3 The Government Pension Fund Global: Evolvement of strategy and management

3.1 New fixed-income framework and benchmark index

3.1.1 Introduction

The Ministry of Finance announced, in the fund report in the spring of 2017,1 than one would upon the equity share of the Government Pension Fund Global (GPFG) being increased to 70 percent assess the implications for other key choices in the investment strategy, including the composition of the fixed-income benchmark for the Fund. The current fixed-income benchmark was set in 2012 on the basis of, inter alia, a trade-off between meeting the liquidity need of the Fund, reducing the volatility of total returns and reaping bond market risk premiums. Said trade-off was based on a 60-percent equity share.

Norges Bank was requested to contribute analyses and evaluations as part of the assessment of the composition of the fixed-income benchmark for the GPFG. The Ministry of Finance received the advice of the Bank in letters of 1 September and 14 December 2017. The Bank proposes, inter alia, a narrowing of the fixed-income benchmark to only include local currency nominal government bonds issued by the US, the UK and Eurozone countries – a reduction in the number of currencies from 22 to three – as well as capping the maturity of individual bonds at about ten years. It was proposed to omit the remainder of the bond market, including corporate bonds and inflation-linked bonds. Furthermore, the Bank recommended that the investment universe remain unchanged, and assumed that the GPFG would continue to be invested in some of the currencies and segments proposed for omission from the benchmark index.

In March 2018, the Ministry of Finance appointed, against the background of the advice from Norges Bank, an expert group to assess the fixed-income investment framework for the GPFG, comprising Professors Ralph Koijen of the Booth School of Business, University of Chicago, and Jules van Binsbergen of the Wharton School, University of Pennsylvania. The Ministry received the group’s report in November 2018. The group recommends a fixed-income benchmark index comprising the most important parts of the bond market as at present, without any cap on maturity. This will, according to the group, ensure an investable benchmark with a broad diversification of risk, and also contribute to the GPFG achieving exposure to important bond market risk premiums.

The expert group’s report and the letters from Norges Bank are available on the Ministry of Finance website.

It was announced in the fund report in the spring of 20182 that the Ministry of Finance was aiming to present its assessments of the fixed-income investment framework for the GPFG in the fund report in the spring of 2019. In view of this process, and against the background of Norges Bank’s advice to retain fewer currencies in the benchmark, it was decided in May 2018 to suspend the inclusion of new currencies in the benchmark index until a new benchmark index has been decided on. This implies that any new markets which the index provider, Bloomberg, may decide to include in underlying market indices would not be included in the benchmark index for the Fund until further notice.

The discussion of a new fixed-income framework and benchmark for the GPFG is organised as follows: The current benchmark index is discussed in section 3.1.2, advice and assessments from the expert group and Norges Bank are discussed in section 3.1.3, whilst the Ministry’s assessments are presented in section 3.1.4.

3.1.2 The current fixed-income benchmark index

The fixed-income benchmark for the GPFG is based on market indices from the index provider Bloomberg. The benchmark index is exclusively comprised of investment-grade bonds, and consists of a government bond portion and a corporate bond portion; see Figure 3.1. The government bond portion constitutes 70 percent and includes local currency nominal and inflation-linked government bonds, as well as supranational bonds.3 The corporate bond portion constitutes the remaining 30 percent and comprises corporate bonds and covered bonds.4 The allocation between the two sub-indices is fixed, with full monthly rebalancing to the chosen weights.

Source Bloomberg and the Ministry of Finance.

As at the end of 2018, the government bond portion of the benchmark index included bonds issued in 22 currencies, ten of which are emerging market currencies. Which markets and individual bonds are included in the benchmark index at any given time is the result of the index provider’s decisions for the underlying market indices. Bonds issued in Norwegian kroner or by Norwegian issuers are not included in the benchmark index.

Local currency emerging market government bonds have been included in the benchmark index since 2012. It was noted in the fund report in the spring of 20125 that including emerging markets might contribute to a somewhat more diversified composition of the benchmark index and an improved ratio between return and risk in the long run, although the measurable effect seemed limited. It was noted, at the same time, that both credit risk in the government bond portion of the fixed-income benchmark and the correlation between the fixed-income benchmark and the equity benchmark would increase as a result of the inclusion of emerging markets.

The currencies included in the government bond portion of the benchmark index are weighted by the relative size of the countries’ economies, as measured by gross domestic product (GDP). The weights are determined annually, based on GDP for the last three years. There is full monthly rebalancing to the fixed GDP weights throughout the year. Individual bonds are weighted by market weights within each country.6

GDP weights for government bonds were introduced in 2012. The Ministry of Finance noted in the fund report in the spring of 2012 that the purpose is broader diversification of the investments whilst also seeking to accord more weight to the ability of states to repay loans, compared to market weights. For government bonds, market weights imply that states with large and growing debt will, as a general rule, be accorded high and increasing weight in the benchmark index.

However, the size of a country’s economy is not a precise measure of the ability or willingness of states to repay bond loans. It was, simultaneously with the introduction of GDP weights, stipulated a management mandate requirement that Norges Bank shall seek to take account of differences in fiscal strength in the composition of the GPFG government bond investments. It was noted that this requirement is meant to highlight that one of the purposes of the government bond investments in the GPFG is to reduce the volatility of overall returns on the Fund.

Some countries have high GDP relative to the value of outstanding government debt. Owing to the size of the GPFG, the GDP weights for such countries must be supplemented by adjustment factors to avoid the Fund holding large percentage ownership stakes in the local sovereign debt markets. Such specific adjustment factors had been established for three countries as at the end of 2018.7

The composition of the corporate bond portion of the benchmark index is based on market weights and includes bonds issued in seven currencies; see Figure 3.1. Bonds issued in these seven currencies encompass about 98 percent of the securities the index provider includes in underlying market indices, as measured by market value as at the end of 2018. It is common practice for private companies to issue bonds in the most used and most liquid currencies, and not necessarily in the currency of the country in which the company is domiciled. As at the end of 2018, the corporate bond portion comprised bonds issued by companies domiciled in more than 50 countries.

Norges Bank may invest the fund capital in securities that do not form part of the benchmark index, including in sub-markets not included in the fixed-income benchmark, within limits stipulated in the mandate from the Ministry of Finance. Such investments will be subject to the 1.25 percentage-point limit on expected tracking error; see section 2.1. Other limits and requirements are also stipulated for the fixed-income investments, including a requirement for the Bank to approve all sovereign bond issuer countries and a specific limit on high-yield bond investments. High-yield bonds involve a higher probability that borrowers will default on debts than do investment-grade bonds. In order to avoid the Bank having to immediately divest bonds that are omitted from the benchmark index for the GPFG because of their credit rating being downgraded, up to 5 percent of the fixed-income portfolio of the Fund may be invested in high-yield bonds.

The investment-grade bond market, as represented in broad market indices from the index provider Bloomberg, comprises many segments and sub-markets with different characteristics; see Box 3.1. The current fixed-income benchmark for the GPFG encompasses about 80 percent of the bond market, as measured by market value as at the end of 2018. Some sub-markets are not included in the benchmark index for the GPFG, on the basis of, inter alia, assessments relating to market structure, concentration risk and whether the bonds are suited for passive portfolio management; see Figure 3.2. These assessments were presented in the fund report in the spring of 2012.

¹ MBS, or Mortgage-Backed Securities, are fixed-income securities backed by residential mortgage portfolios. Such securities are predominantly arranged and guaranteed by US federal institutions.

² ABS, or Asset-Backed Securities, are fixed-income securities backed by portfolios of miscellaneous receivables, such as car loans and credit card debt.

³ CMBS, or Commercial Mortgage-Backed Securities, are fixed-income securities backed by commercial mortgage portfolios.

Source Bloomberg and the Ministry of Finance.

Textbox 3.1 The global investable investment-grade bond market

A bond is a tradable security (loan) with a maturity exceeding one year. The bond issuer (borrower) may for example be government bodies, banks or other major private enterprises. The bond principal is repaid by the issuer upon maturity, and the issuer will typically pay interest (coupon) to the bondholder during the period from issuance to maturity. A bond loan is traded in the primary market by a borrower issuing bonds that are purchased by investors. Bonds are freely tradeable, i.e. investors may purchase and sell bonds between themselves in the secondary market. Most bonds are issued at a fixed nominal interest rate, i.e. the coupon is a predetermined amount. However, bonds are available in several varieties, inter alia, with floating interest rate, with zero coupon or with continuous repayment. Furthermore, some bonds involve various forms of collateral and/or options, such as for example the right to repay the loan before the maturity date.

Treasuries

Local currency nominal government bonds («Treasuries») constitute the largest bond sub-segment and accounted for more than half of the investable investment-grade bond market, as measured by broad market indices from the index provider Bloomberg as at the end of 2018; see Figure 3.3. The government bond market is dominated by a small number of currencies. Nominal government bonds issued in US dollars, Japanese yen, euros and pound sterling accounted for about 90 percent of the nominal government bond market. Emerging market government bonds issued in local currency accounted for just over five percent of the market.¹

Government-related bonds

Government-related bonds include, inter alia, government bonds issued in the currency of another country, bonds issued by municipalities and other government entities, bonds issued by enterprises that are partially owned by or receive grants from the public sector and bonds issued by supranationals, such as the World Bank. Government-related bonds accounted for 11 percent of the bond market as at the end of 2018.

Inflation-linked bonds

Some states issue bonds that provide investors with protection against changes in the purchasing power of invested capital, so-called inflation-linked bonds. Such bonds provide an investor with a real rate of return in addition to a compensation for developments in a pre-agreed price index. Inflation-linked government bonds accounted for just over five percent of the bond market as at the end of 2018.

Securitised bonds

Various types of securitised bonds accounted for close to 15 percent of the investment-grade bond market as at the end of 2018. Such bonds are backed by a portfolio of underlying loans, of which residential mortgages are most commonly used.

The securitised bond market is large in the US, and accounted for close to a third of the US nominal bond market. The US securitised bond market is primarily comprised of bonds backed by residential mortgages that are arranged and guaranteed by federal credit institutions («MBS Passthrough»). The maturity of such bonds is uncertain, because US residential mortgage borrowers are entitled to repay and refinance their fixed-rate mortgages when the interest rate level declines.

The covered bonds sub-segment is primarily comprised of bonds issued by European banks and that are backed by residential mortgages or loans to the public sector. There is no uncertainty as to the maturity of such bonds, as these bonds do not carry the same right to refinancing in the event of a lower interest rate level as US secured bonds.

Investment-grade corporate bonds

The investment-grade corporate bond market is the second-largest bond segment after treasuries, and accounted for just under a fifth of the overall bond market as at the end of 2018.

The US is the largest and most liquid market for bonds issued by private enterprises, and accounted for more than half of the corporate bond market. It is common practice for companies to issue bonds in the most used and most liquid currencies, and not necessarily in the currency of the country in which the company is domiciled. Corporate bonds issued in US dollars, euros and pound sterling accounted for about 94 percent of the overall market for such bonds. Bonds issued in US dollars accounted for close to two thirds of the corporate bond market.

¹ Bloomberg Barclays Global Aggregate Index and Bloomberg Barclays Global Inflation Linked Index.

Source Bloomberg.

¹ The index provider Bloomberg has announced that Chinese government bonds and policy banks issued in local currency from April 2019 will be phased into the broad nominal bond market index on which the fixed-income benchmark for the GPFG is based. This may over time serve to increase the emerging market portion of the broad market index.

3.1.3 Advice and assessments from Norges Bank and the expert group

Currencies, emerging markets and other segments in the government bond portion

Norges Bank refers to internal analyses which indicate, according to the Bank, that there is little risk reduction to be gained by diversifying the fixed-income investments across a large number of currencies for an investor with 70 percent of its investments in an internationally diversified equity portfolio. The Bank proposes, against this background, to reduce the number of currencies in the fixed-income benchmark. The Bank states that a benchmark index comprised of bonds issued in US dollars, euros and pound sterling will be sufficiently liquid and investable for the Fund. However, the Bank sees no operational challenges in including nominal bonds in all the developed market currencies currently included in the fixed-income benchmark.

The Bank proposes that inflation-linked and supranational bonds be omitted from the benchmark index, since these reduce the proportion of nominal government bonds, which are more liquid and play a greater role in reducing overall volatility in the Fund.

Norges Bank notes that the fixed-income benchmark for the GPFG currently includes a range of emerging market currencies. The Bank has found that it can be operationally challenging to invest in line with the benchmark index in these markets, since markets drop in and out of the government bond portion of the benchmark index as a result of the creditworthiness of the issuer countries being upgraded or downgraded. The Bank also highlights that high GDP relative to the size of the local sovereign debt market has resulted in large percentage ownership stakes in some markets.

Investors have, according to the Bank, historically been compensated for the risk of investing in high-yielding currencies, most of which are emerging market currencies. The Bank notes that the current benchmark index is not suited as a basis for systematic strategies for high-yielding currency investments.

Norges Bank is of the view, against this background, that emerging bond markets should now be omitted from the fixed-income benchmark, and states that the Ministry of Finance should delegate the establishment of systematic strategies for high-yielding currency investments to the Bank. The Bank also states that the mandate may, if the Ministry wishes to impose further management restrictions, for example specify what portion of the Fund may be invested in high-yielding currencies not included in the benchmark index.

The expert group’s assessment is that the benchmark index should comprise a broad set of countries and currencies, which the group highlights as providing diversification both during normal times and across changes in market regimes. Bond market volatility and correlations may, according to the group, change quickly and in ways that are difficult to predict based exclusively on historical data analyses. Although a small number of currencies and segments may appear to reflect the risk and return characteristics of the entire bond market, this may change under other market regimes.

The expert group notes that a composition of the fixed-income benchmark for the GPFG with included segments as at present, ensures broad diversification of risk and bond market investability, as well as exposure to the most important fixed-income risk premiums. The group notes that there is a relatively high degree of concentration on various countries in different segments of the bond market. A benchmark index comprising only nominal government bonds issued in three currencies and with specific maturities, as proposed by Norges Bank, will omit more than half of the investment opportunities included in the current benchmark index. The group is of the view that this would reduce the investability of the benchmark index and increase the concentration risk.

The expert group has, furthermore, analysed historical risk and return characteristics of fixed-income portfolios both with and without emerging market government bonds. The analyses indicate that a fixed-income portfolio with emerging markets would over the period 2001–2018 have delivered about 0.04 percentage points higher return per year, and marginally lower volatility, than a portfolio without such bonds. Given an allocation with 70 percent equities, this represents a return difference of about 0.01 percentage points per year. The group emphasises, at the same time, that the findings from such analyses depend on the period of available data.

Corporate bonds

Norges Bank refers to internal analyses indicating, according to the Bank, that corporate bonds contribute to diversification of risk in the fixed-income benchmark, although a fixed corporate bond allocation will nonetheless have little impact on overall risk and return in a benchmark index with an allocation of 70 percent to equities. The Bank proposes, against this background, to omit corporate bonds from the benchmark index. The recommendation is, as with emerging market bond investments, to delegate the establishment of systematic strategies seeking to reap a risk premium in the corporate bond market to the Bank. The Bank also states that the Ministry of Finance might consider stipulating a specific limit on what proportion of the Fund may be invested in corporate bonds. If corporate bonds are nonetheless retained in the benchmark index, the Bank observes that the Ministry of Finance should, inter alia, consider the proportion of such bonds, the number of currencies, the maturity and the weighting principle, as well as whether the current rule for the rebalancing of corporate bonds remains appropriate.

Norges Bank notes, inter alia, that the market and currency risk associated with corporate bond investments in the GPFG will be managed in accordance with the same principles as under the current internal reference portfolio, if the Ministry of Finance omits such bonds from the benchmark index for the Fund. The Bank underscores that it has favourable experience with such risk management. It is noted, as an example, that an investment in US corporate bonds may be funded with a combination of US equities and US government bonds with similar maturity. Such funding solution would, according to the Bank, ensure that the internal reference portfolio has similar risk characteristics to the benchmark index over time along three of the most important risk dimensions: market, interest rate risk and currency risk.

The expert group has, as part of its assessment of corporate bonds in the GPFG, analysed whether corresponding risk and return characteristics can be achieved by replacing corporate bonds with an appropriate combination of equities and government bonds. The group highlights research describing how a portfolio of risk-free bonds and stocks may under certain assumptions be composed to span the risk and return characteristics of corporate bonds. The group emphasises, at the same time, that such strategies are challenging to implement in practice. The strategies require, inter alia, continuous adjustment of the relative portfolio weights of equities and government bonds, which may entail considerable transaction costs. It is also noted that pricing deviations, for example during periods of high demand for government bonds, may result in diverging risk and return characteristics under such strategies. Moreover, the group is of the view that omitting corporate bonds from the benchmark index will, for a large fund such as the GPFG, serve to reduce the investability of the benchmark.

The expert group concludes, on the basis of US data for the period 2001–2018, and in line with earlier research published in financial literature, that a significant proportion of corporate bond return variation is unspanned by equities and government bonds. Furthermore, the proportion thus explained fluctuates considerably over time, and is especially low during periods of financial market turbulence. This implies, according to the group, that the return difference between corporate bonds and a portfolio comprising equities and government bonds – composed for the purpose of providing corresponding risk characteristics – will vary over time, and may become large during periods of financial market turbulence.

Maturity

Norges Bank notes that in a portfolio comprising equities and fixed-income instruments, the contribution made by bonds to overall portfolio volatility will depend on the correlation between the two asset classes. The shorter the maturity of the fixed-income investments, the more robust will, according to the Bank, overall portfolio volatility be to changes in the correlation between equities and fixed-income instruments. Future correlation between equities and fixed-income instruments is uncertain and cannot be controlled. Future maturity in the fixed-income benchmark is also uncertain, but can be managed. The Bank states that the choice of maturity may potentially have major implications for overall Fund volatility , and should therefore be reflected in the benchmark index. The Bank proposes, against this background, that bonds in the benchmark index be subject to an upper limit of about ten years. The Bank is of the view that shorter maturity will serve to reduce uncertainty concerning the overall volatility in the Fund. The effect of shorter maturity on expected return in the fixed-income benchmark depends on the expected term premium. In its equity share advice on 1 December 2016, the Bank assumed an expected term premium of about zero. The Bank states that this remains the Bank’s assumption.

The expert group recommends that no adjustment be made for maturity in the benchmark index. The group emphasises that deviations from market maturity are active investment decisions, and should thus fall within the scope of active management. Reference is made, at the same time, to recent research indicating that investors have historically been compensated with a positive term premium for holding bonds with a longer time to maturity. A potential reason for this may, according to the group, be inflation risk. Although the term premium may be low because inflation is stable at present, this will not necessarily remain the case in coming years. The group notes, moreover, that the GPFG is in any event invested in markets with higher inflation risk than for example the US, which is often used in analyses. There is, according to the group, no conclusive evidence in the research literature to suggest that such term premium has disappeared in global fixed-income markets.

Weighting principle for the government bond portion of the benchmark index

Norges Bank is of the view that the currencies in the government bond portion should be accorded weight relative to the size of the countries’ GDP, as at present, for the reason that GDP weights will ensure that the currency distribution in the benchmark is fairly stable, whilst at the same time preventing the GPFG from lending disproportionately to countries in the euro area with high levels of debt. The currencies in the government bond portion should be rebalanced to GDP weights annually, not monthly as at present, in order to avoid unnecessarily frequent transactions.

The expert group is of the view that the composition of government bonds should be based on market weights. The group notes that the current GDP weights will not necessarily be effective in addressing concentration risk going forward. A more appropriate way of adjusting for such risk may, according to the group, be to adjust each country’s market weight for that country’s impact on the overall portfolio in the case of large yield changes, i.e. idiosyncratic tail risk exposure.

Risk management framework

As a general premise, the current management framework defined in the mandate from the Ministry of Finance imposes, according to Norges Bank, adequate restrictions on how the GPFG may be invested. It is noted, however, that the Ministry may consider introducing specific limits on the proportion of the GPFG which may be invested in the segments proposed by the Bank for omission from the benchmark index. The Bank notes that the Fund will continue to be invested in some currencies and segments that are omitted. It is proposed to abolish the current requirement to take account of fiscal strength in fixed-income management, because, inter alia, the new benchmark index proposed by the Bank implies an improvement in average benchmark credit quality.

The expert group notes that it is challenging to measure and manage bond market risk on the basis of short-term historical correlations alone. Scenario analyses and stress tests of the GPFG fixed-income portfolio may, according to the group, serve to improve the understanding of risk in the Fund. The group notes that the Ministry of Finance may consider requiring Norges Bank to publish such analyses, and believes that this would strengthen communication concerning risk taking in the Fund.

3.1.4 The Ministry’s assessments

Introduction

The current benchmark index for the GPFG and the management restrictions reflect the key aspects of the investment strategy adopted for the Fund, including broad diversification of the investments, harvesting of risk premiums and limited scope for active management. This facilitates, inter alia, broad communication of risk taking in the Fund and endorsement of such risk taking by the Storting. The Mork Commission,8 which in 2016 recommended an increase in the equity share of the GPFG, identified, inter alia, this as being of importance to the capacity of the Fund to absorb risk.

The composition of the fixed-income benchmark must pay heed to the liquidity requirements of the Fund owing to, inter alia, Norges Bank needing to effect equity share rebalancing. The Bank observes, in its advice, that the current fixed-income benchmark is sufficiently liquid, and is of the view that this will not be changed by a higher equity share. The Ministry notes, at the same time, that modifications to the rebalancing provisions, discussed in section 3.3, do not significantly impact the liquidity need of the Fund, compared to the current provisions.

The Ministry notes that the decision in the spring of 2017 to increase the equity share to 70 percent was based on, inter alia, the Mork Commission’s assessment of increased capacity to absorb risk in the Fund. A significant reduction in the risk level of the fixed-income benchmark would result in the expected real rate of return on the GPFG, currently estimated at about three percent, having to be reassessed.

The Ministry is of the view, against this background, that the decision to increase the equity share does not in itself necessitate any significant change in the risk level of the fixed-income benchmark, and is consistent with similar considerations as to meeting the liquidity needs of the Fund, reducing the volatility of total returns and reaping bond market risk premiums as under the current benchmark index. Furthermore, the Ministry has attached weight to a reasonable degree of overlap between the benchmark index and the bond market investment opportunities making the benchmark better suited for measuring Norges Bank’s management performance.

The Ministry is in this report proposing, inter alia, that corporate bonds shall continue to account for 30 percent of the benchmark index and that benchmark bond maturity shall reflect market developments – as at present. However, certain operational challenges associated with the current fixed-income benchmark, as pointed out by Norges Bank, entail a need for facilitating lower transaction costs and increased investability of the benchmark. The Ministry of Finance is, based on an overall assessment, proposing to omit emerging market government and corporate bonds from the fixed-income benchmark for the GPFG. At the same time, investment in such bonds is capped at 5 percent of the fixed-income portfolio, and also subjected to expanded reporting requirements. Furthermore, the Ministry is proposing minor technical modifications to the current GDP weighting of the government bond portion of the benchmark index.

Corporate bonds in the benchmark index

Corporate bonds represent a significant portion of the bond market and have been included in the benchmark index since 2002. The securities included in the benchmark are investment-grade bonds and provide the Fund with some credit risk exposure. The expert group highlights recent research indicating that investors have historically been compensated by excess return for assuming such risk; the so-called credit premium. Moreover, the Ministry of Finance has noted that the group is of the view that there is no conclusive evidence in the research literature to suggest that such credit premium has now been eliminated.

The return difference between corporate bonds and a benchmark index comprising equities and government bonds has according to the expert group varied significantly in the past. If corporate bond investments are exclusively made as part of active management, as proposed by Norges Bank, the analyses of the expert group therefore suggest that one must expect larger deviations between the return on the benchmark index and the actual portfolio – especially during periods of market turbulence. Deviations may deliver both positive and negative excess return. The Ministry notes that one experience from the financial crisis is that negative excess return in active management may prove especially challenging during periods of market turbulence.

The Ministry is proposing that corporate bonds issued in the current seven currencies be retained in the fixed-income benchmark, and that the 30-percent weight be maintained. This facilitates a risk level that approximate that of the current fixed-income benchmark index , as well as maintaining the role of the benchmark as a point of reference for risk taking in the Fund and a relevant basis for measuring Norges Bank’s management performance.

The corporate bond portion of the fixed-income benchmark for the GPFG is currently rebalanced to the fixed 30-percent weight on a monthly basis. The Ministry will in consultation with Norges Bank assess whether there is a need for certain minor modifications to the rebalancing provision for corporate bonds, with a view to reducing transaction costs in asset management.

Currencies, emerging markets and other segments in the government bond portion

Norges Bank is of the view that emerging market government bonds should be omitted from the fixed-income benchmark. It is, according to the Bank, challenging for a large fund like the GPFG to cost-effectively adjust the portfolio to upgrades or downgrades of the issuer countries’ credit ratings. The Bank emphasises, furthermore, that the current benchmark index is not suited as a basis for systematic strategies for investing in high-yielding currencies, of which most are emerging market currencies.

Index providers’ minimum credit rating requirements will generally result in individual countries entering and exiting the fixed-income benchmark over time. The Ministry is of the view that it is reasonable to assume that emerging markets, with, inter alia, less developed capital markets and a relatively lower income level than developed markets, will on average be more vulnerable to political or economic events which may entail changes in credit rating. Furthermore, historical data indicate that the average credit rating is significantly lower for emerging markets than for developed markets, thus implying that emerging markets are generally closer to the threshold defined by the index provider. Upgrades or downgrades to the credit rating of the issuer countries may therefore seem to be more of a challenge for emerging markets than for developed markets.

The Ministry has, at the same time, noted that the expert group’s analyses of fixed-income portfolios with and without emerging market government bonds indicate a very high degree of correlation and small risk and return differences. The analyses disregard any transaction costs as the result of changes to the credit rating of the issuer countries over time. The Ministry emphasises that such analyses are highly sensitive to the choice of time period, and thus should not be accorded too much weight.

The Ministry is of the view that the above discussion suggests that local currency emerging market bonds should be omitted from the benchmark index, in line with the advice from Norges Bank. The Bank observes that there, in principle, are no operational challenges in including all developed market currencies currently covered by the fixed-income benchmark, but proposes the omission of inflation-linked bonds and supranational bonds.

The expert group notes that there is a relatively high degree of concentration on various countries in different segments of the bond market, and observes that a benchmark index comprising only nominal government bonds issued in three currencies and with capped maturities, as proposed by Norges Bank, will omit more than half of the investment opportunities included in the current benchmark index. This would, according to the group, reduce the investability of the benchmark index and increase concentration risk.

The Ministry is proposing that other bond segments included in the government bond portion of the benchmark index for the GPFG be retained as at present. The government bond portion will thus comprise local currency nominal and inflation-linked government bonds issued by all countries classified by the index provider Bloomberg as developed markets in underlying market indices, as well as supranational bonds issued in the same currencies.

Maturity in the benchmark index

Long-maturity bonds are, all else being equal, more sensitive to interest rate changes than shorter-maturity bonds. Norges Bank’s proposal to cap the maturity of bonds in the benchmark index at about ten years will thus, when taken in isolation, serve to reduce volatility in the fixed-income benchmark for the GPFG. This is because the value of the bonds in the benchmark may be less affected by interest rate changes.

The impact of a maturity reduction on overall volatility risk in the GPFG will, on the other hand, depend on the correlation between equities and fixed-income instruments. Overall volatility risk will increase with the maturity of the fixed-income investments if such correlation is positive, and be reduced if such correlation is negative.

Maturity in the fixed-income benchmark is currently determined by market developments. The Ministry emphasises that capping the maturity of bonds included in the benchmark index may have significant implications for volatility in the overall return on the GPFG, as also noted by Norges Bank. Volatility in the Fund may be both higher and lower than without such a modification. In a hypothetical financial market scenario in which bonds increase in value upon an equity market slump, capping maturity in the fixed-income benchmark may, when taken in isolation, result in a larger decline in the market value of the GPFG than in the absence of such cap.

The Ministry notes, at the same time, that the expert group is of the view that there is no conclusive evidence in the research literature to suggest that the term premium has now been permanently eliminated. This implies that a potential modification of maturity in the fixed-income benchmark will not reduce the risk level without simultaneously having an impact on expected return.

The Ministry agrees with the assessment of the expert group that maturity in the fixed-income benchmark should continue to follow market developments. Any decisions to deviate from market maturity are, as at present, to be delegated to Norges Bank within the scope of active management.

Weighting principle for the government bond portion of the benchmark index

Norges Bank is of the view that the current weighting principle with GDP weights should be maintained, although rebalancing should be effected annually to reduce transaction costs.

The Ministry notes that GDP weights limit exposure to countries with high and increasing debt ratio and make it practicable to pay heed to the debt service capacity of states in a simple and readily understandable manner, without the Ministry having to establish a specific loss tolerance on lending to each individual countries, as would be required under the expert group’s proposal. The group’s proposed application of market weights would, at the same time, have resulted in significant changes to the country composition of the fixed-income benchmark.

The Ministry is proposing that the composition of the government bond portion of the benchmark index for the GPFG be determined on the basis of countries’ relative GDP, as at present, but capped at two times market weight for each country. Such a weighting principle is estimated to significantly curtail holdings in small markets, whilst the modifications have lesser impact on other aspects of the government bond composition of the benchmark index. This modified weighting principle will thereby result in the government bond portion of the fixed-income benchmark being sufficiently investable for the Fund, without notable impact on other characteristics. The current framework with specific adjustment factors for individual countries is made superfluous, and can be abolished. Furthermore, the Ministry agrees with Norges Bank’s assessment that the GDP weights internally in the government bond portion should be rebalanced annually, rather than monthly as at present. This will reduce unnecessary transactions resulting from exchange rate fluctuations, and thereby the transaction costs incurred by investing in line with the benchmark index.

Risk management framework

Omitting local currency emerging market government bonds from the fixed-income benchmark for the GPFG, entails that the risk associated with such investments will not be embedded in the benchmark index for the Fund. Norges Bank notes in its advice that the Ministry may consider, if emerging markets are omitted from the benchmark index, to stipulate what proportion of the Fund may be invested in emerging market currencies.

The Ministry notes that emerging market debt is also included in other segments of the bond market and at times issued in other currencies than that of the country in question. Norges Bank currently has scope for investing the fund capital in such bonds, although some sub-segments are not included in the benchmark index for the Fund. In addition, the corporate bond portion of the fixed-income benchmark currently includes emerging market corporate bonds, if such bonds are issued in one of the seven approved currencies of the corporate sub-index.

The Ministry is proposing to stipulate an overall limit on the proportion of the GPFG fixed-income portfolio that may be invested in fixed-income instruments not issued by states or companies domiciled in developed markets. This will limit the total scope of emerging market fixed-income investment and, if applicable, frontier and unclassified markets, including both issuer risk and the proportion of the Fund invested in such currency. Such a framework takes into account the fact that several segments of the bond market are currently not included in the benchmark index, and facilitates a more integrated framework for and management of risk in relation to emerging market fixed-income investments than at present.

As at the end of 2018, the value of local currency emerging market government bonds (GDP weighted) represented about seven percent of the fixed-income benchmark for the GPFG, whilst the same markets would have accounted for about three percent under market weighting. Emerging market corporate bonds represented, at the same time, about one percent of the fixed-income benchmark. The changes proposed to the fixed-income framework imply that such corporate bonds are omitted from the benchmark for the GPFG.

The Ministry is proposing to stipulate the limit on emerging market investments at five percent of the fixed-income portfolio. This corresponds, more or less, to the proportion of such markets in the investable investment-grade bond market as at the end of 2018, as defined by the index provider Bloomberg, but is somewhat lower than the approximately 8 percent under the current benchmark index. Norges Bank notes, inter alia, that one may establish systematic strategies for investing in high-yielding currencies if emerging markets are omitted from the benchmark. Such strategies entail higher risk than broad emerging market investments, which in the view of the Ministry suggests, when taken in isolation, that the limit should be lower than the current emerging market proportion of the benchmark index.

Furthermore, the management mandate for the GPFG stipulates specific reporting requirements for emerging market investments. When fixed-income emerging market investments are now omitted from the benchmark index for the GPFG, the Ministry will subject such investments to additional public reporting requirements, including on scope, investment focus and contribution to relative risk and return in the Fund.

The management mandate for the GPFG also requires Norges Bank to carry out stress tests as part of its measurement and management of risk in the management of the Fund, and requires extreme event risk analyses to form an integral part of risk management. The Ministry agrees with the assessment of the expert group that public reporting of such stress tests may strengthen communication of bond market risk taking in the Fund. The Ministry will stipulate such reporting requirements in the management mandate for the GPFG.

The Ministry notes that there is considerable variation in sustainable debt level also across developed markets. It is therefore proposed to maintain the mandate requirements for Norges Bank to take account of differences in fiscal strength between countries in the composition of government bond investments.

Composition and currency distribution of new fixed-income benchmark for the GPFG

The composition of the new strategic fixed-income benchmark for the GPFG is shown in Figure 3.4. It is proposed to retain all segments currently included in the benchmark index, but limited to developed market government and corporate bonds. A comparison of the currency and country composition of the current and new fixed-income benchmark for the GPFG, based on market data as at the end of October 2018, is provided in Table 3.1.

Source Ministry of Finance.

3.2 The environment-related mandates and unlisted renewable energy infrastructure

3.2.1 Introduction

In the fund report in the spring of 2018,9 the Ministry of Finance proposed an assessment of whether unlisted renewable energy infrastructure investments can be effected within the scope of the dedicated environment-related investment mandates, with the same transparency, risk and return requirements as apply to the other investments in the GPFG. It also proposed a review of the regulation of the environment-related mandates in general, including the size of the mandates.

The following is stated in the recommendation of the Standing Committee on Finance and Economic Affairs relating to the report; see Recommendation No. 370 (2017–2018) to the Storting: «The Standing Committee notes that unlisted infrastructure investment opportunities have been discussed and considered several times, including, inter alia, investment opportunities in renewable energy source development. The Standing Committee requests, against this background, the Ministry to revert to the Storting no later than in next year’s report with a specific mandate proposal for unlisted renewable energy infrastructure investments under the environment-related mandates, with the same transparency, risk and return requirements as apply to the other investments.» The majority of the members of the Standing Committee requested, in connection therewith, the Ministry to assess whether the scope of the environment-related mandates should be expanded.

In a letter of 22 June 2018, the Ministry requested Norges Bank’s assessment of the regulation of the environment-related mandates and how the investment universe of the mandates might be expanded to include unlisted renewable energy infrastructure. The Bank forwarded its assessments in letters of 29 and 30 October 2018. Norges Bank takes the view that unlisted renewable energy infrastructure investments can be implemented within the scope of the environment-related mandates. The Bank believes that the upper limit for the environment-related mandates should be raised in order to enable Norges Bank to exploit the distinctive characteristics of the Fund and implement unlisted renewable energy infrastructure investments in a cost-effective manner.

Furthermore, the Ministry received a report from the consultancy firm McKinsey on 19 December 2018, which describes the global unlisted renewable energy infrastructure market. The Bank’s letters and McKinsey’s report are available on the Ministry website.

McKinsey estimates that the total market value of installations and means of production in renewable energy infrastructure was USD 2,900 billion in 2017 and will increase to USD 4,200 billion in 2030. A major part of the growth is expected, according to both Norges Bank and McKinsey, in emerging markets. Only parts of the total renewable energy infrastructure market will be available to institutional investors. McKinsey estimates the part of the market available to investors in the unlisted market in 2030 at about USD 1,100 billion. In addition, the listed renewable energy infrastructure market is estimated at about USD 500 billion.

Section 3.2.2 presents the background to the environment-related mandates and the Bank’s account of the management of such mandates. The unlisted renewable energy infrastructure market is discussed in section 3.2.3, whilst Norges Bank’s regulation and implementation assessments are discussed in 3.2.4. The Ministry’s assessments are presented in section 3.2.5.

3.2.2 The environment-related mandates

Background

Following a comprehensive public evaluation of the ethically motivated guidelines, the Ministry of Finance proposed the establishment of a specific investment programme focused on environmentally-friendly activity or technology in 2009; see the fund report in the spring of 2009.10 At the time, the Ministry considered specifying a separate investment universe for such investments, which included both private equity and unlisted infrastructure. However, it was proposed in the National Budget for 2010, in accordance with advice from Norges Bank, that the Bank should establish environment-related mandates within the same investment universe and framework as applied to the rest of the Fund. The Ministry noted that the Bank considered environment-related investments to be especially well-suited for active management. It was proposed that the environment-related investments would over time amount to NOK 20 billion.11 In 2012, the mandate scope was quantified at NOK 20–30 billion. This has subsequently been increased twice; first to NOK 30–50 billion with effect from 1 January 2015 and then to NOK 30–60 billion with effect from 1 September 2015.

The current regulation

The current regulation of the environment-related mandates was established in 2015, and takes the form of general wording in the management mandate for Norges Bank on the establishment of such mandates and the normal scope of these. The establishment of a normal range for the investments was intended to highlight that investment opportunities, and thereby the amount of such investment, might vary over time. The Ministry observed, at the same time, that a higher range for such investments would entail restrictions on the Bank’s management that could hardly be justified financially.

The management of the dedicated mandates forms part of the Bank’s active management. This implies that the investments are measured against the benchmark index defined by the Ministry and draw on the scope for deviations therefrom, as measured by expected tracking error.

The Ministry has stipulated specific reporting requirements for the environment-related mandates, which include scope, strategy and asset type. Norges Bank shall, according to the reporting requirement, explain how the intention of the investments is fulfilled. The intention is not specified any further in the management mandate, but was, inter alia, described in the fund report in the spring of 2009:

«The investments must be aimed at eco-friendly assets or eco-friendly technology that is expected to yield clear environmental benefits, such as climate-friendly energy, improving energy efficiency, carbon capture and storage, water technology and management of waste and pollution.»

The detailed specification of criteria for what is considered an environment-related company, thus qualifying for inclusion in the investment universe for the environment-related mandates is delegated to Norges Bank. In order to include a company in the investment universe for the environment-related mandates, Norges Bank requires a minimum of 20 percent of the activities of the company to fall within one or more of the main segments defined as environment-related by the Bank. Environment-related investments are categorised by the Bank as investments in low-emission energy and alternative fuels, clean energy and energy efficiency technology and natural resource management technologies.

Norges Bank has since 2015 reported on responsible investment of the Fund in a separate publication, including the management of the environment-related mandates. The reporting includes, inter alia, the amount invested as at the end of the year, specified into equities and fixed-income instruments, as well as the return on the environment-related equity mandates. In addition, the Bank has in its most recent reports published the ten largest exposures under the environment-related mandates within the abovementioned categories.

Norges Bank’s account

In its letter, Norges Bank observes that the Ministry requires, through the mandate provision on the environment-related mandates, that the Bank’s management shall be active and that the composition of the portfolio shall deviate from the benchmark index. The Bank notes the premise that these investments shall be subject to the same profitability requirements as the other investments in the Fund. It is noted in the letter that both the Bank and the Ministry have previously emphasised that the requirement for environment-related mandates represents a management restriction that will, generally speaking, restrict the scope of the Bank for generating excess return.

The environment-related mandates have been managed both internally and externally since start-up in 2009. The mandates are currently managed internally in their entirety, after the Bank discontinued the externally managed mandates in May 2018 in order to reduce asset management costs.

The Bank notes that what constitutes an environment-related company is, to some extent, subject to discretionary judgement. Such investments may range from large conglomerates with a minor portion of environment-related activities to more pure-play environmental companies in various sectors. Norges Bank has, in line with the stipulations of the Ministry in the fund report in the spring of 2009, focused its environment-related equity mandates on companies in the three main segments defined by the Bank as environment-related; see the discussion in the section on current regulation. Moreover, the Bank has decided that the mandates shall not be invested in oil and gas producers, coal companies and mining companies.

The investments within the scope of the environment-related mandates are currently made in listed equities and so-called green bonds. The market value of the investments was NOK 56.7 billion as at the end of 2018, split into NOK 43.3 billion in equities and NOK 13.4 billion in green bonds. Norges Bank notes that a major part of the Fund will be invested in companies with environment-related activities irrespective of any requirement for the Bank to establish special environment-related investment mandates. About six percent of the companies in the equity benchmark for the Fund are classified as environment-related as at the end of July 2018.12 The bonds included in MSCI Bloomberg Green Bond Index represented, at the same date, 0.3 percent of the fixed-income benchmark for the Fund. In total, this corresponded to about NOK 340 billion.

The environment-related equity mandates are managed in accordance with the same key principles as the other equity investment mandates of the Fund. The asset management objective is to generate excess return, in relation to relevant return measures. The relative return on the environment-related equity mandates has varied over time and with different return metrics. The annual return on the equity mandates has since commencement in December 2009 been 4.5 percent measured in the currency basket of the Fund. This is lower than the annual return on the equity benchmark for the Fund, which was 8.0 percent over the same period. However, the return on the mandates has been slightly higher than that on the equity benchmark over the last five years; see Table 3.2. The return on the environment-related equity mandates has been more volatile than the return on the equity benchmark over the same period. Norges Bank notes in the report on responsible investment for 2018 that the investment universe of the environment-related mandates has been expanded in recent years to include larger companies and that greater emphasis has been placed on developed markets in order to reduce volatility.

The return on the environment-related equity mandates may be compared to the return on various environmental indices. The Bank observes, in its letter to the Ministry, that index providers exercise considerable discretion in their construction of the indices. There are major differences between the indices,13 and there have also, according to the Bank, been considerable changes in their composition over time. Performance in the Bank’s management of the environment-related investments has varied over time and depending on what environmental index such management is measured against; see Figure 3.5.

Source Norges Bank.

Norges Bank states that the risk and return characteristics of the Bank’s investments in green bonds do not differ significantly from the other bond investments with comparable credit and interest rate risk.

The Bank also states that since the environment-related mandates constitute a minor portion of the Fund, the requirement for the Bank to make such investments has had little impact on overall risk and return in the Fund.

3.2.3 The unlisted renewable energy infrastructure market

Production capacity

Renewable energy accounts for an ever-increasing share of total global power generation. McKinsey notes that renewable energy development, measured as installed capacity, has increased significantly over the last decade. In 2017, renewable energy accounted for 25 percent of total global power generation. About 75 percent of this was in the form of hydropower, whilst solar energy and onshore wind power accounted for 17 percent and 7 percent, respectively. The remainder was represented by offshore wind power. Installation and operating costs have declined significantly, and production capacity per dollar invested has thus increased considerably. More than half of new capacity growth has been in emerging markets.

Renewable energy growth is expected to remain high in coming years as well. McKinsey estimates that installed renewable energy capacity will increase by 150 percent towards 2030,14 and explains the expected growth by both supply and demand side factors. A major part of the new capacity growth in coming years can, according to McKinsey, be explained by a further decline in costs for solar and wind power. McKinsey points to a general increase in energy demand, as well as a larger share of electricity in the energy mix to meet global and national emissions targets, as key demand side factors that may explain new renewable energy capacity growth in coming years.

The market available to institutional investors

McKinsey estimates that the total market value of installations and means of production in renewable energy infrastructure in 2017 was USD 2,900 billion and that total market value will increase to USD 4,200 billion in 2030.15 A major part of the growth is expected, according to both Norges Bank and McKinsey, to be concentrated in emerging markets. A significant portion of the renewable energy infrastructure market is government-owned and illiquid. This implies that part of the market is not available to investors. McKinsey has estimated the size of the investable unlisted renewable energy infrastructure market, from which government ownership and illiquid investments are omitted, in 2030 at about USD 1,100 billion.16 In addition, it is estimated that listed renewable energy infrastructure assets will represent USD 500 billion.

McKinsey estimates that 86 percent of the investable unlisted renewable energy infrastructure market will be in solar and wind power in 2030, whilst only 14 percent will be in hydropower. Hydropower will account for a relatively minor share because it is predominantly government-owned, and is expected to remain so. It is furthermore estimated that about 45 percent, or USD 500 billion, of the investable market will be within OECD countries. About 80 percent of the market in 2030 is estimated to be investments in capacity installed after 2017.

Norges Bank notes that reports from various sources indicate that the value of annual new renewable energy production investments has remained stable at around USD 300 billion since 2012. It is emphasised, at the same time, that future investment forecasts are uncertain and vary between different sources. Political decisions, new technology and economic growth may have a major impact on developments in the renewable power generation infrastructure investment market. The Bank also observes that increased activity has been registered in the refinancing of existing projects over the last few years. Such activity has been concentrated in developed markets and several of the transactions have been large.

Norges Bank notes that the risk and return characteristics of renewable energy infrastructure investments will generally vary with the type of asset, whether it is a greenfield or brownfield project, the country or region in which the investment is made, the design of the contract and the choice of financial instrument.

The Bank also states that the renewable energy market is changing and that historical risk and return data will not necessarily provide a good indication of what to expect in coming years. Renewable energy sources are currently competitive in many markets, and a number of new renewable energy infrastructure projects are launched without government subsidies. Project profitability and risk will more than before depend on movements in power prices and the extent to which the developer hedges future revenues through long-term end user contracts. Several countries have established regimes facilitating such contracts.

McKinsey notes that unlisted renewable energy infrastructure investments have several characteristics that appear attractive to institutional investors, although such investments may also entail exposure to political, regulatory and reputational risk for investors; see Box 3.2.

Institutional investors’ approach to unlisted renewable energy infrastructure

McKinsey has surveyed and described unlisted renewable energy infrastructure investments in a sample of 13 institutional investors, including three North American funds, six European funds (four of which are Scandinavian) and three Asian funds. The afore-mentioned funds have expanded their unlisted renewable energy infrastructure investments over the last decade. McKinsey observes that this may be because of the attractive properties of unlisted infrastructure, as well as the increased maturity of renewable energy technologies. Furthermore, technological developments in solar and wind power have resulted in the technical risk associated with such investments now being lower. McKinsey also observes that some investors have faced requirements from their owners to invest in a more environmentally-friendly manner.

The consultancy firm has examined a selection of transactions from the abovementioned investors. It is noted from the study that the investments are spread across several technologies, although most of the investments have been in solar and wind power (both offshore and onshore). Moreover, it is noted that most of the projects have been in OECD countries, primarily in Western Europe and North America. McKinsey observes that the investments are made in both operating assets and in greenfield projects.

An investor considering unlisted renewable energy infrastructure may choose to implement such investments in various ways. The main distinction is between direct and indirect investments, and between debt and equity. Norges Bank notes that direct unlisted infrastructure investments are large in size and that the assets normally have a long lifespan. Institutional investors often choose to implement such investments in collaboration with market participants that have operational and technical expertise in the relevant segment. Indirect unlisted infrastructure investments are primarily made through private equity funds. The Bank states that there are several such private equity funds investing in unlisted infrastructure, although only a small number of these are currently specialising in renewable energy.

Most investors in the unlisted renewable energy infrastructure market invest in companies that develop, acquire, own and/or divest a portfolio of renewable energy infrastructure assets, according to the McKinsey study. The investments are often made in collaboration with other investors.

An investor may also invest in bonds and other fixed-income instruments, including green bonds, that are issued to raise capital for renewable energy infrastructure projects.

3.2.4 Norges Bank’s regulation and implementation assessments

Regulation in the management mandate

Norges Bank is of the view that the operational management of investments in unlisted infrastructure has a number of similarities with unlisted real estate, including the inability to define the unlisted investment strategy via a benchmark index. This is reflected in the regulation of the unlisted real estate investments in the Fund. In order to facilitate the Bank investing in unlisted renewable energy infrastructure in a manner improving the overall risk and return characteristics of the Fund, it is the view of the Bank that such investments should be regulated in the same manner as the unlisted real estate investments in the Fund. It is also noted that the investments might need to be assigned a separate portfolio.

The Ministry has in the management mandate allowed for the unlisted real estate portfolio of the Fund to be invested via subsidiaries of Norges Bank, with a larger ownership stake and in different types of financial instruments. The Bank emphasises that this should also apply to the unlisted renewable energy infrastructure investments in the Fund. As with real estate, the Bank is of the view that it may be appropriate, and ensure the necessary flexibility, to permit holdings in excess of 10 percent of the voting shares of listed renewable energy infrastructure companies.

Norges Bank believes that the scope of the environment-related mandates should be expanded to enable the Bank to exploit the distinctive characteristics of the Fund and implement unlisted infrastructure investments in a cost-effective manner. The Bank notes that the scope for environment-related mandates will encompass both listed and unlisted investments, although in the longer run the Bank may allocate a major part of such scope to unlisted renewable energy infrastructure investments.

Norges Bank states that a possible definition of renewable energy infrastructure in the management mandate may be as follows: «Renewable energy infrastructure is defined as land, real estate and physical assets, onshore or offshore, that are primarily used, or planned used, for the production, storage, transmission and distribution of energy based on renewable energy sources.»

The Ministry is proposing that the unlisted renewable energy infrastructure investments in the Fund be implemented within the current scope for deviations from the benchmark index, i.e. 1.25 percentage points.17 The Bank notes that expected tracking error for the unlisted real estate investments in the Fund is calculated on the basis of a representative time series from an external service provider, but notes that there is not currently any corresponding time series for unlisted renewable energy infrastructure. The Bank will at a later date define a method for calculating tracking error for unlisted renewable energy infrastructure. The mandate requires such method to be approved by the Ministry.

The mandate for the GPFG requires the Executive Board of Norges Bank to set supplementary limits for risk that is not normally captured in the calculation of tracking error. As far as the unlisted renewable energy infrastructure investments in the Fund are concerned, the Bank states that it may at first be appropriate for the Executive Board to set limits with regard to how much may be invested in individual countries, in emerging markets and in greenfield projects. Moreover, the Executive Board may, as at present, stipulate limits on total debt ratio and maximum debt ratio for individual investments, maximum ownership stake and how large a portion of the Fund may be managed by a single external manager. The Executive Board may impose additional requirements in connection with the strategy plan and in the investment mandate for the CEO of Norges Bank Investment Management (NBIM).

Norges Bank is of the view that it would be appropriate for the reporting requirements currently applicable to the unlisted real estate investments in the Fund to also apply to unlisted renewable energy infrastructure investments. The Bank assumes that the current specific reporting requirement for renewable energy in the mandate will be removed.

Implementation

The Bank states that it will at the outset consider direct investments made together with partners. Potential partners may be listed companies in which the Fund is already invested and which are seeking to raise private capital to fund specific projects, other investors, financial institutions and multilateral/regional development banks.

Besides, the Bank notes that the unlisted investments in the Fund will generally involve a larger ownership stake than the listed investments in the Fund. Larger ownership stakes entail increased visibility, but also more control and improved scope for imposing requirements. For investments made together with partners, the voting rights and other ownership rights of the Fund will be regulated through shareholder agreements. The Bank emphasises that it will seek to further the ownership interests of the Fund in the best possible manner through direct board representation and the concluded contracts.

Responsible investment is an integral part of the management of the Fund. The Bank’s principles for responsible investment are, inter alia, based on the UN Global Compact, the G20/OECD Principles of Corporate Governance and the OECD Guidelines for Multinational Enterprises. The guidelines are of relevance to both listed and unlisted investments.

The Bank states that it will attempt to identify all relevant risk ahead of each investment through thorough due diligence. Such reviews will, inter alia, address regulatory risk, environmental risk, labour, health and safety standards, tax, corruption risk and IT security, as well as project sustainability in the broader sense. The Bank is highlighting the Global Real Estate Sustainability Benchmark (GRESB) framework for assessment of the sustainability for individual unlisted real estate investments. This framework was in 2016 expanded to include unlisted infrastructure, and may over time be used by the Bank in its company dialogue and for assessing the sustainability of all unlisted investments.

Norges Bank is of the view that it can reasonably be assumed that the internal asset management costs for unlisted infrastructure will be on a par with the asset management costs for the unlisted real estate investments in the Fund.

There will be a need for hiring some additional personnel, but the investments can, according to the Bank, be implemented with significantly fewer employees than are required for managing the unlisted real estate investments. The Bank will give priority to the establishment of cost-effective solutions and draw on existing management expertise. Operational implementation will benefit from experience with the unlisted real estate investments in the Fund. The Bank states that it will be appropriate to use external experts for assessments of the technical and operational risk of individual investments.

Norges Bank observes that it is important for the investments to be implemented in a manner that protects the other investments in the Fund. The Bank proposes, in accordance with this and in line with practice for the unlisted real estate investments, to implement unlisted renewable energy infrastructure investments via subsidiaries of Norges Bank. It may in many situations be appropriate to establish subsidiaries in Norway. However, it is emphasised that it may vary from investment to investment what constitutes an appropriate structure. The issue of localisation of subsidiaries needs to be considered in each case.

The tax implications of unlisted renewable energy infrastructure investments will, according to the Bank, depend on each investment and needs to be assessed in each case. The Bank states that such assessment will be based on Norges Bank’s general policy for managing tax risk, and also ensure compliance with all applicable tax rules and conformity with generally accepted international tax standards.

The Bank assumes that the Ministry will maintain the mandate requirement that the fund capital may only be invested in unlisted companies and fund structures in countries with which Norway has a tax treaty. It is observed that unlisted infrastructure investments will not, as far as the Bank has been able to ascertain, give rise to any significant new tax challenges beyond those identified for unlisted real estate. It is also emphasised that unlisted renewable energy infrastructure investments can be implemented in a manner that has no tax implications for other investments.

Norges Bank emphasises that it will aim to provide the same detailed information for the unlisted renewable energy infrastructure investments as for the unlisted real estate investments. It is observed that the scope for disclosing information on developments in any investments must be regulated in private agreements. The Bank emphasises that it will, as for unlisted real estate, specify reporting requirements in the agreements with partners and managers to ensure disclosure of information in accordance with the requirements laid down in the management mandate. The return on the unlisted renewable energy infrastructure investments will in the public reporting be compared to relevant return measures, including the return on the securities sold to fund the purchases. The Bank states that it will use a number of metrics and methods to analyse and describe the risk associated with the investments.

According to Norges Bank, the size of the Fund and its limited liquidity need may give rise to advantages when it comes to investing in projects with substantial capital requirements. The Bank states that solar and wind farms currently seem to be the most relevant investment candidates, and that most large projects of this type are found in Europe and the US. An increasing number of renewable energy projects are profitable without subsidies in these regions. It is noted, furthermore, that frameworks have also been established to facilitate long-term power supply agreements at predetermined prices. These developments involve, according to Norges Bank, somewhat lower regulatory and political risk. Market developments imply, at the same time, that the risk associated with unlisted renewable energy infrastructure investments has shifted towards the risk of movements in power prices and the risk in relation to end users that have concluded power purchase agreements. In comparison with regulatory and political risk, the Bank is of the view that these are examples of types of risk which the Fund is better suited to absorb and which the Bank has experience with assessing.

In summary, Norges Bank states that it will approach the investment opportunities and build expertise gradually. The strategy for the unlisted renewable energy infrastructure investments in the Fund will be developed over time and adjusted on the basis of experience. The Bank emphasises that it will to begin with consider projects with relatively low market and operational risk in developed markets.

3.2.5 The Ministry’s assessments

Introduction

The Standing Committee on Finance and Economic Affairs asked, in connection with the deliberation of last year’s fund report, the Ministry to revert to the Storting with a specific mandate proposal for unlisted renewable energy infrastructure investments under the environment-related mandates, with the same transparency, risk and return requirements as apply to the other investments.18 The majority of the members of the Standing Committee requested the Ministry to assess whether the scope of the environment-related mandates should be expanded.

The Ministry has received updated data and assessments of the unlisted renewable energy infrastructure market from Norges Bank and McKinsey. The assessments show that the market for such infrastructure is changing. Government subsidies are of less importance to profitability, and an increasing number of projects are profitable without such subsidies. This development involves somewhat lower regulatory and political risk. Moreover, it is expected that substantial investments will be made in coming years, which may make the market interesting for institutional investors like the GPFG.

The unlisted infrastructure market accounts for a minor portion of the global capital market.19 However, institutional investors such as pension funds and sovereign wealth funds, and especially the large funds, have invested a larger portion in unlisted infrastructure than other investors. As at the end of 2017, the largest funds in the CEM Benchmarking survey20 had on average about three percent of their investments in unlisted infrastructure. Renewable energy is one of the unlisted infrastructure sub-markets. There exists little information on the allocation of institutional investors, on average, to this sub-market. McKinsey estimates the total market value of unlisted renewable energy infrastructure available to institutional investors as at the end of 2030 at USD 1,100 billion.

The Ministry has taken note of Norges Bank’s assessment that unlisted renewable energy infrastructure investments may be implemented within the scope of the environment-related mandates and that the Bank may have advantages relative to other investors. The Ministry has also taken note of the Bank’s intention to adopt a cautious approach and at the outset to consider investing together with partners in developed markets, as well as in projects with relatively low market and operational risk. The Ministry is of the view that the approach adopted by the Bank, along with the Bank’s accumulated unlisted real estate investment expertise and experience, suggests that it would be acceptable to allow for unlisted renewable energy infrastructure under a suitable framework.

General regulation: Not part of the benchmark index, but a separate portfolio

Unlisted renewable energy infrastructure has a number of similarities with unlisted real estate investments and may thus be regulated more or less correspondingly in the mandate from the Ministry.21 There exist no good benchmark indices for unlisted investments, unlike for listed investments, thus limiting the scope of the Ministry for assessing the risk and return characteristics of such investments and for specifying an investment strategy via a benchmark.

The Ministry therefore proposes, in line with the regulation of unlisted real estate, not to establish any designated benchmark index or target for the allocation of the Fund to unlisted renewable energy infrastructure. It will be up to Norges Bank to determine the scope and composition of the unlisted infrastructure investments, within the limits laid down by the Ministry in the management mandate. The Ministry is further proposing that any unlisted renewable energy infrastructure investments will be measured against a broad set of relevant return metrics, including the Bank’s funding of such investments.

Regulation corresponding to that for unlisted real estate implies, moreover, that unlisted renewable energy infrastructure is included in the investment universe (limited to the environment-related mandates) and assigned a separate portfolio, but not included in the benchmark index. The Ministry agrees with Norges Bank’s assessment that key concepts should be defined in the mandate, such as to avoid ambiguity about which investments may be included in the portfolio. The Ministry is proposing that renewable energy infrastructure be defined as follows in the mandate:

«land, real estate and physical assets, onshore and offshore, that are primarily used, or planned used, for the production, transmission, distribution and storage of energy based on renewable energy sources».

Such a definition is in line with the Bank’s proposal and will enable the Bank to exercise an element of discretion when interpreting what may be included in the portfolio. Some projects may, for example, depend on other energy sources to deliver electricity during periods of peak demand or limited production capacity due to local weather conditions. Renewable energy sources may therefore be balanced with non-renewable energy sources.

The unlisted infrastructure investment framework

Norges Bank’s deviations from the benchmark index are primarily managed through the 1.25 percentage point limit on expected tracking error. Unlisted renewable energy infrastructure investments will draw on such limit. The Ministry is proposing that the said limit on deviations remain unchanged. This implies that the Bank must prioritise unlisted renewable energy infrastructure investments against other strategies that give rise to deviations from the benchmark index. The Ministry notes that the Bank will prepare a method for calculating expected tracking error for unlisted renewable energy infrastructure investments. Such method shall be approved by the Ministry.

The Ministry is proposing, corresponding to the regulation of unlisted real estate, the stipulation of an upper limit on unlisted renewable energy infrastructure investments. It is proposed that such limit be put at 2 percent of the investment portfolio. In assessing the upper limit on unlisted renewable energy infrastructure, weight has been attached to the risk of diverging return on such investments from that on listed equities and fixed-income instruments. Norges Bank must thus aim for a smaller portion than 2 percent in its portfolio management in order to avoid breaching the limit, and thereby the divestment of assets, in scenarios of steep and sudden decline in the value of the listed investments. The limit will at the same time, in the view of the Ministry, enable Norges Bank to aim for an unlisted renewable energy infrastructure portion which is sufficiently large to benefit from any economies of scale in this market.

The market value of the environment-related mandates shall currently fall, in normal conditions, within the NOK 30–60 billion range. The Ministry refers to the Bank’s position that the upper limit for the environment-related mandates should be raised to enable Norges Bank to exploit the distinctive characteristics of the Fund and implement unlisted renewable energy infrastructure investments in a cost-effective manner. Norges Bank may invest fund capital in both listed and unlisted assets within the scope of dedicated environment-related mandates. The Ministry emphasises that unlisted renewable energy infrastructure investments shall exclusively be made within the scope of the environment-related mandates. Consequently, the upper limit on environment-related mandates will limit the scope of such investments.

The Ministry is proposing, based on an overall assessment, to increase the upper limit on the normal scope of the environment-related mandates from NOK 60 billion to NOK 120 billion. This corresponds to about 1.5 percent of the market value of the Fund as at the end of 2018. The lower cap, which entails an element of special investment fund allocation, is kept unchanged at NOK 30 billion. The Ministry has taken note of the Bank’s indication that it may in the longer run use a major part of the scope for environment-related mandates for unlisted renewable energy infrastructure investments.

The Ministry emphasises that the scope for environment-related mandates, in aggregate, and unlisted renewable energy infrastructure, in particular, is not established for the purpose of instructing the Bank that the Fund shall be invested in unlisted renewable energy infrastructure, but to provide the Bank with sufficient flexibility to make such investments if deemed profitable. A stipulated range for the environment-related mandates is intended to highlight that investment opportunities, and thereby the scope of such investments, may vary over time. The Ministry notes, at the same time, that dedicated mandates impose, as a general rule, a restriction on Norges Bank’s active management, thus limiting the Bank’s opportunities for generating excess return.

The mandate for the GPFG will, as with unlisted real estate investments, enable the Bank to invest in unlisted renewable energy infrastructure globally, with the exception of Norway. Thorough due diligence will be required and the Executive Board shall set supplementary risk limits for unlisted renewable energy infrastructure, including limits on investments in individual countries, emerging markets and in projects under development.

Permitted instruments and ownership stake limitations

The management mandate for Norges Bank allows for the unlisted real estate portfolio to be invested in real estate via subsidiaries of Norges Bank and in various types of financial instruments, such as fund structures and equity and debt instruments issued by non-listed companies. This offers the Bank flexibility in the implementation of the investments. The Ministry agrees with the Bank’s assessment that a corresponding mandate provision should apply to the unlisted renewable energy infrastructure portfolio.

The GPFG shall be a financial investor. The mandate therefore does not permit the Bank to hold more than ten percent of the voting shares of any one company. An exemption has been granted for ownership interests in listed and unlisted real estate companies. The Ministry proposes a corresponding exemption for investments in unlisted renewable energy infrastructure companies. For listed renewable energy infrastructure investments, it is not proposed to permit ownership stakes in excess of ten percent. The Ministry notes that the GPFG shall be a financial investor in listed markets, whilst there is currently a limited number of listed infrastructure companies that are exclusively or principally engaged in renewable energy activities.

Description of intention, transparency and reporting

What constitutes environment-related investments is not currently defined in the management mandate from the Ministry, but the reporting provisions in the mandate require Norges Bank to describe and assess the manner in which the intention behind these investments is observed. However, such intention is not specified any further in the mandate, but was described in the fund report in the spring of 2009; see the discussion in section 3.2.2.

Both Norges Bank and the Ministry of Finance have previously noted that it is challenging to quantify environmental effects of the environment-related mandates; see, inter alia, the discussion in the fund reports in the spring of 2011 and 2014.22 It is observed, at the same time, that the companies and projects in which the Fund is invested may have various positive environmental effects, whether directly in the form of reduced CO₂ emissions or more indirectly through the development of new technology.23 In its recommendation on the fund report in the spring of 2011,24 the Standing Committee on Finance and Economic Affairs stated that «the majority appreciates the difficulties of precise reporting of the environmental effects of these investments. Open communication on the criteria for investments within the programme, in addition to reporting on the return on such investments, would contribute to this.»

The Ministry proposes, based on an overall assessment, that the intention behind the dedicated environment-related mandates shall in future be safeguarded by stipulating specific requirements applicable to such investments in the management mandate. It is proposed to introduce a definition in line with the discussion in the fund report in the spring of 2009:

«The investments shall be aimed at eco-friendly assets or eco-friendly technology, such as climate-friendly energy, improving energy efficiency, carbon capture and storage, water technology and management of waste and pollution.»

The Ministry is of the view that the requirement in the management mandate for Norges Bank to describe and assess the manner in which the intention of the investments is observed consequently is superfluous, and can be omitted.

The mandate from the Ministry of Finance stipulates a general requirement for the greatest possible transparency about the management of the Fund within the limits defined by a sound execution of the management assignment. Furthermore, a number of reporting requirements have been imposed, including specific reporting requirements for the unlisted real estate portfolio. The Ministry is of the view that it would be appropriate for the reporting requirements currently applicable to the unlisted real estate investments in the Fund to also apply to unlisted renewable energy infrastructure investments. The Ministry has taken note of Norges Bank’s intention to provide the same detailed information for any unlisted infrastructure investments as for the unlisted real estate investments.

In addition, the Ministry proposes an expansion of the reporting requirements for the environment-related mandates, including a requirement for the Bank to describe which investments are included under the mandates and criteria for the selection of such investments. It is also proposed that the Bank shall report the risk and return for the environment-related mandates as a whole, as well as specified by equities, fixed-income instruments and any unlisted renewable energy infrastructure investments. The special reporting requirement on renewable energy in the management mandate for the Bank, will in the view of the Ministry be accommodated through the expanded requirements for reporting on the environment-related mandates in general and unlisted renewable energy infrastructure in particular, and may thus be omitted.

Future process

The Ministry will after the Storting’s deliberation of the fund report prepare a proposal for specific provisions in the mandate for the GPFG, and present these to Norges Bank. It is intended for the changes to enter into effect no later than 1 January 2020.

3.3 New provisions on rebalancing of the equity share

3.3.1 Introduction

The investment strategy for the GPFG is laid down in the management mandate provided for Norges Bank, which defines, inter alia, a fixed strategic allocation between equities and fixed-income securities. In June 2017, the Storting endorsed an increase in the strategic equity share of the GPFG to 70 percent; see Recommendation No. 357 (2016–2017) to the Storting. The strategic equity share expresses a risk level that is acceptable to the owner, and reflects a target for the allocation between the two asset classes. However, the equity share of the actual benchmark index will vary as the result of diverging price developments between equities and fixed-income instruments. Such differences may change the risk and return characteristics of the benchmark index relative to those underpinning the strategic asset allocation. Provisions have therefore been laid down on when and how the equity share shall be rebalanced to the strategic allocation. The equity share is rebalanced through securities trading, and the manner in which this is effected has both return and cost implications.

Rebalancing of the equity share forms part of the long-term investment strategy for the Fund. This strategy is endorsed by the Storting; see the fund report in the spring of 201225, Recommendation No. 361 (2011–2012) to the Storting and the National Budget for 2013. The purpose of rebalancing is to ensure that the benchmark index does not over time deviate significantly from the strategic allocation between equities and fixed-income instruments. Rebalancing may also serve to increase return on the Fund through exploitation of possible time variations in the equity market risk premium. These considerations need to be balanced against transaction cost considerations.

In 2012, it was decided that rebalancing shall be initiated when the equity share deviates by more than four percentage points from the strategic allocation, cf. Section 1-6, Sub-section 4, of the management mandate for the GPFG. The rebalancing has been completed when the equity share of the benchmark index has been reverted to the strategic allocation. Detailed provisions have been laid down on how the rebalancing shall be effected, but these are exempt from public disclosure to prevent the Fund from incurring costs as the result of other financial market participants exploiting information concerning Norges Bank’s trading patterns.

In a letter of 9 June 2017, the Ministry of Finance asked Norges Bank to analyse and assess the need for amending the rebalancing provisions when the new strategic equity share of 70 percent has been established in the benchmark index. Several factors suggested that a new assessment of these provisions would be appropriate. The value of the Fund has increased significantly since 2012 and trading volumes upon rebalancing have thus increased. This may result in higher costs, as the securities trading may influence market prices unfavourably. Furthermore, rebalancing costs may now be higher as the result of the Fund having less scope for utilising current inflows, which are considerably smaller than before, measured as a portion of the Fund. When inflows (and outflows) are used to modify the equity share upon rebalancing, the trading volumes resulting from actual rebalancing are reduced. The decision to increase the equity share from 62.5 percent to 70 percent is also of significance, and will result in fewer expected rebalancings, since return differences between equities and fixed-income instruments need to be larger to trigger a rebalancing.

The Ministry added further details to its request in a letter of 5 March 2018 to Norges Bank. Norges Bank has outlined its analyses and assessments in a letter of 28 August 2018.

3.3.2 Norges Bank’s advice

Norges Bank has assessed how various rebalancing provisions affect transaction costs and the magnitude of deviations between the equity share of the benchmark index and the strategic allocation. The Bank notes in its letter that the equity share will be close to the strategic allocation if rebalancing is triggered by smaller deviations than at present. However, this will entail more frequent rebalancing and higher transaction costs. One way of reducing transaction costs is to rebalance more gradually, such as to effectuate rebalancing over a longer time period.

The Bank recommends that rebalancing be initiated when the equity share deviates by more than two percentage points from the strategic allocation, as compared to four percentage points at present. Moreover, the Bank proposes that rebalancing implementation take place more gradually than under the current provisions. The Bank notes that this combination may reduce both transaction costs and deviations from the strategic equity share. When rebalancing takes place more frequently and over a longer time period, it also becomes more integrated into ordinary portfolio management, thus increasing the scope for using transfers to or from the Fund in rebalancing implementation. This may further reduce transaction costs. The Bank also notes that it has over the years since the financial crisis experienced that it has become more challenging to execute large transactions without affecting market prices.

The Bank states, in its assessment of how rebalancing may affect expected return, that rebalancing adds a certain countercyclical element to the investment strategy in that the Bank purchases the asset class whose return has been relatively low, and sells the asset class whose return has been relatively high, since the last rebalancing. However, past return differences between equities and fixed-income instruments are not necessarily a good indicator of future returns. The Bank’s proposed rebalancing rules are therefore based on a trade-off between low transaction costs and a preference for keeping benchmark weights close to the strategic allocation.

3.3.3 The Ministry’s assessments

The Ministry notes that rebalancing of the equity share in the GPFG forms part of the investment strategy for the Fund. It has, since the current provisions were adopted in 2012, become more challenging to perform rebalancing at low cost. Norges Bank notes that it is more challenging to trade large amounts without unfavourably affecting market prices, and rebalancing amounts have increased in line with the steep growth in fund capital. The scope for reducing costs by using transfers to or from the Fund to adjust the equity share has also been reduced. This suggests, in the assessment of the Ministry, that there is a need for modifying the provisions.

Costs may be reduced by rebalancing more gradually. Daily trading volumes and the risk of unfavourably affecting market prices are reduced when transactions are executed over a longer period of time. This also offers more scope for adjusting the equity share by using current inflows to the Fund. It implies, at the same time, that it may take longer time to adjust the equity share, and thus the deviation between the benchmark index and the strategic allocation will increase. The Ministry therefore agrees with Norges Bank that rebalancing should start earlier than at present, and proposes that rebalancing shall be initiated when the deviation exceeds two percentage points, as compared to four percentage points at present. This involves more frequent rebalancing and increases costs somewhat, but the Bank’s calculations show that total transaction costs will, all in all, be reduced.

The Ministry proposes, against this background, to amend Section 1-6, Sub-section 4, of the mandate on rebalancing of the equity share. The amendment implies that rebalancing shall be triggered when the equity share deviates by more than two percentage points from the strategic allocation of 70 percent. Rebalancing shall also be carried out more gradually than before. The detailed provisions on rebalancing of the equity share are exempt from public disclosure, cf. above. The Ministry has, in its overall assessment, attached more weight to costs and deviations from strategic allocations, than to assessments of expected returns owing to such estimates being more uncertain.

3.4 Equity framework and benchmark index

The Ministry has initiated a review of the equity framework and benchmark, including the geographical distribution of the benchmark index. The equity benchmark serves a key role in furthering the investment strategy, including broad diversification of risk and the reaping of risk premiums. Regular reviews of the benchmark index ensure that its composition is tailored to the objective and distinctive characteristics of the Fund, and also reflect new knowledge and equity market development characteristics.

The Ministry of Finance has, in a letter of 6 November 2018, asked Norges Bank for advice on, and assessments of, the composition of the equity benchmark for the Fund. The Bank was, inter alia, asked to assess the regional distribution of the benchmark index, and to address distinctive characteristics and risk and return properties of emerging markets, as well as experience with investing the Fund in such markets. The Bank was also invited to assess the choice of index provider.

As part of the review, the Ministry has also asked the consultancy firm and index provider MSCI to prepare a report analysing equity market development trends, as well as risk and return implications of various geographical compositions.

No new markets will, against the background of the ongoing review, be added to the equity benchmark for the Fund before a decision has been made on the index composition.

The Ministry intends to present assessments of the equity framework and the composition of the equity benchmark in the report on the Government Pension Fund in the spring of 2020.

3.5 Phase-in of new equity share in the benchmark index

In the report on the Government Pension Fund submitted in the spring of 2017,26 the Government proposed to increase the equity share of the strategic benchmark index for the GPFG from 62.5 percent to 70 percent. This was endorsed by the Storting; see Recommendation No. 357 (2016–2017) to the Storting. In the National Budget for 2018, the Ministry of Finance stated that it had, in consultation with Norges Bank, adopted a plan for the effectuation of the increase to a higher equity share. The Ministry has attached weight to the verifiability of the phase-in provisions, and to the plan being implementable at low cost. The transition plan takes into consideration the uncertainty of future financial market developments. The plan is exempt from public disclosure since it includes market-sensitive information. The Ministry will provide the Storting with further information about the phase-in when it has been completed.