1. 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

2. 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

3. -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

4. 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

5. 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.

6. 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

7. 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

8. 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 (+)

9. 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

10. 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

11. 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

12. 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

13. 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:

14. 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

15. 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.

16. 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 %
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 equities
Fixed income index:
Barclay Capital’s Global Aggregate interest indices for 11 currencies. Approx bonds

17. 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).

18. 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

19. 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

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

21. 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 , 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

22. 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

23. Cumulative return on the fund 1998-2007. NOK billion
4Q Q 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

24. Annualised return rate

25. 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

26. 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.

27. 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.

28. 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.

29. 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

30. 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

31. 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

32. 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.

33. 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.

34. 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…

35. 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

36. Contact details Links Norwegian Ministry of Finance
Asset Management Department
P.O.Box 8008 Dep
NO-0030 Oslo, Norway
Visiting Address: Akersg. 40
Telephone:
Fax:
Ministry of Finance
Government Pension Fund
Norges Bank Investment Management
Council on Ethics