Governance Structure Founded on Act, regulations and separate contracts Office of the Auditor General Legislator Norwegian Parliament Pension Fund Act Performance reports and strategic changes reported in National Budgets and National Accounts Principal Ministry of Finance Advisory / consultancy agreement Norges Bank Audit Regulations Management agreement Advisors Important changes are placed before the Parliament. Ensures parliamentary control of investment strategy. Ensures necessary robustness. “If you have a long term investment strategy – make sure it stays long term when the markets are tumbling!” The Ministry of Finance is responsible for the management of the Fund. The operational management is carried out by Norges Bank (the central bank), which invests the Fund’s capital accordance to guidelines issued by the Ministry. Important changes to the investment guidelines are presented to Parliament before they are implemented. The Ministry receives advice on the investment guidelines from Norges Bank, the Ministry’s advisory council on investment strategy and external consultants. The Ministry uses external consultants for independent performance measurement and benchmarking of performance and costs. Responsibility for auditing the Fund rests with the Office of the Auditor General, in cooperation with Norges Bank Audit. Performance reports Central Bank (NBIM) Manager

Asset management: Clear lines of responsibilities Ministry of Finance – “Owner” overall responsibility (separate asset management department) strategic asset allocation (benchmark + risk limits) monitoring and evaluating operational management ethical guidelines reports to Parliament international advisor on resource funds Central Bank – “Operational manager” separate entity within central bank (NBIM) implement investment strategy (benchmark) active management to achieve excess return risk control and reporting exercise the Fund’s ownership rights provide professional advice on investment strategy I am aware that one of the previous speakers today thinks the ethical challenges related to fund management will be the more difficult ones to handle. I will therefore return to this question a little later on, however briefly. Benchmark: reference portfolio. Increased substantially over the past two years, both geographically to include more markets, and structurally, to include more companies, namely SMEs. Now including 7700 listed companies. Risk limit: expected relative volatility 150 basis points. NBIM:

The Fund’s circumstances General accumulation of assets belonging to the people Finance minister responsible for the management and strategic asset allocation (risk & return choice) Strong risk bearing capacity very long investment horizon no leverage no claims for the immediate withdrawal of funds no direct link to liabilities Governance challenges – Decision making process (speed) Main risk: Political authorities lose faith in the strategy for managing the petroleum wealth

Investment Strategy: Maximise returns Objective: Maximise international purchasing power, taking into account appropriate market risk appropriate operational (reputational) risk ethical guidelines principles of clear lines of responsibility (accountability), professionalism and transparency Implementation: financial investor (avg. holding < 1%, max limit 10 %) passive indexation main contributor to risk active risk budget (max 1.5% tracking error) delegated to Norges Bank Limit raised from 5 % in June 08. Varying geographical exposure, greater in Europe, with 1,3 % ownership of stock markets.

Benchmark for the Pension Fund – Global Strategic benchmark Equities 60 % Fixed Income 35 % Real estate 5 % Europe 50 % Asia and Oceania 15 % America and Africa 35 % Europe 60 % America and Africa 35 % Asia and Oceania 5 % Med unntak av begrensningene som følger av de etiske retningslinjene og utelukkelsen av investeringer i Norge og Burma så er det: ingen geografiske begrensninger på aksepterte børser og markedsplasser ingen begrensninger på valuta i fondets investeringsunivers ingen begrensninger på kredittrisiko i fondets investeringsunivers ingen begrensninger på bruk av derivater, fond og andre instrumenter som naturlig henger sammen med tillatte aktivaklasser eller råvarer Samlet avvik fra referanseporteføljen er likevel begrenset gjennom en øvre grense på relativ volatilitet (150 basispunkter) Investeringsuniverset er imidlertid vesentlig videre enn det som er dekningsområdet for RiskManagers modellering av markedsrisiko Eksempel på instrumenter som ikke dekkes godt av RiskManager: obligasjoner med høy kredittrisiko fra selskaper som ikke er børsnoterte, kompliserte derivater, for eksempel innen ”mortgage backed securities” fondsandeler i mange hedge funds Equity index: FTSE All-Cap Index, 46 countries Approx. 7700 equities Fixed income index: Barclay Capital’s Global Aggregate interest indices for 11 currencies. Approx. 7500 bonds

The investment strategy of the Fund and peers Sammenlikningsgruppen består av verdens 19 største pensjonsfond. Faktiske beholdninger ved utgangen av 2006. ”Andre” består av 2% Hedge-fond, 1% infrastruktur og 1% råvarer. Amerikanske universitetsfond (Endowments) er vel så interessant sammenlikningsgruppe. Disse har en enda lavere andel obligasjoner. Source: Ministry of Finance and CEM Benchmarking Inc (2007).

Why equities? Diversification: Even the minimum risk portfolio has a (small) allocation to equities Long investment horizon Equity risk premium In order to harvest this risk premium, we must tolerate fluctuations in return and fund value from year to year

Large variations in equity returns since 1998 Annual real return in an equity portfolio similar to the Fund since 1900 Number of years Generally, you will find years at the left end of the table followed by years to the right. Granted, there are some exceptions. Real return in percent Source: Ministry of Finance/Dimson, Marsh and Staunton

Equities have significantly outperformed bonds in the long run Source: Ministry of Finance/Dimson, Marsh and Staunton

Our rebalancing strategy means that we buy in falling markets -10 10 20 30 40 50 jan feb mar apr mai jun jul aug sep okt nov des 1998 1999 2000 2001 2002 2003 2004 2005 2006 Purchases in NOK bn 60 80 100 120 140 160 180 Price index, 97:12=100 Equities Equity price Average Figuren viser utviklingen i aksjemarkedet siden 1998 da vi begynte å kjøpe aksjer (blå linje) De røde søylene er kjøp av aksjer i mrd. kroner, og den sorte vannrette streken er den gjennomsnittlige prisen vi har betalt for de aksjene vi eier i fondet i dag. * Vi kjøpte litt aksjer i 1998 da vi gikk fra en portefølje med bare obligasjoner til en portefølje med 40 pst. aksjer. * Vi kjøpte nesten ikke aksjer i 1999 (et av de beste årene de siste 106 årene), men vi kjøpte mye aksjer i perioden 2000-2002, som var tre av de dårligste årene siden 1900. Dette er et resultat av vår valgte strategi. Vi har kunnet velge denne strategien fordi vi har en lang horisont på plasseringene. Så langt har resultatet vært at vi ved utgangen av september i gjennomsnitt hadde betalt en pris som var 38 pst. lavere enn markedsverdien av aksjeporteføljen. Vår evne til å se gjennom de kortsiktige svingningene i markedet har på denne måten vist seg å dempe risikoen i fondet sammenlignet med mange andre fond fordi vi ikke har vært tvunget til å realisere tap i dårlige tider, men tvert imot har kunnet tjene på de store svingningene som vi har erfart siden 1998. En annen risikodempende effekt i vårt fond sammenlignet med mange andre er at både innfasingen av ny kapital og bruken av fondet (avkastningen) spres over svært mange år. Det er derfor ikke usikkerhet knyttet til fondets verdi på ett bestemt tidspunkt som er avgjørende for hvilken strategi vi velger, men fondets verdi over lengre perioder. Source: Norges Bank

Norway’s SWF is large and still growing fast -The Fund’s market value 1996–2011. Billion USD, year end. The Fund has grown rapidly, inline with large govt. surpluses. Any discussion on losses must start with continued capital inflow to the fund, and then the advantage of being a long-term investor. In 2007 the fund will be more than 100 pct. of total GDP. Already more than 100 pct. Of Mainland GDP. Size is broadly in line with ABP (NL). GPFG larger than PGGM (NL) and CalPERS (US) We expect the fund to continue to grow. In 2010 we expect the fun to be more than 3000 billion NOK Source: Ministry of Finance, NB09

Cumulative return on the fund 1998-2007. NOK billion 4Q 07 - 4Q 08: from NOK 504 Bn to – NOK 131 Bn. The numbers measured in value in NOK appears much more pleasant: NOK depreciation corrects the net results upwards by NOK 508 Bn. But still, the most relevant measure for losses remains the fond’s basket of international currencies. Source: Norges Bank

Annualised return rate

2008 Results - 23,3 % net result, - 3,4 % net underperformance against reference portfolio Equity: - 40,70 % Reference value: - 39,56 Adjustment for transaction costs: - 0,82 % net contribution from management Bonds: -0,52 % Reference value: 6,08 % - 6,60 % net contribution from management

2008 Results, Equity Reversal of recent trends (premiums for cyclical industries, commodities and emerging markets) 4 tools to increase yield relative to reference portfolio, all were in the red for 2008: Expanded indexation. Problem: rapid reduction of actors’ risk limits, illiquidity in the market Capital expansions: only 2 out of 6 contributed positively to the net value added of management Internal sector mandates. Problem: US and banking sector External mandates: focus on emerging markets Main contributors to negative result: expanded indexation and sector mandates. Sector mandates: example of correlation with bond markets, losses mainly from US and banking sector.

2008 Results, Bonds Low exposure to subprime MBS More than 80 % of US bonds had AAA credit rating Yet, general real estate crisis had severe impact Increased exposure from credits on portfolio Considerable exposure to European bank bonds Other types of securities also affected General problem: considerable diversification, but limited risk reduction. Exposure to underlying, systemic risk. Positions vulnerable to rise in credit cost. Main remaining challenge: illiquidity in markets Alternative to US and other government bonds. Higher yields, apparent security based on historical data. Other: interest swaps, contracts switching cash flows between govt bonds and others, intl’ money market, real term interest rate bonds; reduced inflation . Opportunity for those able to retain their investments, but risk of further future losses.

Operational corrective measures, bonds Acquiring internal management capability in all investment areas (including US MBS market) Reduction of number of operational mandates, in general and in particular against MBS No more credits on MBS portfolio, reducing risk exposure Interest swaps discontinued Future strategy: Rebalance liquid parts of portfolio Retain illiquid bonds until they mature. Yields are good, but default risk.

Operational corrective measures, equity Results of management within expectations, less need for correction Long term trend: more emphasis on specialised external managers in specific markets/sectors Low prices of shares: opportunity to buy! Reinforced by losses reducing relative share of equity

Risk reduction and surveillance Exceeding risk limit in October 2008 Halting or delaying planned investment changes that contribute to increased expected relative volatility (increased risk) Supplementing quantitative risk models with pragmatic and discretionary methods: Concentration analyses Factor exposure Liquidity exposure Surveying counterpart risk

Conclusions Main strategy remains unchanged More emphasis on exploiting Fund’s advantages in size and investment horizon Prime examples: retaining positions in illiquid papers, expanding portfolio in a low-price environment

Ethical guidelines and corporate governance Two main ethical obligations: The obligation to ensure sound financial returns so that future generations will benefit from the petroleum wealth. The obligation to respect fundamental rights for those who are affected by the companies in which the Fund invests. exercise ownership rights – corporate governance avoid investments in companies whose practices constitute an unacceptable risk that the Fund is or will be complicit in grossly unethical activities Ethics is not one uniform idea, but a myriad of ideas in many different areas. This is the arena of investor responsibility. So, we have asked ourselves the question: which ethical obligations should we as a large institutional investor meet? The owners of the Fund are the Norwegian people and future generations of Norwegians. Any investor has an obligation to ensure long-term return for its owners. We see this obligation as an ethical one, because the owners are our future generations that we wish to benefit from this wealth. We also believe we have an ethical obligation to influence the companies in which we invest and to encourage these companies to respect the environment and fundamental human rights. As a last resort, we can sell our shares to avoid running the risk of contributing to gross violations of rights. We have chosen to build our Ethical Guidelines on an international structure, with emphasis on International Conventions relating to corporate governance, human rights and the environment.

Exercise of ownership rights The overall objective of the ownership effort is to safeguard the (long-term) financial interests of the Pension Fund The principles governing the exercise of ownership rights: the UN Global Compact the OECD Principles of Corporate Governance and the OECD principles for Multinational Enterprises Priority areas corporate governance children’s rights environment Tools for exercising ownership rights voting contact with portfolio companies contact with regulatory authorities contact and collaboration with other investors SPU er bredt investert og har en lang tidshorisont. Fondet vil trolig være tjent med at selskaper på sikt respekterer grunnleggende etiske normer. Aktivt eierskap skal være med å sikre den langsiktige avkastningen. Eierskapet skal også brukes for å påvirke selskaper i positiv retning på områder som menneskerettigheter, miljø og korrupsjon. Eierskapsutøvelsen er fondets sentrale etiske virkemiddel. Norges Bank har ansvaret for å utøve eierrettigheter. Prinsippene for eierskapsutøvelse er basert på OECDs Corporate Governance Guidelines (prinsipper for tradisjonell virksomhetsstyring), OECDs Guidelines for Multinational Enterprises og på FNs Global Compact (som sier at selskaper skal respektere menneskerettigheter, arbeidstakerrettigheter, miljø, samt bekjempe alle former for korrupsjon). Virkemidler: Norges Bank benytter ulike virkemidler for å utøve aktivt eierskap. Stemmeretten er sentral i så måte. Banken bruker stemmeretten for mesteparten av sin aksjeportefølje og søker i dette arbeidet å inkorporere sentrale temaer innen selskapsstyring, etikk og miljø. Norges Bank kontakter også selskaper direkte utenom generalforsamlingene, knyttet til de sentrale satsningsområdene. Banken har tatt og tar kontakt med styrene i enkeltselskaper eksempelvis for å diskutere temaer som arbeidsforhold hos underleverandører og utfordringene ved å ha virksomhet i områder der det er risiko for at menneskerettigheter ikke blir overholdt. Norges Bank deltar i formelle og uformelle nettverk med andre investorer for å sikre større gjennomslag for sine interesser (eksempel: Principles for responsible investment – initiert av FN i samarbeid med et knippe store investorer, herunder SPU v/Norges Bank) Det er ofte nødvendig å samarbeide med andre aksjonærer for å få gehør hos et selskap. Norges Bank inngår derfor samarbeid fra sak til sak med andre investorer. Behovet for investorsamarbeid vil til en viss grad styre hvilke saker banken har mulighet til å prioritere. Som et ledd i eierskapsutøvelsen tar Norges Bank også kontakt med regulerende myndigheter. Banken har gitt innspill til høringer bl.a. til US Securities and Exchange Commission (SEC) vedrørende informasjon om lederlønninger for amerikanske selskaper. I samarbeid med tre andre investorer har Norges Bank henstilt SEC om å legge til rette for at aksjonærer får reell og effektiv innflytelse over valg av styremedlemmer i amerikanske selskaper. Banken rapporterer årlig rapport om sin utøvelse av eierrettighetene i SPU. Dette er et viktig instrument for å kunne følge utviklingen i arbeidet.

Exclusion of companies based on Negative screening and Ad-hoc assessment Negative screening (products) weapons that through their normal use may violate fundamental humanitarian principles (e.g. cluster munitions and nuclear arms) Ad-hoc exclusion (production methods and conduct) serious violations of fundamental ethical norms (human rights incl. child labour, corruption, severe environmental damage) forward-looking assessment The Ministry of Finance has excluded 29 companies as of October 2008, based upon recommendations by the Council on Ethics Det virkemiddelet som hittil har fått størst medieoppmerksomhet er utelukkelse av selskaper fra fondet. Dette skyldes nok i stor grad at alle beslutninger om uttrekk, og begrunnelsen for disse, gjøres offentlig kjent. Terskelen for å trekke ut selskaper fra fondet skal være høy. Selskapenes normbrudd må være av en alvorlig, systematisk eller grov karakter for at dette virkemiddelet tas i bruk. Videre er det bare tilfeller hvor det er risiko for normbrudd fremover i tid som dekkes av retningslinjene. Filtrering = den etiske vurderingen er gjort på forhånd (implisitt automatisk utelukkelse). Man har definert hvilke produkter som per se anses å være grovt inhumane: visse våpentyper som ved normal anvendelse bryter med grunnleggende humanitære prinsipper. 17 selskaper er utelukket fra fondet etter dette kriteriet, 7 involvert i produksjon av klasevåpen, 9 involvert i produksjon av kjernevåpen, og 1 selskap på grunn av produksjon av antipersonell landminer. Ad-hod uttrekk = den etiske vurderingen gjøres ut fra den aktuelle og framtidige atferden til selskapet. Langt større grad av skjønn enn i vurderingen av hvilke selskaper som skal filtreres ut. Uttrekk gjøres på bakgrunn av selskapers atferd, for å unngå at fondet løper en uakseptabel risiko for å medvirke til grove brudd på grunnleggende etiske normer. 4 selskaper er blitt trukket ut etter dette kriteriet på grunn av henholdsvis risiko for medvirkning til grove eller systematiske brudd på menneskerettigheter og medvirkning til alvorlig miljøskade. Prosedyren er at Etikkrådet gir en tilråding til Finansdepartementet, som deretter fatter en beslutning. Finansdepartementet skal i tillegg til Etikkrådets tilråding vurdere andre hensyn, f.eks. om eierskapsutøvelse kan være egnet. Selv om departementet hittil har fulgt alle tilrådinger fra Etikkrådet, vil det ikke ligge noe dramatikk i om man i en enkeltsak skulle komme til en annen konklusjon. Mer om arbeidsfordelingen i neste plansje…

SWF- Elements of transparency Governance structure Lines of responsibility Guidelines and reporting Risk management systems Supervision Audit Investment objectives Purpose Investment horizon Rules governing allocations to and withdrawals from the fund Investment strategy and implementation Fund size Risk and return Asset composition Individual holdings Rebalancing strategy Phasing-in of new investments

Contact details Links Norwegian Ministry of Finance Asset Management Department P.O.Box 8008 Dep NO-0030 Oslo, Norway Visiting Address: Akersg. 40 Telephone: +47 22 24 41 63 Fax: +47 22 24 95 91 E-mail: postmottak@fin.dep.no Ministry of Finance www.government.no/en/dep/fin Government Pension Fund www.government.no/gpf Norges Bank Investment Management www.nbim.no Council on Ethics www.etikkradet.no