Report No. 20 to the Storting (2008-2009)

On the Management of the Government Pension Fund in 2008

Ministry of Finance

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Part 1
Main aspects of the management of the Government Pension Fund

1 Main aspects of the management of the Government Pension Fund

1.1 Background and purpose of the fund

The Government will pursue a policy based on sound, long-term management of Norway’s petroleum wealth. Such management reflects a fundamental social perspective and is an overarching priority for the Government. Our job is to ensure that this wealth can benefit all generations, whilst at the same time making an important contribution to stability in output and employment.

The Government Pension Fund comprises the Government Pension Fund – Global and the Government Pension Fund – Norway. It was established with effect from 1 January 2006 as a superstructure encompassing two former funds: the Government Petroleum Fund and the National Insurance Scheme Fund (Folketrygdfondet). The purpose of the Government Pension Fund is to support government savings to finance the pension expenditure of the National Insurance Scheme and long-term considerations in the spending of government petroleum revenues.

The savings of the Government Pension Fund take the form of general fund accumulation. The Fund is integrated with the Fiscal Budget, so that growth in the Fund reflects an actual accumulation of financial assets for the State. Consequently, there is no requirement that the assets of the Pension Fund shall at all times represent a certain share of the pension liabilities of the State under the National Insurance Scheme.

Under the Act of 21 December 2005 no. 123 relating to the Government Pension Fund (the Pension Fund Act), the Ministry of Finance has been charged with managing the Fund. The Ministry determines the general investment strategy for the fund and the ethical guidelines, and also follows up its operational management. The task of carrying out the operational management of the two parts of the Government Pension Fund has been delegated to Norges Bank and Folketrygdfondet respectively. The Government Pension Fund does not have its own Executive Board or administrative staff.

The Government’s ambition is for the Government Pension Fund to be the best managed fund in the world, entailing that best international practice must be sought for in all aspects of the management. The goal for the management of the Government Pension Fund is to achieve maximum financial return with moderate risk. In this way, we can help ensure that future generations will be able to draw the maximum possible benefit from our savings.

By virtue of our long-term investments in a large number of the world’s companies, we have a responsibility for and an interest in promoting good corporate governance and safeguarding environmental and social concerns. The Government will therefore give priority to being a responsible investor in its management of the fund.

In Report no. 24 (2006–2007) to the Storting, the Government announced it would be making an evaluation of the ethical guidelines for the Government Pension Fund – Global. The objective of this evaluation is to ensure that the ethical guidelines are functioning as intended, as well as to maintain broad support for the guidelines and collect input that can help strengthen the ethical profile of the Fund. This process was initiated in January 2008, and the results of the evaluation are presented in a separate chapter in this Report.

This Report consists of two parts: Part I provides an overall description of the main aspects of the management of the Government Pension Fund, with a focus on giving the presentation a non-technical form as far as is possible. Part II contains a more detailed analysis of themes discussed in Part I. The Ministry has also prepared documentation memoranda of a more technical nature, which will be published on the Ministry of Finance’s website (www.government.no/gpf).

Part I is organised as follows: Section 1.2 discusses the investment strategy for the Fund, including proposals for further development of the strategy for the Government Pension Fund – Global and a new review of whether – and if so, to what extent – active management is to be continued. Section 1.3 discusses responsible investments and provides a more detailed description of the ownership effort in Norges Bank and Folketrygdfondet and the results of the evaluation of the ethical guidelines for the Government Pension Fund – Global. Section 1.4 provides an overview of the management performance of the Government Pension Fund, with a special focus on performance developments during 2008, while Section 1.5 presents the work on developing the management framework.

In Part II, Chapter 2 contains a more detailed account of the Ministry’s efforts relating to the investment strategy for the Government Pension Fund. Chapter 3 contains a report on the work done on the ethical guidelines for the Government Pension Fund in 2008, and Chapter 4 discusses the evaluation of the ethical guidelines for the Government Pension Fund – Global. Chapter 5 provides detailed analyses of the return and risk associated with the Government Pension Fund. Chapter 6 describes the framework and follow-up regime for the management of the Fund.

The Act relating to the Government Pension Fund, the regulations relating to the management of the Fund, with supplementary provisions, and the respective management agreements are appended to this Report. The annual reports of Norges Bank and Folketrygdfondet are appended by reference (see www.norges-bank.no and www.ftf.no). The Council on Ethics’ annual reports are available on www.etikkradet.no. The recommendations and assessments of Norges Bank and the Strategy Council regarding the proposed changes to the investment strategy for the Government Pension Fund – Global, and the consultative statements submitted in connection with the evaluation of the ethical guidelines for the Government Pension Fund – Global are available on the Ministry of Finance’s website (www.government.no/gpf).

1.2 The investment strategy for the Government Pension Fund

1.2.1 About the investment strategy

What constitutes a good investment strategy for the Government Pension Fund is determined by the characteristics of the Fund, the purpose of the investments, the owner’s (the people of Norway, represented by the political authorities) tolerance of risk, and assumptions about how the financial markets work. See Chapter 2 for a more detailed discussion.

The purpose and characteristics of the Fund

The Government Pension Fund is an instrument for general savings on the part of the State and, unlike traditional pension funds, is not ear-marked for specific liabilities. In view of the prospects of continued high petroleum revenues in the years to come and a responsible fiscal policy, the Fund is set to grow and have a very long investment horizon. The Fund is not subject to short-term liquidity requirements. Against this background, the Government Pension Fund will therefore, generally speaking, have a higher risk-bearing capacity than other funds that it is reasonable to compare it with.

There is broad political support for the Fund to be managed with a view to achieving the maximum possible return, at a moderate level of risk, so as to enable future generations to derive the maximum possible benefit from the wealth as well. The Government Pension Fund shall therefore have broad diversification of risk and a clear financial objective. There is also broad support for the ethical framework for responsible management of the Fund. Broad political support for the investment strategy for the Fund provides a democratic underpinning and represents an important contribution to maintaining the investment strategy over time, including in periods of major market fluctuations.

The investment strategy for the Government Pension Fund is developed with a view to maximising the overall return on the assets of the Fund, given the owners’ risk tolerance, the size and characteristics of the Fund, sound investment practice and fundamental governance principles (see Chapter 2).

The Fund as a responsible investor

The goal of good financial returns is closely linked to the wish to be a responsible investor. This responsibility entails ensuring that the Fund is managed in a way that promotes better functioning, legitimate and efficient markets and sustainable development in the broadest sense. A broadly diversified investor – often referred to as a universal owner – will benefit from making sure that good corporate governance and environmental and social issues are safeguarded. It follows from the task of manager of the public’s funds that widely shared ethical values must be taken into account. In some cases, the concerns of ensuring long-term financial returns and taking widely shared values into account will coincide, but not always. For example, the Fund will not invest in companies that are in gross breach of fundamental ethical norms, regardless of the effect this will have on returns.

The goal is for the Government Pension Fund – Global to be managed responsibly in a manner that takes good corporate governance and environmental and social issues into account. The Government requires that responsible management of the Fund is arranged in such a way that support is ensured among the population of Norway and legitimacy among market participants. One goal in the role as a responsible investor is to promote sustainable development in economic, environmental and social terms, and this is regarded as a precondition for good financial returns over time. The Government wants the Government Pension Fund – Global to promote good corporate governance in companies the Fund has an ownership stake in and to encourage the companies to respect fundamental ethical standards. The Government will continue to refrain from investing in companies that are in serious or systematic breach of fundamental ethical norms.

To meet these goals, the Ministry wants to integrate the goals of good corporate governance and consideration of environmental and social aspects into all parts of the management. This is in keeping with the United Nations’ Principles for Responsible Investments (PRI) that the Ministry of Finance as formal owner of the Fund has now adopted. Norges Bank, as operational manager, has been involved in the development of these principles and has supported them since they were launched in spring 2006.

However, the Fund is not suitable for safeguarding all the ethical commitments we have as a nation. The State has other political, regulatory and financial instruments at its disposal that in many cases will be better suited to ensuring fulfilment of these kinds of obligations than laying down constraints on the management of the Fund. We have the greatest chance of success, in the sense of exerting a positive influence, if the focus and instruments target the role the Fund has as a financial investor. This also means that the Fund shall not be used as a development aid or foreign policy instrument.

The benchmark portfolios

The investment strategy for the Government Pension Fund is expressed through the composition of the Fund’s strategic benchmark portfolio. The current benchmark portfolio consists primarily of listed equities and investment grade bonds. Equity investments represent ownership interests in the production of goods and services, and the value of such investments will therefore reflect expectations as to the future profits of businesses. Bond investments are investments in transferable loans that shall be redeemed by the issuer on a certain date together with a predetermined interest rate.

The Ministry of Finance has formulated a long-term investment strategy based on the assumption that the portions to be invested in various asset classes and geographical regions can be determined on the basis of assessments of expected long-term returns and risks. Importance has been attached to the premise that contributions to the diversification of the risk associated with the investments improve the risk-adjusted return. The Ministry of Finance has therefore chosen a broad representation of the world’s stock and bond markets in the benchmark portfolio it has set for the Government Pension Fund – Global (see Figure 1.1). The indices making up the benchmark portfolio for the Fund include a representative selection of securities, and developments in these largely reflect market developments in the relevant countries.

Figure 1.1 Strategic benchmark portfolio for the Government Pension Fund1 — Figure 1.1 Strategic benchmark portfolio for the Government Pension Fund¹

The benchmark index for equities in the Government Pension Fund – Global comprises almost 7,700 companies across 46 countries, whilst the benchmark index for bonds comprises more than 10,000 individual securities across approx. 1,600 issuers in the currencies of 21 countries. By way of comparison, the benchmark index for equities in the Government Pension Fund – Norway comprises 196 companies in 4 countries, whilst the benchmark index for bonds comprises 270 individual securities across 62 issuers in the currencies of 6 countries.

Assumptions about the way the markets work and active management

In Report no. 16 (2007–2008) to the Storting, the Ministry described its fundamental assumptions about the way the markets work that underpin the Fund’s investment strategy. For example, the Ministry assumes that financial markets are largely “efficient”, both at any given point in time and over time. This means that market prices generally reflect relevant information about the securities. Furthermore, consistent with generally accepted theory and practice, it is assumed that it is normal to expect a higher average return over time on equities than on investments in fixed income instruments, because the risk associated with equities is higher. However, the magnitude of this excess return remains uncertain. Because the returns in different markets and segments do not move in line with each other, the Ministry also assumes that it may be possible to achieve a better trade-off between return and risk by spreading investments across several markets and market segments. This is the background against which the benchmark portfolio for the Government Pension Fund is spread across a broad range of geographical regions, countries, sectors and companies.

It follows from the guidelines laid down by the Ministry of Finance for management of the Government Pension Fund that Norges Bank and Folketrygdfondet may also invest in other securities and instruments than those included in the respective benchmark portfolios. At the same time, an upper limit has been established for permitted deviation from the benchmark portfolio in active management. It is the responsibility of Norges Bank and Folketrygdfondet to assess how the risk allowance can best be used to generate excess returns. By making investments in securities and instruments that fall outside the scope of the benchmark portfolio, and by investing other portions of the Fund in certain securities than are implied by the benchmark portfolio, Norges Bank and Folketrygdfondet are drawing on their permitted tracking error for the purpose of achieving an excess return.

With financial markets that are generally efficient, it is difficult for active managers to achieve a return in excess of the market return. In keeping with this, the framework for the management of the Fund has been designed such that developments in the return on the Fund over time largely follow developments in the benchmark portfolio that the Ministry of Finance has defined.

However, deviation from the benchmark portfolio will seldom be zero, partly because pure index management is not a relevant option. This must be seen in connection with the following factors, among others:

The composition of the benchmark portfolio is constantly changing. It is not rational for the manager to set up an actual portfolio that is at all times identical to the benchmark portfolio.
The manager must have the necessary flexibility to be able to strike a balance between the concern for cost efficiency and the need to follow the index closely.
It will be necessary to deviate from the composition of the benchmark portfolio when it is difficult to get hold of the individual securities in the index. In this case, the permitted tracking error will have to be used to invest in other securities that provide approximately the same exposure.
The manager must have the opportunity to exploit any weaknesses in the way the index has been constructed.
The manager must have the opportunity to invest in individual securities in markets that for various reasons it is not appropriate to include in the benchmark portfolio.

In a letter to the Ministry of Finance dated 14 March 2009, Norges Bank voiced a number of opinions concerning active management. The letter is enclosed as Appendix 2 to this report. In this letter, Norges Bank assumes that the markets the Fund is invested in are largely efficient and that it is therefore challenging to create consistent value added by forming expectations about developments in the prices of various financial assets. The bank points out that strategies to achieve excess returns in general must be founded on exploiting the characteristics of the Fund, such as, for example, its size, low costs and long time horizon. In this context, the bank attaches particular importance to the following:

Active management provides an opportunity to achieve exposure to systematic risk factors that it can be difficult to represent properly in the benchmark portfolio.
A long-term investor with a capacity for risk ought to be able to benefit from the fact that risk premiums for the different asset classes vary over time.
The size of the Fund constitutes an advantage because it permits the Fund to assume relatively large positions in individual situations without any material effect on the risk in the management. As a large investor, the bank will be able to achieve favourable terms in the primary market for equities, while the Fund as a passive investor will only buy shares when they are included in the benchmark index and in a situation where the size of the Fund can affect the price. These constitute opportunities that are not available to the average investor.
The bank has a considerable advantage through the opportunity it has to implement its investment strategy with significantly lower costs than the average investor.
As the investment universe and the benchmark portfolio of the Fund are gradually expanded, exposure increases to markets where there is less grounds to believe that the hypothesis of market efficiency holds true.

Norges Bank also believes that if major investors, such as the Government Pension Fund – Global work exclusively on the assumption that other participants ensure efficient price formation, this can undermine the functioning of capital markets. Furthermore, the bank points out that it is important that large institutional owners like Norges Bank are not passive, but protect their rights as a minority shareholder. The bank writes that:

“Overall, an element of active management is necessary for Norges Bank to have legitimacy when carrying out important parts of the management assignment.”

The Ministry shares the bank’s view that the markets the Fund operates in are largely efficient and that a strategy aimed at achieving excess return must be based on exploiting the characteristics of the Fund. A certain framework for active management is also in keeping with practice in large international funds.

The Ministry also agrees that maintaining the legitimacy of the Fund is important and that this requires that Norges Bank has an organisation with sufficient weight and credibility to safeguard the financial interests of the Fund vis-à-vis individual companies.

The legitimacy of the active management strategies must be based on an explicit, credible strategy for achieving excess returns that exploits the characteristics of the Fund. In its letter, Norges Bank writes that the scope of active management over time will depend on the results that can be achieved.

For investments in new asset classes such as real estate, infrastructure and unlisted equities, performance will depend more on active investment choices, since passive indexing is not an alternative. An organisation with competence in active management in general, for example, competence linked to evaluating external managers, will be an advantage in the further development of the Fund.

In connection with using external consultants with specialist expertise, the Ministry will assess experiences in active management in Norges Bank. See the more detailed discussion in Box 1.3.

1.2.2 Evolvement of the investment strategy for the Government Pension Fund – Global

Introduction

The Government Pension Fund – Global has grown rapidly since the Fund received its first capital allocation in 1996. Over the years, the Fund has grown to become one of the largest funds in the world. The fund capital has significantly outgrown the levels envisaged for the first few years after the initial capital allocations were made.

There has been a gradual evolvement in the investment strategy for the Government Pension Fund – Global. The Fund has invested in equities since 1998. In 2000, emerging markets were included in the benchmark portfolio for equities, whilst in 2002 the benchmark portfolio for bonds was expanded through the inclusion of non-government-guaranteed bonds (i.e. corporate bonds and mortgage-backed bonds). In 2006, the investment universe was further expanded. It was decided, following the Storting’s deliberation of Report no. 24 (2006–2007) to the Storting, to include the small-cap segment in the benchmark portfolio for equities and to increase the equity portion of the benchmark portfolio from 40 per cent to 60 per cent. In 2008 it was decided to start work to build up a portfolio of property investments (cf. Report no. 16 (2007–2008) to the Storting). It was also decided to expand the benchmark portfolio by including more emerging stock markets. In addition, the limit on ownership stakes for equity investments in individual companies was raised from 5 per cent to 10 per cent.

The evolvement of the investment strategy for the Government Pension Fund – Global reflects the fact that many important strategic choices have already been made, such as concerning the distribution between equities and fixed income instruments and the scope of the equity and fixed income portfolios. The Ministry’s future efforts to evolve the investment strategy will be premised on how to achieve a further improvement in the trade-off between return and risk by further spreading the investments and better utilising the characteristics of the Fund without any significant changes to the overall level of risk. Decisions that involve more comprehensive changes to the investment strategy that are expected to have a material impact on the overall risk associated with the Fund will be submitted to the Storting prior to the implementation of any changes.

The sources of the return on the Government Pension Fund – Global have thus far been focused, in particular, on the fact that through ownership of equities and bonds, it is possible to reap returns by assuming market risk in relatively liquid markets. The benchmark portfolio of the Fund has been gradually expanded.

The goal of the investments in the Government Pension Fund – Global is to achieve maximum financial return with moderate risk. The Government Pension Fund – Global has several special characteristics that distinguish it from a number of other funds (cf. Report no. 16 (2007–2008) to the Storting). The Fund is large in terms of its market value, it has large inflow of capital, the investments are highly diversified over a broad investment universe, and it has a long investment horizon. Nor are there any concrete commitments linked to the asset pool, meaning the short-term liquidity requirement is limited. It is natural for the future work on evolvement of the investment strategy to be focused on determining a strategy that makes best possible use of these characteristics of the Fund.

Natural types of evolvement of the investment strategy may thus be:

further diversification of risk by, for example, including more countries or asset classes in the benchmark portfolio of the Fund, and
considering investments that benefit from the Fund’s size, long-term perspective, and ability to hold less liquid assets. It is particularly pertinent to consider changes to the strategy that can provide compensation in the form of somewhat higher expected returns in exchange for reduced tradability (liquidity).

This kind of evolvement of the investment strategy for the Government Pension Fund – Global may result in an asset allocation that is more similar to the composition of other international funds.

A basic premise in the work to evolve the strategy is the need for adequate limits on other types of risk than market risk as well, such as operational risk. Another requirement will be the need for follow-up of the operational management that helps ensure that the interests of the managers are aligned with the objective of the general investment strategy for the Fund.

Below is a brief discussion of new assessments linked to emerging bond markets, high yield bonds, the regional and currency distribution, and investments that can promote the goals of consideration of environmental and social aspects and good corporate governance (known as ESG factors). See Chapter 2 for a more detailed discussion.

High yield bonds and emerging bond markets

It may now be natural in the work to further develop the Fund’s investment strategy to look more closely at the composition of the benchmark portfolio for fixed income instruments. This ensues partly from the fact that the Ministry stated in Report no. 16 (2007–2008) to the Storting that it would embark on an evaluation of emerging bond markets at a later stage in light of the fact that these markets were already included in the actual portfolio. Furthermore, there may be grounds to consider whether there are other aspects of the composition of the benchmark portfolio that ought to be reviewed in more detail, including whether it is appropriate to expand the portfolio to also include corporate bonds with high credit risk (i.e. higher than investment grade).

To this end, the Ministry invited Norges Bank and the Strategy Council to shed light on and give advice on the composition of the benchmark portfolio for interest bearing instruments. In a letter dated 3 November 2008, Norges Bank states that it is natural to consider including bond investments in emerging markets and corporate bonds with high credit risk in the benchmark portfolio. After an overall assessment that identified a number of major operational challenges, among other things, Norges Bank recommends not expanding the benchmark portfolio in these areas for the time being.

In a letter dated 20 March 2009 to the Ministry of Finance, the Strategy Council writes that in principle expanding the benchmark portfolio to also include high yield bonds and bonds issued in emerging markets is consistent with the desire to ensure further risk diversification and the desire to reap liquidity premiums.

However, the Council also points out that high yield bonds have some undesirable risk properties in periods of economic downturn in that the return tends to follow the return on equities, and run counter to the yield on government bonds. Including high yield bonds in the benchmark portfolio for fixed income securities might weaken the ability of the fixed income benchmark to protect the fund capital in periods of recession. Against this backdrop, and in light of the reputational risks, the Strategy Council recommends that the fixed income benchmark not be expanded to include high yield bonds at this point in time.

With regard to the issue of whether the benchmark portfolio for interest bearing securities should be expanded to include bonds issued in emerging markets (in local currencies), the Strategy Council refers to the fact that limited data makes it difficult to assess the historical return and risk of these kinds of investments. It is also pointed out that investment in emerging bond markets entails a number of operational challenges. Against this backdrop, the Strategy Council recommends not expanding the fixed income benchmark with bonds issued in emerging markets in local currencies at this juncture. At the same time, the point is made that the matter should be reconsidered when more information is available.

The Ministry has taken note of Norges Bank’s and the Strategy Council’s recommendations and that for the time being it is not recommended to expand the benchmark portfolio for interest bearing instruments with high yield bonds and bonds issued in emerging markets. The Ministry is therefore working on the assumption that it is not pertinent to implement this type of change in the imminent future. These issues will be reassessed, and the Storting will be informed of the findings at a later date.

The letters from Norges Bank and the Strategy Council have been published on the Ministry of Finance’s website (www.government.no/gpf).

The regional and currency distribution

Another topic that the Ministry would like to review in more detail is the regional and currency distribution in the benchmark portfolio for the Government Pension Fund – Global. The distribution here is based on the goal of preserving the international purchasing power of the Fund in the best possible way. Norway’s import pattern has been an important reference, along with the consideration of the broadest possible spread of the Fund’s risk and the Fund’s role as a financial investor with emphasis on low transaction costs.

The Ministry will continue to work on these issues. Regardless, any plans for changes in this area will be some way off in the future. Since this area is of strategic importance for the Fund, any changes will be presented to the Storting before they are implemented.

New investment programmes

In Report no. 16 (2007–2008) to the Storting, the Government announced that it would consider the financial and ethical effects of so-called positive screening as a tool to earmark a small portion of the funds in the Government Pension Fund – Global for investments in environmental technology or developing countries. The question of ear-marking was raised in the public consultation document about the evaluation of the ethical guidelines for the Government Pension Fund – Global:

“The Ministry will study in more detail the possibility of setting a small part of the Fund aside for ear-marked investment purposes within, for example, such as environmental technology or developing countries.”

Many of the bodies consulted have commented on this point and are generally positive to this kind of ear-marking.

The long investment horizon and the broad ownership both suggest that the Government Pension Fund must adopt a broader perspective on the consequences of positive or negative repercussions than is required by investors and corporate management who have a shorter investment horizon and portfolios with less risk diversification.

At the same time, the special characteristics of the Government Pension Fund – Global suggest that investments in unlisted markets such as real estate, infrastructure and unlisted equities should be increased. Other comparable funds emphasise in particular parts of their unlisted investments as examples of investments that can both yield an attractive financial return and contribute to positive social and environmental ripple effects.

The size of the Government Pension Fund – Global means that it is possible over time to build up specialised competence and increase risk diversification, at the same time as more cost-effective investments are made than are possible for smaller investors. At the same time, size is a general challenge in unlisted markets, because there are clear capacity constraints linked to how much that can be invested and how quickly. Consequently, it will necessarily take some time before the Government Pension Fund – Global can have such large investments in these markets that they have a significant impact on the Fund’s total return and risk.

Most comparable funds invest in unlisted equities through fund-like structures. Unlisted equity funds can be divided into two main categories: start-up funds (venture capital), which invest in relatively new enterprises with a potential for rapid growth, and acquisition funds (buyouts), which buy control of a company and then restructures the company and improves its profitability. Acquisition funds manage far more capital than venture capital funds.

Investments in infrastructure, such as electricity and water supplies, toll roads, airports and telecommunications, have traditionally constituted a very limited market. However, increasing private participation and the growing need for private funding have made these kinds of investments interesting for long-term financial investors. The market for this type of investments is expected to grow in the years to come. The return on and the risk associated with infrastructure investments will vary widely among the different projects, but it is normal to assume that the return and risk of developed projects will resemble the return and risk associated with investments in real estate. As is the case for real estate, investments in infrastructure will also contribute to diversifying the risk in the Government Pension Fund and to reaping gains over time by investing in less liquid assets.

In Recommendation no. 283 (2007–2008) to the Storting, a majority of the Standing Committee on Finance stated that the Government Pension Fund – Global should be allowed to invest in infrastructure. The majority referred to the fact that infrastructure is a rapidly growing asset class among institutional investors, partly as a result of the large needs for infrastructure investments in emerging economies. It was also pointed out that a fund that aims to represent best international practice in all aspects of its management must develop investment competence in the asset classes that major institutional investors are active in. The Committee also underlined the need to uphold the requirements concerning quality and verifiability of the fund management performance.

In this Report to the Storting, the Ministry proposes that a new investment programme be established aimed at environment related investment opportunities. Work will also be continued on assessing whether it is pertinent to establish an investment programme aimed at sustainable investment opportunities in emerging markets. In this respect, the Ministry is following up the suggestions made in connection with the consultation concerning the evaluation of the ethical guidelines.

In contrast to ear-marking money for a particular fund, the Ministry intends the new investment programme to run across asset classes and that the scope of the investment will vary according to the opportunities at any given time.

On the basis of the characteristics of the Fund, the Ministry is assessing various investment alternatives for the investment programme. For the environmental programme, sub-markets in the areas infrastructure and unlisted equities, environmental bonds and placement of parts of the listed equities portfolio based on an environmental index are most relevant. The investments must be aimed at eco-friendly assets or eco-friendly technology that is expected to yield indisputable environmental benefits, such as climate-friendly energy, improving energy efficiency, carbon capture and storage, water technology and management of waste and pollution. It has been decided that any infrastructure investments will have to target climate-friendly energy in particular. In the unlisted markets, any such investments will be made through funds, but it may be demanding to identify funds that focus exclusively on environmental projects. In these kinds of cases, a minimum framework must be defined for the funds’ environmental exposure.

Future assessments of a possible investment programme aimed at sustainable growth in emerging markets will consider investments in unlisted equities and infrastructure in emerging markets, among other things. These assessments will attach importance to finding a system for these kinds of investments that constitutes an appropriate and natural evolvement of the strategy of the Fund and that safeguards the need for good risk management. This will be more demanding in emerging markets than in the established markets that will make up most of the investments in the environmental programme.

There will normally be capacity constraints on investments in unlisted markets, and especially on investments in emerging economies and sub-markets for eco-friendly technology and energy. The size of the markets and access to good managers and funds represent capacity constraints. The Ministry is therefore estimating that the entire amount for the environmental programme and the possible investment programme aimed at sustainable growth in emerging markets will constitute around NOK 20 billion, invested over a five-year period. However, there is uncertainty linked to the capacity of the unlisted markets. NOK 20 billion will entail substantial investments in terms of the size of the markets and investments in other, comparable funds internationally.

Like the other investments in the Government Pension Fund – Global, the investment programme shall contribute to attainment of the goal of the highest possible financial return with a moderate level of risk.

Any unlisted investments might be in small sub-markets that it is difficult to get exposure to and where the risk is higher than for investments with a higher degree of risk diversification. Although the risk is higher than for other investments, the Ministry believes there are reasons to assume that these sub-markets will grow considerably in the long term and that they ought to be included as part of the Fund’s investments. Before investment can commence, a number of matters must be clarified, including assessments of environmental criteria, the expected return and risk of the investment alternatives, and the size and accessibility of the markets. Large parts of the investments will be able to be made through new asset classes, entailing among other things that satisfactory ways of measuring and evaluating return and risk must be found. In addition, required rates of return, risk limits, provisions for responsible management and reporting requirements must be defined to ensure fulfilment of the Ministry’s objectives for the investments.

The Ministry will present the Storting with a more concrete plan for the future work in this area in the National Budget for 2010.

1.2.3 Status of adopted changes to the strategy

Emerging equity markets

During 2008, two previously adopted changes in the investment strategy for the Government Pension Fund – Global were implemented through the benchmark portfolio for equities being extended to include small listed companies and more emerging markets. At year-end 2008, the benchmark portfolio for equities contained just under 7,700 companies, compared with 2,400 companies before the changes, and the number of markets in the benchmark portfolio classified as emerging markets has increased from 5 to 23. The implementation of these changes is discussed in more detail in Chapter 2.

Equity portion

It was previously decided to increase the equity portion of the benchmark portfolio from 40 per cent to 60 per cent. In consultation with Norges Bank, it has been decided to make a gradual transition to the new benchmark portfolio based on striking a balance between expected returns and transaction costs. Lower returns on equities than bonds in 2008 and historically large transfers to the Fund throughout last year led to major purchases of shares in 2008. Shares have generally been purchased at prices that are much lower than when the decision to increase the equity portion was adopted in summer 2007.

The gradual increase in the equity portion and the simultaneous drop in the market value of the world’s stock markets have resulted in a large increase in the Fund’s average ownership stake in the stock markets. In the space of one year, this share has risen from approx. 0.5 per cent to 0.75 per cent. This means that in 2008, the Fund has acquired rights to a share in all the future profits from another 0.25 per cent of the world’s listed companies.

However, the major drop in share prices in stock markets around the world towards the end of 2008 meant that at year-end, the equity portion was barely 50 per cent, compared with 53 per cent at the end of September 2008. The raising of the Fund’s equity portion will continue in 2009. The Fund’s holdings in the world’s listed companies will thus probably increase further.

Real estate investments

Following the Storting’s deliberation of Report no. 16 (2007–2008) to the Storting, the Ministry has continued to work on the plans to invest up to 5 per cent of the Fund in real estate.

The majority of the property investments are expected to be made through unlisted instruments. This poses challenges linked to a number of aspects, including the measurement and assessment of return and risk, and it is therefore necessary to establish special required rates of return, risk limits and reporting requirements to ensure fulfilment of the Ministry’s objectives for the investments in real estate.

In connection with the work on compiling regulations for real estate investments in the Government Pension Fund – Global, the Ministry has been advised by the U.S. company Partners Group. The advice from Partners Group is based on best practice for similar funds internationally. The Ministry is aiming to finalise the new regulations in 2009.

In 2008, the global real estate market had poor returns and suffered a significant drop in turnover. The Ministry is not intending to lay down a fixed investment plan for the coming years, as the phasing-in will have to be adapted to the market conditions and capacity. In the first few years, the investments will probably be concentrated in a number of chosen areas, and it will take time to build up a global real estate portfolio with a high degree of risk diversification. The Ministry assumes it will take several years before the real estate portfolio constitutes 5 per cent of the Fund.

The rules for investments in real estate will be included in a new regulation governing the management of the Government Pension Fund – Global. See the more detailed discussion of this in Section 1.5.4 and Chapter 6.

1.3 Responsible investments

1.3.1 Reporting on the work on the ethical guidelines in 2008

The ownership efforts of Norges Bank

Norges Bank is responsible for exercising the ownership rights of the Government Pension Fund – Global. The overall goal for the exercise of ownership is to safeguard the Fund’s financial interests. The ethical guidelines for the management of the Fund are premised on high returns over time being dependent on sustainable development, in the financial, environmental and social sense.

Norges Bank bases its exercise of the ownership rights of the Fund on the belief that it is better and more effective to concentrate on a few important topics than to spread the resources thinly over many areas. Norges Bank has therefore sought to identify a few concrete areas of commitment for its exercise of ownership. Importance is attached to ensuring that the topics are relevant for investors in general and for the Fund in particular, and that the topics are suitable for dialogue with companies and/or regulatory bodies, as well as increasing the prospects for real results. The topics must also be justifiable in light of the financial requirements. Pertinent areas of commitment include good corporate governance, children’s rights and protection of the environment.

Good corporate governance is important in order to ensure the Fund’s financial return over time and is a necessary condition to ensure that shareholders have real influence and dialogue with the companies. In this way, it is also a prerequisite for work on social and environmental issues. At the end of 2008, Norges Bank had established or continued dialogue with 16 companies concerning issues linked to corporate governance and shareholder rights.

A shareholder’s primary means of expressing his opinion is by voting at general assemblies. In 2008, Norges Bank took part in 7,871 general assemblies and voted on almost 70,000 issues. Norges Bank publishes its vote in each individual matter and has established principles for how it votes. Norges Bank has generally voted in favour of the proposals forwarded by the management of the companies in 2008, but voted against 11 per cent of the proposals. Norges Bank has voted against candidates for the board of directors if the board as a whole does not satisfy the bank’s expectations concerning sufficient independence from the company’s management or dominant owners. The bank also votes against managerial salary schemes in cases where there is no obvious link between performance and reward.

Norges Bank has prepared a document “NBIM Investor Expectations on Children’s Rights”, to clarify to companies what expectations the bank as an investor has concerning children’s rights. The document is aimed, in particular, at companies that operate in areas or sectors where there is a high risk of children’s rights being violated. In 2008, efforts in this area have concentrated on four markets: India, Brazil, China and West Africa. At year-end 2008, Norges Bank was in dialogue with 130 companies and involved in 19 corporate commitment projects linked to child labour, risk management in the supplier chain and the board’s competence in issues related to child labour. A commitment project with a company is far more extensive than a dialogue. Dialogue may be limited to making contact with the company, without any meetings being held, whereas a commitment project entails entering into a process with the company with defined goals and time limits. Commitment projects with companies will often run for several years.

Norges Bank regards it as important for a long-term investor to influence how companies work with or against government authorities when it comes to establishing binding climate legislation that can result in significant reductions in greenhouse gas emissions. The bank therefore takes steps to ensure that relevant companies that the Fund has a stake in have defined strategies that support sustainable economic and ecological development. The ownership work in this area is aimed especially at the energy sector and energy intensive sectors. In 2008, Norges Bank has focused in particular on the conduct of certain companies in connection with the national climate change regulations in the USA. Norges Bank has continued seven established commitment projects with U.S. companies, holding a total of 15 meetings with these companies. Norges Bank is part of the Carbon Disclosure Project (CDP) – an independent organisation that gathers and publishes information about companies’ emissions of greenhouse gases. Through its involvement in CDP, Norges Bank encourages transparency in the companies and in this way is also a catalyst in efforts to reduce emissions of greenhouse gases.

In November 2008, Norges Bank announced that the bank is taking part in a new petition by 135 funds calling for wealthy nations to reduce their emission of greenhouse gases by 25–40 per cent by 2020, calculated on 1990 levels, in keeping with the recommendations of the UN Intergovernmental Panel on Climate Change (IPCC).

Norges Bank also participates in other forms of collaboration and contact with other investors. For example, the Bank supports the development of new accounting standards (IFRS) concerning “country-by-country reporting” for companies engaged in extractive industries. These kinds of standards will serve to simplify valuation of the companies and counteract corruption and illegal use of closed jurisdictions (“tax havens” or “closed jurisdictions”). Norges Bank has also contributed to the development of the UN-initiated Principles for Responsible Investment (PRI). This is an important international platform that focuses on the investor role. The bank bases its exercise of ownership and interaction with other investors on these principles. The Ministry of Finance as formal owner of the Fund has adopted these principles. The principles are described in more detail in Chapter 3.

The ownership efforts of Folketrygdfondet

Folketrygdfondet is responsible for exercising the ownership rights through management of the Government Pension Fund – Norway. The Executive Board of Folketrygdfondet has laid down guidelines for the exercise of ownership in the Fund pursuant to which the overarching objective is to safeguard the financial interests of the Fund. Folketrygdfondet has defined ethical principles for its investment activities. These principles are an integrated part of the guidelines for Folketrygdfondet’s exercise of ownership, in order to help promote long-term wealth creation. Good corporate governance and corporate management shall promote the rights of owners and other stakeholders in relations with the companies, as well as ensure that the management mechanisms of the companies work appropriately.

In order to safeguard shareholder value, Folketrygdfondet deems it important to follow up the managerial salary policies of the companies. This involves evaluating whether managerial salary schemes are structured in such a manner as to actually contribute to more effective and performance-oriented corporate management, etc. Folketrygdfondet also examines any option schemes, and what these imply in terms of value transfer from the shareholders to companies’ management teams.

In order to ensure the most objective and precise assessment of the ethical attitudes and actions of the companies, Folketrygdfondet gathers information from open sources such as annual reports, the media and the Internet. Folketrygdfondet also gathers information directly from the companies through a survey of all the Norwegian companies in which the Fund holds ownership interests. The survey relates to the integration and handling of environmental and social concerns and was first carried out in 2006. Companies that do not respond to the survey or that provide unsatisfactory answers are followed up individually. Folketrygdfondet has a consistently positive impression of the level of attention, standards and practices in the companies that have taken part in this survey so far.

Folketrygdfondet has been involved in the development and launch of the project Bærekraftig verdiskaping (Sustainable Value Creation) – a collaboration between 12 of the largest institutional investors in Norway. Through this collaboration, these investors have carried out a questionnaire survey among the companies that were admitted for listing on the main index of the Oslo Stock Exchange in 2008. The findings of the survey were presented on 10 December 2008. The goal of the project is to influence Norwegian listed companies to work towards sustainable development and long-term value creation.

Exclusion of companies

The Council on Ethics for the Government Pension Fund – Global is an independent advisory body charged with submitting recommendations to the Ministry of Finance on the screening and exclusion of individual companies, on the basis of the ethical guidelines for the Fund. The Ministry decides whether a company is to be excluded from the Fund and bases its decisions on the Council’s recommendations, among other things, but will normally also seek Norges Bank’s assessment as to whether the Bank is able, through its exercise of ownership, to reduce the risk of contribution to grossly unethical conduct. The Council on Ethics has five members and maintains its own seven-person secretariat. The secretariat conducts surveillance of the companies the Fund owns shares in and investigates and prepares matters for the Council.

Companies may be excluded from the Fund pursuant to the ethical guidelines for the Government Pension Fund – Global through:

negative screening to identify companies producing weapons that violate fundamental humanitarian principles in their normal use, or that sell weapons or military material to states mentioned in the supplementary guidelines for management of the Fund, and
exclusion of companies if an investment entails an unacceptable risk of contributing to actions or omissions that must be deemed grossly unethical.

So far 32 companies have been excluded from the investment universe of the Fund. Of these, 22 were excluded because they contribute to the production of inhumane types of weapons. The other ten companies were excluded to avoid an unacceptable risk that the Fund will contribute to serious or systematic human rights violations or severe environmental damage. In 2008, the Ministry excluded a total of six companies, of which one was excluded because the company produces cluster weapons that are prohibited pursuant to the Convention on Cluster Munitions. The Ministry also excluded one company that sells military materiel to Burma. In addition, the Ministry has excluded four companies on the basis of an assessment that the companies’ operations contribute to severe environmental damage.

1.3.2 Evaluation of the ethical guidelines for the Government Pension Fund – Global

Introduction

The main aim of the evaluation of the ethical guidelines is to assess whether the guidelines are fulfilling their intended purpose, and maintain broad political support for the ethical guidelines, as well as to gather any feedback that may contribute to strengthening the profile of the Government Pension Fund – Global as a responsible investor.

As part of the evaluation process, the Ministry has carried out a number of activities to gather information and views from Norwegian and international stakeholders alike. This includes a public consultation process where more than 50 bodies gave feedback consisting of proposals for changes and improvements to the current system to ensure that ethical concerns are safeguarded in the management of the Fund.

The main conclusions from the evaluation show that the ethical guidelines are based on a solid foundation and have proven to be robust over time. Many important aspects can therefore be maintained. In light of international developments and experiences with the ethical guidelines so far, the Government is proposing some changes and adjustments to the current goals and instruments (see Box 1.1). At the same time, a number of additional measures are being proposed in order to bolster and refine the efforts to ensure the Fund is a responsible investor.

Textbox 1.1 General overview of the results of the evaluation of the ethical guidelines for the Government Pension Fund – Global

The results of the evaluation process and the changes and new measures being planned for, can be summarised by the following main points:

Highlight the Government Pension Fund – Global’s position as a responsible investor by

clarifying the overall objective for work as a responsible investor,
establishing a new investment programme on environment, and assessing a new investment programme for development in emerging markets,
initiating a broad study to assess how the challenges of climate change can affect the financial markets and how investors ought to act in light of this, and
the Ministry adopting the UN Principles for Responsible Investment (PRI) and participating directly in international initiatives so as to be involved in putting on the agenda how the concerns of good corporate governance and environmental and social responsibilities can most efficiently be safeguarded within the role of financial investor.

Continue the high ambitions in the operational management by

requiring that Norges Bank integrates the consideration of good corporate governance and environmental and social responsibilities into its operations with regard to several parts of the management of the Fund, in keeping with the bank’s adoption of the PRI principles,
asking Norges Bank to prepare more documents outlining its expectations. The Ministry will ask for expectations documents within the areas environmental protection and corporate governance. With regard to environmental protection, a document regarding companies’ strategy to combat climate change is regarded as particularly relevant. A document regarding transparency and reporting on payment flows in companies may help counteract use of secrecy jurisdictions to hide illegal actions,
carrying out public consultations in connection with major changes in the priority areas for the exercise of ownership, and
laying down new requirements concerning transparency and reporting linked to the exercise of ownership.

Further develop the exclusion mechanism by

excluding tobacco manufacturers from the Fund’s investment universe,
clarifying which issues the Ministry believes should be given priority when making decisions on exclusion, including the expected impact of this kind of decision,
making the content of the various criteria for exclusion more available to the companies and others,
facilitating a description of the Council on Ethics’ work methods and publication of a description of the principles for selecting companies that are to be studied more closely, and
ensuring that a procedure be devised and published for how cases pertaining to reinclusion of excluded companies in the portfolio will be handled.

Improve the interaction between the instruments by

making sure that any assessment of whether a company should be excluded considers whether there are other instruments better suited to achieving the Fund’s main goals as a responsible investor,
establishing a watch list of companies as a new instrument, and
facilitating a system for interaction and coordination between the Council on Ethics and Norges Bank.

A broad approach

To maintain the Fund’s solid position as a responsible investor, the Ministry proposes that good corporate governance and environmental and social factors shall be integrated to a greater degree as relevant factors in the overall work on management of the Fund. This is in line with international developments and will entail a raised ambition level in this area. The role as responsible investor will be one of the premises for the Ministry of Finance’s work on investment strategy for the Fund (see the more detailed description in Chapter 2). Furthermore, the Ministry will demand that such considerations shall be safeguarded at other stages of the investment process, in accordance with the PRI principles.

According to the current guidelines, there are three tools for promoting the Fund’s ethical obligations: exercising ownership rights, negative screening and exclusion of companies from the universe of permitted investments. The new approach will provide more tools in the role of responsible investor. The new tools will be added to the existing tools and are not intended to undermine their significance.

Clarifying an overarching objective

The ethical guidelines do not specify overarching goals or targets that apply to the guidelines as a whole. The two mechanisms – exercise of ownership rights and the exclusion mechanism – are based on different objectives, respectively ensuring the long-term financial interests of the Fund and avoiding involvement in grossly unethical acts or omissions. The Ministry proposes clarifying the overarching objective for the Fund as a responsible investor (see the more detailed description in Section 4.3.2 and Box 4.2).

The overarching objective will guide the work as a responsible investor and the instruments that can be employed on behalf of the Fund. In relation to the current guidelines, the proposal represents stronger emphasis on the desire to contribute to positive changes in sustainability issues and with respect to companies’ conduct in corporate governance and social and environmental matters.

Continuing and adjusting the exclusion mechanism

The Ministry wants to continue its policy that the Fund must not have investments that entail contribution to companies’ serious or gross violations of fundamental ethical norms, pursuant to the same criteria as today. In addition it intends to exclude tobacco producers from the Fund’s investments (see below). There are also plans to further clarify the issues that the Ministry believes ought to be given priority when making a decision on exclusion. For example, the Ministry believes that it must be possible to attach importance to the expected effects of an exclusion when using this instrument, beyond the fact that the aim is to avoid contribution to grossly unethical activity. The exclusion mechanism ought not to be regarded in isolation, detached from other work on responsible management.

The Fund’s increased investments in emerging markets will entail new challenges for application of the ethical guidelines. This is discussed separately. The same applies to application of the ethical guidelines in war and conflict zones.

Measures are going to be introduced to ensure predictability for the companies in the portfolio. The Ministry will work to make the interpretation and the content of the various criteria for exclusion more readily available by amending the way it organises information. The Ministry believes publication of the Council on Ethics’ methods and principles for selecting companies that are to be studied more closely, is an appropriate measure. The Ministry will also ensure that a procedure for reinclusion of excluded companies in the portfolio is prepared and published.

Negative screening of companies from the portfolio on the basis of the companies’ products

The Ministry is intending to continue negative screening of companies that manufacture weapons that violate fundamental humanitarian principles in their normal use and companies that sell weapons or military material to states mentioned in the supplementary guidelines for management of the Fund. At present, this means Burma. In addition, a new screening criterion is being planned to cover companies that produce tobacco.

Negative screening of companies that produce tobacco has been considered on several occasions. Several commenting bodies have said that tobacco should be included in the screening mechanism. Negative screening of entire product groups is a very powerful tool and ought to be restricted to exceptional cases where it can be shown that there is clear consensus among the population of Norway. There have been developments in the period after the Graver Committee proposed the current ethical guidelines, both internationally through a convention dedicated to tobacco control (which came into force in February 2005) and nationally through restrictions of the Smoking Act in 2004, which must be deemed to represent such a clear shared set of values relating to screening of tobacco producers. With respect to questions of excluding other unhealthy or socially unbeneficial services from the Fund’s investment universe, including alcohol, there has not been the same degree of norm development that can provide a similarly clear anchoring nationally or internationally. In addition, tobacco is a product in a class by itself in that it can cause serious health problems when used as intended.

In the Ministry’s opinion, it is the production of tobacco that shall form the basis for screening. Thus, selling tobacco will not be encompassed by this criterion. The Ministry will study in more detail different methods for delimiting screening of companies that produce tobacco. Trying to operate with zero tolerance for all tobacco production may prove to entail particular challenges, although this will be the starting point when the criterion is formulated. Screening of companies that produce tobacco from the Government Pension Fund – Global is discussed in more detail in Chapter 4.

Exercise of ownership rights

The Ministry intends to continue the main principles of the current ethical guidelines as far as exercising ownership rights is concerned. In addition to the work that is already being done in this area, the Ministry is planning a number of new measures that will support a high level of ambition and a high degree of transparency concerning how ownership rights are safeguarded. The Ministry will formally require that Norges Bank integrates the consideration of good corporate governance and environmental and social responsibilities into its operations with regard to several parts of the management of the Fund, in keeping with the PRI principles that the bank has adopted. The bank will also be subject to new formal requirements concerning transparency and reporting on work linked to the ownership efforts.

Norges Bank has selected a number of focus areas for exercising ownership rights. The Ministry supports this. Choosing focus areas is an important issue, and the Ministry proposes introducing a process whereby it is consulted in advance about important changes to or expansion of focus areas. The Ministry may decide that significant changes must be subject to a public consultation process before a final decision is made. In the Ministry’s opinion, publication of the document detailing the bank’s investor expectations on children’s rights has been very successful, and the bank ought to compile more publications outlining its expectations. An important area in this context will be expectations linked to environmental issues. A document on companies’ strategies to combat climate change is deemed particularly relevant. The Ministry is also going to ask Norges Bank to prepare an expectations document regarding transparency and reporting on payment flows in companies. Clear expectations from investors like the Government Pension Fund – Global in this area can counteract use of closed jurisdictions to conceal unlawful acts, such as corruption, money laundering and tax evasion, etc., and in this way contribute to better functioning, legitimate markets. Publication of more expectations documents would help create transparency about the work related to ownership rights and also safeguard the companies’ need for predictability.

Interaction between the various instruments

In line with what has been said above about an overarching objective for working as a responsible investor, the Ministry believes that there is a need to coordinate the use of instruments to a greater degree than the current system provides. The same applies to the activities of Norges Bank and the Council on Ethics.

The Ministry is planning a new provision whereby before deciding to exclude a company, it must be assessed whether other instruments might be better suited to achieving the Fund’s objective as a responsible investor. This is already partly in place in that on receiving a recommendation on exclusion of a company, the Ministry asks Norges Bank whether the exercise of ownership might be used to reduce the risk of new breaches of the guidelines. This will yield a more targeted use of the instruments as a group and will help ensure that exclusion really is the last option when other measures have been considered. The Ministry is also planning to formalise the use of a watch-list as a new instrument. In some cases, the decision to put a company under observation may be a good alternative, as it can be assumed that this will encourage the company to amend its conduct or will prompt the company to provide more information to clarify the situation. It is thought that the use of a watch-list will be particularly apt in cases where there is great uncertainty about future developments.

Closer collaboration and coordination will necessitate adaptations in the mandates and methods of both Norges Bank and the Council on Ethics. Once the Storting has considered the results of the evaluation, the Ministry will continue to work on the details of a new system in dialogue with the Council on Ethics and Norges Bank.

Market developments

The Ministry’s assessment in last year’s report on the management of the Fund was that the development in the market value of the Government Pension Fund over the previous five years (i.e. 2003–2007) was very positive, taken as a whole, despite the fact that performance in 2007 was affected by the turmoil in the international financial markets in the second half of the year (see Chapter 1 of Report no. 16 (2007–2008) to the Storting). This reflected both strong average returns on the benchmark portfolio of the Fund and that excess returns had been generated in active management. The development in the value and management performance of the Fund in 2008 changes this picture significantly.

After a period of strong growth in the world economy (see Figure 1.4a), major difficulties in the financial markets since summer 2007 have contributed to a sharp decline and deterioration of the economic outlook internationally. In several countries, the authorities have implemented comprehensive measures in recent months in an attempt to stabilise the financial markets and dampen the impact of the financial crisis on the economy. Despite significant monetary policy and financial policy actions and other special measures in many countries aimed at providing capital for the banks, it seems that the growth in the world economy in 2009 will be weaker than for many decades.

The international financial crisis has had serious repercussions. After several years with a broad upturn in stock markets, share prices have plummeted during the last year (see Figure 1.4b). Further, the gradual tightening of American and European monetary policy in the years 2005 to 2007 has now been more than reversed, and bond yields have fallen significantly in 2008, (see Figure 1.4c). The premiums in the international money market have risen steeply as a result of a lack of confidence in the financial system, and it has become much more expensive for banks and other, non-financial enterprises to get long-term funding. The financial crisis has led to a sharp increase in the compensation required by investors when investing in securities involving credit risk (see Figure 1.4d).

The volatility that we have seen in the international financial markets for almost two years now has meant that many banks and financial institutions have had to post huge losses on securities and lending. This development reflects the fact that the widespread use of new, complex financial instruments made it difficult to ascertain who had incurred a loss, and confidence among banks and financial institutions has thus been severely undermined. The financial crisis entered a more serious phase in mid-September 2008, with the bankruptcy of the American investment bank Lehman Brothers. The credit flow in the money and credit markets slowed up, and many banks faced problems refinancing their loans. The situation has become so difficult for many financial institutions in the USA and Europe that the authorities have had to implement rescue packages to ensure continued operation.

1.4.2 The return on the Government Pension Fund

It is the real return on the Government Pension Fund in international currency that is relevant for purposes of measuring developments in the purchasing power of the Fund. According to Table 1.1, the real return (after the deduction of management costs) on the Government Pension Fund – Global’s investments in 2008 was -24.4 per cent, when measured in local currency. This is the poorest performance since the Fund was established. The Government Pension Fund – Norway achieved a real return of -28.8 per cent last year – again the weakest result in the Fund’s history.

Average annual net real return on the Government Pension Fund – Global since the beginning of 1997, which was 4.3 per cent at year-end 2007, had dropped to roughly 1.5 per cent at year-end 2008 (see Table 1.1).

In Report no. 16 (2007–2008) to the Storting, the Ministry stressed that there is considerable uncertainty linked to estimates of return, and historically, experience shows that return fluctuates widely. The risk associated with the return on the Fund is discussed in more detail in Box 1.2. It is stated here that there have been significant fluctuations in realised real returns, even when measured over longer periods of time. In the Ministry’s opinion, the experience we have now does not provide grounds for changing the estimate of 4 per cent real return as a reasonable expectation for long-term return. This estimate is based on assumptions that the Strategy Council has previously described as reasonable and appropriate for analyses of long-tern return and risk. In this context, the Strategy Council referred to estimates from other funds, among other things.

The subsequent discussion of the management performance is based on nominal return data, since the goal is to compare results achieved with the return on a benchmark portfolio. Not much information would have been added by adjusting the return data for inflation for this purpose.

Table 1.1 Annual real returns on the Government Pension Fund – Global¹ and the Government Pension Fund – Norway² , less management costs. 1997-2008. Per cent.

Net real return	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008	1997-2008
Pension Fund – Global	7,15	8,20	10,93	0,35	-3,66	-6,62	10,75	6,30	8,46	5,57	1,05	-24,38	1,50
Pension Fund – Norway	5,60	-2,29	6,24	3,08	0,97	0,49	13,31	10,12	7,28	8,55	8,43	-28,77	2,12

¹ Geometric real return in international currency calculated on the basis of a weighted average of consumer price growth in the countries included in the benchmark portfolio on the Fund.

² Geometric real return in Norwegian kroner.

Source Norges Bank, Folketrygdfondet og Ministry of Finance

The return on the Government Pension Fund – Global

The nominal return on the Government Pension Fund – Global was -23.3 per cent in 2008, as measured in foreign currency. This is the weakest result achieved in the entire period (see Table 1.2). Measured in Norwegian kroner, the return on the Fund was -6.7 per cent in 2008. The fact that the return in kroner is considerably less negative than the return measured in the Fund’s currency basket is due to the depreciation of the Norwegian krone against the currencies in the Fund’s currency basket in 2008.

The nominal returns on the sub-portfolios of the Government Pension Fund – Global since the beginning of 1998 are illustrated in Figure 1.7.

The risk associated with the Government Pension Fund – Global, as measured by the standard deviation of returns, was roughly 14 per cent in 2008, when measured nominally in local currency. By comparison, the average level of risk for the last five years was 7.8 per cent (see Table 1.2).

Table 1.2 Average annual return and annual standard deviation of returns on the Government Pension Fund – Global, as measured in the Fund’s currency basket, 1998-2008. Per cent and percentage points.

	Entire period	Last five year	2008
Benchmark portfolio (currency)
Average return per year	2,98	3,16	-19,93
Standard deviation	6,42	7,00	12,60
Actual portfolio (currency)
Average return per year	2,94	2,74	-23,30
Standard deviation	6,88	7,81	14,01
Excess return (NOK)
Average return per year	-0,04	-0,43	-4,10
Standard deviation (tracking error)	0,76	1,03	1,84

Source Norges Bank and Ministry of Finance.

2008 was a dramatic year for the financial markets. The international stock markets saw their value almost halved, and there has not been another single year with such poor returns in the last 100 years as 2008. These factors are also reflected in the performance of the Government Pension Fund – Global.

According to the calculations of the risk associated with the return on the overall benchmark portfolio for the Government Pension Fund – Global, such poor results as were achieved in 2008 will occur very rarely (see Box 1.2).

Textbox 1.2 The risk associated with the return on the Government Pension Fund – Global

Over time, a higher return is expected on the equity investments in the Fund than on the investments in fixed income securities, because the risk associated with equities is higher. This higher risk manifests itself in large fluctuations in the return on the Fund. The choice of equity portion is largely a choice of the degree of fluctuation that can be accepted on the return of the Fund and how this risk is weighed up against the higher expected returns in the long term.

In Report no. 16 (2007–2008) to the Storting, the risk associated with the return on the Government Pension Fund’s investments was described in three ways: a simulation model was used to describe potential future developments in the Fund; historical returns in the equity and bond markets were used to describe fluctuations in returns over the last hundred years; and historical returns in previous financial market crises were used to illustrate what the return on the Fund would have been in these periods.

The various approaches were used to produce an estimate of normal fluctuations in the Fund, expressed in the form of statistical measures of the uncertainty linked to expected and historical average return. Developments in both the equity and the fixed income market in 2008 were unusual. At the same time, these analyses show that the negative real return observed in 2008 is within the range of what must be expected, on rare occasions with the current equity portion. However, it is uncertain how seldom this kind of event is as it is difficult to model rare events, and because even with 100 years’ historical data, we have few observed falls in value of this magnitude.

Using simulations based on the same parameters as described in Report no. 16 (2007–2008) to the Storting, it is estimated that such a poor result as was achieved in 2008 can be expected to occur very seldom: roughly once every 350 years. However, calculations based on historical returns indicate that such low returns can occur more frequently. Historical real returns on a portfolio that resembles the portfolio the Fund has had in the last year would have been lower than -21.0 per cent in two of the years since 1900 (1920 and 1974). The reason that the estimate based on a model simulation deviates so widely from the historical data is partly that the distribution of probability on which the simulations are based underestimates the frequency of sharp drops in the financial markets. However, the simulations presented in the two previous reports to the Storting on the management of the Government Pension Fund have had the goal of shedding light on return and risk over longer time horizons than one year (horizons of 15 years have been chosen). The model will work better over longer time horizons. The models and the underlying assumptions will be documented on the Ministry’s website (www.government.no/gpf).

Greater annual fluctuations in returns are a natural outcome of increasing the equity portion to 60 per cent. At the same time, expected long-term real return will also increase. The estimates of long term risk (volatility) and real return (geometric) shown in Report no. 16 (2007–2008) to the Storting, are 9.2 per cent and 4.2 per cent respectively, measured in local currency. It has been calculated that the probability of the real return over a 15-year horizon being lower than 4 per cent is roughly 46 per cent, whereas the probability of the real return being less than zero over a 15-year period is around 4 per cent. Similarly, a 68 per cent probability has been calculated for the real return over a 15-year period being between 1.8 and 6.7 per cent, while there is a 95 per cent probability that it will be in the range -0.5 to 9.3 per cent. Figure 1.5 illustrates these probability intervals and compares them with the average real return over rolling 15-year periods since 1900 of a global portfolio consisting of 60 per cent equity and 40 per cent bonds and with a regional distribution similar to the one in the Government Pension Fund – Global. Historical return over these rolling 15-year periods is generally within the simulated 95 per cent probability intervals, but there are also periods with higher and lower returns. The figure demonstrates that the fluctuations in the simulated 15-year returns are slightly less extreme. Over even longer periods of time, historical real return is seldom outside the simulated probability intervals, see Figure 1.6, which shows rolling 30-year rates of real return. The return for the period is outside the 95 per cent interval in only three years (2004, 2006 and 2007), and then it is higher. This indicates that the model calculations are consistent with historical real returns, assuming a long investment horizon.

Figure 1.5 Annualised (geometric average) real return over rolling 15-year periods since 1900 of a global portfolio consisting of 60 per cent equity and 40 per cent bonds and with a regional distribution similar to the one in the Government Pension Fund – Globa... — Figure 1.5 Annualised (geometric average) real return over rolling 15-year periods since 1900 of a global portfolio consisting of 60 per cent equity and 40 per cent bonds and with a regional distribution similar to the one in the Government Pension Fund – Global.^{1, 2}

Figure 1.6 Annualised (geometric average) real return over rolling 30-year periods since 1900 of a global portfolio consisting of 60 per cent equity and 40 per cent bonds and with a regional distribution similar to the one in the Government Pension Fund – Globa... — Figure 1.6 Annualised (geometric average) real return over rolling 30-year periods since 1900 of a global portfolio consisting of 60 per cent equity and 40 per cent bonds and with a regional distribution similar to the one in the Government Pension Fund – Global.^{1, 2}

As illustrated in Figure 1.8, there have been relatively large fluctuations in the returns on the Fund in the past too. The figure shows the fluctuations in quarterly returns on the benchmark portfolio for the Fund, demonstrating that the spikes in the best quarters match or are bigger than the slumps in the worst quarters, with the exception of the fourth quarter 2008. However, what distinguishes the developments last year from those in previous periods is the number of quarters in a row with negative returns. The fluctuations underline the importance of measuring performance over a long period.

Figure 1.7 Accumulated nominal return on the sub-portfolios of the Government Pension Fund – Global, as measured in the Fund’s currency basket. Index as per yearend 1997 = 100

Figure 1.8 Quarterly nominal returns in the Government Pension Fund Global’s benchmark portfolio

The investments in the Government Pension Fund have a long-term perspective. The Government Pension Fund is large and will have a long lifespan. In contrast to other pension funds, the assets are not ear-marked for specific liabilities, and the capital of the Fund is fully funded by equity. There is little risk that the owner of the Fund will have to make large withdrawals over a short period of time. There is therefore little risk of negative returns alone leading to the Funds having to sell its assets. The situation is thus very different to that of many other international investors, who have had to sell risky assets at low prices because of the financial crisis and capital adequacy requirements. Against this backdrop, the Government Pension Fund – Global is well positioned to bear the risk the Fund is currently facing. At the same time, the slump in share prices in the international stock market in 2008 also entails that the shares being purchased as a result of the decision to raise the Fund’s equity portion are being bought at much lower rates than predicted when the decision to increase the equity portion of the Fund was made (see Section 1.2.3). The Fund’s average stake in the international stock markets is now more than 0.75 per cent, which is a large increase on the year before. This yields a correspondingly larger right to future profits from listed companies all over the world.

Norges Bank may, in its management of the Government Pension Fund – Global, deviate from the benchmark portfolio stipulated by the Ministry, within a limit for expected tracking error of 1.5 percentage points (see Section 1.2). The contribution from such active management is measured on an ongoing basis by way of developments in the value of the Fund being compared to developments in the benchmark portfolio. In 2008, the return on the Government Pension Fund – Global was 4.1 percentage points less than the return on the benchmark portfolio, measured in Norwegian kroner. This corresponds to NOK 88 billion. Measured in the Fund’s currency basket, excess return was -3.4 per cent. Return measured in the Fund’s currency basket provides the best expression of the change in the international purchasing power of the Fund. In the past, the difference between the excess return as measured in kroner and in foreign currency was relatively minor. In the past, the Ministry of Finance has reported excess return in Norwegian kroner and is continuing to do so in this Report, to ensure comparison with previous years. The Ministry will consider whether the measuring principle ought to be changed in the future.

From 1998 until the end of 2008, Norges Bank has had an annual average negative excess return of 0.04 percentage points. Active management in 2008 achieved its poorest results since the Fund was established.

Up until 2006, Norges Bank had reported an excess return compared with return on the benchmark portfolio for nine years running. In the two years 2007 and 2008, active management produced a negative excess return. The excess return achieved in the years 1998–2006 is outweighed by the negative excess return from active management in the last two years. At the same time, there have been sizeable differences in the results achieved by the management of the equity and fixed income assets. Although both equity and fixed income management produced a negative excess return in 2008, the largest share of the total negative excess return came from the management of the fixed income assets. Taken over a longer period, Norges Bank has achieved a positive excess return in its equity management, but a negative excess return on fixed income management.

The disappointing results within fixed income management are primarily due to the fact that Norges Bank’s active bond investments have generally been exposed to the same level of underlying systematic risk (liquidity risk and credit risk). Large positions that were built up in a situation where the risk premium on liquidity and credit was low fell in value simultaneously when the market was driven by major adjustments in valuations of these risk factors. In its report on the management of the Government Pension Fund – Global in 2008, Norges Bank writes that the crisis in the financial system revealed that risk-taking in the various mandates for fixed income management was not sufficiently independent and that many of the management mandates in the bank had a combined exposure to liquidity and credit risk that was not observed in normal market conditions. The bank’s report provides a more detailed account of the decomposition of the negative excess return on different management strategies (see the discussion in Box 5.3 in Chapter 5 of this report).

The Ministry has previously described the developments in the excess return achieved in the fixed income portfolio, pointing out that seen over a longer period, Norges Bank has reaped liquidity and credit premiums, which is analogous to selling insurance against liquidity and credit crises (see Report no. 16 (2007–2008) to the Storting). The crisis in the credit markets that started in autumn 2007 has led to large falls in the value on these positions and can be compared with an insurance company having to pay out insurance to policyholders in connection with an accident.

The realised losses on the investments in the fixed income portfolio still constitute a small part of the total negative excess return. The current yield is high, which not only reflects that credit risk has increased, but also high liquidity and risk premiums in the markets. The valuation of these bonds is an estimate of their real value in the current market conditions. Estimates will be subject to change, reflecting developments in the markets. Norges Bank states that they are expecting to hold most of these securities until maturity. The face value will be received on maturity for all the securities that have not defaulted.

The results achieved by Norges Bank’s active management must be assessed over a long period, but in the Ministry’s opinion performance in 2008 was not satisfactory. In this context, the Ministry refers to the measures that Norges Bank has implemented related to active management (see the more detailed discussion in Section 1.5).

Table 1.3 Average annual return (nominal) and annual standard deviation of returns on the Government Pension Fund – Norway, measured in kroner 1998-2008. Per cent.

	Entire period	Last five years	2008
Benchmark portfolio
Average return per year	3,54	1,00	-28,79
Standard deviation	8,53	11,70	21,79
Actual portfolio
Average return per year	4,18	1,96	-25,09
Standard deviation	7,90	10,86	20,55
Excess return
Average excess return per year	0,64	0,96	3,70
Standard deviation (tracking error)	1,46	1,69	2,46

Source Ministry of Finance and Folketrygdfondet.

The return on the Government Pension Fund – Norway

The Government Pension Fund – Norway adopts a long investment horizon. The fact that Folketrygdfondet, in its capacity as manager of the assets of the Fund, is a large player in a relatively small capital market may entail certain limitations as to the scope for large changes to the composition of the portfolio in the short term. In line herewith, the Ministry is focusing on performance developments over time in its follow-up of Folketrygdfondet’s performance.

The return on the Government Pension Fund – Norway in 2008 was -25.1 per cent, measured in Norwegian kroner (see Table 1.3). This is the poorest performance achieved in the period 1998–2008, and is due to the crisis in the stock markets last year. The nominal returns on the sub-portfolios of the Government Pension Fund – Norway are illustrated in Figure 1.9.

Figure 1.9 Accumulated nominal return on the Government Pension Fund – Norway, measured in NOK. Index as per yearend 1997 = 100

The risk in the Government Pension Fund – Norway in 2008 was 20.6 per cent, as measured in kroner. This is almost a doubling of the risk level compared with the last five years as a whole. Some of the increased risk can be linked to the termination of the sight deposit arrangement in 2006.

Folketrygdfondet’s active management achieved good results in 2008. The return on the Government Pension Fund – Norway was 3.7 percentage points higher than the return on the benchmark portfolio. This is the highest excess return achieved in the entire period 1998–2008. The Ministry is pleased with Folketrygdfondet’s management performance in 2008.

1.4.3 Management costs

Norges Bank shall, pursuant to the management agreement entered into with the Ministry of Finance in respect of the Government Pension Fund – Global, be compensated for the actual management costs, up to a maximum limit, which for 2008 has been fixed at 0.10 per cent (10 basis points) of the average market value of the Fund. The maximum compensation limit is determined on the basis of a number of factors, including information on costs associated with this type of management in funds of corresponding size. The Ministry of Finance commissions the Canadian company CEM Benchmarking Inc. to prepare the analyses on which these cost comparisons are based. In addition to the reimbursement of costs up to the maximum limit, Norges Bank is compensated for such part of the fees of external managers as are incurred as a result of the excess return achieved.

Management costs for 2008, exclusive of performance-related fees, were NOK 1,678.4 million. This represented an increase of 10.8 per cent over 2007. The average size of the Fund decreased by 12.9 per cent, implying that costs measured as a share of the average portfolio dropped from 0.08 per cent (8 basis points) in 2007 to 0.078 per cent (7.8 basis points) in 2008. Consequently, management costs exclusive of performance-related fees are well below the maximum limit. Including performance-related fees paid to external managers, costs amounted to NOK 2,165.2 million, which represents 0.11 per cent (11 basis points) of the average market value when calculated as an annual rate.

In addition to management costs, costs are also incurred linked to completion of the individual transactions. Norges Bank submits regular reports on transaction costs linked to management of the Government Pension Fund – Global. In this context, the Ministry would like to point out that Norges Bank has done a lot to improve the efficiency of the transaction process within equity management. In its annual report for 2007, the bank stated it had improved profitability by means of electronic trading and that it has used better access to trading data to reduce total trading costs in the Fund. According to Norges Bank’s calculations average costs on share trading dropped from over 40 basis points in 2003 to roughly 25 basis points in 2007, entailing annual savings on transaction costs of several hundred million kroner. At the same time, the bank also points out that decreasing volatility in the markets is another important explanation for the drop in costs linked to trading shares.

The costs incurred by Folketrygdfondet in its management of the Government Pension Fund – Norway in 2008 represent NOK 85.7 million, or 0.084 per cent (i.e. 8.4 basis points) of the average assets, not including extraordinary pension costs and depreciation. The management costs are thus well within the defined limit for management fees (see Appendix 8 of Report no. 16 (2007–2008) to the Storting). The management costs associated with the Government Pension Fund – Norway are not entirely comparable to the costs associated with the management of the Government Pension Fund – Global. Norges Bank has opted to use external management mandates, which when taken in isolation are more expensive than internal management. Furthermore, the asset management carried out by Norges Bank is more extensive, partly because the assets of the Government Pension Fund – Global are spread across many more countries and companies than those of the Government Pension Fund – Norway. On the other hand, asset management is subject to economies of scale that Norges Bank benefits from.

There has been a significant rise in costs from 2007 to 2008 in Folketrygdfondet’s management of the Government Pension Fund – Norway. Part of this increase can be ascribed to the fact that in connection with the implementation of the new management framework for the Government Pension Fund – Norway, more stringent requirements have been set regarding risk management, control and reporting (see Report no. 16 (2007–2008) to the Storting). Against this backdrop, large investments have been made in new control systems to meet the new requirements in the framework. Much of the increase in expenses from 2007 to 2008 are one-off outlays, but it must nevertheless be expected that the costs of managing the Government Pension Fund – Norway will be higher in the future than they have been in the past, partly as a result of the current expenses linked to operating the new control systems.

1.5 Development of the management framework for the Government Pension Fund

The Government Pension Fund consists of two portfolios: the Government Pension Fund – Global and the Government Pension Fund – Norway. The management framework for the Fund must be adapted to the special characteristics of each portfolio, including the size of the fund, inflow of capital, investment strategy and organisational aspects. The Ministry works constantly to refine and develop the provisions in the framework.

1.5.1 The management framework for the Government Pension Fund – Global

The Government Pension Fund – Global is regulated by the following sets of rules (see Appendix 1):

Act of 21 December 2005 no. 123 relating to the Government Pension Fund
Regulation of 22 December 2005 on Management of the Government Pension Fund – Global
Guidelines for management of the Government Pension Fund – Global
The management agreement between Norges Bank and the Ministry of Finance of 12 February 2001

Management is also affected by the Act on Norges Bank and the Monetary System of 24 May 1985 no. 28 (Norges Bank Act). This Act does not regulate management of the Government Pension Fund – Global directly, but lays down terms for the organisation of Norges Bank and the division of responsibilities between the bank’s various governing bodies. It therefore defines an organisational framework for Norges Bank, which also applies to its capacity as asset manager.

The Ministry of Finance’s investment strategy for the Government Pension Fund – Global covers both the strategic benchmark portfolio and limits on Norges Bank’s deviation from the benchmark portfolio. In this Report, the Ministry states that in spring 2010 it will present the Storting with a review as to whether – and if so, to what extent – active management is to be continued.

Parallel to this work, the Ministry will continue to work on developing the management framework. It is challenging to ensure that the framework is continuously developed in keeping with the investment strategy, growth in the assets of the Fund and international developments in the framework and supervision methods for large asset managers. In last year’s report, the Ministry described the results of a review of internationally recognised standards and best market practice for risk management within asset management (see Chapter 5 of Report no. 16 (2007–2008) to the Storting). The description of best market practice was based on a reference group consisting of several large funds and investment banks.

Common views on which institutions represent best practice for risk management within asset management are subject to change. Some of the institutions that were generally regarded as leading within risk management have since encountered serious problems and have been forced to ask for help from their respective authorities. It therefore seems likely that the international norms for risk management will continue to change in the future. This will also affect the Ministry’s further development of the regulations for the management of the Government Pension Fund – Global.

Below is an overview of the Ministry of Finance’s work linked to following up the requirements entailed by the framework regarding Norges Bank’s risk management in connection with its management of the Government Pension Fund – Global and a description of ongoing and planned projects linked to work on the management framework (see Chapter 6).

1.5.2 Follow-up of the requirements in the framework concerning risk management and control

The responsibilities of Norges Bank’s governing bodies

The current management framework for the Government Pension Fund – Global allows Norges Bank to invest in a way that deviates from a pure indexing of the benchmark portfolio (passive management), if it can be documented that the bank as a minimum is adhering to internationally recognised standards and methods of risk management for such positions (active management). For example, the management guidelines state:

“Valuation, measurement of return and management, measurement and control of risk shall comply with internationally recognised standards and methods. The Fund shall not invest in markets, asset classes or instruments unless compliance with these requirements can be documented.”

The operative management of the Government Pension Fund – Global has been delegated to Norges Bank and is carried out by a separate department in the bank: Norges Bank Investment Management (NBIM). The Executive Board has the executive authority in the bank (see Section 5, first paragraph of the Norges Bank Act). The Executive Board is responsible for making sure that asset management is practised in accordance with the framework defined by the Ministry of Finance. One of the Executive Board’s main tasks within its operative asset management thus comprises constantly monitoring Norges Bank’s ability to measure and control risk, and ensuring that the allowed investment universe in terms of both markets / currencies and use of instruments is at all times delimited so that the qualitative requirements in the management framework for the Fund are satisfied.

Section 5, third paragraph of the Norges Bank Act reads

“The Supervisory Council supervises the Bank’s activities and ensures that the rules governing the operations of the Bank are observed.”

The Supervisory Council must therefore also supervise that Norges Bank follows the instructions set out in the regulatory framework for the Government Pension Fund – Global. The Supervisory Council has 15 members, all of whom are elected by the Storting (see Section 7 of the Norges Bank Act). The Supervisory Council submits annual statements to Storting on the Executive Board’s minutes of meetings and supervision of the bank.

The rules defined in the Norges Bank Act concerning the tasks of the bank’s governing bodies are brief and general and do not define clearly what the executive authority of the Executive Board covers or what should be included in the Supervisory Council’s supervision of the bank’s operations. In the Ministry’s opinion, the bodies’ responsibilities for control and supervision need to be defined more clearly in the Act (see Section 1.5.3).

The Ministry of Finance’s follow-up of Norges Bank’s operational management of the Government Pension Fund – Global

According to Section 2 of the Act relating to the Government Pension Fund, the Ministry of Finance is responsible for managing the Government Pension Fund – Global. Operational management has been delegated to Norges Bank. In order for the Ministry of Finance to fulfil its management responsibility, it must have a robust framework and good follow-up routines vis-à-vis Norges Bank.

In connection with the changes in the framework that came into force on 1 January 2006, the Ministry of Finance stated that external consultants would also be used in the follow-up of Norges Bank’s asset management. In the National Budget for 2006, it is stated that:

“Norges Bank operates a specialised asset management regime. By imposing reporting requirements, the Ministry will be better placed to identify areas where, with the help of external expertise, it can evaluate Norges Bank’s compliance with instructions set out in the regulatory framework. The Ministry plans regular due diligences of the fund, and particularly the bank’s risk management, in collaboration with consultants possessing suitable expertise. The Ministry will be reporting on this to the Storting in suitable documents.”

The first risk-based due diligence on the basis of the new requirements in the framework relating to Norges Bank’s active management was initiated in autumn 2006. Following a competitive tender, the Ministry of Finance chose an international team from Ernst &Young to review Norges Bank’s risk management and control procedures. The Ministry has described the content of the final report and the bank’s comments in Report no. 16 (2007–2008) to the Storting. Here it was described how in the period 2006–2008 Norges Bank has undertaken a number of projects to further improve the bank’s risk management, including:

establishment of an Audit Committee for the Executive Board,
establishment of a separate internal audit department,
strengthening of external auditing through cooperation with Deloitte AS,
reorganisation of NBIM,
significant reinforcement of the independent risk management function (RPA)
new framework for operational risk, and
projects for the implementation of new systems for counterparty risk and for the pricing and verification of positions independently of those who make investment decisions.

In a letter dated 20 October 2008 to Norges Bank, the Ministry requested information about the status of the Executive Board’s efforts to improve the bank’s risk management in its asset management. The Executive Board’s response is discussed in Chapter 6 and is appended to this Report as Appendix 3.

Norges Bank has done much to improve risk management in connection with its management of the Government Pension Fund – Global (see above). The Ministry is also positive towards the reorganisation of the bank’s asset management that came into effect on 1 March 2008.

It follows from the letter from the Executive Board of Norges Bank dated 12 February 2009 that the bank has introduced new internal guidelines with stricter limits on deviation from the benchmark portfolio along several new dimensions.

Under the current system, the Fund is managed by means of a simplified general framework for active management, supplemented with requirements that Norges Bank must prepare internal guidelines that ensure that the bank as a minimum adheres to internationally recognised standards and methods of risk management for active positions. In the Ministry’s opinion, experience acquired over the last three years indicates that a more granular system is required to regulate risk in active management.

The discussion of the results achieved by active management in Section 1.4 points out that active management of fixed income assets was responsible for a large share of the total negative excess return. This must be seen in connection with the fact that Norges Bank’s active bond investments have generally been exposed to the same level of underlying systematic risk (liquidity risk and credit risk) (see the discussion in Section 1.4). The active management strategies that have resulted in substantial negative excess return on the fixed income side have not drawn on the limit for their permitted tracking error to the same degree, reflecting that this measure of risk does not sufficiently capture risk linked to events that occur very rarely (but which can have huge consequences when they do occur). The Ministry will consider new requirements intended to limit risk in active management in the form of supplementary risk mesaures. At the same time, the regulations for active management must also necessarily be of a general nature to ensure that the responsibilities ascribed to the governing bodies of the bank are not transferred to the Ministry in practice. Norges Bank has been given a management role with a certain degree of freedom in how this role is executed, and it is neither appropriate nor desirable that this type of activity is subject to detailed regulation and ongoing management by the Ministry.

The National Budget for 2006 described the Ministry’s plans to carry out regular due diligences of the Fund, and particularly the bank’s risk management, in collaboration with consultants possessing suitable expertise (see the discussion above). To follow this up, Report no. 16 (2007–2008) to the Storting describes the completed due diligence project consisting of an external review of Norges Bank’s risk management systems (referred to as the Ernst & Young project). The Ministry is now planning a new external due diligence (see the discussion in Box 1.3).

Textbox 1.3 External review of risk management and active management in the Government Pension Fund – Global

The guidelines for the management of the Government Pension Fund – Global and the management performance have been discussed regularly in reports to the Storting since the Fund was established. There is broad political support for the guidelines for management of the Government Pension Fund – Global, which has allowed Norges Bank a certain degree of freedom to deviate from the benchmark portfolio for the Fund in its management of the Fund since 1998, when the Fund first started investing in equities. Throughout this period, the limit on tracking error has remained stable at 1.5 per cent. Within the limit on tracking error, there has been a gradual development in the way the external constraints on allowed investments have been regulated. See the more detailed discussions in the National Budget for 1998, the National Budget for 2001, the National Budget for 2006 and the annual reports to the Storting on the management of the Fund. There has not been disagreement in the Storting on the limits on active management in the deliberation of these reports.

In the discussion of the way the markets work and active management in Section 1.2, it was stated that both the Ministry of Finance and Norges Bank work on the assumption that the markets the Fund operates in are largely efficient and that a strategy for active management must therefore be based on exploiting the characteristics of the Fund. It is also stated that the framework for active management must be assessed in light of a number of factors, including the bank’s defined strategies and performance.

The National Budget for 2006 described the Ministry’s intention to introduce regular due diligences of Norges Bank’s management of the Fund and particularly the bank’s risk management, in collaboration with consultants possessing suitable expertise (see the discussion in Section 1.5.2). Report no. 16 (2007–2008) to the Storting describes the due diligence project consisting of an external review of Norges Bank’s risk management systems (referred to as the Ernst & Young project). Chapter 6 contains a discussion of Norges Bank’s account of the work done to strengthen risk management in the Fund. There is also an account of the Ministry’s efforts to amend the Bank’s regulatory system for active management, including the need to set supplementary limits for risk-taking in active management that go farther than the current upper limit on tracking error.

In its report on the management of the Government Pension Fund – Global in 2008, Norges Bank writes that the financial crisis has entailed major challenges for risk management and risk control as a result of the fact that historical correlations between various risk factors no longer held true, at the same time as the liquidity of most markets was reduced substantially. This has had an especially major impact on fixed-income management. Norges Bank therefore stresses that the bank is learning from these experiences and is strengthening its contingency measures related to risk management, including increased efforts to find complementary methods for measuring risk.

With use of external consultants with specialist expertise, the Ministry will reassess the status of risk management and the experiences in active management in Norges Bank. The Ministry will also ask Norges Bank to prepare a business plan with a more detailed description of the main strategies for achieving excess returns. Against the backdrop of the external due diligence and Norges Bank’s plan, among other things, the Ministry will in spring 2010 present the Storting with more information and an assessment of whether or to what extent active management of the Government Pension Fund – Global ought to be continued.

In light of its poor performance in 2008, among other things, Norges Bank has implemented a number of changes in its active management of the Government Pension Fund – Global. The bank has established two main areas within its management of fixed-income assets: a portfolio for indexing and rebalancing and a portfolio containing large, illiquid positions. These positions will be reduced, at the latest when the bonds reach maturity. As the bank describes the current management of fixed income assets, the risk associated with the remaining deviation from the fixed income benchmark is linked to positions with substantially reduced tradability. Reduced tradability entails that the bank cannot make major changes in the portfolio in the short term. The Ministry is assuming that for the time being, and with the exception of the positions that are difficult to sell mentioned above, Norges Bank will manage the fixed income portfolio such that the actual portfolio closely resembles the benchmark portfolio.

1.5.3 Proposition to the Odelsting on amendment of the Norges Bank Act

Parallel to this Report to the Storting, the Government is also submitting a Proposition to the Odelsting on a number of amendments to the Norges Bank Act. The Ministry has already described the need for amendments to the provisions in the Norges Bank Act concerning accounting and auditing (see the discussions in Report no. 16 (2007–2008) to the Storting and Report no. 19 (2007–2008) to the Storting). In June 2008, the Ministry circulated a consultation document on this to relevant bodies. In this Proposition to the Odelsting, the Ministry proposes imposing an obligation to keep accounts on Norges Bank pursuant to the Accounting Act. The need for a defined framework for registration and documentation of transactions etc. also suggests that it should be established in law that Norges Bank has a statutory bookkeeping obligation pursuant to the Bookkeeping Act. The Ministry also wants the possibility to lay down in regulations special rules concerning annual accounts, annual reports and bookkeeping for the bank that either complement or deviate from the provisions given in or pursuant to the Accounting Act and the Bookkeeping Act to regulate any special conditions associated with its operations as central bank.

There is broad consensus that the current audit arrangements, whereby the Supervisory Council appoints a Central Bank Auditor who is formally employed by the bank, are no longer satisfactory. The auditor should formally be entirely independent of the bank. In the Proposition to the Odelsting, the Ministry proposes a system whereby the Supervisory Council appoints an external auditor. In the consultative round, the Office of the Auditor General and the Norwegian Confederation of Trade Unions proposed that the Office of the Auditor General should take over the audit of Norges Bank. The Ministry has not been able to endorse this kind of arrangement for several reasons. Firstly, this would, in the Ministry’s view, necessitate changes in the system whereby the Supervisory Council is the Storting’s supervisory body in relation to the central bank. This system is anchored in Article 75, first paragraph, litra c) of the Constitution, where it is stated that:

“It devolves upon the Storting to supervise the monetary affairs of the Realm.”

The Supervisory Council approves the bank’s accounts. It would be unnatural to separate this task from the task of appointing an auditor. Secondly, it would, in the Ministry’s opinion, be unfortunate if the Office of the Auditor General was to perform the financial audit of Norges Bank and also perform performance audits in the Ministry of Finance, in order to assess whether the Government Pension Fund – Global is being managed in accordance with the intentions of the Storting. The bank’s audited accounts will be a material basis in connection with the Office of the Auditor General’s assessment of whether the Ministry of Finance has managed the Fund in compliance with the intentions of the Storting. If it is the Office of the Auditor General that has audited these accounts, it would then have to judge the Ministry of Finance’s management on the basis of accounts it had audited itself. An external auditor chosen by Norges Bank would therefore improve the Office of the Auditor General’s ability to undertake an independent audit of the Ministry of Finance’s management. On the grounds of these and similar arguments, the Storting decided in 2007 to transfer the responsibility for auditing Folketrygdfondet and the Government Pension Fund – Norway from the Office of the Auditor General to an external auditor chosen by the Ministry of Finance (see Section 13 of the Act relating to Folketrygdfondet and Recommendation no. 77 (2006–2007) to the Odelsting, pp. 1–2).

It would be natural for the Supervisory Council, in its capacity as responsible for the audit of the bank, to lay down an audit programme. This kind of programme would define priorities for the audit, over and above the financial audit, including a plan for so-called certification assignments. A typical certification assignment might be asking for an assessment of the efficiency and effectiveness of the bank’s internal control. If the bank had an appointed, external auditor, the Ministry of Finance would be able to enter into dialogue with the Supervisory Council and make suggestions for the audit programme in order to ensure that the Ministry of Finance’s follow-up needs vis-à-vis the Government Pension Fund – Global are safeguarded. If the Office of the Auditor General was going to audit the bank’s accounts, the Ministry of Finance would be prevented from this as the Office of the Auditor General is also charged with auditing the Ministry of Finance. The Office of the Auditor General cannot audit the Ministry of Finance on behalf of the Storting and at the same time also perform audit tasks that the Ministry has asked the Supervisory Council to have done. An arrangement with an appointed, external auditor would thus serve to strengthen the overall follow-up of the Fund.

The Proposition to the Odelsting also proposes a more precise description of the tasks ascribed to the bank’s governing bodies and a clarification of the division between the Supervisory Council’s supervisory responsibilities pursuant to the Norges Bank Act, and the Ministry of Finance’s follow-up responsibilities pursuant to the Act relating to the Government Pension Fund.

1.5.4 Review of the rest of the framework for management of the Government Pension Fund – Global

For some time now, the Ministry of Finance has been reviewing the regulations with the aim of refining them. The review was motivated by a number of considerations. There is a general need to review the regulations, which show signs of the fact that they have been continuously added to and amended over time, as the Fund has grown in value and complexity. In addition, the decision to invest up to 5 per cent of the Fund in real estate (see Chapter 2) and the evaluation of the ethical guidelines (see Chapter 4) necessitate revision of the guidelines.

The regulations should aim to regulate special risk factors within asset management in compliance with best international practice relating to risk measurement and management. The distribution of responsibility between the operational manager (Norges Bank) and the owner of the assets (the Ministry of Finance) must be clearly defined. The regulations must also ensure that there are clear reporting routines and transparency regarding management. The Ministry is basing its review on industrial and supervision driven standards of risk management.

In connection with the review of the regulations, the Ministry will impose stricter requirements on Norges Bank’s management. For example, supplementary limits will be set for risk-taking in active management that go farther than the current upper limit on tracking error. This may entail stricter requirements for risk diversification for the active positions and that risk limits are established for a number of main categories of risk. The Ministry will also consider whether limits ought to be set for leverage and short positions.

The Ministry is aiming to complete its review of the regulations so that a new regulation governing the management of the Government Pension Fund – Global can enter into force on 1 January 2010. See also the more detailed discussion in Chapter 6. Reference is also made to the plans for a review of the active management (see Box 1.3). Any further changes to the guidelines as a result of this review will only be implemented once the Storting has considered the matter.

1.5.5 The Santiago Principles for management of sovereign wealth funds

Through its work in the International Working Group of Sovereign Wealth Funds under the direction of the IMF, the Ministry has contributed to the development of the Generally Accepted Practices and Principles for Sovereign Wealth Funds – known as the Santiago Principles (see the discussion in Report no. 16 (2007–2008) to the Storting and the National Budget for 2009). The Santiago Principles express good principles for management of sovereign wealth funds. For example, they express that the distribution of roles and responsibilities between the players involved must be clear, that the investment policy must be clearly and publicly expressed, and that the Funds should have ethical standards. The principles are to be treated as minimum standards, and the current framework for the Government Pension Fund – Global already satisfies all these standards. However, a number of the principles are only implied in the current regulations for the management of the Government Pension Fund – Global, and in its work on the new regulation on the management of the Fund, the Ministry will seek to ensure that the principles are stated more clearly.

When the Santiago Principles were presented in October 2008, a wish was voiced to explore the possibility of establishing a forum for sovereign wealth funds that could continue to further develop and refine these principles. Norway wants to support this work aimed at building confidence and contributing to the continuation of a stable, open international investment climate and financial markets that function smoothly.

1.5.6 Folketrygdfondet’s management of the Government Pension Fund – Norway

Folketrygdfondet was established as a separate company by special statute with effect from 1 January 2008. Report no. 16 (2007–2008) to the Storting described the new framework for Folketrygdfondet’s management of the Government Pension Fund – Norway. The new framework implies a clarification of the division of responsibility between the Ministry and the Board of Directors of Folketrygdfondet. The Ministry stipulates general investment limits, whilst the Board of Directors of Folketrygdfondet is responsible for the operational management of the Government Pension Fund – Norway. All the provisions governing the management of the Government Pension Fund – Norway are appended to this Report in Appendix 1.

Risk management and control procedures

The new management framework for the Government Pension Fund – Norway lays down much stricter requirements concerning, among other things, measurement, management and control of risk and reporting than previously. Against this background, Folketrygdfondet has been working on implementing new management and control systems in the management to ensure that the systems for risk management and control satisfy the requirements laid down in the new framework. The requirements are based on the premise that measurement, management and control of different categories of risk follow best international practice and internationally recognised methods. The Ministry expects that most of the work on implementation of new control systems as a result of the requirements laid down in the new framework will be finished during the course of this year.

Accounting rules

In Report no. 16 (2007–2008) to the Storting, the Ministry stated that it would be assessing the need for further regulations containing more detailed provisions about the accounting rules for the Government Pension Fund – Norway. The background for this is that the Act relating to the Government Pension Fund does not contain direct provisions on accounting rules.

Against the backdrop of the need to clarify the accounting rules for Folketrygdfondet and the Government Pension Fund – Norway, the Ministry published Regulation of 10 November 2008 no. 1264, which lays down detailed provisions concerning annual accounts, etc. for Folketrygdfondet including the Government Pension Fund – Norway (see Chapter 6).

The Ministry will present a more detailed assessment of the need to introduce international accounting standards (IFRS) for Folketrygdfondet including the Government Pension Fund – Norway once more experience has been acquired with the new management framework for the Fund.

Footnotes

”The Economics of Climate Change – The Stern Review” (2006)

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Report No. 20 to the Storting (2008-2009)

On the Management of the ­Government Pension Fund in 2008

Part 1 Main aspects of the management of the Government Pension Fund

1 Main aspects of the management of the Government Pension Fund

1.1 Background and purpose of the fund

1.2 The investment strategy for the Government Pension Fund

1.2.1 About the investment strategy

The purpose and characteristics of the Fund

The Fund as a responsible investor

The benchmark portfolios

Assumptions about the way the markets work and active management

1.2.2 Evolvement of the investment strategy for the Government Pension Fund – Global

Introduction

High yield bonds and emerging bond markets

The regional and currency distribution

New investment programmes

1.2.3 Status of adopted changes to the strategy

Emerging equity markets

Equity portion

Real estate investments

1.3 Responsible investments

1.3.1 Reporting on the work on the ethical guidelines in 2008

The ownership efforts of Norges Bank

The ownership efforts of Folketrygdfondet

Exclusion of companies

1.3.2 Evaluation of the ethical guidelines for the Government Pension Fund – Global

Introduction

Textbox 1.1 General overview of the results of the evaluation of the ethical guidelines for the Government Pension Fund – Global

A broad approach

Clarifying an overarching objective

Continuing and adjusting the exclusion mechanism

Negative screening of companies from the portfolio on the basis of the companies’ products

Exercise of ownership rights

Interaction between the various instruments

Other topics and measures

1.4 Management performance

1.4.1 Developments in the market value of the Government Pension Fund

Market developments

1.4.2 The return on the Government Pension Fund

The return on the Government Pension Fund – Global

Textbox 1.2 The risk associated with the return on the Government Pension Fund – Global

The return on the Government Pension Fund – Norway

1.4.3 Management costs

1.5 Development of the management framework for the Government Pension Fund

1.5.1 The management framework for the Government Pension Fund – Global

1.5.2 Follow-up of the requirements in the framework concerning risk management and control

The responsibilities of Norges Bank’s governing bodies

The Ministry of Finance’s follow-up of Norges Bank’s operational management of the Government Pension Fund – Global

Textbox 1.3 External review of risk management and active management in the Government Pension Fund – Global

1.5.3 Proposition to the Odelsting on amendment of the Norges Bank Act

1.5.4 Review of the rest of the framework for management of the Government Pension Fund – Global

1.5.5 The Santiago Principles for management of sovereign wealth funds

1.5.6 Folketrygdfondet’s management of the Government Pension Fund – Norway

Risk management and control procedures

Accounting rules

Footnotes

On the Management of the Government Pension Fund in 2008

Part 1
Main aspects of the management of the Government Pension Fund