Executive summary

Climate risk arises because there is uncertainty about future climate change, social developments, climate policy and technological development. Considerable uncertainty at many levels gives rise to significant climate risk. Climate risk has some distinctive characteristics that are different from other issues investors have to deal with, since it unfolds over a very long horizon, raises fundamental ethical questions, and is characterised by potentially dramatic consequences and great uncertainty that is difficult to quantify.

Given its diversified investment strategy, the Government Pension Fund Global (GPFG) is relatively resilient to moderate climate change and a predictable climate policy, while dramatic climate change or abrupt policy shifts will represent significantly greater challenges for the planet as well as the world’s financial markets and the GPFG. The most important way to reduce climate risk is through effective and predictable climate policy, as well as strengthening resilience to deal with unexpected outcomes.

The GPFG plays a special role in Norwegian economic policy, and the fund’s management has provided inspiration and had a normative impact on investors in Norway and abroad for several years. In our view, there is now a need to advance the work on climate risk. We believe that it should be Norway’s ambition that the fund’s work on climate risk should be world leading. We therefore propose:

• A set of principles for managing the GPFG’s climate risk, which can stand the test of time.
• That the work on climate risk is anchored in the mandate issued by the Ministry of Finance, under which Norges Bank’s responsible investment is based on an overall long-term goal of zero emissions from the companies in which the fund has invested, in line with the Paris Agreement.
• Further development of Norges Bank’s ownership activities to influence companies’ behaviour and strengthen the market’s functioning through better climate risk reporting.
• Special regulations for measurement, management and reporting of climate risk.

The fund is large, and the investments are spread across a large number of companies in various industries around the world. Climate risk can affect all sectors of the economy in different ways, and a large fund that is broadly invested has nowhere to hide. The fund thus benefits from, and, based on its mandate, should contribute to the achievement of the targets of the Paris Agreement, and that the transition to a zero-emission society takes place in an orderly manner. An ambitious and successful international climate policy reduces the physical climate risk for the fund. A predictable climate policy and an orderly, gradual decarbonisation of the economic system reduce the risk of sudden changes in the value of the fund’s investments and financial instability.

An important starting point for management of climate risk is that the overall climate risk in the financial system is high. However, there is no reason to believe that climate risk will be systematically mispriced in the market over the long time horizon that is relevant for determining the fund’s benchmark index. The investment strategy for the fund is based on the fact that the financial markets are characterised by strong competition, that risk diversification lends robustness to the fund, and that it is generally not possible to improve the ratio between return and risk for the fund by excluding investments with specific characteristics. The broadest possible diversification of the fund’s investments is a cornerstone of the fund’s investment strategy. This should remain in place.

At the same time, climate risk is potentially significant for the fund, and the Ministry of Finance should change the mandate for the management of the GPFG to improve management of this risk. Based on the mandate changes, Norges Bank’s responsible investment and active ownership should be strengthened and the requirements for measuring, managing and reporting climate risk increased.

As the manager of the GPFG, Norges Bank has a coherent chain of ownership tools for addressing climate risk. The key tool for managing the GPFG’s climate risk is active ownership, since this is aimed directly at the source of the fund’s climate risk. In addition, Norges Bank may choose a different composition of the portfolio than that which follows from the benchmark index determined by the Ministry of Finance. If active ownership eventually turns out not to be successful, and the assessment is that a company does not have a convincing transition strategy and invests in bad projects rather than paying dividends, the bank can divest from the company.

Through targeted and effective active ownership, Norges Bank can contribute to understanding and influencing the robustness of the business models of the companies the fund has invested in, as well as emphasising the importance of capital discipline so that companies have underlying investment projects that benefit from climate-related opportunities and are profitable in the transition to a low-carbon economy. Capital discipline means, among other things, that fossil fuel companies with weaker profitability prospects return surplus capital to the owners in the form of dividends, which gives investors the opportunity to invest capital in new investment opportunities related to the green transition. Active ownership can help strengthen the financial market’s general ability to price climate risk and channel capital into profitable projects in the transition to a low-carbon economy.

If active ownership eventually turns out not to be successful, and the assessment is that the company’s prospects are characterised by weak profitability, poor investment opportunities and little ability to transition, the bank can divest from the company. If there is an unacceptable risk that the company is associated with serious environmental damage or leads to greenhouse gas emissions to an unacceptable degree, observation or exclusion is relevant.

Better reporting on climate risk from the companies will make financial markets more well-functioning, in that information about this risk will be more readily available and consequently can form the basis for more correct pricing. With more robust business models and more correct pricing of risk, the transition risk in the financial system will gradually be reduced. Emission developments in line with the Paris Agreement should serve as the reference point for the fund’s ownership activities and for the dialogue with the companies in which the fund has invested.

Norges Bank should demand that the companies they have invested in stress test their business models against various climate policy scenarios, including a scenario in which the goals of the Paris Agreement are achieved. In this way, it will be easier to identify deviations from decarbonisation pathways consistent with the climate targets, and to quantify possible economic consequences of this. This in turn provides a better basis for both targeted active ownership and more correct pricing of companies in the market. We also propose that Norges Bank be requested to regularly stress test the portfolio against various climate policy pathways. This will provide a more complete picture of this risk, and be consistent with the reporting requirements the fund itself sets for the companies in which it invests. For the Ministry of Finance as owner of the fund, this reporting will also contribute to a better understanding of risk related to the national wealth and public finances.

We have proposed that climate risk be incorporated separately in the bank’s principles for responsible investment management. This means that the fund shall contribute to developing best practice internationally.