It is an honour for me to give this talk on the management of the Norwegian Petroleum wealth and the Government Pension Fund Global. I would like to thank the sponsors, the Columbia Center on Sustainable Investment, the Tamer Social Enterprise Program, and the Center on Global Economic Governance, for hosting this event.
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Distinguished researchers, ladies and gentlemen,
It is an honour for me to give this talk on the management of the Norwegian Petroleum wealth and the Government Pension Fund Global. I would like to thank the sponsors, the Columbia Center onSustainable Investment, the Tamer Social Enterprise Program, and the Center on Global EconomicGovernance, for hosting this event.
Let me only mention three of the many reasons why I have looked forward to this presentation:
Firstly, we are happy to share our experience in managing our resource wealth. Resource management is important. For many countries resource wealth seems to have been a curse rather than a blessing. We do not claim to have the one and only model that will suit all. But we have experience that can benefit other countries. And in all modesty, I think Norway can claim some success. The first instalment in the Fund was made in 1996. Today, the Fund is considered one of the largest sovereign wealth funds in the world.
We have grown from zero to USD 865 billions in 18 years.
Secondly, in managing the fund, we have benefitted from knowledge and expertise found right here at Columbia University. It was agreed from the outset that the development of the Fund’s strategy should be based on solid financial research and comprehensive professional assessments from leading experts internationally. Thus, it was natural for us to approach Columbia University and Professor Andrew Ang, who is considered one of the top academics within the financial research community. I would like to thank professor Ang for his tremendous work for the Fund and valuable input over a period of almost 10 years.
Thirdly, I appreciate the opportunity to discuss the management of the Fund at one of the World’s most prominent universities. The Government emphasizes transparency in all aspects of the fund. Events such as this help the fund staying one of the most transparent funds in the World.
Let me start by giving you an outline of the topics I will address:
- The Fund mechanism
- Governance of the Fund
- How we have performed
And how we ensure responsible management of the Fund
For thousands of years Norwegians have known how to harvest fish from the North Sea – but when we struck oil, we had to go abroad. We needed experience, technology, and funding. We needed international oil companies, from the Netherland, UK and the US. Foreign help aided us to not only recover oil, but to build up a knowledge-based oil and gas industry that our entire welfare system rests upon today.
Oil was discovered on the Norwegian sector of the Continental shelf in 1969 and production began in 1971. It took about 10 years before the government’s revenues became substantial. In 2012, Norway was ranked the 6th largest exporter of gas and the 14th largest exporter of oil in the world.
Petroleum accounts for roughly 20% of the size of the Norwegian economy, around 30% of total state revenues, and about half of Norwegian exports. But the sector only employs about 1% of aggregate employment (in man hours). The high share of GDP makes the petroleum resources important to the Norwegian economy, moreover they give us a fiscal leeway different from most other countries.
When your university was founded in 1754 Norway was a rather poor country in Europe. Today, we are in the Ivy League in economic terms. Oil and gas has indeed helped economic development in Norway. But petroleum is not our most import resource. The future earnings of the labor force are by far our most important resource – also in a resource rich country such as Norway.
A responsible economic policy is the best course of action to reduce Norway’s dependence on the price of oil. We will continue to save large parts of current oil and gas revenues. And invest the saving in a well-diversified global portfolio of financial assets to reduce the dependence on the value of remaining oil reserves. Through the fund we transfer oil wealth into financial wealth that also will benefit generations to come.
This graph shows that it is challenging to be rich. Rich in resources. The evidence, as documented by Columbia University’s Jeffrey Sachs, suggests poor growth performance in a number of resource-rich countries.
There are several explanations for such a negative correlation between resource endowment and growth performance:
- Dutch disease - lack of fiscal discipline: Large revenue flows will urge labor to move out of traditionally profitable sectors and into sectors that are booming from the spending of fresh petroleum revenue. As a result, sectors such as traditional manufacturing grow smaller and with that the innovation capacity and potential productivity gains inherent in these sectors. At a later stage, when revenue flows dry up it will take time to rebuild production capacity and knowledge in traditional sectors and the economy will suffer from low growth.
- Bad investments, you invest too much at home with the intention of diversifying the economy.
- Loss of focus in structural policy, you don’t do unpopular reforms – simply because you don’t have to as long as the resource revenues are flowing.
- Poor governance. Resource wealth is often associated with weak government institutions. If you don’t have the proper system of handling the revenue stream, this gives growth to rent seeking activities.
Whereas these explanations indeed bear some truth for some countries, it hardly applies to all resource-rich countries.
Two aims guided the establishment of the Fund:
Firstly, we wanted a mechanism ensuring that the petroleum wealth benefits both current and future generations
Secondly, we wanted to shelter the domestic economy from overheating due to oil financed demand
The idea of a petroleum fund was launched as early as in 1983. But then the aim was not to save for future generations – at that time it was limited confidence in the ability of the State to develop a long-term savings fund. The aim was rather to smooth out the spending of petroleum revenues over a limited number of years. But the idea of a petroleum fund matured, and in 1990 the Parliament passed an act establishing the Government Petroleum Fund.
The chart illustrates the main principle for this wealth management problem, namely how to transform the oil windfall gain into a smooth development in consumption, enabling higher consumption over time. The issue is therefore that temporary and highly volatile proceeds from petroleum activities should be decoupled from government spending.
So how is this fund mechanism working? All state petroleum revenues are transferred to the Fund and invested abroad. This helps shelter the domestic economy and the exchange rate from the volatility of petroleum revenues.
The spending rule guides how much the Government should use of the return from the fund to finance Government spending. Over time the government should spend no more than the real rate of return of the Fund in order to preserve its real value for future generations. While the capital in the Fund may be spent only once, the real return enables a permanently higher level of government expenditure over time.
The real return is estimated at 4 per cent. But the spending rule allows for a flexible response to the prevailing economic conditions: In periods of high economic growth spending is less than the long term target of 4 per cent. In periods of economic downturn, spending exceeds the long term target of 4 per cent. Large changes in the fund value may be phased in over a few years.The rule supports a stable economic development by allowing for a gradual increase in the spending. It shelters fiscal policy from oil price volatility and uncertainty. And automatic stabilizers are allowed to work fully.
There is no direct earmarking of petroleum income for specific spending purposes. But the Government has emphasised that growth enhancing measures – tax reductions, spending on innovations, research and infrastructure – should be given priority as the return from the fund is increased to finance Government spending.
The fiscal policy framework implies, in principle, a perpetual time-frame for the Fund’s investments. Whilst the capital in the Fund may be spent only once, the real return enables a permanently higher level of government expenditure over time.
Norway has healthy Government finances, low unemployment and has seen years of high economic growth. But we also face challenges ahead.
Over the next decades, government spending linked to an ageing population will increase rapidly – as in most other OECD countries. Total petroleum production, however, already peaked in 2004 and will play a less important role in our economy going forward. This is illustrated in the chart to the right, showing a decline in projected net cash flow from petroleum activities in the years to come.
The rapid rise in public pension expenditure and concurrent decline in oil and gas revenues represent a challenge to public finances, stressing the need to save a large part of current petroleum revenues. The Fund will help us in order to finance increased spending on an aging population. But we also have to focus on increasing the productivity, not least in the public sector. That is a key aim of the Government.
I will now present the framework for the management of the Government Pension Fund Global and the long-term investment strategy.
The governance framework is marked by a clear division of roles and responsibilities between the political authorities and operational management of the Fund.
- The Fund is the Norwegian people’s savings. The Parliament has given the overall responsibility for the management of the Fund to the Ministry of Finance.
- The Ministry of Finance determines a clearly defined benchmark with risk limits, monitoring and evaluating the operational management. The Ministry also determines the framework for the Fund’s responsible management. We report regularly to Parliament on all important aspects concerning the management of the Fund. All significant changes to the Fund’s investment strategy are presented to Parliament before being implemented. This helps to ensure broad-based political support for important strategic choices. This again enables a robust and long-term strategy. A broad parliamentary basis and support of the general public for important elements of the fund management is a prerequisite for the long-term investment strategy to truly remain long-term. This is especially the case in times of uncertainty and severe market turmoil. The anchoring-process served us well during the financial crisis of 2008, as members of Parliament refrained from proposing any significant changes to the investment strategy, despite heavy losses in the equity portfolio.
- But the Ministry of Finance is not managing the day-to-day operations of the Fund. The operational management has been delegated to Norges Bank (the central bank) which is responsible for implementing the investment strategy. The bank reports on the performance of the Fund to the Ministry on a quarterly basis. Norges Bank makes investment decisions on a purely financial basis and independently from the Ministry.
A clear and appropriate governance framework is a prerequisite for sound management of the Fund.
The Government emphasizes a high degree of transparency in the management of the Fund. Transparency:
- is a prerequisite to ensuring public support for the management of the petroleum wealth
- it builds trust and support for fund management - both domestically and internationally, and
- contributes to a robust investment strategy by anchoring the risk profile with stakeholders
The Ministry reports to Parliament on all important matters related to the Fund. We also publish all advice from external consultants (you can find the reports on the Ministry’s website).
The asset manager reports on performance, risk and costs every quarter. Further, the manager publishes an annual report including listing of all fund holdings; equities, fixed income and real estate. Voting records are also published.
Let me now move on to the Fund’s investment strategy.
The overarching objective for the investments is to achieve the maximum possible return, given a moderate level of risk. This enables more welfare to be financed over time by the return on the Fund. The Fund is not an environmental or foreign policy instrument. Multiple aims will make it difficult to assess the performance of the fund. And we do not believe the Fund is an effective or appropriate vehicle in promoting political aims.
The investment strategy is derived from our understanding of how financial markets work, together with the characteristics of the Fund. The Fund is different from the average investor in that it is large, has a very long investment horizon, has few needs for liquidity, and is government-owned. These characteristics influence our risk-taking capability, and may give advantages in certain areas relative to other investors.
The strategy is in particular characterized by:
- diversification through investments in a global portfolio of equities, bonds and real estate
- the harvesting of different types of risk premia, including the equity premium
- exploiting the Fund’s long investment horizon by inter alia investing in unlisted real estate
- a moderate degree of active management, i.e. the Fund follows the global benchmark indices closely
- a responsible management, taking into account environmental and social aspects
- a cost efficient management
- a clear governance structure
The investment strategy has been developed over time. It is based on comprehensive professional assessments. And on assessments of risk and return in the long run. In order to generate a satisfactory long term financial return, one must accept risk.
The investment opportunities accessible to the Fund, both with regard to countries, asset classes and financial instruments have been gradually expanded. The Fund investments are widely diversified across regions, countries and sectors in order to reduce risk.
Some milestones are:
- From 1996 to 1998, the fund capital was invested in the same manner as the central bank’s foreign currency reserves (i.e. government securities only).
- In 1998 we decided to invest 40 per cent of the Fund in equities. The equity allocation was further increased to 60 per cent in the years 2007-2009 based on considerations of risk and return in the long run.
- Corporate bonds were included in the fixed income portfolio in 2002 to increase diversification.
- We have gradually increased the exposure to emerging markets both in the equity and fixed income portfolio.
- In 2011 the Fund started to invest in unlisted real estate, introducing a third asset class.
- Responsible management is important to the people of Norway. Ethical guidelines were introduced in 2004 and a more integrated responsible investment strategy was implemented in the new investment mandate in 2010. Several changes to the framework for responsible management were also made with effect from January this year. I will return to this later in my presentation.
The Fund is invested globally with the following strategic asset allocation: 60% equities, up to 5% in real estate and the rest in bonds.
The starting point determining the investments is the composition of the benchmark indices by the Ministry of Finance. We use standard indices, FTSE for equity and Barclays for fixed income. The geographical distribution is based on global market weights for equities and corporate bonds. A market-weighted portfolio reflects the capital available to the Fund in global listed equity markets, and may be regarded as the portfolio of the average global investor. The allocation to government bonds are by and large according to the relative size of the countries’ economies, as measured by GDP. The size of a country’s economy may express the country’s ability to repay loans and fulfil obligations better than market weights (the size of borrowing).
The principles of market value weights and GDP-weights imply that the geographical distribution will change over time, in line with market developments and relative GDP growth of countries included in the index.
Within specified risk limits the manager may deviate from the benchmark index set by the Ministry. The actual investments in individual countries are thus determined by the manager, Norges Bank.
The asset allocation implies that the Fund is invested in a well diversified global portfolio of equities, bonds and real estate. The manager has used the leeway to deviate from the benchmark to further diversify investments by adding markets and currencies which are not included in the index.
At yearend 2014, investments in equity and fixed income instruments were spread across 75 individual countries and 47 currencies, and in excess of 9 000 companies and 1 100 individual issuers.
The investment strategy states that up to 5% of the Fund value can be invested in real estate over time. At yearend 2014 2.2% of the Fund was invested in real estate. Norges Bank’s objective is investing 1% in real estate in each of the coming two years. A higher portion invested in real estate implies a lower proportion invested in bonds.
The Fund made its first unlisted real estate investment in 2011, in Regent Street in London. The first unlisted property investment in the US was made in February 2013 in three major US cities.
The purpose is to build a global portfolio of real estate.
The strategy implies that the Fund is a financial investor with relatively small ownership stakes in a large number of companies worldwide. The Fund is not allowed to own more than 10 percent of any single company in the equity portfolio.
As you can see from this chart, ownership in listed companies globally averaged 1.3% at the end of 2014, and 0.9% for bonds.
The equity portion is the single most important decision for total portfolio risk. A high equity portion means that we must be prepared for significant fluctuations in the value of the Fund from time to time. The Fund has a high risk bearing capacity. Hence, the strategy is not predicated on minimising the volatility of returns.
Historically, there have been large fluctuations in equity returns as showed in the chart. But over time, equities have strongly outperformed bonds.
By its large size, the Fund is to some extent confined to harvest risk premia in “classical” listed equity and fixed income markets as many strategies are not scalable.
Rebalancing rules of the Fund’s equity portion ensures that the risk and return characteristics of the benchmark do not deviate significantly from the fixed strategic weight. And the rule has proved profitable, improving the ratio between risk and return.
When equity markets performed poorly as in 2008 the Fund sold bonds and bought equities to maintain the fixed proportion of 60 percent equities. In accordance with the rebalancing rule, the fund sold bonds and invested some 150 billion US dollars in the world’s equity markets in 2008 and 2009. As the markets subsequently rebounded in 2009 and 2010, our additional investments in equities proved profitable.
The Fund’s asset allocation is different from other comparable funds. According to a study by CEM Benchmarking in 2013, other funds had allocated 3% and 8% to unlisted investments in infrastructure and real estate, respectively. Our fund has a cap on 5% real estate and has not opened up for infrastructure.
On Friday the government announced a new assessment of investment in real estate and infrastructure. The Fund’s special characteristics, such as size and long investment horizon, merit such a review.
The Ministry has appointed a group of experts (names listed in the chart) to assess whether the Fund’s current limit of 5% real estate should be increased and whether it should be opened up for investments in infrastructure.
If investment in unlisted infrastructure is permitted in general, Norges Bank will also be allowed to invest in unlisted infrastructure within the renewable energy sector and emerging markets.
As with all other investments by the Fund, such investments will have to be evaluated on the basis of expected returns and risk.
I will now briefly comment on the Fund’s performance.
The Pension Fund was established by law in 1990, but the first transfer of 2bn kroner was not made until six years later. Since then, the Fund has grown rapidly and was per year-end 2014 valued at more than 6 400 billion kroner – or about 865 billion US dollars. This makes the Fund one of the world’s largest single-owned funds. The value has increased steeply in recent years, and it currently corresponds to about 2½ times the mainland GDP.
Close to 54% of the value of the Fund is due to net inflow of oil revenues while 36% is due to returns on the investments and the rest currency fluctuations.
The Fund has become an important source for funding of government expenditures. In 2015, the transfers from the Fund will cover 11% of the total budget expenses.
Returns in recent years have been very favourable relative to the expected rate of return over time. This reflects strong growth in the prices of both equities and bonds. But as all investors know, we cannot always count on such favourable developments in financial markets. A number of factors serve to highlight the considerable uncertainty as to developments in the value of the Fund over the next few years. Bond yields are currently very low. In addition, net inflows to the Fund in coming years depend on the development in the price of oil, which is subject to considerable uncertainty.
The fiscal policy guideline calls for the petroleum revenues to be phased gradually into the Norwegian economy, more or less in line with developments in the expected real return. The real rate of return was estimated at 4 percent. So how does this expected return compare to the average actual annual real return on the Fund, i.e. the nominal return adjusted for inflation and asset management costs? Since January 1997 to December 2014 it has been as estimated, 4.0 percent.
A group of experts, chaired by Andrew Ang of Columbia Business School, assessed two years ago the performance of the Fund. They concluded that the management performance has been good. The group also recommended building on the good results by increasing the scope for deviations from the benchmark index. They referred to four activities believed to add value: diversification, rebalancing including enhanced indexing, exposure to systematic risk factors and security selection. These are all activities that the Fund is currently undertaking.
Last Friday, the Government presented plans to increase the limit on deviations from the benchmark index in order to take further advantage of such activities to increase the return of the Fund.
The Government emphasizes ethical awareness in the management of the Government Pension Fund.
We also believe that over the long run, sound financial return is considered dependent on a sustainable development in economic, environmental and social terms.
The people of Norway wants assurance that the fund capital is invested in accordance with responsible investment practices. The strong public opinion on this issue is underlined by the fact that members of the Norwegian parliament initiated the process of establishing ethical guidelines for the Fund.
The first ethical guidelines came into force in 2004 after a comprehensive public hearing on the principles in the guidelines. The Ethical Council was established the same year.
In 2013 we received advice from the Strategy Council for the Fund to further strengthen the strategy. New measures were introduced in 2014 (implemented from January this year) including a new division of responsibilities for the exclusion of companies.
The Ministry of Finance decides on the overall framework for responsible management including the guidelines for observation and exclusion of companies from the Fund.
Norges Bank exercises the Fund’s ownership rights while the Council on Ethics makes recommendations on the observation and exclusion of individual companies.
Until 2014, the Council on Ethics gave independent advice to the Ministry of Finance on the exclusion of companies. Due to changes to the framework for responsible management from January this year, following the discussion in Parliament last year, the decisions on observation and exclusion of companies are now carried out by Norges Bank.
To preserve the legitimacy of the Fund, and to ensure that the investment strategy may in practice remain long-term, it is vital that our ownership in the various companies worldwide is generally acceptable to the Norwegian citizens. The strategy for responsible investments is transparent and predictable, and based on internationally recognized standards and principles.
The overall purpose of the ownership efforts is to safeguard the Fund’s financial interests.
As part of Norges Bank’s work on responsible management, the bank has developed a number of strategic focus areas, of which three are related to good corporate governance and three are related to environmental and social issues, including children’s right, climate change and water management.
We have several instruments at our disposal to promote the Fund’s role as a responsible financial investor. Exclusion of companies is one of these instruments.
Companies shall be excluded from the Government Pension Fund if they produce certain products or sell weapons to specific states. Companies may also be excluded if there is an unacceptable risk that they contribute to, or are responsible for, grossly unethical activities, including serious or systematic human rights violations, and gross corruption.
40 companies are excluded from the Fund under the product-based criteria. 18 of these companies have been excluded on the basis of production of weapons that violate fundamental humanitarian principles in their normal use, whilst 21 companies are excluded for producing tobacco. An additional 21 companies are excluded under the conduct-based criteria, and 13 of these companies are excluded because they are deemed to cause severe environmental damage.
The disinvestment movement has had an impact in Norway as well. NGOs and several members of the Parliament have argued that the Fund should disinvest from companies engaged in coal production – some would also like to exclude oil and gas companies.
In April 2014 the Ministry appointed an expert group to look at how we should address the issue of climate gas emissions from coal and petroleum companies. The Expert Group’s presented its report in December last year. The report included several recommendations;
- Active ownership and engagement are the appropriate primary tools to address climate-related issues.
- The Fund should continue to support relevant climate change research.
- New exclusion criterion – “contribution to climate change”. However, the Expert Group does not recommend an automatic exclusion of all coal and petroleum producers from the Fund. There is no ethical basis for exclusion of the coal sector – fossil fuels will still be paramount to economic development in years to come, also with a new ambitious climate agreement in line with the two degree target.
- The ownership efforts should be the primary tool, and the exclusions and engagement processes should be well coordinated.
- The Fund should not function as a climate policy instrument. Use of the Fund as a policy instrument beyond what is compatible with its role as a financial investor would be both inappropriate and ineffective.
The Government agrees that ownership effort is the most efficient tool in addressing climate issues in the management of the Fund. Investors need to have a seat at the table to be able to influence companies’ conduct. Norges Bank has already implemented many of the recommendations from the expert group in this respect. In addition the government has proposed a new exclusion criteria, based on conduct related to greenhouse gas emissions.
Let me turn back to the initial issue about how large natural resources impact policy and the lessons from Norway in avoiding the so-called resource curse. Yes, the Fund and the way we have managed our resource wealth has indeed benefitted the Norwegian economy. And it provides future generations with a share of the wealth. But let me also be clear: We have our challenges – today and ahead.
This article from Financial Times February 2014 referred to “a Norway on cruise control”. In this article the FT referred points to low average annual hours per worker and a rapid increase in unit labour cost. Our high GDP per capita, it claims, is largely dependent on oil.
This picture of the Norwegian needs to be qualified. For example, participation in the workforce is high so the hours worked per capita are on par with the EU average. The largest part of our income stems from the mainland economy, not from oil and gas. But still it’s important to make sure that the large oil revenues do not result in complacency. We need to spend the revenues wisely. We still need to make the public sector more efficient, reduce red tape and bureaucracy, and reduce the overall tax level, to keep a steady growth in the overall economy.
The investment strategy and management framework for the Government Pension Fund Global do by no means represent a universal ideal, but rather reflect the political and ideological context in which the Fund operates. If I should try to summarize some of the key experiences from Norway’s way of managing a large petroleum wealth, I would highlight the following:
We have chosen a framework where we separate spending from current accrual and where the proceeds are invested abroad. A well-designed fund mechanism serves as a tool to support wise and long-term budget decisions.
Further, the management is premised on a clear governance structure, in which the Parliament, the Ministry of Finance, and Norges Bank, as well as internal and external asset managers all have different roles and responsibilities. Clear lines of responsibility are prerequisites for good asset management over time.
We place significant emphasis on a high degree of transparency. I believe this is essential for the public and Parliament to have confidence in the management of the Fund, and it would not (in the Norwegian context) have been possible for the State to accrue such large and visible financial wealth without being open about the manner in which it is managed.
Another key feature is that the Fund’s investment strategy has been developed over time, based on comprehensive professional assessments. We have also stressed that the risk in the management of the Fund must be managed, controlled and communicated in a clear and effective manner. Furthermore, to be able to assume this risk, one must anchor the overall risk profile of the investment strategy with key stakeholders. Broad political support for the main features of the fund management is imperative to being able to stay firmly on course through challenging market environments.
The Norwegian economy is open to trade and investments. With a small population, we benefit greatly from international trade and economic interaction. The Fund has made us even more dependent – and interested – in developments internationally. At the end of 2014, the Fund’s investments in the US alone added up to USD 275 billion.
So this will probably not be the last time you see me at Columbia University.