Part 1
The management of the Government Pension Fund

1 Introduction

Main aspects

The purpose of the Government Pension Fund is to support government savings to finance the pension expenditure of the National Insurance Scheme and long-term considerations in the spending of government petroleum revenues. Sound, long-term management of the Government Pension Fund will help ensure that Norway’s oil wealth can benefit all generations.

The Government Pension Fund comprises the Government Pension Fund Global (GPFG) and the Government Pension Fund Norway (GPFN). The operational management of the two parts of the Government Pension Fund is conducted by Norges Bank and Folketrygdfondet respectively, within guidelines laid down by the Ministry. The Government Pension Fund is not a separate legal entity and does not have its own executive board or administrative staff.

The Government’s ambition is for the Government Pension Fund to be the best managed fund in the world. This entails identifying leading international practice in all parts of the Fund management and striving for this.

Through the investment strategy, the Ministry of Finance strives to take advantage of the characteristics of the Fund such as its size and long investment horizon and to attain the best possible trade-off between return and risk.

The Fund’s investments have a very long time horizon. The strategy is therefore based on assessments of expected long-term returns and risks. It is also seen as important to have broad diversification of investments among different regions, asset classes, sectors and companies.

The Fund’s investment strategy appears to work well. From the Fund’s establishment until year-end 2007, the average annual real rate of return exceeded the Ministry’s long-term expectations. The returns in 2008 changed this picture significantly. The global financial crisis had a dramatic impact on the financial system and the economy in many countries. This was one of the main causes of the unusually large negative returns in international equity markets, which dominated the performance of the Government Pension Fund in 2008.

A strong recovery in 2009 largely reversed the losses incurred in 2008. In 2009, the return on the Fund was the highest since its establishment. The lessons learned from the last two years do not indicate any need to adjust the estimate of 4 per cent real return as a reasonable expectation of the Fund’s long-term rate of return.

At the same time, experience also shows that we must be prepared for market volatility from time to time. The Government Pension Fund is well positioned to withstand such volatility. The Fund does not have obligations forcing holdings to be sold as a result of poor performance. The investment strategy does not, therefore, aim for minimal value fluctuations in the short term. A strategy devised only to minimise annual fluctuations would have yielded significantly lower expected returns.

The Fund’s investments are spread over several thousand individual equities and bonds in the international financial markets. This helps ensure broad diversification of risk in the Fund. Nevertheless, there will always be a risk of losses on individual investments in this kind of portfolio. The purpose of the investment strategy for the Fund is not to avoid losses on individual investments, but to ensure that the sum of investments provides maximum financial return with a moderate level of risk.

In its annual reports to the Storting on the management of the Government Pension Fund, the Ministry puts considerable emphasis on illustrating the risk of short-term fluctuations in the Fund’s performance. One way of illustrating the Fund’s risk in different periods of market volatility is to simulate the Fund’s rate of return during different crises. Figure 1.1 illustrates how the GPFG would have performed in two historical crises, compared with its actual performance during the financial crisis.

¹ These simulations are based on the current asset allocation and regional distribution. The analysis of the historical crises does not contain return data for corporate bonds, as these data are not available.

Source Ministry of Finance and Dimson, Marsh and Staunton (2009)

For example, the crisis in the 1930s would have led to a 3 percent decline in the value of the Fund in the first year and further declines of close to 3 percent and 13 percent in the following two years. However, the rate of return in the fourth year would have compensated for these losses. The figure also shows that the losses incurred in this financial crisis were somewhat greater than they would have been in previous downturns. At the same time, this crisis so far appears to have been shorter, and it appears that the losses will therefore be recovered more quickly.

Many useful lessons can be learnt from the financial crisis for the management of the Government Pension Fund. One valuable lesson is the importance of maintaining the strategy over time. One should not abandon the strategy and sell securities immediately after they have fallen in value. It is the very risk of reductions in value that investors are rewarded for taking. In order to reap this reward, an investor must have the will and the ability to maintain the strategy even during periods of market volatility. The financial crisis can therefore be said to have tested the robustness of the Fund’s strategy.

The Storting’s deliberation of last year’s report on the management of the Government Pension Fund showed that there is still broad agreement on the general long-term strategy for the Fund. However, it also underscored the importance of continuous development of methods to identify, manage and communicate different risk factors that can affect the Fund’s rate of return.

Active management of the GPFG

The Ministry of Finance has determined the main features of the investment strategy for the Fund by establishing a benchmark index. Norges Bank can deviate from this benchmark within guidelines set by the Ministry. This is called active management. The purpose of active management is to achieve return in excess of what would have been achieved by investing exactly as stipulated by the benchmark index.

The financial crisis revealed that the risks associated with the active management of the fixed income portfolio had not been sufficiently identified and communicated. The Ministry of Finance believes it is essential that active management is based on a solid foundation and that it has broad-based support. The experiences gained from the management of the Fund in 2008 revealed a need for reassessment of the foundation for active management in order to clarify the role active management would play in the overall investment strategy in the future.

In last year’s report on the management of the Government Pension Fund, the Government announced that it would return to the Storting in spring 2010 with more information and an assessment of whether and to what extent active management of the GPFG ought to be continued.

The Ministry’s assessment of the role of active management is based on the general investment strategy. The role that active management should play as part of the overall strategy should therefore be based on weighing expected returns against expected risk and on an assessment of the degree to which active management is useful in exploiting the characteristics of the Fund. The report considers various strategies for active management and the scope of active management.

The Ministry intends to maintain a certain limit to deviate from the Fund’s benchmark index. A pure passive management strategy would be expected to add unnecessary costs and the Fund’s special characteristics nevertheless points to a potential for positive excess returns that to some extent should be exploited. Beyond this, a certain degree of active management will have positive spill over effects on other parts of the management.

At the same time the Ministry intends to implement several changes that together will give less room for active management. Key changes are:

• The present maximum limit for expected tracking error of 1,5 per cent is replaced by regulations stating that Norges Bank should aim for a tracking error not exceeding 1 per cent. At the same time it is recognised that the limit can be exceeded in special circumstances.

• Norges Bank is required to set supplementary risk limits to limit deviations from the benchmark index that empirically are not well captured by tracking error. Examples of such supplementary risk limits are limits on deviations from the benchmark measured nominally in kroner and requirements regarding minimum overlap between the benchmark portfolio and the actual portfolio.

• Norges Bank is cut off from leveraging the portfolio with the aim of increasing the Fund’s exposure to risky assets. This restriction will exclude some of the strategies that previously have been used in active management of the fixed income portfolio.

• The Bank will also be required to measure and report on the Fund’s exposure to systematic risk factors.

• Several of these changes are already implemented in the guidelines given by the Executive Board of Norges Bank to Norges Bank Investment Management (NBIM). Beyond this, several measures aimed at strengthening the supervision of the management have been implemented the last few years, see section below on the management framework.

GPFG’s real estate investments

It has previously been decided to invest up to 5 per cent of the GPFG’s assets in real estate. This is the third largest asset class in the world after equities and bonds. Many large international funds invest in real estate. The decision to include real estate as a separate asset class can be regarded as a natural continuation of the strategy to exploit the characteristics of the Fund and as a means of spreading the investments more widely. This report presents the guidelines for investments in real estate, which came into force on 1 March this year.

Responsible investment practices

The Government Pension Fund is managed on behalf of the Norwegian population. The population’s widely shared ethical values form a basis for the responsible management of the Fund. We must ensure a good, long-term return from which future generations can benefit. A good financial return over time depends on sustainable development in economic, environmental and social terms. By virtue of our long-term investments in a large number of the world’s companies, we therefore have a responsibility for and an interest in promoting good corporate governance and safeguarding environmental and social concerns.

In 2008, the Ministry of Finance conducted a broad evaluation of the ethical guidelines for the GPFG. The findings were presented to the Storting in last year’s report. The Ministry has implemented a number of new measures to promote responsible investment practices. The measures focus on factors that can have an impact on the long-term return of the Fund, including good corporate governance and the integration of environmental and social considerations in all parts of management. The Ministry has initiated a new programme aimed at environment-related investment opportunities and is participating in a research project to study in more detail how climate challenges can affect the financial markets. The work linked to active ownership and exclusion has also been strengthened in line with our ambition of contributing to sustainable development. This was reflected in the new guidelines for responsible investment practice, introduced on 1 March this year, which are presented in this report. The new guidelines replace the existing ethical guidelines of 19 November 2004.

Performance of the Government Pension Fund in 2009

In 2009 the GPFG achieved a return on investments of 25.6 per cent, or NOK 613 billion. This is the best result achieved since 1998. The GPFN investments yielded a return of 33.5 per cent last year, which corresponds to more than NOK 29 billion. Norges Bank’s active management achieved excellent results last year, especially on its fixed income investments. This must be seen in the context of the gradual normalisation of the bond markets internationally and the reversal of the low market prices on fixed income securities in 2008. In 2009 Folketrygdfondet achieved poorer results than the benchmark for equities and better results than the benchmark for bonds. The overall result was weaker than the benchmark.

The combination of high petroleum revenues and moderate rates of return means that the Government Pension Fund is now one of the largest funds in the world. At year-end 2009, the market value of the Fund was NOK 2,757 billion (see ­figure 1.2). This corresponds to more than one year’s total GDP in Norway, or roughly NOK 570,000 per capita in Norway.

Source Ministry of Finance

The growing accumulation of financial capital means that the Fund is a major owner in the financial markets. Internationally, the value of the GPFG equalled roughly 1 percent of the total value of the world’s listed companies at year-end 2009.The value of the GPFN equalled on average 4.4 percent of the total value of the Norwegian companies listed on the Oslo Stock Exchange.

The management framework

Improvements in the management framework play an important role in the Minstry’s work related to the management of the Government Pension Fund. The report discusses various measures that have been implemented in recent years to improve the management of the Government Pension Fund. Important measures include:

• more extensive reporting to the Storting from 2007 in a separate report on the management of the Fund,

• amendment of the Norges Bank Act to clarify the division of roles between the Executive Board and the Supervisory Council of Norges Bank,

• new auditing arrangements and introduction of statutory internal auditing in Norges Bank,

• new regulations on risk management and internal control in Norges Bank,

• improving Norges Bank’s internal management structure, with clearer division of roles and responsibilities between the Executive Board and the investment management department (NBIM),

• substantial organisational changes at NBIM resulting in significantly strengthened risk management and strengthened risk reporting,

• the strengthening of the Executive Board’s oversight of NBIM, inter alia through a new investment mandate for the Chief Executive Officer of NBIM containing more detailed rules about what the GPFG can be invested in and the level of risk in the Fund as well as new principles for risk management, and

• reorganisation of Folketrygdfondet as a company by special statute, establishment of new audit arrangements and introduction of new guidelines for the management of the GPFN that entail much stricter requirements concerning measurement, management and control of risk and reporting than previously.

In addition to these measures, the Ministry has also announced that it will be introducing new rules for Norges Bank’s active management, see the relevant section above. The Bank has itself published its internal guidelines for risk measurement and management.

Status of risk management in the GPFG

In last year’s report on the management of the Government Pension Fund, the Government announced that it would reassess the status of risk management in the GPFG. In the National Budget 2010 the Government said that it believes that it is appropriate for such an external review of the risk assessment within the Bank’s asset management to be conducted as a certification assignment given by Norges Banks Supervisory Council to the bank’s external auditor.

This report gives a review of a report from the auditor (Deloitte) on design and implementation of the organisational structure and the framework for management of operational risk within the Bank. The certification assignment gives and independent assessment of the status of risk management within Norges Bank, including whether risk management is designed and implemented in accordance with relevant frameworks and standards. The review shows that the Bank in all material aspects has designed and implemented an organisational structure and a framework for management of operational risk that are in line with recognised standards, and that the Bank in all material espects has followed up the recommendations from the previous review of risk management as concern organisational structure and the framework for management of operational risk.

Summary

In the Ministry’s opinion, the Government Pension Fund has weathered the financial crisis well. There is still broad support for the long-term investment strategy, and the strong performance last year has largely reversed the losses incurred in 2008. The financial crisis has taught us a number of important lessons, including our understanding of the risk factors that affect the Fund’s returns and the need for better methods to identify, manage and communicate the Fund’s exposure to these factors. The Ministry, Norges Bank and Folketrygdfondet have invested a great deal of time and effort in recent years to improve the management of the Government Pension Fund. Several measures have only recently been implemented or are going to be introduced during the coming year. The Ministry believes that these measures together will ensure a significant strengthening of the management of the Fund.

This Report consists of two parts: Part I provides an account of the management of the Government Pension Fund on the basis of the three main areas of the Ministry’s responsibilities relating to the Fund: the investment strategy, responsible investment practise, and monitoring and development of the management framework. Part II contains feature articles on a number of topics discussed in Part I.

The Government Pension Fund Act, the Regulations relating to the management of the Fund, with supplementary provisions, and the respective management agreements are available on the Ministry’s website (www.regjeringen.no/gpf). The annual reports of Norges Bank and Folketrygd­fondet are appended by reference (see www.norges-bank.no and www.ftf.no). The Council on Ethics’ annual reports are available on www.etikkradet.no.

2 Investment strategy

2.1 Foundation of the Fund’s investment strategy

The Government Pension Fund’s investment strategy is derived from the purpose and characteristics of the Fund, the owner’s return expectations and risk preferences, as well as views on how the financial markets work.

2.1.1 Purpose and characteristics

The Government Pension Fund is an instrument for general savings that is managed with a view to ensuring a good financial return. In the Government Pension Fund Act, the Storting resolved that the Ministry of Finance is responsible for the management of the Fund.

Allocations to and withdrawals from the Fund are integrated with the Fiscal Budget. Due to the prospects of a continued inflow of petroleum revenues and a responsible fiscal policy, the Fund is still set to grow and therefore has a very long investment horizon.

The Fund is already one of the world’s largest funds. Its size is expected to provide economies of scale in the management. The total management costs, measured as a share of the Fund’s market value, will be lower for a large fund than for a small fund. Economies of scale also make it possible to accumulate expertise in all parts of the management, which will be an advantage when the Fund’s investments are to be spread across new markets, countries or financial instruments.

The Fund’s long-term investment horizon is also of great importance to the investment strategy. Firstly, the investment horizon influences the Fund’s tolerance of volatility in the short and medium term. Secondly, it is of significance to the work on responsible investment.

In addition to the Fund being large and for the long-term, it does not, unlike traditional pension funds, have any specific liabilities. There is little risk that the owner of the Fund will make large withdrawals over a short period of time. The Fund has, therefore, a greater risk-bearing capacity than many other investors. Many investors may lack both the capacity and willingness to take market risk after a period of weak results. This will not, to the same extent, be the case for the Government Pension Fund. The allocation of the actual investments is adjusted regularly in order to conform with the strategic asset allocation (so-called rebalancing). This has meant that the Fund has systematically sought to purchase assets after they have fallen in value.

The Fund’s investment goal is to achieve the highest possible return. At the same time certain fundamental requirements and prerequisites must be met:

• The Fund should have a market risk that is acceptable to the owners – the Norwegian people as represented by the government.

• The Fund should have good control of operational risk, i.e. the risk of financial loss or loss of reputation as the result of defective internal processes, human error, systems error or other loss caused by external circumstances that are not a consequence of the market risk associated with the portfolio.

• The Fund should be a responsible investor. In the long term the Fund’s financial return depends on sustainable development in economic, environmental and social terms. The Fund should not make investments that represent an unacceptable risk of the Fund contributing to grossly unethical acts.

• The Fund’s characteristics as a large and long-term investor should be exploited in the best possible manner.

• The Fund should follow good governance principles. The actual organisation of the activities should be based on a clear division of responsibilities. Decisions concerning the management of the Fund must be based on knowledge and professionalism. Transparency is a prerequisite for maintaining confidence in the current management model. At the same time, transparency is an important contribution to well-functioning financial markets, inasmuch as it means that there is no major uncertainty on the part of other market participants when it comes to the modus operandi of a large participant like the Government Pension Fund.

A closer look at responsible investment

The goal of good financial returns is closely linked to the ambition to be a responsible investor. This responsibility entails ensuring that the Fund is managed in a way that promotes well-functioning, legitimate and efficient markets and sustainable development in the broadest sense. Investors who are broadly diversified – both geographically and across different types of investments – are often referred to as «universal owners». Such owners will benefit from making sure that good corporate governance and environmental and social issues are safeguarded, since considerations of this type may influence their long-term returns. For example, one company shifting costs onto the environment, which can increase this company’s returns in isolation, may have a negative impact on other companies in the portfolio. This can result in a weakening of the overall portfolio return. This question is discussed in more detail in the special topic article on universal ownership in Chapter 3.

It also follows from the mandate as manager of national savings that widely shared ethical values must be taken into account. In some cases, the concerns of ensuring long-term financial returns and taking widely shared values into account will coincide, but not always. For example, the Fund will not invest in companies that are in gross breach of fundamental ethical norms, regardless of the effect this will have on returns.

It is important that the GPFG’s responsible investment practice is carried out in such a way that support among the population of Norway and legitimacy among market players is ensured. This demands a high degree of transparency, predictability and a high level of expertise. The GPFG is a major and visible investor and has, therefore, a special responsibility to monitor and contribute to the development of the leading international practice in this area.

The Fund is not capable of safeguarding all the ethical commitments we have as a nation. Other political, regulatory or financial instruments will often be better suited to safeguard these commitments. The Fund has the greatest chance of exerting a positive influence if the focus and instruments are a natural consequence of the Fund’s role as a financial investor. The Fund’s objective is not to act as for example a development aid or foreign policy instrument.

2.1.2 Views on how the markets work

The investment strategy must be based on fundamental assumptions on how the financial markets work. The Fund’s investment strategy is based on the following views:

• Market efficiency : The Ministry assumes that the financial markets are largely efficient in the sense that new information is reflected quickly in the prices of financial assets.

• Diversification: Since the returns between different investments do not move wholly in step with each other, a better trade-off between the expected return and risk can be achieved by diversification of the investments. Because of this relationship, the benchmark of the Government Pension Fund is spread across a broad range of geographical regions, countries, sectors and companies. The benchmark indices are based on a principle of market capitalisation weights. This means, for example, that the composition of the benchmark for equities reflects the companies’ relative share of the value of the combined equity market in each region.

• Risk premiums : The risk associated with the Government Pension Fund’s benchmark is reduced through broad diversification across regions, countries, sectors and companies. A higher return is expected to compensate the remaining risk in the benchmark. For example, a higher average return is expected on the equity investments than on investments in bonds, because the return fluctuations of equities are higher. However, the magnitude of this excess return, or equity risk premium, remains uncertain. The Fund’s investments are also exposed to various types of systematic risk factors other than market risk, such as for example credit risk and liquidity risk. See a more detailed discussion of various types of risk premiums in Chapter 7.

• Benchmark and active management : The Fund’s benchmark is meant to reflect the owner’s preferences of the balance between risk and expected return. With financial markets that are broadly efficient, it is difficult to achieve a higher return than the market return through active management without taking higher risks. In keeping with this, the Government Pension Fund’s management guidelines have been formulated so that the Fund’s risk over time largely follows the benchmark set by the Ministry, see discussion on active management in Section 2.3.

• Manager and market liquidity : Selection and monitoring of the manager is of great importance if parts of the investments are made in less liquid markets, where it is not easy to trade securities without influencing the prices. It will normally be relatively straightforward for an investor to achieve the market return in liquid markets, while performance in illiquid markets depends, to a significantly higher extent, on the skills of the manager. When transferring the Fund’s investments gradually from liquid to less liquid markets, more weight must be attached to the quality of the control systems and the formulation of incentives, for example in relation to fees.

• Responsible investments: The integration of environmental, social and governance considerations (ESG considerations) into the management is partly due to the possibility of market failures that it is in the financial interest of the Fund to counteract. Good corporate governance to help ensure that companies operate in accordance with the long-term interests of owners, and efforts to promote well-functioning and well-regulated markets, are examples of this. For a long-term and broadly diversified investor, sustainable economic development in the long term will also be decisive for the Fund’s return over time.

There is no easy answer to what the GPFG’s correct level of risk is. It will depend on the risk tolerance of the owners, as represented by the government. In recent years, the Fund’s benchmark has gradually been expanded to include new market segments, countries and asset classes. In conjunction with the Storting’s support of the Government’s plans to increase the equity portion of the GPFG gradually to 60 per cent in 2007, this has contributed to defining what constitutes an acceptable level of risk in the Fund. The changes in the Fund’s investments in recent years have been in direction of greater weight on investments in real assets such as real estate and equities. This reflects a desire to improve the trade-off between the expected return and risk, where risk is defined as the uncertainty associated with the future development of the Fund’s international purchasing power.

The types of changes to the Fund’s investment strategy that are submitted to the Storting are subject to a decision-making process that contributes to ensuring a robust strategy. The decision-making process is, at the same time, time-consuming, and therefore less suitable for decisions where timing is of the essence. The size of the Fund also limits how swiftly major changes to the Fund’s asset allocation can be implemented without the market impact imposing considerable costs on the Fund. Changes to the Fund’s general investment strategy will, therefore, not be based on an expectation that the periods when markets or market segments subsequently emerge as «cheap» or «expensive» can be identified in advance.

The desire to seek a consensus on the Fund’s investment strategy may contribute to a reduction in the return on the Fund. This will, for example, be the case if the Fund is systematically late when it comes to investing in new market segments or in markets where investors could in retrospect have reaped a premium by making early investments.

However, the desire for a consensus may also be an advantage. If consensus views on how the market works also remain valid over time, then it will make the Fund’s strategy more robust. A robust theoretical foundation of the strategy means that the strategy can be maintained during times of market unrest, which is an important contribution to avoiding the classical trap of «buying high and selling low». The Fund’s ability to rebalance the Fund’s exposure across various asset classes has contributed to a higher return over time.

The Ministry intends to provide broad reporting on the management of the Government Pension Fund to the Storting on a regular basis, with main emphasis on the annual report presented in the spring. The Ministry desires to address the need for maintaining and developing the strategy by annual reviews. At the same time, the strategic choices are made on the premise that they are to remain unchanged over a long period of time. More frequent reviews of the investment strategy are, therefore, not considered to be appropriate.

2.2 Expected long-term real rate of return and risk in the GPFG’s benchmark

In Report no. 16 (2007-2008) and Report no. 20 (2008-2009) to the Storting the Ministry of Finance described what market assumptions the calculation of the GPFG’s expected long-term return and risk is based on. The Ministry worked out these assumptions around two years ago, and they were evaluated and found to be reasonable by the Ministry’s Advisory Council on Investment Strategy. More specifically, assumptions for the long term real return and risk (volatility) were prepared for the global equity and bond indices that are part of the Fund’s strategic benchmark, and for a globally diversified real estate portfolio. The correlation coefficients between the real return of these asset classes were also estimated. These expected values are reproduced in Tables 8.1 and 8.2 in Chapter 8.

The market assumptions are based on an analysis of historical returns and a review of recent research literature. The assumptions are meant to apply in a very long-term perspective. They represent estimates for the average annual rate of return and risk (volatility) over a period of several decades, or over a period that is long enough to encompass many economic cycles and the associated periods of growth and decline in the financial markets. In the short to medium term, for example over a 10 to 20-year period, the expected values can deviate from the long term values. However, the Ministry has not prepared special estimates for a medium term horizon.

The estimates for the expected real return and risk should be evaluated on a regular basis in light of new information. The financial crisis and its impact on the world’s capital markets over the last couple of years represent important new information in this respect. It is, therefore, interesting to look more closely at to what extent the financial crisis has changed the historical average real return and risk, and to what extent it alters the Ministry’s estimates.

It is the development of the Fund’s real value in foreign currency, or its international purchasing power, that is relevant. A review like this one should, therefore, focus on the real return rather than the nominal return. The inflation risk linked to the various asset classes that are included in the GPFG’s benchmark can thus be captured. For example, nominal government bonds emerge as more risky for the Fund when emphasis is placed on the real rate of return, since the inflation risk is a significant factor in pricing this asset class. Investments that directly or indirectly provide the right of ownership to real assets, such as shares and real estate, provide better protection against this type of risk over time.

It turns out that the asset returns during the financial crisis in 2008-2009 have not influenced the historical average returns and risk to any significant degree, as shown in Chapter 8. Stock market volatility has increased marginally, from 15 per cent at the end of 2007 to 15.6 per cent at the end of 2009, based on the average from 1900. The historical distribution of annual real stock market ­returns has also become somewhat more skewed in the direction of a lower returns. This is discussed in more detail in Chapter 8.

There are no unambiguous and generally recognised research results that suggest a major re-evaluation of the expected long term real return and risk, solely as a result of the financial crisis.

On the other hand, long term structural developments or global macro trends, such as productivity, economic policy, demographics, environmental and climate changes, access to natural resources and geo-political developments will undoubtedly be of greater significance to the long term expected return and risk. The Ministry will evaluate such long term risk factors, and in this context it is currently engaged in a study of long term climate impacts on capital markets, in cooperation with other major international funds, see Box 2.1. It is expected that the results of this work will be presented in the autumn of 2010.

Given the information available, there are no grounds for significant changes to the Ministry’s long term market expectations as they were formulated two years ago. Nevertheless, a few minor adjustments have been made. Firstly, it seems reasonable, based on historical volatility, to adjust the expected equity volatility up from 15 per cent to 16 per cent. Secondly, it is natural to assume a weak degree of negative skewness in the distribution of the annual real return on equities. This can provide more realistic estimates of the risk of major losses in the GPFG’s strategic benchmark. There is no change in the expectations linked to bonds or real estate investments. Updated market expectations are shown in Table 8.4 in Chapter 8.

The Ministry’s estimate for the return on government bonds is somewhat higher than the historical average, while the opposite is true for equities. The estimates for volatility are close to the historical averages for both bonds and equities. The reason for the deviations from the historical returns are explained in more detail in Chapter 8.

With the revised estimates, the portfolio simulations give values for the expected real return and risk for the GPFG’s benchmark as shown in Table 2.1. The calculations are made by means of simulation of the development of the portfolio’s value 15 years into the future (60 per cent equities and 40 per cent bonds). This horizon is long enough to include long term effects such as several rebalancings of the portfolio, and a weak degree of mean reversion in the equity markets, but not so long that the calculations lose their relevance to economic planning in the short term.

In this type of simulation the asset classes’ value will follow different paths, which can deviate significantly from the expected value. Return and risk can thus be estimated.

There are only small changes in the calculated return and risk compared with the figures given in the two previous reports to the Storting. The expected average (geometric) annual real return on the GPFG’s benchmark is still a little over 4 per cent, while the expected annual portfolio volatility increases a little, to 9.8 per cent. The standard deviation of the average annual real return over 15 years is 2.5 per cent, see fourth column in Table 2.1. It is estimated with 68 per cent probability that the annual real return will be between 1.6 and 6.9 per cent over a 15-year period. It should also be noted that there is a significant estimated probability (around 46 per cent) of an annual real return of less than 4 per cent over a 15-year period. In addition, there is a relatively small estimated probability (5.3 per cent) that the accumulated real return will be less than zero, an increase of 1.6 percentage points relative to the previous estimate.

Figure 2.1 illustrates the uncertainty of the development of the real value of the strategic benchmark 15 years into the future, given an investment of 100 (in local currency) at the end of 2009, and zero net injections or withdrawals throughout this period. There are estimated probabilities of 68 per cent and 95 per cent, respectively, that the real value will lie within the orange and brown fan-shaped fields. The expected path is marked by a fat, solid line. While it is expected that the real value will increase by 87 per cent over a 15-year period (the real value will increase from 100 in 2009 to 187 in 2024), there is a high probability that the outcome will be different.

Source Ministry of Finance

Historical data shows that there is significant variation over time in the real return of globally diversified equity and bond portfolios. This gives rise to historical time variations in the real return on a hypothetical portfolio close to the GPFG’s benchmark, with 60 per cent equities and 40 per cent bonds. Over rolling 15-year periods, the fluctuations in the annualised real return on such a benchmark are large. Over longer periods, for example rolling 50-year periods, the fluctuations are significantly smaller, see Figure 2.2. Similar fluctuations must also be expected in the future. The question of whether such fluctuations can be forecasted is discussed in Chapter 8.

Source Dimson, Marsh and Staunton (2009) and the Ministry of Finance

Figure 2.2 also shows that the annual average real return on a portfolio close to the GPFG’s benchmark has been higher than 4 per cent over both the last 15 and 50 years.

These calculations apply to the GPFG’s benchmark. The development of the actual portfolio will deviate from the benchmark as a result of active management and management costs. Over the last 12 years the Fund has had an average gross return that is 0.25 percentage points higher than the benchmark’s return, and overall costs corresponding to 0.10 per cent of the portfolio. The actual return has, therefore, on average been 0.15 percentage points higher than the benchmark’s return. If a corresponding margin is applied to the future, then the expected annual real return would be around 4.4 per cent.

It is emphasised that there is considerable uncertainty regarding the estimates for the expected return. Empirical data shows that the return can fluctuate a great deal. This uncertainty is so great that there is no reason to change the current real return estimate of 4 per cent, which forms the basis of the guidelines for economic policy, based on the return achieved since 1997. Not until the actual real return has been significantly higher or significantly lower than 4 per cent over many years, will there be grounds for considering whether the estimate of 4 per cent represents too high or too low an expectation for the future real return.

2.3 Evaluation of the active management of the GPFG

2.3.1 Introduction

The Ministry of Finance determines the general investment strategy for the GPFG. The Ministry presents important issues to the Storting prior to implementation. The task of carrying out the operational management of the Fund has been delegated to Norges Bank. Norges Bank shall seek to achieve the highest possible return on the Fund’s assets within the guidelines set by the Ministry of Finance.

The Ministry of Finance has determined a strategic benchmark and limits for the permitted divergence between the Fund’s actual investments and the benchmark. The strategic benchmark is a detailed description of how the Fund’s assets should be invested. The benchmark is divided between equities (60 per cent) and fixed income (40 per cent), and across three geographical regions, see Figure 2.3. Going forward, the fixed income allocation will be reduced gradually in favour of a real estate allocation of up to 5 per cent.

Source Ministry of Finance

The composition of the benchmarks for equities and bonds is based on market capitalisation weights within each geographical region. This means that if the GPFG’s investments in European equities corresponded to 1 per cent of the market capitalisation of all the companies in Europe, then the benchmark will include a 1 per cent interest in each individual company in the index. Even though the Ministry of Finance determines a benchmark for the Fund that is company specific, there is no individual assessment of each individual company in the benchmark.

To the extent that the actual portfolio deviates from the benchmark there will be a difference in the return between the two portfolios. Passive management means that the manager tries to follow the benchmark as closely as possible. Active management means that the manager tries, within certain limits, to achieve excess returns by deviating from the benchmark.

The Ministry lays down guidelines for the scope of active management. A limit has been set for how much the difference in return between the actual portfolio and the benchmark is expected to vary (so-called expected tracking error). Under certain statistical assumptions, and provided Norges Bank fully utilises the limit, the current limit for annual tracking error of 1.5 per cent means that the difference in return between the actual investments and the benchmark is expected to be less than 1.5 percentage points in two out of three years. The difference is expected to be less than 3 percentage points in 19 out of 20 years, and less than 4.5 percentage points in 99 out of 100 years.

The expected tracking error limit of 1.5 per cent was first outlined in the National Budget for 1998. The Ministry stressed that the Fund’s investments should largely reflect the Fund’s benchmark. It was pointed out at the same time that factors such as cost-effective management of the market portfolio, the need for flexibility during a period of significant transfers to the Fund and a certain degree of active management all pointed towards setting a limit for the permitted divergence. It was concluded that a limit of 1.5 per cent should be established.

In the National Budget for 2001 the question of the tracking error limit was assessed once again, following, among other things input from Norges Bank. Weaknesses associated with the relative volatility measure were also pointed out then. The Ministry wrote for example:

«It is emphasised, however, that there will always be sources of error in a model-based measurement of market risk, and measurements of the expected relative risk can, therefore, never be interpreted as completely accurate for the actual market risk that exists. Norges Bank also uses a number of other analysis tools to monitor the market risk in the various portfolios.»

The Ministry concluded that the limit of 1.5 per cent should be continued.

In the National Budget for 2006, the Ministry aimed, in accordance with input from Norges Bank, to make several adjustments in the guidelines for Norges Bank’s management of the Fund. These adjustments opened up for a somewhat broader investment universe. New requirements were stipulated at the same time for valuation, measurement of the rate of return, risk management and control. At that time, the Ministry mentioned several weaknesses with expected relative volatility as a measure of risk. The Ministry wrote:

«There are some markets and instruments where there are weaknesses associated with the measurement of relative volatility. This applies, for example, to bonds issued by non-listed companies and by companies with substantial government ownership. The same applies to bonds that are traded at significantly lower rates than face value.»

It was premised at the same time that these weaknesses would be identified by other procedures within the bank’s measurement of risk. It was pointed out that the bank’s formal approval system for investments in new countries, instruments or asset classes etc., would require documentation on how the market and credit risk are to be measured. Reference was also made to the fact that Norges Bank’s management and its risk management in particular would be reviewed by external expertise.

The changes that were mentioned in the National Budget for 2006 did not entail any change to the tracking error limit of 1.5 per cent. This has thus been fixed since 1997.

For 2008 Norges Bank reported that the actual return was 3.4 percentage points lower than the return on the benchmark. Such results must be expected on rare occasions, given a full utilisation of the risk limit. The result, however, was unexpectedly poor given the risk that was actually reported, which was significantly lower than the maximum permitted tracking error. There were significant differences between the results for the equity and fixed income management. The negative excess return of the fixed income portfolio was 6.6 percentage points, while it was approximately 1.2 percentage points for the equity portfolio.

The Ministry of Finance concluded in Report no. 20 (2008-2009) to the Storting that the results of the active management must be evaluated over a long period of time, but that they were not satisfactory in 2008. This statement must be seen in connection with the fact that the underlying risk in the management has not been identified and communicated appropriately. The Government announced at the same time that it would return to the Storting in spring of 2010 with more information and an assessment of whether and to what extent active management of the GPFG ought to be continued.

2.3.2 Evaluation process

As notified in last year’s report, the Ministry has evaluated the experiences with active management and the foundation for active management in the future. The Ministry has made use of external expertise for this work. The process has had a broad theoretical foundation, and the importance of including different opinions has been emphasised.

Four reports have been written. A group comprised of three internationally recognised financial experts, Professors Ang, Goetzmann and Schaefer, have, on behalf of the Ministry of Finance, evaluated the theoretical basis for active management, assessed the results in the GPFG since the Fund was established and given advice for active management in the future. In addition, Norges Bank has in a letter dated 23 December 2009 (including a detailed report) to the Ministry of Finance presented its evaluation and a plan for the Fund’s active management going forward. Two reports on active management in other funds have also been written on the Ministry’s behalf by the consulting firm Mercer. The four reports were published in December 2009 and have been the subject of public debate, at, for example, a seminar held by the Ministry of Finance on 20 January. Chapter 1 of the report from Ang, Goetzmann and Schaefer and Norges Bank’s letter (without the detailed report) have been enclosed as Appendices 3 and 4 to this report. The reports and material from the conference on 20 January were published in their entirety on the Ministry’s website (www.regjeringen.no/gpf).

2.3.3 Theoretical basis for active management

Neither the report from Professors Ang, Goetzmann and Schaefer nor the letter from Norges Bank, suggest following the Fund’s benchmark mechanically through passive management. Both reports also point out that the GPFG has some advantages compared with other funds, and that these advantages should be exploited through active management.

Professors Ang, Goetzmann and Schaefer have reviewed the academic research on active management. They think that the literature shows that it is difficult to «beat the market» through active management. Nevertheless, they do not rule out that some market participants with advantages related to information, research and trading could achieve a financial gain.

Reference is also made to the fact that many of the research results that are available on the profitability of active management have been based on funds with significantly higher costs than the GPFG. Several studies show that these funds have achieved an excess return before costs, but negative excess return when the costs are deducted. If Norges Bank can keep its costs low due to its size, and attracting capable managers at the same time, then these studies indicate a certain potential for excess returns.

Even though the markets are efficient, there can be good reasons to deviate from a market-weighted benchmark. Professors Ang, Goetzmann and Schaefer believes that the Fund should deviate from market weighted benchmark indices, but these deviations should in their opinion consist of deliberate positions against other systematic risk factors in addition to the market risk. Systematic risk factors are sources of risk that investors cannot get rid of through diversification. Those who are willing to take such risks will be compensated in the form of higher expected returns. Professors Ang, Goetzmann and Schaefer’s preferred solution is to modify the benchmark indices so that Norges Bank can be measured against an index that includes several of these risk factors in the future. They write:

«In the case of several systematic risk factors, empirical studies clearly reject that the market portfolio is efficient, and other static or time-varying combinations of assets provide a better trade-off between return and risk».

According to this they recommend that four main elements can be included in active management when exposure to systematic risk factors is included in the benchmark:

• time varying overweighting or underweighting of risk factors that are included in a new benchmark,

• exposure to less established new risk factors and possibly new segments and markets outside the benchmark,

• investments related to the Fund’s role as responsible investor and strategic ownership in individual companies,

• a certain room for company-specific strategies.

A more detailed description of this is provided in Table 8 of the report from Ang, Goetzmann and Schaefer. In addition, they point out the need for cost-effective management of the market portfolio.

Professors Ang, Goetzmann and Schaefer have analysed the results of active management of the Fund from 1998 and until the end of September 2009. Their conclusion is that the degree of active management has been very limited, but that it has contributed to improving the Fund’s results. They also point out that a large portion of the results in the active management can be explained by exposure to systematic risk factors. The evaluation of the active management of the GPFG is discussed in more detail in Chapter 14.

In its review of the literature, Norges Bank concludes that it is possible under certain circumstances for investors to acquire an information advantage that can be exploited to achieve excess returns. They point out at the same time that the cost level of the management determines how much of this excess return that will be passed on to the customer. Norges Bank believes that they can exploit the Fund’s size and long-term perspective in the active management. Their ambition is to achieve an average annual net value added from active management of around 0.25 percentage points over time. In other words, the expected net return is 0.25 percentage points higher than what could have been achieved with passive index management. In the Bank’s view, the results achieved since 1998 support such an expectation. The Bank writes:

«The scope and orientation of active strategies will, over time, be determined by results. In 2001, Norges Bank set a target of annual value added through active management of 0.25 percentage points. This target was quite ambitious given the relative risk associated with the fund"s management. After 12 years of active management, our assessment is that the experience has largely been positive. The annualised annual excess return relative to the benchmark portfolio currently stands at 0.22 percentage points, which is close to the target. This performance confirms that active management can make an important contribution to the overall return on the fund over time. Assuming an unchanged regulatory framework, Norges Bank will retain this target of an annual excess return of 0.25 percentage points.»

Norges Bank also emphasises that active management has a positive reciprocal impact on other aspects of their management of the GPFG, including active ownership. It is expected that such a reciprocal impact will become more important in the future if the Bank increases its involvement in individual companies. At the same time, Mercer’s analysis of other funds’ experiences of active ownership concludes that the choice between active or passive management is more important with respect to what types of issues are addressed in the active ownership than for the actual effectiveness of the active ownership. For example, active ownership by passive managers will normally be based more on principles and focus to a lesser extent on influencing individual companies.

In principle, active management based on the analysis of individual companies should have a positive spill-over effect on active ownership. In principle the exercise of ownership rights can contribute to increasing the value of the companies the Fund has invested in, and information from active management analysis can be utilised in the exercise of ownership rights. Mercer finds that the two activities are integrated to a limited extent in other funds, and that it is difficult to identify any reciprocal impact. Norges Bank appears, therefore, to place greater emphasis on integrating these activities than other funds.

On behalf of the Ministry of Finance the consulting firm Mercer has conducted a survey on active management that included 14 of the largest funds in the world. In Mercer’s view these funds are representative of large, long-term international funds. The funds were asked, for example, about their use of active management and planned changes in the use of active management. The survey confirms that it is common practice in other funds to include an element of active management. Only one of the funds had limited active management to strategies in less liquid markets. Moreover, the survey showed that the funds felt that their long-term horizon was an important advantage in active management. In addition, their ability to keep costs down and hold onto internal expertise was also pointed out as comparative advantages. The funds were also asked whether they had changed the practice of active management after the financial crisis. None of the funds replied that they had plans for any major reduction in the scope of active management, but several were planning to implement changes related to risk management, control and evaluation of the active management. With regard to actual active management strategies, it appears that several funds planned to increase their exposure to less liquid positions and reduce exposure to leveraged strategies.

2.3.4 Main strategies for active management

The management model for the GPFG has been adapted to a clear division between active and passive management. The Ministry of Finance is responsible for the Fund’s benchmark, while Norges Bank seeks to achieve a higher return than the benchmark within given limits for active management. In practice, the division between active and passive management is not completely clear. Even passive management requires a competent manager who can make active choices on a continuous basis related to the execution of the management, and the distinction between what constitutes a good adaptation to the benchmark and what is active management may vary.

In the management of real estate, the active management element will necessarily be significant. This is because it is not possible to construct portfolios with only a small tracking error in relation to existing indices. The discussion on active management below is limited, therefore, to equities and bonds. Examples of three main strategies for active management that are all described in the report by Professors Ang, Goetzmann and Schaefer and in the letter from Norges Bank are given below.

Strategies for management of the market portfolio

Strategies for management of the market portfolio consist of active choices that are meant to exploit weaknesses in the Fund’s benchmark. These weaknesses are related in part to the fact that the Fund’s benchmark is not fully representative of the entire market, and in part to how often and in what way the benchmark changes: Several weaknesses have been pointed out:

• Professors Ang, Goetzmann and Schaefer refer to studies that suggest that the prices of securities are influenced by major transactions. For example, there is a tendency for equities that are included in an index to increase in price on the day they are included, presumably because many large investors purchase these equities at the same time. For the GPFG this means that there will be costs associated with following the current benchmarks mechanically.

• Norges Bank points out that while the Fund’s benchmark for equities represents the stock market well, the benchmark for fixed income covers only a limited portion of the investment opportunities for fixed income instruments. For example, the index does not contain any bonds with less than one year left to maturity, floating-rate bonds or bonds with credit ratings lower than BBB. This means that parts of the market for fixed income are excluded from the benchmark.

• Another weakness of the fixed income index is the fact that the benchmark weights of each bond is calculated based on the notional value of bonds outstanding. This means that the bond issuers with relatively large amounts of debts are allocated a high weight in the index and that a passive manager automatically ends up lending large amounts to issuers with a high debt ratio.

• The issuer’s other loans are not taken into consideration in the overall weighting of the benchmark index. This means that the weight in the benchmark is not necessarily representative of the issuer’s overall debt. In principle, a passive manager must accept the weighting of the index, while a manager that can deviate from the index can refrain from investing in a company’s bonds or investing less than what the index weight suggests based on an evaluation of a company’s overall debt.

• Norges Bank also points to weaknesses related to how and how often the bond index changes. It must be assumed that these weaknesses lead to high transaction costs for a manager who follows the benchmark mechanically:

  • A passive manager must, in principle, sell a bond when there is less than one year left until the bond is to be redeemed.

  • Bonds that no longer satisfy the credit rating requirements are removed from the index at 5:15 p.m. on the last trading day each month. Bonds, with an upgradet credit rating are included at the same instance. According to Norges Bank it is natural to observe major price fluctuations at this point in time. By refraining from conducting these transactions at the same time as the index changes, the transaction costs can be reduced.

  • It can take up to a month from when a bond is issued until it is included in the index. A passive manager will have to wait to buy the bond until the last trading day of the month in question, while a manager that can deviate from the index can seek to obtain a premium by purchasing a bond at a time other than when the index change takes place, for example, in connection with the issuance of the bond.

• Moreover, the index does not differentiate between how liquid the bonds are. In principle, a passive manager will be forced to buy bonds that will be difficult to trade. This has, for example, consequences for the costs of rebalancing the Fund’s equity portion.

The bank also writes that life insurance companies and pension funds are subject to regulations concerning the matching of their bond investments to their pension liabilities. These adaptations can create opportunities for the GPFG, which is not subject to the same restrictions. Price differences can arise correspondingly between different classes of shares and between shares in the same company that are traded on different markets. Norges Bank believes that the GPFG can utilise such differences in its adaptation to the market portfolio.

Norges Bank writes that deviations from the benchmark, based on a desire for effective management of the market portfolio, will generally be of a short-term nature and related to benchmark changes and specific company events. In cases where management of the market portfolio entails the replacement of securities in the benchmark that are regarded as expensive with elements outside the index that are considered to be cheap, this may nevertheless increase the potential for major losses in periods of turmoil. There are two reasons for this. Firstly, the assets that are invested in will typically be more difficult to trade than those that are included in the benchmark. Market turmoil will lower the prices of these assets relatively more than the assets in the benchmark. Secondly, a fall in prices during periods of turmoil will be reinforced by the fact that many other market participants have corresponding positions that they will be forced to reverse.

Company-specific strategies

Company-specific strategies are based on a fundamental analysis of individual companies and the equities and interest-bearing securities they have issued. These strategies are managed internally by Norges Bank and through external managers.

The key common denominator for the bank’s various internal management mandates based on company-specific strategies is the fact that the decisions are made based on a detailed analysis of the individual company’s financial situation, the individual company’s strategies and other company-relevant development characteristics. The mandates do not have any common approach beyond this. Norges Bank attaches importance instead to giving each individual employee the opportunity to decide what the best analytical tool is, given the manager’s investment views and approach. This is meant to strengthen the diversity and reduce the risk of group thinking that may occur if all the managers adapt to the same investment process.

External management assignments based on company-specific strategies are awarded to organisations with special expertise within clearly defined investment strategies. In recent years an increasing number of these mandates have been granted in markets that the bank considers less efficient, i.e. markets where information is not reflected as quickly in the prices for financial assets. This applies in particular to emerging markets.

Size may be an advantage in the analysis of company-specific strategies. By virtue of its size, the GPFG can more readily obtain information directly from the companies they invest in and thereby make the management less dependent on information through third parties.

Norges Bank points out that size and a long-term perspective form the foundation of the advantages in connection with the identification, selection and follow-up of external managers. These advantages manifest themselves in the Bank’s ability to negotiate competitive terms and the availability of adequate resources to cover a broad range of sources of information.

There are no research results that can confirm that size gives an information advantage, but the bank points to its own results as support for the fact that they can deliver excess return over time.

Professors Ang, Goetzmann and Schaefer write that the Fund’s historical results only provide weak support for positive contributions to the Fund’s return from company-specifie active strategies over time. Nevertheless, they believe that there is theoretical support for some amount of this type of active management. In addition, they write that this type of active management should constitute a limited part of the active management dependent on the costs, and that this type of active management can also have spill-over effects on other parts of the management of the Fund.

The bank believes that company-specific strategies in the equity market will have the same type of risk as the equity market investments in general. Active management will be realised by a number of smaller portfolios that lead to risk diversification. This diversification over many mandates can lead to exposure to systematic risk factors. Such risk factors are discussed in more detail below. The bank points out that the measurement and management of the Fund’s exposure to all types of systematic risk factors will be an essential part of their risk function.

Systematic risk

Professors Ang, Goetzmann and Schaefer have evaluated the Fund’s active management results and find that the results are systematic, see discussion in Chapter 14. By studying the development of the active management results since 1998, they have calculated that more than two-thirds of the variations in the Fund’s overall excess return can be explained statistically by so-called systematic risk factors. When they analyse the equity and fixed income management separately, controlling for those factors which are considered most relevant to each asset class, the factors explain less of the development of the results. Exposure to systematic risk factors explains almost a third of the development of the results of the equity management and about half of the development of the results of the fixed income management.

Common to the systematic risk factors is the fact that they are documented types of risk that investors have historically been able to collect risk premiums from over time. The analysis shows that risk factors such as liquidity and volatility in particular have been important. This means that Norges Bank has reported good results as long as there was a continuous improvement in liquidity and during periods with little turbulence in the markets. The results worsened in 2008, with a sharp reduction in market liquidity and major fluctuations from day to day.

The bank has organised the active management by delegating responsibility for position taking to many decision makers that work independently of each other. Nevertheless exposure to systematic risk will normally arise. One of the systematic risk factors to which reference is made in the report is differences in the return based on whether the companies are large or small. Even though the GPFG’s deviation from the benchmark for equities is a result of many independent decisions, the analysis performed by Professors Ang, Goetzmann and Schaefer shows that the Fund has had a greater exposure to relatively small companies than the Fund’s benchmark.

In addition to the exposure to systematic risk factors that arises as a result of company-specific strategies, the manager can choose more direct exposure to systematic risk factors. This exposure can be stable or based on an assessment that time variations in the return from these factors can be identified in advance. Such positions will not be a result of many independent individual positions, but a result of a conscious choice to make the Fund’s results dependent on the development of one or more risk factors.

Experience with active management until now shows that the reported returns can be high and the measured risk low over many years, but that periods with very negative results may arise. Exposure to systematic risk factors is in many cases characterised by such a profile. Exposure to systematic risk factors will then be identified to a limited extent by traditional measures of risk such as relative volatility, since it can take a long time before this risk appears in historical return data. Therefore the risk must be monitored by other means. In its letter, Norges Bank writes that they evaluate how the exposure to systematic risk can influence the risk of individual strategies and the Fund as a whole.

2.3.5 The Ministry’s assessments

In accordance with what was announced in last year’s report, the Ministry has assessed how and to what extent the active management of the GPFG is to be continued.

Should active management be continued?

In the evaluation of whether active management can be expected to improve the Fund’s results over time, the Ministry has attached particular importance to the following:

• Both Norges Bank and the three professors, Ang, Goetzmann and Schaefer, believe that there is no compelling scientific evidence to recommend a purely passive indexing strategy. The Ministry shares this view.

• The benchmark indices for the Fund’s equity and fixed income portfolio are determined by the Ministry of Finance on the basis of long-term assumptions. Both the reports from Professor Ang, Goetzmann and Schaefer and Norges Bank point to weaknesses in the Fund’s benchmark, especially for the fixed income investments. A certain degree of divergence from the benchmark is therefore necessary to give Norges Bank an opportunity to exploit the weaknesses of the current benchmark and to establish a cost-effective index management.

• The current limit for active management is greater than what is viewed as necessary as far as cost-effective management of the benchmark is concerned. The survey Mercer conducted confirms that this is in accordance with the practice of other funds throughout the world. Mercer’s survey also shows that all the funds in the survey had some element of active management and only one of these funds had restricted active management to strategies in less liquid markets.

• The reports received all point out that the Fund’s size and long-term perspective should be utilised to the Fund’s advantage through active management. Size can entail negotiation strength, reduced costs and the ability to attract the necessary expertise. At the same time, size can be a disadvantage, as some active management strategies are not scalable to a relevant extent. The Fund’s long-term perspective may be an advantage in active management, due, for example, to the fact that the Fund will not be forced to realise losses at unfavourable times.

• The Ministry has also experienced that flexibility to exercise judgment and make active choices has been especially important in periods when the functioning of the markets has been impaired, like in 2008. One example of this was the phasing in of a higher equity allocation throughout 2008 and 2009. With a falling equity market it was necessary to make decision on whether the Fund’s bond allocation should be reduced through the sale of all types of bonds or just the most liquid bonds. A certain degree of active management can contribute to maintaining the expertise to exercise such judgment.

• Norges Bank has stated that active management can have a positive spill-over effect, for example, on the Fund’s exercise of ownership. The Ministry emphasises the Fund’s role as a responsible investor. Over time the Fund has increased its ownership in the world’s listed equities, and it is currently the largest owner of listed equities in Europe. This represents both an obligation and opportunity to exercise ownership rights. Exercising ownership rights, also in relation to individual companies, is necessary to safeguard the Fund’s economic interests. Even though other funds might view the choice between active and passive management as significant in the effectiveness of active ownership, the Ministry is supportive of the fact that Norges Bank appears to attach importance to exploiting the potential that should lie in the reciprocal impact between the active management of individual companies and the exercise of ownership. The bank’s use of environment-related active equity mandates may be an example of this, since environmental management and water management are also defined by the bank as focus areas for exercising ownership. Whether the bank is successful in this area will be a natural topic of discussion in the follow-up of the bank’s management in the future.

• There will also be a reciprocal impact between the bank’s advice on the Fund’s long-term strategy and experiences from active management. For example, the recommendations to include additional emerging markets in the Fund’s benchmark in 2007 were made after the bank had acquired expertise through active management in such markets. Correspondingly, the bank had experience from the management of shares in small listed companies before this segment was included in the benchmark. When the bank acquires experience through active management and small investments in new markets, the operational risk associated with large investments following the same markets’ subsequent inclusion in the Fund’s benchmark, is reduced.

In the opinion of the Ministry there should still be a certain flexibility for deviation from the benchmark in the management of the Fund. There is no compelling scientific arguments in favour of a purely passive indexation. It would be unnecessarily costly to follow these indices mechanically, and the special characteristics of the Fund provide potential for excess return over time, which should be exploited to some extent. In addition to this, there is reason to assume that a certain degree of active management will have a positive reciprocal impact on other aspects of the management.

Assessment of the scope and organisation of active management

The limits for active management are part of the Fund’s overall investment strategy. The basis for evaluating the limits of active management should therefore, as is the case for other parts of the strategy, build on striking a balance between the expected return and risk. In this context, the Ministry has particularly emphasised the following:

• As discussed above, the Ministry of Finance assumes that the financial markets are largely efficient in the sense that new information is quickly reflected in the prices of financial assets. This suggests that the possible excess return from active management is limited. At the same time, the external review has shown that there are weaknesses in the Fund’s benchmark indices and that the Fund may have advantages with regard to active management, associated, for example, with costs and its long-term perspective. This suggests that there should be some room for deviations from the benchmark.

• A given loss should be perceived just as negatively by the owner, regardless of the cause of the loss. Therefore, a strategy with little benchmark risk and a relatively high degree of active management should be perceived as equivalent to a strategy that has more benchmark risk and correspondingly a lesser degree of active management. Nevertheless, experience from the financial crisis showed that a negative excess return from active management of 3.4 percentage points was a greater challenge to confidence in the management than the losses of 19.9 per cent in the benchmark. In the opinion of the Ministry, this reflects that the risk associated with the active management strategies was not identified and communicated as well in advance as the risk that was present in the benchmark. With a broader anchoring of the active management this aspect of the investment strategy should be more robust in future periods of negative excess returns. Nevertheless, a certain degree of importance must be attached to the fact that significant negative excess returns in individual years may weaken confidence in the manager, even if the more long term results are good. This in itself suggests that a moderate limit for divergence from the benchmark should be maintained.

• The analyses that have been conducted confirm that it is the benchmark defined by the Ministry of Finance that is the major contributor to the Fund’s risk. The impact of active management has been very moderate compared to the Fund’s overall risk. The report from Professors Ang, Goetzmann and Schaefer contains an updated summary of academic research on active management and its relevance to the GPFG, see Chapter 6. The professors’ advice does not specify for a specific limit for active management, but it is the Ministry’s opinion that their report supports that the limit should still be moderate.

• The net value added from active management in line with the bank’s own ambition of 0.25 percentage points annually will over time account to significant amounts. In comparison, in the evaluation on whether to increase the Fund’s equity allocation from 40 per cent to 60 per cent, it was assumed that the change could increase the Fund’s average annual return by 0.4 percentage points.

In addition to assessments of the return and risk, the Ministry has evaluated whether the limits on active management would have consequences for the alignment of interests between the Fund’s owner and manager. The management of the GPFG requires that Norges Bank recruits and retains employees with special expertise. These persons are recruited in competition with others in a market where the use of performance-based compensation is widespread. This applies to both active and passive management. Even if the objective of performance-based compensation is to ensure that the manager has the same interest in a good return as the owner, there is nevertheless a risk that individuals or groups receive incentives that do not coincide with the owner’s management goal. For active management this will apply in particular if there is a big difference between the time horizon of an active management strategy and the evaluation period used in the bonus system.

Challenges related to potential conflicts of interest between the owner and manager can, therefore, in itself, suggest a reduced degree of active management. At the same time, the owner of the Fund has a clear interest in the establishment of a performance-based management culture, with a focus on both increased income and reduced costs. A well-designed compensation scheme can support this. The Ministry has submitted the new guidelines for the management of the GPFG to a public consultation process, see a more detailed discussion in Chapter 4. In this proposal it is suggested that Norges Bank must develop a system of employee compensation on the investment management side which is supportive of the goals that have been set for the management of the Fund’s assets. NBIM senior management do not have performance-based compensation systems, and persons with control functions do not have compensation based on the Fund’s return. Moreover, the Ministry emphasise that a clear division of responsibility and roles, clear monitoring and control functions and transparency in all aspects of the management will reduce the possible detrimental effects of performance-based compensation systems.

With regard to the formulation of the risk limit for active management, Professor Ang, Goetzmann and Schaefer recommend that a target for active risk should be defined, rather than an absolute limit as is the case today.

The Ministry does not want to define a target for expected tracking error. In some situations such a target could encourage the manager to take more risk than is desired. There are, on the other hand, good arguments for making the constraints less sensitive to general volatility in the market.

One disadvantage of risk management based on a maximum limit for the expected tracking error as it has been practiced up until now is the fact that the measured expected tracking error has increased a great deal during periods of general turmoil in the financial markets. This has occurred even though the bank has not changed its active positions. The Executive Board of Norges Bank has established a guideline that the bank shall only utilise 75 per cent of the limit for tracking error during normal periods. This suggests a tracking error of up to 1.1 per cent. Norges Bank has thus established a buffer to safeguard against an increase in the measured tracking error as a result of special market conditions.

With strict adherence to a maximum limit, the manager can in principle be forced to sell the Fund’s assets at unfavourable times. The method that is used to calculate the expected tracking error is important in this context. In a letter to the Ministry of Finance dated 21 October 2009, Norges Bank has notified that it will support a change to the method used to calculate the expected tracking error. Up until now, the tracking error has been calculated on the basis of daily observations, and the latest observations are given more weight than earlier observations. In practice, a great deal of emphasis has been placed on the latest daily observations in the market. Calculating the risk on weekly prices and with three years of historical data will mean that the sensitivity to general volatility will be less. Changes in the expected tracking error will thus be attributed more to changes in the bank’s positions and less to whether the markets are generally in a period of large or small variations in the return. A restructuring of the calculation methodology may lead to a greater correlation between the time horizon of the active investment decisions and the measurement period of active risk. It may also make this measurement more relevant to the continuous risk management.

The immediate effect of such a potential change will be an increase in the measured expected tracking error, so that the degree of active management permitted in the near future will be somewhat less than with the previous calculation method. This is because the volatility associated with the financial crisis will be part of the calculation when the calculations are based on the performance of the last three years. With the previous method of calculation, observations from the financial crisis will no longer be an important part of the input data.

In addition, allowing the expected tracking error to exceed the limit in very special circumstances can in the Ministry’s opinion reduce the problems associated with the current formulation of the limit further.

When the maximum limit is made less absolute than today, it is natural also to reduce the actual limit. By making allowances for the fact that the risk impact may be higher than expected during periods of particularly high volatility, utilisation of the limit can be higher than it has been up until now. Based on an overall assessment, the Ministry has therefore decided that the limit for the expected tracking error of the GPFG should be lowered from the current limit of a maximum of 1.5 per cent. In the new regulations for management of the Fund, the Ministry will require that Norges Bank should aim for an expected tracking error not exceeding 1 per cent. At the same time it is recognised that the expected tracking error may be higher in special circumstances. Our experience from 2008 showed that it was not appropriate to reduce the divergence from the benchmark, even though the measured expected relative volatility was higher than the limit of 1.5 per cent. The enforcement of the new limit must allow for a similar assessment in exceptional circumstances where the expected tracking error exceeds 1 per cent.

Tracking error is a statistical measure of risk. The advantage of this measure is that risk is quantified across asset classes, markets, instruments and currencies. At the same time the Ministry has pointed out in previous reports to the Storting that this measure of risk has many limitations. Our experience from the last two years is an example of this.

Of decisive importance to the scope of active management is how one on aggregate limits the active management risk. In this context, tracking error can be regarded as one of several relevant indicators of the scope of the active management. An adjustment to the limits of expected tracking error, which is being proposed now, must therefore be seen in the context of what other measures have been implemented, or will be implemented, to limit the risk associated with the active management overall.

Norges Bank has already carried out a major restructuring of the way it measures and manages risk. This is evident, for example, by supplementary methods for the measurement and management of risk. In addition to risk modelling based on historical returns (as tracking error), risk is measured and managed within the areas of concentration analysis, factor exposure and liquidity.

The concentration analysis consists of measurements that are not based on a quantitative model, but on how large the divergence from the benchmark is, measured nominally in Norwegian kroner. The aim is to form a picture of the risk that is not dependent on the many assumptions of the model calculations. Factor exposure measures the portfolio’s exposure to systematic risk factors. Special attention is given to exposure to liquidity. For example, the bank measures the size of its positions relative to the volume that is traded in the market. This provides a basis for estimating how quickly the investments can be changed. Norges Bank has also placed restrictions on leveraging the portfolio. The limits that Norges Bank’s Executive Board has set for the supplementary risk targets and the consequences of this on the Fund’s investments are discussed in more detail in Section 3.3.

The Ministry believes that the requirements that are now stipulated in the bank’s own internal guidelines, the changes that will be made in the Ministry’s guidelines to the Bank, see Section 4.2, and other measures that have been implemented to strengthen the control and supervision of the management, represent targeted measures to limit the risk associated with active management. A continuation of active management in combination with measures to limit risk better is also consistent with the current strategies of other funds, as described in Mercer’s report on active management in other major funds throughout the world.

Within the limits that now have been set for the active management, the Ministry assumes that Norges Bank will actively manage the market portfolio in order to exploit various weaknesses in the benchmark indices, see the discussion above. There will still be room for a certain degree of active management beyond this. The Ministry believes that it is natural that the Bank itself evaluates the appropriate structure for this within the limits that have been set. This will ensure that an ongoing assessment is made of what strategies are appropriate in different market conditions. The Ministry will set requirements for the reporting of the risk and returns associated with active management, and it will review this management regularly, see the discussion below.

Measurement of the results from active management

In isolation, the costs associated with active management are higher than the costs associated with passive management. Since the aim of having a degree of active management is to achieve a higher return than with passive management, the most relevant question for the owner is whether the active management has achieved a higher return after costs than it would have with a hypothetical passive management. The difference in the return can be referred to as the net value added from active management.

The result of active management is nevertheless normally measured as the difference between the Fund’s gross return (return before management costs) and the return on the benchmark. This can be referred to as the gross excess return. The difference between the gross excess return and the net value added from active management is illustrated in Figure 2.4.

While the gross excess return follows from the Fund’s accounts, the net value added from active management must be estimated, since the actual return is compared with the return from a hypothetical passive management. To estimate the net value added, it must be taken into consideration that transaction costs are incurred in the actual portfolio, that the Fund has income from security lending and that the management costs would have been lower with passive management. Since the estimates for income and costs with passive management are based on a significant degree of discretion, the calculated net value added will also be associated with a significant degree of uncertainty.

Transaction costs are incurred in the management of the Fund’s portfolio that are not taken into account in the benchmark. In principle, it can be expected, therefore, that passive equity and fixed income funds have a lower rate of return than the benchmark, see discussion in Box 2.2.

It is likely that Norges Bank’ transaction costs for the management of the GPFG have been higher than many other funds due to the large injections to the Fund over the last twelve years and several expansions of the Fund’s benchmark to include less liquid market segments that to some extents are less well-functioning. In the National Budget for 2010 the Ministry of Finance reported, for example, that the overall costs associated with the phasing in of new capital, increasing the weight of the equity portion to 60 per cent, phasing in of new emerging markets and phasing in of shares in small listed companies were estimated to total NOK 8.7 billion. In addition, there are transaction costs associated with the ordinary maintenance of the portfolio. These are costs that are not taken into account in the benchmark.

Norges Bank has calculated that the Fund’s costs related to the investment of new capital, changes to the composition of the Fund’s benchmark and rebalancing have been around 0.10 per cent annually on average since 1998. There are also running costs because the composition of the benchmark is constantly changing. Norges Bank has estimated this cost to be 0.04 per cent annually.

Security lending entails that the actual portfolio has income that is not included in the calculation of the benchmark’s return. Norges Bank can lend securities in the portfolio in return for compensation. Income from this activity is included in the figures for the gross excess return. The Fund has annual average income of around 0.05 per cent of the Fund’s value from security lending. Both active and passive managers can earn income from such lending. The experience from 2008 and 2009 is that these activities are not without risk. Security lending requires good knowledge of the counterparties and market, good technological solutions and a solid legal framework. In the same manner as other strategies that aim to create value for the Fund, this activity is also based on the manager"s expertise. There is a reciprocal impact between this expertise and expertise in active management. To a certain degree it is therefore more reasonable to count lending income as additional income from active management. This adjustment has, therefore, been marked by a broken line in Figure 2.4.

Source Ministry of Finance

Based on the bank’s estimates for the transaction costs and income from security lending, it appears that the benchmark’s return less 0.10 – 0.15 percentage points would be a reasonable estimate of the return from a passive indexing of the portfolio.

While the security lending income follows from the bank’s accounts, the transaction costs since 1998 have been based on estimates. The Ministry has asked the consulting firm Mercer to obtain return data for passive global equity and bond funds. Even though the results from the passively managed funds in Box 2.2 are not directly comparable with the GPFG, they do support the bank’s estimates for the results from hypothetical passive management in the opinion of the Ministry.

As is illustrated in Figure 2.4, adjusting the gross excess return to represent the net value added from active management also requires that an estimate is made for how much higher the management costs would have been as a result of active management. Norges Bank has estimated on an uncertain basis that on average around half of the average annual management costs of 0.10 per cent are related to active management.

The Ministry of Finance uses the Canadian company CEM Benchmarking Inc (CEM) to prepare the comparisons of the GPFG with other major funds throughout the world, see discussion in Chapter 13. CEM’s study also makes it possible to compare the management costs from active and passive management in other major funds throughout the world. CEM divides the management costs into costs that are necessary to support functions and management costs that are directly linked to payments for investment activities. Costs of support functions include various overhead costs, fees for custodial services, book keeping, etc.

Norges Bank’s costs for support functions totalled 0.03 per cent in 2008. These are costs that will be incurred in general even if the bank chooses to assign the actual investment task to external passive managers. In 2008 Norges Bank’s costs for support functions were higher than the median costs in other funds, which was just under 0.02 per cent.

Costs directly related to investment activities in the Fund totalled 0.08 per cent of the value of the GPFG in 2008. The median values for costs directly related to investment activities in other funds are illustrated in Table 2.3. The median value for direct management costs for external passive management is just under 0.04 per cent, while the median costs for internal passive equity management is under 0.01 per cent. The median costs for the passive management of bonds are about the same.

Based on CEM’s figures for 2008, it appears, therefore, that overall management costs, which include costs related to necessary support functions and the direct costs related to investment activities, in the range of 0.03-0.06 per cent are a reasonable estimate for a hypothetical passive management. Based on this approach, it appears in other words that Norges Bank’s estimate for the additional cost of active management since 1998 of around 0.05 per cent is reasonable.

In its annual report on the management of the GPFG in 2010, Norges Bank makes reference to the fact that their estimate for the net value added from active management is around the same as, or somewhat higher than, the reported gross excess return of 0.25 percentage points. This is based on an actual rate of return that is 0.15 percentage points higher that the benchmark after all the costs have been deducted, and an estimated net return from hypothetical passive management that is at least 0.10 percentage points lower than the benchmark.

Norges Bank reports gross excess return as a measure of the results from active management. This is supplemented by estimates of the net value added from active management. Even though the gross excess return is only an estimated measure of the results from active management, the Ministry will emphasise this figure in the future. There are several reasons for this.

• The gross excess return is well-defined, reasonably easy to measure and based on the Fund’s accounts. Net value added will be based on hypothetical passive management and will, therefore, necessarily encompass discretional estimates.

• Gross excess return is an ordinary measure of excess return that is also used by other funds throughout the world. It is therefore a good point of departure for comparison of the results with other funds.

• The calculation of Norges Bank’s net value added so far does not give any reason to believe that there have been major or systematic differences between the two methods for measuring the Fund’s excess return.

In the future the Ministry will continue to emphasise keeping both the transaction and management costs at an acceptable level. Accordingly, the Fund’s management costs will still be measured and compared with other funds and reported to the Storting. Up to now these comparisons have shown that the Fund has lower costs than other funds. Since the benchmark’s return is not adjusted for actual transaction costs, this also gives Norge Bank an incentive to minimise the Fund’s transaction costs.

An expectation of excess return over time

In the regulations concerning Norges Bank’s management of the GPFG, the Ministry of Finance has formulated a goal of achieving excess return. It is stated in Section 2 of the regulations:

«Norges Bank shall seek to achieve the highest possible return on the investments in foreign currency within the investment limits set out in the regulations and guidelines issued under these regulations.»

The Ministry has evaluated whether the ambitions of the results from the active management should be quantified. Norges Bank has pointed out that an expressed goal for the highest possible return within a limit for active management can improve the quality of several aspects of their activities. This includes the bank’s task to invest new capital in the market, maintenance of the portfolio, active management, active ownership and the provision of advice to the Ministry of Finance concerning the Fund’s long-term investment strategy. When this goal is formulated as expectations for all employees, it means that everyone must contribute to improving the quality of the management.

Professors Ang, Goetzmann and Schaefer write that the current constraints, which entail a maximum limit for the expected relative volatility, do not encourage Norges Bank to exercise active management to any great extent. They believe that this may have contributed to a underutilization of the banks capacity for active management. The professors recommend that a target be defined, rather than a maximum tracking error limit.

The Ministry has evaluated whether such a target or an interval should be set for tracking error. Such an interval would have both a maximum and minimum limit. This will therefore encourage stable utilisation of the limit for the tracking error. As discussed above, it may have unfortunate effects if the manager is encouraged to avoid a tracking error that is too low. Experience shows that the financial market alternated between periods of large and small fluctuations. If periods with low volatility also result in a low expected return, it may be unfortunate to encourage a greater divergence from the benchmark to maintain a level of relative volatility when the return opportunities appear to be limited. A narrow range may mean that more risk is taken systematically when the compensation for adding risk is at its lowest level. The problem is worsened if significant portions of the divergence from the benchmark entail exposure to systematic risk factors that are not taken into account in the expected tracking error alone, because negative outcomes rarely occur.

In the opinion of the Ministry, it is more appropriate to express the ambitions for the active management of the Fund by quantifying an expectation for the net value added from active management over time. The Fund’s net value added from active management should also be viewed in relation to the limit for divergence from the benchmark.

Norges Bank’s ambition to achieve an annual net value added of 0.25 per cent from active management on average was originally based on a maximum limit for tracking error of 1.5 per cent. Now that tighter constraints are being proposed for the active management, it is natural to evaluate whether the Ministry should quantify the expectation for the annual net value added to less than per cent.

There is no easy answer to what a reasonable ratio would be between risk and return in the active management. Some facts that can be mentioned nevertheless include:

• Norges Bank’s own goal: Norges Bank writes in a letter that they have a target for the net annual value added from active management of 0.25 percentage points. In the current guidelines from the Executive Board to the Chief Executive Officer of NBIM, a limit of 75 per cent of the maximum limit has been set for the utilisation of the tracking error limit. In reality this means that NBIM expects a net value added of 0.25 per cent with a maximum limit for expected tracking error of 1.1 per cent.

• Experience from active management at other managers: With risk in the active management corresponding to a tracking error of 1 per cent, a gross excess return of 0.25 annually will normally be considered a good result, but this must be evaluated over a relative horizon and viewed in the context of whether tracking error is a good expression of risk.

• Results achieved: Norges Bank has achieved annual an annual gross excess return of 0.25 per cent on average since 1998. The supplemental limits for active management risk that have been proposed now will in particular limit the Fund from some of the strategies that were previously used for the management of the Fund’s bond portfolio. Overall, these strategies have not contributed to any excess return since 1998.

On the basis of an overall assessment, the Ministry has decided that an annual net value added from active management of around per cent on average should be expected over time. At the same time the excess return must be evaluated based on the risk that is associated with this activity. If Norges Bank only uses part of the active management limit, then a somewhat lower result should be regarded as satisfactory. As described above, as an approximation it will be measured as gross excess return, i.e. the difference in the return between the actual portfolio and the benchmark.

When calculated over long periods of time, an excess return of around 1/4 percentage points annually will represent a significant contribution to the overall return on the Fund. With the current size of the Fund, this corresponds to NOK 5-6 billion annually.

Active management is expected to only provide a moderate increase in the Fund’s overall risk over time. Measured by the Fund’s standard deviation, which is a normal measure of risk, active management has only increased the Fund’s risk since 1998 to a limited extent. The volatility in the actual portfolio for the entire period from 1998 to 2009 was 7.6 per cent, compared with 7.1 per cent for the benchmark. This is illustrated in Figure 3.8, which shows small deviations in the risk as measured by the standard deviation of the benchmark and actual portfolio, also over shorter periods of time, with the exception of the last two years. Our experience from the last 12 years shows that the reported excess return was high and stable for many years, but with huge fluctuations in 2008 and 2009. This must be seen in light of the special market conditions during the financial crisis. Exposure to systematic risk factors is characterised in many cases by such a skewed profile for the results achieved over time. Even if positive excess return is assumed over time, periods of negative excess returns must still be expected.

Regular review of the active management

The estimates for the return from active management in the future are uncertain. Over time the active management must be assessed overall based on the results achieved. Regular and broad reviews of the active management are prerequisites for maintaining a certain element of active management. Such reviews may result in an upward or downward adjustment of the degree of active management. In connection with these reviews it will also be natural to assess whether the gross excess return still appears to be representative of the creation of value from the active management. Other circumstances that should be illustrated are whether Norges Bank utilises the potential reciprocal impact between active ownership and active management.

The Ministry will plan regular reviews of the active management in the beginning of each Storting period. An interval of four years seems reasonable in light of the fact that the results must be assessed over time. A scheme that entails regular reviews will reduce the need for more ad-hoc-like assessments after periods of weak results. This promotes at the same time a better anchoring of this aspect of the Fund’s management.

2.3.6 Further work on systematic risk factors

Professors Ang, Goetzmann and Schaefer recommend that more emphasis is placed on work on the Fund’s exposure to systematic risk factors. The professor’s point out that the active management of the Fund has given the Fund exposure to systematic risk factors. They believe that this has improved the Fund’s overall results and that a fund like the GPFG should be exposed to such factors, because it is a way of exploiting the Fund’s special characteristics.

The Ministry concurs with the assessment that more attention should be paid to systematic risk factors in the management of the Fund. It should be assessed, for example, whether there are any risk factors that the Fund should not be exposed to, or whether there are any factors that the Fund is not currently exposed to, but that should be included in the Fund’s investments. The basis for such assessments will be an analysis of the return and risk characteristics of the risk factors. Several risk factors are described in Chapter 7 based on their historical performance. The analysis shows, for example, that some of the factors have historically had a higher probability for a very low return than a very high return, and that some factors yield a negative return when the equity market falls. These are characteristics that may affect the Fund’s overall results if the exposure becomes substantial.

The question of whether there are any new factors that the Fund should be exposed to is closely linked with the recommendation from the professors that importance should be attached to the analysis of systematic risk when considering further diversification of risk in the Fund’s benchmark.

Professors Ang, Goetzmann and Schaefer believe that the Ministry of Finance should change the Fund’s benchmark so that exposure to systematic risk factors is integrated into the benchmark to the greatest possible extent. The role of active management will thereafter consist of overweighting or underweighting the various risk factors and exposure to factors that are not included in the benchmark due to various reasons, as well as a role to some degree for positions based on an analysis of individual companies.

In the opinion of the Ministry of Finance such a reorganisation of the benchmark may have several advantages. Exposure to systematic risk factors may be one way of exploiting the Fund’s advantages to achieve a higher return on the Fund’s risk. It will, therefore, be consistent with the Ministry’s expressed goal of developing the Fund’s investment strategy with a view to improving the diversification of risk in the Fund and better exploiting the advantages of the Fund. In such a case the Ministry of Finance will discuss the exposure to such factors and the consequences for the Fund’s expected return and risk in reports to the Storting, in the same manner as the consequences of a higher equity allocation were discussed earlier. An expansion of the benchmark with exposure to systematic risk factors may also make it easier to evaluate the results from the active management.

The Ministry believes at the same time that our interest in the Fund’s investment strategy having a firm theoretical foundation suggests that it is too early to make a decision on whether systematic risk factors should be included in the benchmark. There is a need to investigate further what factors should be included, what exposure is then desirable, and how the Fund will achieve exposure to these factors.

In other contexts the Ministry has considered it an advantage that the development of the Fund’s investment strategy has benefited from the experience of others. As far as the Ministry is aware, there are no other major funds in the world that have formulated their investment strategy based on the inclusion of systematic risk factors in the benchmark in the manner that is proposed. In the opinion of the Ministry, this supports the need to spend more time on studying the question of an alternative benchmark.

Even though it has been recognised professionally that there are several systematic risk factors in the market, there is uncertainty related to what these factors are and how stable they are. Some of the factors are well documented by historical return data, but lack a recognised theoretical explanation. Other factors have a certain theoretical foundation, but it appears uncertain how lasting the return associated with them actually is.

Professors Ang, Goetzmann and Schaefer believe that it is possible to develop good, investable indices for systematic risk factors. At the same time they write that it is beyond the scope of their assignment to propose a new benchmark for the Fund, and that there is a need to examine a transition to a new benchmark more closely. The Ministry agrees with this.

If the benchmark is to be changed in accordance with the proposal from Professors Ang, Goetzmann and Schaefer, new indices must be established for the relevant risk factors that are suited for investments on a large scale. There are currently no such indices for many of these factors.

Even passive management of the exposure to systematic risk factors will likely involve leveraging the portfolio, the use of derivatives and short positions, and a higher transaction volume compared with a conventional benchmark. This can increase the costs related to following the benchmark. It also places high demands on the Fund’s risk management and suggests a close evaluation of the operational conditions.

There will also be a need to study the consequences of a more complex benchmark with regard to the division of responsibilities and roles between the Ministry and Norges Bank. Experience from the financial crisis emphasises the need for ensuring that the risk associated with the Fund’s investments is well understood and accepted by the public. Therefore it must also be assessed how easy it would be to communicate strategies that are based on systematic exposure to risk factors.

The Ministry will return to the question of a reorganisation of the Fund’s benchmark in accordance with the recommendations from the researchers in the annual report on the management of the Fund in the spring of 2011. The Ministry aims to evaluate such an approach in cooperation with other major funds throughout the world.

In light of Norges Bank’s letter and the report from Professors Ang, Goetzmann and Schaefer there is nevertheless a need to evaluate alternative benchmark indices for the Fund’s bond investments, since both point out weaknesses in the current benchmark.

With a continuation of the current benchmark and constraints on active management, as the Ministry is proposing now, exposure to systematic risk factors should nevertheless be give more attention. Exposure to systematic risk factors in the active management must be measured, managed and communicated. Norges Bank has already included exposure to systematic risk factors in its new framework for the measurement and management of risk. This will also be a requirement in the new guidelines for the management of the Fund that the Ministry has announced.

2.4 Active management of the GPFN

In the Ministry of Finance’s letter to Folketrygdfondet dated 18 December 2009, the Ministry requested an assessment of the relevance to the GPFN of the four reports received in connection with the evaluation of the active management of the GPFG. The Ministry pointed out that it would be natural in this context to look at any differences between the GPFG and the GPFN with regard to special characteristics, investment universes, ownership shares, characteristics of the marketplace, etc. Folketrygdfondet replied to the Ministry of Finance in a letter dated 29 January 2010. The letter is enclosed as Appendix 2 to this report. Folketrygdfondet has summarised its assessments as follows:

• «An illiquid and volatile Norwegian capital market creates other challenges than for a major player in a much more liquid global market. This applies, for example, to the consideration of how the market works.

• In order to achieve a portfolio that closely follows an index, active investment choices are required even for passive management. This also requires proper expertise and entails a cost level for passive management that is almost the same as for active management.

• As a major shareholder in Norwegian companies the role as owner is regarded as being safeguarded significantly better through the active management of the portfolio.

• Factor-based benchmarks are regarded as not very suitable for a major investor in the Norwegian market. Based on the fact that there are few observable factors, the establishment of an appropriate benchmark based on known systematic factors is regarded as not very realistic.

We believe that active management of the GPFN will be the best way to create added value also in the future. Through responsible investment activities and a good follow-up of ownership, Folketrygdfondet’s investment philosophy will best contribute to safeguard the Fund’s financial assets in the long term and in a well-functioning financial market.»

The Ministry will present its assessments related to the active management of the GPFN in the annual report to the Storting on the management of the Fund in the spring of 2011.

2.5 Further work on the investment strategy

2.5.1 Primary organisation

The GPFG comprises over 95 per cent of the overall Fund capital, and this percentage will increase in the future with the continued inflow of petroleum revenues. It will therefore be natural that work on the development of the Fund’s strategy is primarily aimed at the GPFG.

Many important choices have been made with respect to the investment strategy of the GPFG in recent years. In the opinion of the Ministry the current benchmark reflects an acceptable level of risk for the Fund. The sources from which the return and risk associated with the Fund have originated thus far are primarily linked to the fact that a market return has been achieved through a benchmark consisting of relatively liquid equity and bond markets. The benchmark has been expanded gradually and the diversification of risk has increased.

Future work on the investment strategy will focus in particular on evolving the strategy so as to exploit the special characteristics of the Government Pension Fund in the best possible manner, see discussion above. Further development will seek to diversify the risk further and increase the weight of investments that benefit from the Fund’s size, long-term perspective and ability to hold less liquid assets. The decision to invest up to 5 per cent of the Fund in real estate is an example of such a change. The Ministry of Finance published new guidelines for investments in real estate on 1 March 2010. These are discussed in more detail in Section 2.5.2.

A basic premise for developing the strategy is sound management of risks other than market risk, such as operational risk. The strategy development must also take into account the Fund’s role as a responsible investor.

In Report no. 20 (2008-2009) to the Storting the Ministry presented the result of an assessment of the Fund’s ethical guidelines. The work on the development of the Fund’s role as a responsible investor is an integrated part of the work on the Fund’s overall investment strategy. Sections 2.5.3 and 2.5.4 discusses the status of the work on assessing the ethical guidelines and new investment programmes.

In its work on developing the Fund’s investment strategy, the Ministry of Finance makes use of advice from Norges Bank and others with special expertise. In the National Budget for 2010, the Ministry announced a change in its use of external advisors. More specialised and broader problems related to the Fund’s investment strategy suggest use of specialised external expertise. Accordingly, the Ministry will use external evaluation assignments to survey the leading practice among other investors and to form a foundation for key investment decisions based on a study of the results from academic research. Such assignments have also been awarded earlier, most recently in connection with an assessment of the active management. The external studies that were ordered in connection with our work on investments in real estate are another example. In this connection a review of the results from academic research was ordered from Professors Hoesli and Lizieri and input on the rules for real estate management was ordered from the Partners Group.

In addition, the Ministry aims to arrange public external evaluations of the Ministry’s work on the investment strategy on a regular basis in the future. Such a practice will result in increased transparency and debate on the important choices that are made in relation to the Fund’s investment strategy. In the National Budget for 2010, the Ministry announced that it would return to the question of how this work should be organised. The Ministry plans for the evaluations to be made by a group consisting of 3-5 persons. The composition of the group should vary over time, and both Norwegian and foreign specialists should be represented. The group will comment on the analyses that have been presented in connection with the Fund’s investment strategy in the annual reports on the Fund. They will also be able to discuss other matters related to the Fund’s investment strategy and give input on topics that the Ministry can examine in more detail. The evaluation will thus be able to give input to our long-term work on developing the Fund’s investment strategy.

The evaluations are limited to the Fund’s investment strategy. Other aspects of the management, such as the results from the operative management and risk management of the Fund, are subject to other external evaluations. Reference is made, for example, to Norges Bank’s Supervisory Council’s work on certification assignments and the discussion of these assignments in Chapter 4, Mercer’s evaluation of the operative management in 2003, Ernst & Young’s report on the Fund’s risk management, which was presented in the annual report on the Fund in 2008 and the analyses of the Fund’s results in the report from Professors Ang, Goetzmann and Schaefer, which was presented in Section 2.3.

The first report on the Ministry’s work on the investment strategy should be presented in the autumn of 2010, so that it can be used as input for work on the next report to the Storting on the management of the Government Pension Fund in the spring of 2011.

2.5.2 Real estate investments

It has previously been decided to invest up to 5 per cent of the GPFG in real estate, see Report no. 16 (2007-2008) to the Storting. Real estate is the third largest asset class globally after equities and bonds. Key reasons for including real estate in the GPFG included further risk diversification in the Fund, harvesting premiums in less liquid assets, and increasing the Fund’s investments in real assets, in order to preserve the Fund’s international purchasing power in the best way possible.

After the Storting’s deliberation of Report no. 16 (2008-2009), the Ministry has continued to work on the establishment of more detailed rules for the real estate investments, see for example the discussion in the National Budget for 2010. Key elements of the new guidelines for real estate investments include required rates of return, risk limits and reporting requirements. In connection with its work on the guidelines, the Ministry has received, for example, advice from the Swiss company Partners Group. The advice from Partners Group is based on the best practice in major funds throughout the world.

The Ministry of Finance stipulated guidelines for investments in real estate on 1 March this year. Parallel to this work, the Ministry will work on rules for the management of the GPFG, see discussion in Section 4.2. The separate rules for real estate that entered into force on 1 March will be incorporated into the combined regulations for the GPFG.

The rules stipulate that Norges Bank shall invest up to 5 per cent of the GPFG in a separate real estate portfolio. When the real estate portfolio approaches 5 per cent, fluctuations in the value of the real estate portfolio in relation to the value of the Fund will make it necessary to stipulate divergence limits. The Ministry will return to this question.

The guidelines for the real estate portfolio permit investment in both listed and unlisted real estate, as well as bonds and derivatives related to real estate. The rules are principle based. Ministry’s guidelines cover the key principles. These rules must accordingly be supplemented by Norges Bank through internal guidelines and limits. Thus a great deal of responsibility lies with Norges Bank with respect to the formulation of specific rules and limits. At the same time, extensive reporting requirements are imposed on Norges Bank.

For the equity and bond portfolios in the ­GPFG, the Ministry of Finance’s choice of benchmark indices is a key element of the Ministry’s risk management, because guidelines have been given in terms of how much Norges Bank can deviate from the indices in the active management. The benchmark indices are also an important basis for measuring Norges Bank’s results from the active management.

It will, however, not be possible to engage in passive management of unlisted real estate by assembling a portfolio equivalent to the real estate index, because it is not possible as a rule to purchase a share of the properties included in the index in the same manner as shares can be purchased in companies that are included in the equity indices. In addition, real estate indices are not equally representative of the overall market. Thus there is little reason to distinguish between active and passive management, or utilise real estate indices to manage the Fund’s risk in the real estate portfolio. Real estate investments will therefore be managed actively.

Even though the real estate indices have weaknesses, the return on a global real estate index will be the best basis available for evaluating how good the return on the Fund’s real estate portfolio has been. The Ministry has therefore chosen a specially adapted version of the global real estate index from the English index provider International Property Databank (IPD) as a return target for the GPFG’s real estate portfolio.

In the definition of the return target, the Ministry has assumed that the scope of the real estate portfolio’s investments in listed real estate companies will be limited over time. If this assumption changes, then the Ministry will consider the use of an index of listed real estate companies as the return target for the listed portion of the portfolio. In accordance with the guidelines issued by the Ministry, Norges Bank shall stipulate a multi-year strategic plan describing how the bank will achieve the highest possible net return (after costs) on the real estate investments in compliance with the regulations.

The rules state that the risk in the real estate portfolio shall be diversified. A general requirement has been stipulated that the investments shall be diversified geographically, across sectors and across types of real estate and the associated financial instruments. Before investments can be made, the Ministry will stipulate a strategic country and sector distribution and the associated exposure deviation limits. In addition, the bank will be required to limit the risk through, for example, limits on investments in emerging markets and real estate under development and limits for the maximum investments that can be made in an individual year. Limits must also be set with respect to leverage.

It is expected that the majority of the real estate investments will be made through unlisted funds and corporate structures. These real estate instruments may have debt elements like companies in the GPFG’s equity portfolio. The debt ratio will depend, for example, on economic, regulatory and tax-related circumstances. In cases where Norges Bank participates and establishes a specific instrument, the bank can influence the debt ratio. In the guidelines there is a requirement that the investments must not be leveraged for the purpose of increasing exposure to risky assets. The real estate portfolio may only be leveraged in order to effectively execute the management assignment. This entails, for example, that the bank must have an opportunity to invest in established structures where leverage is the normal practice.

Many international institutional investors, such as pension funds and insurance companies, are exempt from taxation in their home countries in the same manner as the GPFG. Unlisted real estate funds and companies are often incorporated in jurisdictions that offer tax regimes where most of the return is taxable in the investor’s home country so that the institutional investors benefit from this, see Report no. 16 (2007-2008) to the Storting. The Ministry’s rules for real estate investments set special requirements for what countries unlisted companies and funds can be established in. They must be established in OECD countries, countries that Norway has tax treaties with, or countries from which Norway may demand tax information pursuant to other agreements based on international law.

To limit risk, there is also a requirement that the bank perform a due diligence review of individual investments in which the various types of risk are surveyed and documented.

The guidelines stipulate that the bank must integrate environmental, social and governance considerations in its real estate management. In terms of the environment, the bank is required to emphasise energy efficiency, water consumption, waste manage, etc.

Special phasing-in rules have been established for real estate investments, which stipulate requirements that the bank shall seek to diversify the investments over several years and across the relevant risk factors. It must be expected that capacity limitations will entail that that the portfolio will focus on certain individual real estate markets in the beginning. Access to competent managers with local knowledge is an example of a capacity limitation. It is therefore expected that it will take many years for the bank to build up a real estate portfolio that represents 5 per cent of the Fund’s total capital. The regulations stipulate that the pace of phasing in will be determined by the bank’s long-term return and risk expectations in the capital markets. It must be expected that the rules can be adjusted during the phasing in period, as experience is gained within this new investment area. Upon completion of the phasing in period, the Ministry plans to evaluate the bank’s real estate management during this period.

2.5.3 Work on responsible investments

In 2008, the Ministry of Finance conducted a broad evaluation of the Ethical guidelines for the GPFG. The results were presented to the Storting in last year’s report. The Ministry has implemented a number of new measures with a view to promoting responsible investment practices. In this context, factors that can have an impact on the long-term return, including good corporate governance and environmental and social issues in all parts of the management of the Fund have been emphasised. Among other measures, the Ministry has initiated a new investment programme aimed at environment-related investment opportunities and is participating in a research project to study in more detail how climate challenges can affect the financial markets. Work linked to active ownership and exclusion has also been strengthened in keeping with the aim of making use of the opportunities we have to contribute to sustainable development. This was defined in the new guidelines for responsible investment practices, which were introduced on 1 March this year and are presented in this report. The new rules replace the Ethical guidelines laid down on 19 November 2004. The Storting gave its approval to the Government"s plan, see Section 3.2 of Recommendation no. 277 (2008-2009) to the Storting.

Box 1.1 in Report no. 20 (2008-2009) to the Storting gives an overall summary of the results from the evaluation of the ethical guidelines. The follow-up of the results is described in various sections of this report. The Ministry gives an overall summary of the measurers and implementation of measures, as well as references to where they are discussed in the report in Box 2.3.

2.5.4 New investment programmes

In Report no. 20 (2008–2009) to the Storting, the Government outlined plans for the establishment of a new investment programme aimed at environment-related investment opportunities. Whether an investment programme could be established for investment opportunities in sustainable growth in emerging markets was also to be assessed.

A prerequisite for the new investment programmes is the fact that it must be possible to implement them based on the Fund’s role as a financial investor, with the associated return and risk requirements. Through such investments, the Fund’s special characteristics as a long-term and broadly diversified investor, can be exploited, at the same time as special expertise can be built up in growth areas. These initiatives also fit in well with the Fund’s role as a responsible investor, where one of the main goals is to ensure a long-term financial return by contributing to sustainable development in an economic, environmental or social sense.

Plans for the environmental programme include being able to invest in market segments in the area of infrastructure and unlisted equities, and in a selection of listed equities or bonds based on environmental criteria. For the investment programme aimed at sustainable growth in emerging markets, investments in unlisted equities and infrastructure will be considered.

The assumption is that the total amount for these investment programmes may be around NOK 20 billion, invested over a five-year period. In the National Budget for 2010, the Government proposed investments of around NOK 4 billion for 2010 based on environmental criteria. It was pointed out that it is natural that such investments are initially made in instruments and markets that are already permitted, such as listed equities and bonds. These kinds of investments will not be very different from the current investments in terms of operational challenges and will therefore be able to be made relatively quickly.

In the National Budget for 2010 reference was made to the fact that the Ministry has made a preliminary survey of investment opportunities within the environmental programme and found several opportunities with clearly defined environmental criteria in the Fund’s existing investment universe. Three opportunities were mentioned:

• Environmental bonds. Investments in bonds that exclusively finance eco-friendly projects.

• Environmental equity indices. Investments based on an equity index where the individual company weightings are influenced by environmental criteria.

• Active management with environmental criteria. Active management that attaches weight to environmental criteria, at the same time as the manager seeks to create an excess return above a given benchmark.

In a letter to Norges Bank dated 25 August 2009, the Ministry of Finance requested a review of matters related to the investment programmes and made specific reference to the three aforementioned alternatives.

With regard to environmental investments within the current investment universe, the bank replied in a letter to the Ministry of Finance dated 18 September 2009 that it could carry out such management assignments and recommended active equity management based on the current ordinary benchmark. The reply letter was discussed and published as an appendix to the National Budget for 2010.

On the basis of this letter, the Ministry sent a letter to Norges Bank dated 24 November 2009, in which the bank was requested to give a more detailed description of how an active management strategy within the environmental programme could be implemented and regulated in the most appropriate manner. The bank was also requested to comment on how investments in bonds that were to finance eco-friendly projects exclusively, such as the World Bank Green Bonds, could be regulated. The bank’s reply letter dated 3 February 2010 has been published on the Ministry of Finance’s website (www.regjeringen.no/spf).

In the fourth quarter of 2009, Norges Bank established several environment-related active equity mandates. The bank currently has around NOK 7 billion under management with such mandates. The mandates are managed both internally by Norges Bank and externally by management ­organisations with special expertise in specific ­areas. The environment-related active management mandates include a global mandate that invests in companies that develop clean energy technology and a global water mandate.

The costs associated with Norges Bank’s active environment-related equity mandates will be on par with other actively managed mandates. Norges Bank believes that the general environmental objectives are safeguarded through the bank’s definition of the investment universe and benchmark for the various mandates. With regard to environmental bonds, the bank writes that it will continuously consider investments in environmental bonds as part of the operative management. Norges Bank will seek to invest in these types of bonds if it can achieve market-based terms that essentially correspond to normal bonds issued by the same issuer. The number of environmental bonds available is still very limited, and the market terms, such as the question of earmarking, are regarded as unclear. Norges Bank finds accordingly that it is not very appropriate to establish special regulations, including a minimum limit, for these types of investments.

Norges Bank believes that it will be able to meet the goals of the Ministry of Finance with respect to the environmental programme within the current investment universe and mandate. In the view of the bank, this programme will not have any significant impact on the Fund’s overall risk profile, and it will be possible to implement the programme within the current limits for the operative management. In accordance with the bank’s input, the Ministry does, therefore, not plan to issue any special rules for active equity management with environmental criteria or investments in environmental bonds. The Ministry sees it as positive that the bank has established several environment-related active equity mandates in line with the intentions of the investment programme, and that they currently have around NOK 7 billion under management with such mandates. The bank intends to increase these investments in 2010. This entails an acceleration of the investments under the environmental programme in relation to what was suggested in the National Budget for 2010.

The Ministry will stipulate special reporting requirements for the environmental programme in the new rules for the management of the ­GPFG. These reporting requirements will be of an overarching nature. It will be difficult to stipulate requirements for detailed reporting based on environmental criteria, due, for example, to the fact that no market standard has been established for such reporting. The general reporting requirements will at the same time not result in any unnecessary limitation of Norges Bank’s investment opportunities.

The Ministry will also continue to evaluate the possibility to invest portions of the environmental programme in equity indices that attach weight to environmental factors.

Reference is made in the National Budget for 2010 to the fact that the Ministry will continue to consider unlisted investments within the environmental programme and whether a programme aimed at sustainable growth in emerging markets should be established. Advice from Norges Bank will represent important input in this work. In a letter of 18 September 2009, the bank wrote that the evaluation of investments outside the current investment universe will demand an extensive survey of the investment opportunities and a thorough evaluation of the expected return and risk associated with such investments. Norges Bank will also evaluate whether the bank can establish an organisation to implement this type of management. Norges Bank will undertake these evaluations and aims to present its conclusions to the Ministry in 2010.

The Ministry will present the status of the work on the new investment programmes in the National Budget for 2011.

3 Follow-up of the management

3.1 Introduction

This chapter concerns the follow-up of the management of the Government Pension Fund. The Ministry believes that broad reporting on the asset management is important as it helps build confidence in the Fund and its structure.

Section 3.2 provides an account of the results achieved by the Government Pension Fund Global (GPFG) and the Government Pension Fund Norway (GPFN), while section 3.3 presents the work linked to the following up of the asset management framework. Section 3.4 discusses the corporate governance activities of Norges Bank and Folketrygdfondet and the work of the Council on Ethics.

3.2 Management performance

3.2.1 Main aspects

The last two years have been very demanding for the Government Pension Fund, with a financial crisis of historical proportions in 2008, followed by a strong recovery in 2009.

Comprehensive government packages to stabilise the financial system and dampen the decline in economic activity are two important factors why this financial crisis so far appears to have been shorter than previous crises (see chapter 1). The excellent results from the management of the Government Pension Fund in 2009 means that the losses incurred in 2008 had largely been recovered by year-end 2009.

Developments in the market value of the Fund

Source Ministry of Finance

Source Ministry of Finance, Norges Bank and Folketrygdfondet

At year-end 2009, the total market value of the Government Pension Fund was NOK 2,757 billion (see figure 3.1). This represents an increase of NOK 394 billion on the previous year. The increase in the Fund capital reflects the injection of new funds (NOK 169 billion) and the high returns on the investments (NOK 642 billion). The appreciation of the Norwegian krone reduced the value of the Fund measured in Norwegian kroner (NOK 418 billion), but the value of the krone does not affect the Fund’s international purchasing power. Figure 3.2 shows the increase in the total market value of the Government Pension Fund in 2009 broken down into various components.

At the end of 2009, the market value of the GPFG was NOK 2,640 billion. 1 This constitutes an increase of NOK 365 billion during the year. The equity portfolio was valued at NOK 1,644 billion, while the fixed-income portfolio was valued at NOK 996 billion. The equity portion of the Fund at year-end 2009 was just above 62 per cent (see box 3.1).

Textbox 3.1 The equity portion of the GPFG benchmark

The investment strategy for the GPFG is expressed through a strategic benchmark. This benchmark defines a particular distribution of the Fund capital among different asset classes (equities, bonds and real estate) and different geographical regions. The Ministry defines the composition of portfolio, which has fixed weights.

The strategic benchmark currently consists of 60 per cent equities and 40 per cent bonds. A real estate portfolio representing 5 per cent of the Fund is gradually going to be built up, entailing a corresponding reduction in the bond portion. The portfolio is also divided into three geographical regions, with Europe weighted heaviest. The equity portion was previously 40 per cent, but in summer 2007 it was decided to increase it to 60 per cent. The equity portion was gradually increased until it reached 60 per cent at the end of the second quarter 2009 (see the presentation in the National Budget 2010).

The benchmark includes several thousand limited companies and bond loans, selected on the basis of the criteria the index providers use for inclusion of securities in the benchmark. The Ministry has chosen FTSE as provider of the benchmark for equities, which consists of equities included in the FTSE Global Equity Index Series All Cap. A modified version of this index is used for the management of the GPFG, encompassing 46 countries. The index consists of a given number of national indices weighted according to market value. The Ministry has chosen Barclays Capital as provider of the benchmark for bonds, which consists of the bonds included in the Barclays Global Aggregate and Barclays Global Real indices. These two indices encompass the currencies of 21 countries. The benchmark consists of a fixed number of sub-indices based on currencies and sectors with weights based on nominal outstanding amount.

The composition of the actual benchmark is based on the strategic benchmark. Variations in developments in equity values between countries and variations in developments in stock prices and bond yields will entail that the equity portion of the actual benchmark will deviate from the strategic weights over time. For this reason, a rebalancing regime has been established for the GPFG that entails that in certain circumstances attempts are made to bring the weights in the actual benchmark back into line with the weights in the strategic benchmark. In connection with the development of the rebalancing regime, the desire for minimum deviation from the strategic benchmark was weighed up against the transaction costs incurred as a result of frequent rebalancings. The developments in the equity portion of the actual benchmark are shown in figure 3.3.

Source Ministry of Finance

Altogether for the period 1996–2009, gross inflow to the GPFG was NOK 2,323 billion before deductions for management costs. The total return on the GPFG in the same period is NOK 482 billion before management costs, and measured in the Fund’s currency basket, while a stronger krone exchange rate reduced the NOK value of the Fund by NOK 151 billion. Total management costs for the period are NOK 13 billion.

At year-end 2009, the market value of the GPFN was NOK 117 billion, up NOK 29 billion from the beginning of the year. The value of the equity and fixed-income portfolios was NOK 73 and 44 billion respectively, and the equity portion was just below 63 per cent at year-end.

Developments in the real return on the Fund

It is the real return on the Government Pension Fund that is relevant for measuring developments in the purchasing power of the Fund over time. Table 3.1 shows that net real return on the GPFG in 2009 was 23.5 per cent, measured in the Fund’s currency basket. This is the highest annual return since the Fund was established. Since 1997 the average annual net real return has been slightly above 3 per cent.

The investments in the GPFN achieved a real return of 29.9 per cent in 2009 – again the highest return achieved since 1997. Average annual net real return in the same period is 4.0 per cent.

The discussion below uses nominal return data, since the goal is to compare the return achieved on the actual investments with the return on the Fund’s benchmark. Little information would have been added by adjusting the return data for inflation.

The report below is also based on gross nominal return, i.e. before deductions of management costs. As stated in chapter 12, this reporting principle is in keeping with international standards, such as the Global Investment Performance Standards (GIPS). Management costs are discussed in more detail in section 3.2.4.

Market developments

After several years of strong growth in the world economy, major difficulties in the financial markets led to a sharp decline and deterioration of the economic outlook internationally. The first signs of turmoil in the international financial markets were seen in summer 2007 and culminated in huge losses on securities and loans among many banks and financial institutions which led to a severe undermining of confidence among banks and financial institutions. The bankruptcy of the U.S. investment bank Lehman Brothers in mid-September 2008 marked a critical phase in the financial crisis. Liquidity in the money and credit markets dried up, and many banks faced problems with refinancing. The situation was so difficult for many financial institutions in the USA and Europe that the authorities implemented rescue plans to ensure their continued operation. In many countries, comprehensive government packages were introduced in an attempt to stabilise the financial markets and dampen the impact of the financial crisis on the economy. Despite significant monetary- and fical stimulies, growth in the world economy in 2009 was weaker than for many decades and inflation fell (see figure 3.4a). The second half of 2009 saw a slight pick-up in economic growth. Forecasts for 2010 predict modest growth.

The financial crisis had huge repercussions in all parts of the financial markets. After several years’ upturn in the stock markets, prices dropped sharply throughout 2008 and into the first quarter of 2009 (see figure 3.4b). However, the government packages helped stabilise financial markets, and growth resumed through the rest of the year.

Throughout 2007 and 2008, the central banks reduced interest rates in the USA and the eurozone, and bond yields fell significantly. Expectations about international economic growth increased throughout 2009, with a slight rise in bond yields (see figure 3.4c). The riskpremiums in the international money markets also rose steeply towards the end of 2008 as a result of a lack of confidence in the financial system, and it became much more expensive for banks and other enterprises to get long-term funding. As confidence returned through 2009, the riskpremiums were gradually reduced, but at the start of 2010 they were still slightly higher than before the financial crisis (see figure 3.4d).

Source Ecowin

Both internationally and nationally there is much debate about the causes of the financial crisis, what lessons can be learnt, and what steps should be taken to prevent future crises. A number of processes have been initiated internationally, by the EU, IMF and G20 group and others, to look at the international regulations concerning capital requirements, the pro-cyclicality in the current regulatory framework, executive remuneration, international collaboration, etc. On 19 June 2009, the Government established the Financial Crisis Committee. This committee’s mandate is to analyze incentive structures in the financial sector and the impact these schemes may have had on the sales of different types of financial products, the capital allocation, and the creation of imbalance in the markets. It has also been asked to provide a description of the various international initiatives that have been implemented in the wake of the financial crisis and an assessment of what ought to be done on the national, European and global levels to prevent similar crises in the future. The Committee is due to submit its report by 31 December 2010. Once the Financial Crisis Committee has made its recommendations, it will be natural to assess whether the committee’s findings and assessments are relevant for the management of the Government Pension Fund. The Ministry will return to this in its annual report on the Fund to be presented in spring 2011.

3.2.2 Developments in the performance of the GPFG

The discussion below distinguishes between the return and risk resulting from general market developments in areas where the Fund is invested and the return and risk caused by the investment choices made by Norges Bank in its active management.

The return on the GPFG can be measured both in Norwegian kroner and in the currency basket of the benchmark. 2 When measuring in Norwegian kroner, the return will be influenced by developments in the Norwegian krone exchange rate relative to the currencies in which the Fund is invested. Since the international purchasing power of the Fund is unaffected by fluctuations in the Norwegian krone, the discussion below reports the return as measured in the Fund’s currency basket.

In the presentation below, the risk associated with the Fund is based on the standard deviation of the returns and is a measure of the fluctuations in the return figures (volatility). 3

Developments in the benchmark for the GPFG

The benchmark for the GPFG consists of equities and bonds that are spread across many geographical regions, countries and sectors. Consequently, the return on the benchmark for the Fund reflects the general price performance of the international securities markets (see box 3.1).

In 2009, the return on the benchmark was 21.5 per cent (see table 3.2). This is primarily due to a sharp rise in equity markets around the world. The return on the benchmark for equity investments was 32.5 per cent last year, while the benchmark for fixed income investments yielded a return of 5.1 per cent. However, the sharp fall in the international stock markets in 2008 has resulted in moderate average annual return on the equity benchmark over the last five years.

At the same time as the return on the benchmark in the last five years has been below the average return for the entire period 1998–2009, fluctuations in returns have increased (see figure 3.5). The average annual standard deviation of the returns on the benchmark for the last five years was 8.8 per cent. The increased fluctuations reflect the substantial fluctuations in returns during the last two years in particular, but must also be seen in the context of the increase in the equity portion of the benchmark. A larger percentage of equities would normally contribute to greater fluctuations in the return of the benchmark, because equity prices tend to fluctuate more than bond prices.

Source Ministry of Finance and Norges Bank

Developments in the actual portfolio of the GPFG

The actual investments will deviate somewhat from the benchmark set by the Ministry. The deviations reflect active investment decisions by Norges Bank. The purpose of these deviations is to achieve a higher return on the actual investments than the return on the benchmark, within the predefined limit for deviations (see the more detailed discussion in section 2.3). The risk and return in the actual portfolio will therefore deviate somewhat from the risk and return on the benchmark.

According to table 3.2, gross nominal return on the actual portfolio in 2009 was 25.6 per cent, measured in the currency basket. This is the best performance achieved since the Fund was established.

Source Ministry of Finance and Norges Bank

Source Ministry of Finance and Norges Bank

The Fund’s equity portfolio performed strongly in 2009, with an overall return of 34.3 per cent, while the fixed income portfolio yielded a return of 12.5 per cent. The good results achieved by the fixed income portfolio reflect the gradual normalisation of the bond markets throughout the year and a decrease in the risk premiums. In the last five years, both the equity portfolio and the fixed income portfolio have yielded an average annual nominal rate of return in excess of 4 per cent.

Source Ministry of Finance and Norges Bank

Source Ministry of Finance and Norges Bank

The developments in the nominal return on the equity- and fixed income portfolios in the GPFG are illustrated in figure 3.6, while figure 3.7 shows the developments in the returns on the actual portfolio and the benchmark.

Textbox 3.2 Correlation between the return on the benchmark for the GPFG and the actual portfolio

Figure 3.10 shows the correlation between the return on the actual portfolio of the GPFG and its benchmark. Each individual point in the figure represents the return in a particular month, where the return on the Fund’s actual portfolio can be read on the vertical axis, while the return on the benchmark can be read on the horizontal axis. The black line indicates where the two returns would have been identical. The orange line is the regression line, i.e. the line that fits the observed returns best. As illustrated in the figure, there is close correlation between the two return series, not only as an average over time, but also in the monthly observations. If the Fund had been managed passively, all the brown points in the figure would have been on the diagonal black line. In practice, the points are quite close to this line. This reflects the moderate degree of active management (see the discussion in section 2.3).

The fact that the orange line is slightly steeper than the black line indicates that the actual portfolio has had a tendency to achieve a higher return than the benchmark in periods with strong price developments and a lower return in periods with weak market developments.

As explained in section 2.3 and chapter 14, the results achieved by active management can be partially explained by exposure to systematic risk factors, especially liquidity and credit risk. Several of these risk factors have correlated significantly with general market developments, especially in 2008 and 2009.

The Fund’s risk in 2009, measured as the standard deviation of the returns, was 12.6 per cent (see table 3.2). This is higher than the average over the last five years and for the entire period 1998–2009. Figures 3.8 and 3.9 show that there has been a close correlation between the risk and returns in the actual portfolio and the risk (measured as the standard deviation of the rate of return) and returns in the benchmark for the Fund.

The figures indicate that the decisions relating to establishment of the Fund’s general investment strategy are the primary determinants of both the Fund’s return and the level of risk (see box 3.1 and the article on systematic risk factors in the GPFG in chapter 14).

Source Ministry of Finance and Norges Bank

Developments in the excess return on the GPFG

Deviation from the benchmark set by the Ministry leads to differences between the return on the Fund’s actual portfolio and the return on the benchmark. This is called the excess return and is a measure of the contribution made by Norges Bank’s active management to the Fund’s total return.

It is not obvious that the Fund would have achieved the same return as the benchmark if the Fund had only been managed passively, i.e. had followed the benchmark closely. This is because of the transaction costs that are incurred whenever the benchmark is changed, there is an inflow of capital to the Fund, or changes are made to the Fund’s investment strategy. Index management may also generate income from security lending. The GPFG has a very large inflow of capital compared with other funds, both in absolute terms and as a share of the value of the Fund. Moreover, in recent years, the Fund has gradually moved into markets with higher transaction costs, such as emerging equity markets. There is therefore reason to assume that it would not have been possible to achieve the benchmark return in the period by passive management alone (i.e. by following the index closely). Section 2.3 provides a more detailed discussion of how gross excess return is adjusted for different cost and income components.

In 2009, the GPFG had a gross excess return of 4.1 percentage points, measured in the Fund’s currency basket. 4 This corresponds roughly to more than NOK 80 billion. The Fund’s active management achieved its best result since the Fund was established, mainly due to the strong performance in the management of the fixed income portfolio. From 1998 until the end of 2009, Norges Bank has achieved an annual average gross excess return of 0.25 percentage points. This is in line with the Bank’s own objectives (see the more detailed discussion in section 2.3).

Norges Bank’s active management is performed using a large number of external fund managers with specialist competencies, in addition to the Bank’s internal managers. Norges Bank awards external management mandates in markets and segments where it is either not practical or not realistic to build up internal competencies. A relatively large share of the external mandates, are in emerging markets. Externally managed assets constituted NOK 316 billion at year-end 2009, corresponding to 12 per cent of the Fund. Most of the mandates are equity mandates. External management was responsible for approx. 16 per cent of the Fund’s total excess return in 2009.

Textbox 3.3 Measuring the excess return in the currency basket of the Fund and in Norwegian kroner

In previous reports on the management of the Government Pension Fund, the Ministry has reported the excess return measured in Norwegian kroner. In last year’s report, the excess return was reported both in foreign currency and in Norwegian kroner, and at the same time the Ministry announced that it would be assessing whether the principle for reporting the excess return ought to be changed in the future.

The return on the actual portfolio and the return on the benchmark measured in foreign currency will generally differ from a calculation of the return measured in Norwegian kroner, if the krone exchange rate changes relative to the currency basket. This of course also applies to the excess return. There is no reason to expect any significant differences between excess return measured in foreign currency and excess return measured in Norwegian kroner in the long term.

The relationship between excess return measured in Norwegian kroner and excess return measured in foreign currency can thus be expressed:

(1) excess return in Norwegian kroner = excess return in currency x (1 + change in exchange rate)

If the changes in the exchange rate are relatively small and the excess return is small, then the difference between the excess return measured in Norwegian kroner and the excess return measured in foreign currency will be small. The sign of the figures on which excess return is calculated will always be the same, whether they are measured in Norwegian kroner or foreign currency, but the absolute value will vary according to changes in exchange rates. At times when the excess return is positive and the krone appreciates (as was the case in 2009) or when the excess return is negative and the krone depreciates (as was the case in 2008), excess return measured in Norwegian kroner will be lower in absolute terms than excess return measured in foreign currency (see figure 3.11). Inversely, excess return measured in Norwegian kroner will be higher in absolute terms, than excess return measured in foreign currency, when the excess return is positive and the krone is depreciating or when the excess return is negative and the krone appreciates.

Source Ministry of Finance

Table 3.3 Excess returns on GPFG measured in Norwegian kroner and in the currency basket of the benchmark, and real exchange changes

Excess returns GPFG	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009
Measured in currency basket	0.18	1.23	0.27	0.15	0.3	0.55	0.55	1.07	0.14	-0.24	-3.37	4.03
Measured in kroner	0.20	1.24	0.28	0.15	0.25	0.59	0.53	1.10	0.14	-0.22	-4.10	3.47
Difference (percentage points)	0.02	0.02	0.01	0.00	-0.04	0.04	-0.03	0.03	0.00	0.02	-0.73	-0.57
Exchange rate change	9.60	1.25	3.94	-2.94	-15.06	6.54	-4.60	2.87	-1.88	-7.82	21.69	-14.11

¹ Excess return is calculated as the arithmetic difference between the return on the Fund and the return on the benchmark, calculated geometrically.

² Positive figures for the change in exchange rate mean that the Norwegian krone has weakened, while negative figures mean that the krone has grown stronger.

Source Ministry of Finance and Norges Bank

The analysis of the manager’s performance ought to be based on the currency the manager uses as his base currency. The currency basket of the benchmark is Norges Bank’s base currency. As owner, the Ministry of Finance attaches importance to the overall returns measured in foreign currency, since it is developments in the international purchasing power of the Fund that are relevant in the long term, and this can be regarded as the sum of the return on the benchmark and the excess return from active management measured in foreign currency. In light of these considerations, the Ministry has chosen to change the principle for reporting the excess return. Henceforth, excess return will be reported in the currency basket of the Fund.

Equity management achieved an excess return of 1.8 percentage points in 2009, whereas fixed income management had an excess return of 7.4 percentage points. The excellent results from the active management of fixed income portfolio stemmed mainly from illiquid positions established before the financial turbulence started two years ago. In its report on the management of the GPFG in 2009, Norges Bank writes that roughly a quarter of the total excess return in the fixed-income portfolio in 2009 was from U.S. mortgage-backed bonds while roughly one-third was from investments issued by European banks. Ten per cent of the total excess return of the fixed income portfolio last year was from money market investments, and around 5 per cent was from inflation-linked bonds. The excess return from fixed income management last year must however be considered in the context of the negative excess return of 6.6 percentage points in 2008.

Source Ministry of Finance and Norges Bank

Since 1998 an annual average gross excess return of 0.56 percentage points has been achieved in equity management, while fixed income management achieved an annual average gross excess return of 0.11 percentage points in the same period.

Actual tracking error measured as the standard deviation of the excess return is a measure of the fluctuations in the excess return (see figure 3.13). Since summer 2007, there has been a marked increase in actual tracking error, especially in the fixed income management.

Source Ministry of Finance and Norges Bank

The actual portfolio of the GPFG can be regarded as consisting of two portfolios: the benchmark and the deviation portfolio – the latter a portfolio consisting of the deviations between the invested portfolio and the benchmark. Consequently, the risk associated with the Fund will depend on the risk associated with the benchmark, the risk associated with the deviation portfolio, and the correlation between the returns on the benchmark and deviation portfolio.

Looking at the entire period as a whole, the difference between the overall risk associated with the Fund and the benchmark is small (see figure 3.9). This is partly because Norges Bank has only relatively moderate room to deviate from the index, and only parts of the deviation limit have been utilised.

The performance of Norges Bank’s active fixed income management is illustrated in figure 3.14a, which shows a substantial drop in the accumulated excess return from the second half of 2007 and into the first quarter of 2009, and a corresponding strong upturn in the last three quarters of 2009. Figure 3.14c also illustrates that the accumulated gross excess return for the fixed income management, measured in Norwegian kroner, is negative for the entire period as a whole by approx. NOK 3 billion. Correspondingly, figures 3.14b and 3.14c illustrate the performance of the equity management. The figure illustrates that the events after summer 2007 had less impact for the accumulated excess return of the equity management. The total accumulated gross excess return for equity management, measured in Norwegian kroner 5 , is positive for the entire period as a whole by approx. NOK 25 billion, meaning that accumulated gross excess return for the Fund as a whole is NOK 22 billion. This is also a reasonable estimate of the total value creation through active management in the period (see the more detailed discussion in section 2.3).

Source Ministry of Finance and Norges Bank

The analysis by professors Ang, Goetzmann and Schaefer 6 shows that a substantial share of the excess return achieved in the period January 1998 to September 2009 can be explained by systematic risk factors. This applies to the fixed income management in particular, but also to the equity management (see the discussion in chapter 14 of this report).

The Ministry’s assessment in last year’s report, which concluded that the results achieved by active management in 2008 were not satisfactory, must be considered in light of the fact that the risk factors in the fixed income management had not been sufficiently identified and communicated. However, the Ministry is very satisfied with Norges Bank’s management of the Fund once the financial crisis had started. Particularly important in this respect was the Bank’s handling of the holdings of illiquid bonds. This paved the way for a considerable excess return in 2009. The Ministry is satisfied with the fact that the value that has been generated through 12 years’ active management is in line with the Bank’s own goals (see section 2.3).

The Ministry is also satisfied that Norges Bank, on the basis of experiences from the last few years, has implemented comprehensive measures to limit the risk entailed by active management. Among other things, there have been changes in the management of the fixed income portfolio, external management mandates have been terminated, and the investment strategies for bonds that were used prior to the financial crisis have largely been discontinued. See section 3.3 for a more detailed discussion.

3.2.3 Developments in the performance of the GPFN

Developments in the benchmark for the GPFN

The return on the benchmark for the GPFN is closely linked to developments in the Norwegian and Nordic securities markets. In 2009, the return on the Fund’s benchmark was 35.7 per cent (see table 3.4). This is the highest return since 1998 and is primarily due to a sharp rise in the Norwegian and Nordic equity markets. The average annual rate of return on the Fund’s benchmark over the last five years was 4.8 per cent.

The benchmark for the GPFN is made up of four sub-benchmarks. 7 The return on the Norwegian equity benchmark has been significantly higher than the return on the Nordic equity benchmark. The mean difference for the last five years is 5.9 percentage points, partly as a result of the appreciation of the Norwegian krone against the other Nordic currencies in this period. The Norwegian equity benchmark has also yielded returns that are on average 4.7 percentage points higher than the return on the Norwegian fixed-income benchmark in the same period.

There has been a significant increase in the measured risk of the Fund’s benchmark in the last few years (see figure 3.15). In the last five-year period, the standard deviation was 13.1 per cent, measured as an annual average. This is almost 4 percentage points higher than the level for the entire period 1998–2009. The fluctuations in the benchmark’s return have primarily been driven by considerable fluctuations in equities.

Source Ministry of Finance and Folketrygdfondet

The increased risk associated with the GPFN in recent years is partly the result of increased market volatility as a consequence of the financial crisis, but is also due to the significant changes in the Fund’s asset allocation in December 2006 as the sight deposit arrangement was terminated. This increased the share of the equity portfolio, and Report no. 24 (2006–2007) to the Storting underlined that greater annual fluctuations in the GPFN’s returns thus were to be expected.

Considering the entire period since 1998, the fluctuations in the Norwegian equity benchmark have been greater than in the Nordic equity benchmark, and the gap has widened in recent years. The risk associated with the Norwegian fixed-income benchmark has been relatively low throughout the same period.

Developments in the actual portfolio of the GPFN

The actual portfolio of the GPFN deviates somewhat from the benchmark, mainly due to active investment decisions on the part of Folketrygdfondet. The objective of these decisions is to achieve a higher rate of return on the actual portfolio than on the benchmark. The rate of return on and the risk associated with the actual portfolio will therefore deviate somewhat from the rate of return on and the risk associated with the benchmark.

The return on the GPFN in 2009 was 33.5 per cent measured in Norwegian kroner (see table 3.4). This is the best result achieved since 1998 and is primarily due to a sharp increase in the Norwegian and Nordic equity markets throughout 2009. Figure 3.16 illustrates the developments in the nominal return on the GPFN.

Source Ministry of Finance and Folketrygdfondet

Source Ministry of Finance and Folketrygdfondet

The Fund’s risk in 2009 was 11.7 per cent measured as the standard deviation of the rate of return. This is at roughly the same level as it has been for the last five years. Figures 3.18 and 3.19 show that there has been a high degree of correlation between the actual portfolio and the benchmark.

Source Ministry of Finance and Folketrygdfondet

The figures indicate that the decisions embedded in the Fund’s general investment strategy, operationalised through the determination of the benchmark, are the primary determinants of both the rate of return and the variation in the Fund’s return (see box 3.4). The Ministry’s computations show that approximately 93 per cent of the return on the Fund can be attributed to the the general investment framework for the Fund, while the remainder can be attributed to the investment choices made by Folketrygdfondet within the guidelines laid down by the Ministry.

Source Ministry of Finance and Folketrygdfondet

Developments in the excess return on the GPFN

Table 3.4 shows the average excess return and the standard deviation of the excess return (actual tracking error) for the Fund as a whole and for the four sub-portfolios (Norwegian and Nordic equities, and Norwegian and Nordic fixed income).

In 2009, gross excess return was -2.2 per cent. Folketrygdfondet’s active management thus entails that the return on the Fund’s investments last year was 2.2 percentage points below the return on the benchmark. This is one of the weakest performances achieved since 1998. The poor result was mainly due to negative excess return in the management of Norwegian equities, while the management of the fixed-income portfolio achieved record results. The Norwegian fixed-income management achieved an excess return of 2.1 per cent.

There have been significant fluctuations in the excess return achieved over time (see figure 3.21). Although the GPFN achieved a gross negative excess return in 2009, the average annual gross excess return for the last five years is 1.1 percentage points, and 0.5 percentage points for the entire period 1998–2009.

Textbox 3.4 Relationship between the return on the benchmark for the GPFN and the actual portfolio

Figure 3.20 shows the correlation between the return on the actual portfolio of the GPFN and the return on the benchmark (see box 3.2). The figure indicates a close connection between the two, similar to that for the GPFG.

The slope of the orange curve in the figure is less steep than that of the black curve, indicating that the actual portfolio has tended to yield lower returns than the benchmark in periods with strong price developments and higher returns in periods with relatively weak market developments. This is consistent with Folketrygdfondet’s long-term investment profile, which has tended to yield lower returns on their equity portfolios relative to their benchmarks in periods with rapidly rising prices, and is also an important factor in explaining why Folketrygdfondet achieved a substantial positive excess return in 2008 and a negative excess return in 2009.

Source Ministry of Finance and Folketrygdfondet

Source Ministry of Finance and Folketrygdfondet

The developments in active management risk (tracking error) for the GPFN as a whole are illustrated in figure 3.22. The fluctuations in the excess return for the Fund as a whole have varied between 0.8 per cent and 3.0 per cent in the period 1998–2009. The highest risk level was seen in the 12 month period after the bankruptcy of the U.S. investment bank Lehman Brothers in autumn 2008. Actual tracking error since 1998 is 1.5 per cent. Figure 3.22 shows that actual tracking error has clearly been highest for the Norwegian and Nordic equity portfolios.

Source Ministry of Finance and Folketrygdfondet

The developments in the Norwegian fixed income portfolio are illustrated in figure 3.23a, which shows a decline in the accumulated excess return in the period from 1998 up until autumn 2008. This decline is primarily attributable to poor results from the management of fixed-income assets in the period between summer 2003 and summer 2005. 8 From the second half of 2008 until the end of 2009 there has been a corresponding substantial upturn in accumulated excess returns. Figure 3.23b illustrates that there have been substantial fluctuations in accumulated excess return for the Norwegian equities portfolio (see box 3.4). Total accumulated gross excess return for the Norwegian equity management, measured in Norwegian kroner, is positive for the period as a whole by more than NOK 4 billion, while accumulated gross excess return for the entire Fund is roughly NOK 3 billion (see figure 3.23c).

The results achieved by Folketrygdfondet’s active management must be evaluated over a long period. The Ministry of Finance notes that the Fund’s overall excess return in 2009 was negative, but is satisfied with the good results achieved in the management of the fixed-income portfolio. The Ministry is also satisfied with the fact that Folketrygdfondet since 1998 has achieved an average gross excess return of 0.5 percentage points per year.

Source Ministry of Finance and Folketrygdfondet

3.2.4 Management costs

According to management agreement between the Ministry of Finance and Norges Bank regarding the management of the GPFG, Norges Bank is compensated for actual management costs up to an upper limit, in 2009 fixed at 0.10 per cent (10 basis points) of the average market value of the Fund. The maximum compensation limit is determined on the basis of several factors, including information on costs associated with this type of management in funds of similar size. The Ministry of Finance commissions the Canadian company CEM Benchmarking Inc. to prepare the analyses on which these cost comparisons are based (a more detailed discussion is provided in the special topic article in chapter 13 of this report). In addition to the reimbursement of costs up to the upper limit, Norges Bank is compensated for the fees of external managers incurred as a result of achieved excess return (performance-related fees).

Management costs for 2009, exclusive of performance-related fees for external managers, were NOK 1.826 million, an increase of close to 9 per cent from 2008. Over the same period, the average size of the Fund increased by more than 14 per cent, implying that costs measured as a share of the average portfolio dropped from 0.082 per cent (8.2 basis points) in 2008 to 0.078 per cent (7.8 basis points) in 2009. Consequently, management costs exclusive of performance-related fees are well below the upper limit. Including performance-related fees paid to external managers, costs amounted to NOK 3.228 million, which represents 0.14 per cent (14 basis points) of the average portfolio size. This constitutes an increase of 3 basis points compared with 2008, largely due to the excellent results achieved by the external managers.

In addition to management costs, costs are also incurred in connection with the completion of individual transactions. Norges Bank submits regular reports on transaction costs linked to the management of the GPFG (see the more detailed discussion in section 2.3).

The management costs associated with the GPFN are not entirely comparable to the costs associated with the management of the GPFG. Norges Bank uses external managers, a practice in general more costly than internal management. Furthermore, the asset management carried out by Norges Bank is more extensive, partly because the assets in the GPFG are spread across many more countries and companies than those in the GPFN. On the other hand, Norges Bank benefits from economies of scale in asset management.

Folketrygdfondet has made significant investments in new management systems in the last two years, in part because the new management framework for the GPFN entailed stricter requirements regarding risk management, control and reporting (see Report no. 16 (2007–2008) to the Storting). These investments have increased the management costs in recent years. Some of this increase in costs was one-off outlays, but one must nevertheless expect that the costs of managing the GPFN will be higher in the future than they have been in the past.

The management costs for the GPFN in 2009 were just over NOK 91 million. In 2008 the management costs were NOK 89 million, plus a one-off cost of NOK 15 million in pension liabilities related to the Folketrygdfondet’s conversion to a company by special statute, resulting in total costs of NOK 104 million. The average size of the Fund decreased by almost 8 per cent from 2008 to 2009, implying that costs measured as a share of the average portfolio dropped from 0.098 per cent (9.8 basis points) in 2008 to 0.093 per cent (9.3 basis points) in 2009.

The Ministry attaches importance to the management costs of the GPFN being kept at a low level. Analyses carried out by CEM Benchmarking Inc. show that Folketrygdfondet’s total management costs are relatively low, compared with other large funds internationally.

3.3 Follow-up of the management framework

3.3.1 Introduction

A central aspect of the Ministry’s work on the Government Pension Fund is continuous improvement of the Fund’s management framework. Ensuring that the framework evolves in keeping with the investment strategy, the Fund’s asset growth and international developments in the framework and supervision methods for major asset managers is demanding.

Last year’s report on the Fund pointed out that opinions concerning what constitutes best practice for risk management in asset management are changing. Some of the institutions generally regarded as leading in risk management encountered serious problems during the financial crisis and were forced to seek help from the authorities. The Ministry stated that it thus seems likely that the international norms for risk management will change. This will also affect the Ministry’s further development of the regulations for the management of the Government Pension Fund.

As stated in chapter 6 of last year’s report, a process consisting of several steps has been chosen to further develop both the framework and the follow-up regime for the Fund. Important measures implemented in the last couple of years in the Ministry, in Norges Bank and in Folketrygd­fondet to improve the monitoring and supervision of the management of the Fund include:

• bolstering the Ministry of Finance’s capacity within asset management (a separate division was established in 2006),

• more extensive reporting to the Storting from 2007 (in a special report on the management of the Fund, submitted each spring),

• clarification of roles between the Executive Board and the Supervisory Council of Norges Bank (from 2010 stipulated in the Norges Bank Act),

• a new auditing system for Norges Bank (from 2010) including use of an external auditor appointed by the Supervisory Council, introduc­tion of statutory internal auditing in Norges Bank, and introduction of a system of certification assignments whereby an external auditor reviews the Bank’s internal control systems and other guidelines for asset management and assesses whether they comply with the recognised guidelines and international standards,

• strengthening of the Supervisory Council’s supervisory function through a separate secretariat,

• new regulations on risk management and internal control in Norges Bank (from 2010),

• new accounting rules in keeping with international accounting standards (from 2011),

• strengthening of the Bank’s governance structure in asset management, with clearer distribution of roles both between the Executive Board and NBIM, and within NBIM (from 2009),

• strengthening the Executive Board’s follow-up of NBIM, for example through a new investment mandate for the Chief Executive Officer of NBIM containing more detailed rules about what the Fund can invest in and the degree of active management risk and new principles for risk management in asset management (see box 3.5), and

• reorganisation of Folketrygdfondet as a company by special statute, establishment of new auditing arrangements and introduction of new management guidelines with significantly stricter requirements concerning measurement, management and control of risk and reporting than previously.

In addition to these measures, the Ministry has also announced that it will be introducing new rules for the management of the GPFG (see the more detailed discussion in section 4.2).

Textbox 3.5 New rules for asset management in Norges Bank

Source Norges Bank

The Ministry of Finance has issued guidelines for the management of the GPFG. The Executive Board of Norges Bank set more detailed rules based on the Ministry’s rules. In 2009, the Executive Board of the bank introduced a new investment mandate for the CEO of the asset management unit (NBIM) and set new principles for risk management.

The new investment mandate for the Executive Director of NBIM provides detailed rules about what the Fund can invest in and how great a risk may be taken in the active management. The delimitation of the risk entailed by active management is based on quantitative and qualitative factors. In addition to restrictions on utilisation of the limit on tracking error, supplementary risk limits have been set for deviations from the benchmark along several other dimensions (such as liquidity risk and credit risk), and minimum requirements concerning overlap between the actual portfolio and the benchmark (see figure 3.24) have been imposed. Upper limits to leverage have also been set. As can be seen from figure 3.25, there has been a marked reduction in the use of leverage in the GPFG. This must be seen in the context of the extensive reorganisation of the management of fixed-income assets, among others, with less emphasis on strategies entailing leverage and use of derivates.

Security lending appears in the accounting balance of the GPFG, in that the gross value of the Fund’s investments in bonds and short-term investments is greater than the net value of the fixed-income portfolio. The balance of the GPFG is included in Norges Bank’s annual accounts, as approved by the Supervisory Council. The balance of the GPFG is also reported to the Storting in the report on the central government accounts.

Source Norges Bank

3.3.2 Status of risk management in the GPFG

In Report no. 20 (2008–2009) to the Storting, the Ministry stated that a new external review of the risk management in the GPFG would be conducted, with the assistance of external consultants with specialist expertise. The Ministry of Finance pointed out in the National Budget for 2010 that the most pertinent way of conducting an external review of this nature would be as an assurance review given to the bank’s external auditor by the Supervisory Council of Norges Bank. In a letter to the Ministry of Finance dated 17 September 2009, the Supervisory Council of Norges Bank agreed to such an arrangement, stating that six sub-projects will be considered for assessment by assurance reviews over a two-year period, of which the first two sub-projects comprise a review of the design and implementation of the organisational structural and framework for the management of operational risk.

In a letter to the Ministry of Finance dated 4 March 2010, the Supervisory Council of Norges Bank submitted a report from the Bank’s external auditor (Deloitte) on the assurance review concerning risk management in NBIM. The report reviews the design and implementation of the organisational structure and framework for the management of operational risk. The assurance review provides an independent status assessment of the Bank’s risk management, including whether the risk management has been designed and implemented in accordance with the relevant guidelines and standards.

The report from Deloitte includes:

• a review of whether NBIM has designed and implemented an organisational structure and a framework for operational risk management in line with the applicable guidelines and relevant standards, and

• a review of whether NBIM has followed up the recommendations in Ernst & Young’s report from 2007, as reported in Norges Bank’s letters to the Ministry of Finance dated 19 December 2007 and 12 February 2009 (for the recommendations concerning organisational structure and operational risk).

Regarding the first point, Deloitte finds that the Bank’s organisational structure and framework for operational risk management in all material respects have been designed in accordance with the principles of the Financial Services Authority’s regulations on risk management and internal control. It also concludes that the organisational structure in all material aspects has been designed in accordance with the principles laid down in the internationally recognised standard COSO ERM. Deloitte also finds that the framework for managing operational risk in all material respects has been designed in accordance with the principles of the COSO ERM, with the exception of two aspects. The first non-compliant aspect identified by the auditors pertains to weaknesses related to the system for assessing the link between individual risk factors, and the second non-compliance is linked to the fact that risk assessments are based on residual risk after control measures have been implemented, and not on a systematic assessment of the inherent risk (before control measures). Deloitte also finds that the organisational structure and framework for the operational risk management in all material aspects have been implemented as designed.

Regarding the Bank’s follow-up of the recommendations in Ernst & Young’s report concerning organisational structure and framework for managing operational risk, Deloitte finds that Norges Bank in all material respects has responded to the recommendations, as described in the Bank’s letters to the Ministry dated 19 December 2007 and 12 February 2009, with two exceptions: inadequate linking of the risk tolerance limits (for operational risk) with stress scenarios, and the fact that key risk indicators have not been established as part of the system for monitoring operational risk exposure.

The Ministry is satisfied that a system has now been established in collaboration with the Supervisory Council of the Bank for regular, independent review of the Fund’s risk management. The auditor’s review shows that the Bank has basically designed and implemented an organisational structure and a framework for the management of operational risk that are in accordance with recognised standards. The Ministry is also satisfied that the auditor finds that the Bank has largely followed up the recommendations made in the previous review of risk management concerning organisational structure and the framework for managing operational risk.

The management of the Fund is subject to ongoing development and improvement. The Ministry believes that it will always be possible to identify some areas for improvement in a large and complex enterprise. In recent years, significant changes have been made to the management of the Fund, which together will contribute to a substantial strengthening of the management. The Ministry expects that this work will continue, partly on the basis of the independent review conducted by the Bank’s auditor.

3.4 Active ownership in the GPFG and GPFN and the work on the exclusion mechanism

3.4.1 Introduction

The GPFG and the GPFN have been subject to ethical guidelines since 2004. The Ministry of Finance conducted an evaluation of the ethical guidelines for the GPFG in 2008. As an outcome of this evaluation process, new guidelines for responsible investment were introduced on 1 March 2010. The new guidelines are discussed in more detail in section 4.6. The ownership activities of the GPFN and the GPFG are based on a common platform of internationally recognised principles. However, the tools deployed in this work are somewhat different because of the differences in terms of the size and investment strategies of the two funds.

The GPFG only invests in foreign assets. The Fund’s investment strategy is reflected by a benchmark comprising broad equity and fixed income indices. At year-end 2009, the Fund had equity investments in more than 8.300 companies. Norges Bank’s average ownership stake in these companies is 1 per cent. The work on responsible investment is adapted to this strategy, a main goal of which is to contribute to good corporate governance and responsible social and environmental corporate practices. The Fund shall avoid investments in companies involved in grossly unethical production or behaviour.

The GPFN is primarily invested domestically. At year-end 2009, the Fund had holdings in a total of 53 companies listed on the Oslo Stock Exchange and 116 companies in Denmark, Finland and Sweden. Folketrygdfondet’s average stake in the Norwegian companies included in the portfolio of the GPFN is 5.1 per cent. Its stake in other Nordic companies is 0.2 per cent. In its management of the GPFN, Folketrygdfondet emphasises positive selection of companies and active ownership of these companies. This strategy is suited to an investment universe that is well-defined and comprised of a relatively limited number of companies.

In this chapter, the Ministry reports on the main aspects of the active ownership carried out by Norges Bank and Folketrygdfondet. It also reports on the work of the Council on Ethics in 2009.

Active ownership

The basic principles for active ownership are the same for the GPFG and the GPFN (see box 3.6). Norges Bank and Folketrygdfondet have formulated their own principles for active ownership, based on these basic principles. The ownership activities of Norges Bank and Folketrygdfondet are discussed in more detail in sections 3.4.2 and 3.4.3 respectively.

Exclusion of companies

According to the Fund’s 2004 ethical guidelines, companies will be excluded from the investment universe of the GPFG if they are involved in production or undertakings that imply an unacceptably high risk of the Fund contributing to grossly unethical activities. Since 2002, the Ministry of Finance has excluded 48 companies, based on recommendations from the Council on Ethics for the GPFG. The 2004 ethical guidelines were replaced on 1 March 2010 when new guidelines for responsible investment practice were introduced, including guidelines for observation and exclusion from the GPFG. See section 4.6 for a more detailed discussion. The new guidelines continue the exclusion mechanism for companies that produce specific products and companies that are responsible for or contribute to grossly unethical behaviour.

The Ministry of Finance has adopted the principle that a Nordic company owned by both the GPFN and the GPFG shall be removed from the investment universe of both funds if the Ministry decides to exclude the company. This is established in Report no. 24 (2006–2007) to the Storting and article 5.4.1 of the supplementary guidelines for the management of the GPFN. On these grounds, the Ministry of Finance has decided to exclude one company from GPFN.

The basis for exclusion of companies is discussed in more detail in section 3.4.4 below.

On investments in areas affected by war and conflict

In Report no. 20 (2008–2009) to the Storting, the Ministry discussed issues related to the application of the ethical guidelines when companies operate in areas affected by war and conflict. Companies’ activities in such areas pose particular challenges. It will sometimes be the case that a company makes a positive contribution to the population of states affected by war and conflict. Companies may for example maintain economic activity, provide jobs, produce necessities or in some cases provide a certain degree of protection or social services, such as schools or medical services. At the same time, high levels of conflict often entail a higher risk of human rights violations such as forced labour and attacks on civilians, often linked to use of local security forces.

In 2009, the UN Global Compact initiated a project to establish clearer guidelines for companies with activities in areas affected by war or conflict. The guidelines are being prepared by a broad-based group of organisations, companies and investors in which the Ministry of Finance and the Council on Ethics are involved. The objective of the project is to provide guidelines for companies and investors on what can be regarded as responsible corporate practice in conflict areas. The Ministry of Finance and the Council on Ethics have presented the project to Norwegian non-governmental organisations and will endeavour to take into account comments made by these.

The Ministry of Finance will continue to follow this project until the planned launch at the Global Compact Leaders’ Summit in June 2010. The new guidelines shall address the particular challenges companies face in conflict-affected areas and thus go further than the Global Compact’s principles discussed in box 3.6. It is expected that these principles will be followed by companies that have joined the Global Compact and by investors that have adopted the UN Principles for Responsible Investment (PRI). The guidelines will emphasise the dependence between companies’ profitability and long-term returns and how they handle the type of risk entailed by operations in war and conflict areas.

It is the Ministry’s view that it is positive that the guidelines are prepared in consultation with representatives of companies, investors and organisations. This increases the likelihood of the guidelines being recognised and adhered to.

3.4.2 The ownership activities of Norges Bank

Norges Bank is required to take good corporate governance and environmental and social issues into account in its operative management of the GPFG (see the discussion of the new guidelines for Norges Bank’s work on responsible management and exercise of ownership rights in section 4.6). The Bank shall integrate the considerations of good corporate governance and environmental and social issues into its investment activities, in line with internationally recognised principles for responsible investment. These considerations shall be integrated in accordance with the Fund’s investment strategy and role as financial manager. In executing its management assignment, the Bank shall give priority to the Fund’s long-term investment horizon and that they are broadly placed within the markets included in the investment universe.

Norges Bank’s ownership principles were revised in 2009. The principles are based on internationally recognised, global standards, such as the OECD Principles of Corporate Governance and Guidelines for Multinational Enterprises and the UN Global Compact. They are complemented by Norges Bank’s guidelines for voting and Norges Bank’s expectations documents on how portfolio companies should deal with child labour, climate change and water management. Norges Bank is a founding member of the UN Principles for Responsible Investment (PRI). Both the Ministry of Finance and Norges Bank have signed the PRI, and have a duty to evaluate compliance with the principles each year. The principles are described in more detail in box 3.6.

Focus areas in the exercise of ownership

During the course of 2009, Norges Bank has refined and strengthened its active ownership activities. Norges Bank has focused on six strategic priority areas in particular:

• equal treatment of shareholders

• shareholder influence and board accountability

• well-functioning, legitimate and efficient markets

• children’s rights 

• climate change

• water management

Good corporate governance is necessary for the development of profitable businesses. It safeguards shareholders’ rights and ensures a fair distribution of returns. The equality of shareholders and shareholder influence is therefore central to Norges Bank’s corporate governance activities. The focus area «well-functioning, legitimate and efficient markets» encompasses fundamental questions about the way markets work as well as issues concerning good corporate governance. The bank has been active in efforts to improve market standards, including liquidity and transparency in the market for covered bonds in Europe. Norges Bank has also focused on environmental and social factors that influence companies’ business environments and development, and thus also the Fund’s assets. The priority areas climate change, water management and children’s rights were selected on this basis.

Water management was one of two new focus areas for Norges Bank in 2009. The second was the promotion of well-functioning and efficient financial markets.

Corporate governance instruments

The tools at Norges Bank’s disposal in its corporate governance efforts are linked to the bank’s position as owner of many companies. Shareholders’ primary means of expressing their opinion is by voting at annual general meetings. Norges Bank publishes each individual vote and has established principles for voting. Norges Bank is working actively to contribute to more efficient processes for global voting, and aims to vote at all the annual general meetings of companies the Fund has holdings in.

Other tools Norges Bank uses include dialogue with individual companies, collaboration with other investors, participation in international networks and organisations, input to regulatory authorities, research, and public communication of opinions and expectations.

When choosing between several possible instruments. Norges Bank also considers their expected efficiency. Sometimes it is most expedient to strive to exert an influence through regulations, as these have an impact on all the companies in a market sector. In other cases, change can be achieved through dialogue with one or more companies. There has been an increase in this type of activity.

Voting and shareholder proposals

Norges Bank’s principles for good corporate governance entail that the chairman of the board shall be independent of the company’s management. One of the board’s main tasks is appointing and if necessary, replacing the chief executive. The board shall contribute to long-term strategy and value creation in addition to monitoring the company’s activities and risk. An independent chairman is a prerequisite for the board’s ability to carry out these tasks and monitor the management.

In 2009 Norges Bank voted against candidates for chairman in companies when such candidates were also the chief executive. For the first time, the bank proposed amendments to the articles of association in five U.S. companies to prevent the same person being both chairman and CEO.

The independence of the board was also an issue in European markets like Germany and France, and in Japan. There was increased pressure from international and local investors for greater independence in Japan, where with few exceptions, the board of directors tends to consist of members of the company management.

A large number of the environment-related shareholder proposals were related to greenhouse gas emissions and how companies should set targets for reducing emissions. Norges Bank maintained the policies of 2008 and supported proposals where the board could specify its targets.

Cooperation with other investors

Norges Bank cooperates with other investors in efforts to improve corporate governance standards. Cooperation means results can be achieved more efficiently. Norges Bank and other investors sent a joint statement on equitable treatment and protection of shareholders to the standard setters and government authorities in the Netherlands and Sweden. Norges Bank was represented by another European investor at general meetings in Taiwan, where the lack of effective voting in companies was probed.

Norges Bank has regular dialogue with other government institutions to exchange information and experiences. The Bank discussed voting, capital increases, board changes and other topics in 2009.

Dialogue with companies

Norges Bank prepared documents detailing its expectations of how companies deal with climate change and water management in 2009. The Bank was in dialogue with 77 companies concerning children’s rights in the cocoa, seed production, textiles, mining and steel sectors. Norges Bank conducted dialogue on climate change with 24 companies in the energy and cement industries and on water management with 14 companies in the automotive, construction, mining, oil and gas, retail and media industries.

In its dialogues on corporate governance, Norges Bank raised the issues of equitable treatment of shareholders, shareholder influence and the board’s roles and responsibilities. The Bank urged the companies to appoint an independent chairman of the board, and addressed cases where minority shareholders’ rights were not safeguarded. Examples of this are discrimination in connection with acquisitions, as well as differences among shareholders concerning their right to vote and receive dividends.

Input to the regulatory authorities: improve market standards

Getting the authorities and other standard setters to raise corporate governance requirements makes it easier to hold the board and management accountable for their decisions and strengthen the protection of shareholders’ rights. This is an effective way of safeguarding the Fund’s assets in the long term.

In 2009 Norges Bank worked to raise the standards for management and monitoring of companies in the United States, the United Kingdom, the Netherlands, Brazil, Sweden and China. The Bank also participated in the preparation of the new global principles for corporate governance through the investor network International Corporate Governance Network (ICGN).

In the United States, Norges Bank worked to ensure independent board directors and increased competition for board positions. In the United Kingdom, Norges Bank suggested that board members should be subject to re-election each year. The Bank supported demands to the Hong Kong Stock Exchange for increased transparency in project assessments and environmental impact analyses ofexploration and extraction companies.. In the Netherlands, Brazil, Sweden and Hong Kong, Norges Bank emphasised equitable treatment and protection of shareholders, particularly in connection with acquisitions. The rules on the Stockholm Stock Exchange were changed in October in line with recommendations from Norges Bank and other investors, so that buyers of companies must pay the same price for shares with reduced voting rights as for shares with increased voting rights.

Sector collaboration

In some cases, it might be most expedient to conduct dialogue with several companies in the same sector to ensure an impact on an entire industry. In June 2009 the companies Monsanto, Bayer, Syngenta and DuPont announced that they had entered into a partnership to combat child labour in the seed production industry. This collaboration was initiated by Norges Bank. The industry standard CropLife Position on Child Labor in the Seed Supply Chain was published by a global industry organisation for the plant research industry. The standard sets out the common efforts the companies will make to eliminate the use of child labour by suppliers and other partners in the seed sector. The Bank will continue its dialogue with the four companies.

Following up individual companies

Only in exceptional cases does Norges Bank make public its communication with a company. In October 2009, the Bank sent an open letter to the board of Volkswagen AG, criticising the company for providing insufficient information about transactions with its parent company Porsche SE, and the company’s owners: the Porsche and Piëch families. These families control Porsche SE and thus also have indirect control of Volkswagen AG.

It is important, both as a principle and financially, for Norges Bank to prevent controlling owners from enriching themselves at the expense of the other shareholders.

Within the focus areas children’s rights, climate change and water management, Norges Bank has issued dedicated expectations documents for company behaviour. In these documents the Bank describes how companies should manage the risks associated with these factors. Norges Bank’s objective is to ensure that the companies create positive long-term financial value with acceptable social and environmental repercussions. The documents are used both as a starting point for mapping and analysis of various sectors and as a basis for feedback and dialogue with individual companies. The public has the opportunity to provide input to the formulation of expectations documents through a consultation process, introduced in the wake of the evaluation of the ethical guidelines in 2009.

Norges Bank is introducing systematic reporting on how companies in the portfolio meet the expectations concerning the management of risks associated with climate change, water management and children’s rights. The first report of this type assessed the extent to which 430 companies satisfied Norges Bank’s expectations concerning children’s rights in 2008. On the basis of the findings in the report, the Bank contacted the companies that did not have child labour policies and suggested how their protection of children’s rights could be improved. In a new report on these companies’ behaviour one year later, Norges Bank found that 33 percent of the 135 companies that were contacted had improved their performance and reporting on child labour and children’s rights.

The number of companies that disclose their policy on child labour had increased by 62 percent, while the number of companies that say they are considering the risks associated with child labour had more than tripled. There was also an increase in the number of companies that reported preventive and corrective action plans related to child labour, both in their own activities and in the supply chain. These improvements were most evident within cocoa production and textiles retail. Mining and steel companies had an increasing number of policies on child labour. Transparency improved in all sectors.

The article in chapter 9 of this report discusses use of expectation documents in more detail.

3.4.3 The ownership activities of Folketrygdfondet

The Executive Board of Folketrygdfondet has laid down guidelines for active ownership in the GPFN. The guidelines are based on the Norwegian Code of Practice for Corporate Governance and the UN Global Compact, as well as the OECD principles for corporate governance and for multi-national companies. Folketrygdfondet has formally adopted and signed the UN-initiated Principles for Responsible Investment (PRI). These principles are described in more detail in box 3.6.

At the end of 2009, Folketrygdfondet decided to support the Carbon Disclosure Project (CDP). Through its participation in the CDP, Folketrygdfondet will have access to information about companies’ climate strategies that can be used to evaluate the way different companies handle potential risks and opportunities linked to climate change and how the management deals with these issues.

The overarching objective of Folketrygdfondet’s active ownership is to safeguard the financial interests of the Fund. In order to help promote long-term wealth creation, Folketrygdfondet has defined ethical principles for investment activities that have been included in Folketrygdfondet’s guidelines for active ownership.

Key aspects of active ownership

Good corporate governance and management promotes the rights of owners and other stakeholders and also ensure that company management mechanisms work as intended. Important principles underpinning Folketrygdfondet’s corporate governance efforts are:

• ensuring the establishment of clear ethical principles and ethical guidelines

• ensuring the equitable treatment of shareholders

• safeguarding the rights of shareholders and their scope for promoting corporate governance

• ensuring that the appointment of directors is well prepared, related to defined competency requirements and vested in the shareholders

• ensuring the establishment of remuneration models that are goal-oriented and prudent, and which do not impair shareholder value.

In December 2007, the Executive Board of Folketrygdfondet adopted ethical principles for the management of the GPFN based on the ethical principles that were stipulated in 2004 (see the discussion in Report no. 16 (2007–2008) to the Storting).

Folketrygdfondet submits a report on its active ownership each year, normally in the autumn. The report gives an account of Folketrygdfondet’s ownership activities and addresses, among others things, the following:

• special matters deliberated at annual general meetings

• relevant matters Folketrygdfondet has raised with the companies

• the number and type of offices held by employees of Folketrygdfondet

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

Information gathering and company dialogue

In order to ensure the most objective and precise assessment of companies’ ethical attitudes and actions, Folketrygdfondet gathers information from publically accessible sources such as annual reports, the media and the Internet, and information provided directly by the companies.

Folketrygdfondet is currently involved in the Bærekraftig Verdiskaping (Sustainable Value Creation) project with the largest investors in Norway. This is an informal investor collaboration to promote sustainable development and long-term value creation in Norwegian listed companies. This collaboration is increasing the availability of both the amount and breadth of information with potential relevance for the GPFN’s long-term returns (see the more detailed presentation below).

In 2009, Folketrygdfondet allocated more resources to the work on responsible investment, especially on the analysis side. In this way, Folketrygdfondet will be able to perform more comprehensive analyses of companies’ governance, human rights, ethics, environmental efforts and other factors that may affect long-term value creation. This has led to these issues being broached in meetings with the management of the companies to a much greater degree than previously.

In 2009 Folketrygdfondet has been in direct dialogue with several companies in order to influence them to improve their public reporting on environmental and corporate social responsibility issues. Investors ought to have access to information on companies’ efforts to reduce their social and environmental risks. Folketrygdfondet has pointed out to the companies that they want more extensive reporting within these areas and will continue to follow up this matter in 2010.

In its dialogue with one portfolio company, Folketrygdfondet has called for guidelines for compliance with human rights and labour rights for one of the company’s subsidiaries. The company responded that it will consider preparing clear guidelines for this subsidiary. Folketrygdfondet plans to follow up this commitment through further dialogue in 2010.

Instruments

Folketrygdfondet’s ethical guidelines apply to the entire investment portfolio. In following up the ethical principles, Folketrygdfondet attaches particular importance to assessments of whether the company bases its business on actions or omissions that involve human rights violations, child labour, environmental damage, corruption and other violations of fundamental ethical norms. Different methods are used in the follow-up of the various sub-portfolios.

Folketrygdfondet’s investment philosophy is based on the view that active ownership is the most appropriate instrument for following up the Norwegian equity portfolio. If a situation arises that gives grounds to query the conduct of a company in which the Fund is invested, the issue shall be raised with the company. In this way, an attempt is made to influence the company to correct unacceptable practices. The ownership of fixed-income securities does not provide the same ownership rights as equities and thus neither do they entail the same ownership responsibilities. Nevertheless, Folketrygdfondet raises ethical and other issues linked to its fixed-interest investments. If violations of Folketrygdfondet’s investment principles are found, relevant steps will be considered and initiated. One possible action is active ownership through dialogue. For Norwegian companies in which the Fund has both equity and fixed income investments, a slightly broader set of tools is available in the contact with the companies, such as voting at annual general meetings.

As far as investments in Nordic equities or fixed-income securities are concerned. Folketrygdfondet follows the decisions made by the Ministry of Finance on the basis of recommendations by the Council on Ethics for the GPFG. This means that if the Ministry of Finance decides that the GPFG is not to invest in particular companies, these companies are also excluded from the investment universe of the GPFN. In keeping with this system, Folketrygdfondet divested from a Nordic company that produces tobacco.

Following up individual companies

Folketrygdfondet continuously monitors the equity and fixed-income portfolio by means of Internet searches in sources around the world. This means that over 80.000 sources are monitored and more than half a million new items are scanned each day. The searches are systematic, and Folketrygdfondet is notified if companies in the portfolio are linked to key ethical topics such as corruption, human rights, child labour and environmental issues. The purpose is to monitor whether the companies are complying with their own guidelines. A similar monitoring system has also been established for the investments in bonds.

Participation in international initiatives and collaboration with other investors

Folketrygdfondet adopted and signed the UN Principles for Responsible Investment (PRI) in 2008. By signing the PRI, the organisation commits to a «comply or explain» approach. Folketrygdfondet’s Ownership Report for 2009 describes how Folketrygdfondet follows up the UN principles.

At the end of 2009 Folketrygdfondet decided to join the Carbon Disclosure Project (CDP) 2010. CDP is an independent not-for-profit organisation that maintains the largest database of corporate climate change information in the world, including measurements and reporting of emissions of greenhouse gases. The target group of the CDP is listed companies, but investors also support the CDP’s objectives. Each year, the CDP conducts a survey on climate change and emissions of greenhouse gases among the largest listed companies in the world. The information the companies provide can be used to evaluate risks and opportunities linked to climate change and how the management deals with these issues in companies in which Folketrygdfondet has a holding or wishes to invest.

In 2009, Folketrygdfondet took part in the Bærekraftig Verdiskaping (Sustainable Value Creation) project for the second time. The objective of this project is to actively influence Norwegian companies listed on the stock exchange to develop sustainably, as this is an important prerequisite for long-term value creation. Through the project, the investors sent out a questionnaire to all the companies listed on the main index of the Oslo Stock Exchange. The companies were asked to answer questions about whether they have guidelines covering key elements of corporate responsibility and sustainability, to whom these guidelines apply, where they are anchored, how they are implemented, and reporting on compliance. The survey also inquired about the board’s responsibilities in these areas. Good corporate governance is an important element of ensuring sustainable value creation.

The questionnaire was sent to 73 of the largest companies on the Oslo Stock Exchange in 2009, and 34 companies (47 per cent) responded. The survey revealed wide variation in how far the companies have come in their efforts to ensure responsible and sustainable business operations. Health, safety and environment (HSE) and corporate responsibility are areas that most companies deal with on the board level, and most companies believe they have board members who have specialist knowledge in these fields. HSE is also the area where most companies have some kind of management system, control routines, defined targets, and where non-compliance affects the management’s pay. Human rights and labour rights are the areas where the companies on aggregate score the lowest. The survey also revealed that the companies score relatively highly on «guidelines» and «board responsibility», but do less well on «reporting and communication».

The results from the second round of the questionnaire showed a positive development and progress among the companies compared with 2008. For example, the four companies that did not respond to the questionnaire in 2008 chose to respond in 2009. In addition, several companies achieved markedly better scores in 2009, compared with 2008, and in 2009 there were no companies with scores in the lowest quartile, compared with three in 2008. This suggests that the project is increasing awareness of and actions linked to issues such as good corporate governance, ethics and environmental measures among Norwegian companies.

The Bærekraftig Verdiskaping (Sustainable Value Creation) project has helped initiate a number of positive processes. The purpose of this survey is not only to map the status of the companies’ efforts in this area, but also to help ensure that companies are encouraged to improve their own work linked to sustainable value creation. The findings from 2009 will be incorporated into Folketrygdfondet’s ongoing analysis of the companies it invests in and will form the basis for dialogue with the management of the companies.

3.4.4 Reporting on the work linked to exclusion of companies from the GPFG

Introduction

According to the guidelines for observation and exclusion from the GPFG introduced on 1 March 2010, companies shall be excluded if they are complicit in or themselves responsible for grossly unethical activities. The specific criteria for exclusion on the basis of products and exclusion on the basis of conduct have been continued from the ethical guidelines for the GPFG from 2004. The criteria are shown in box 3.8. As per 15 March 2010, the Ministry of Finance has excluded a total of 48 companies on the basis of recommendations from the Council on Ethics. These companies are listed in tables 3.5 and 3.6.

The Council on Ethics’ work on product-based exclusion

The criteria for product-based exclusion are such that all companies with production covered by the guidelines shall be excluded from the Fund. The Council on Ethics has established a monitoring system to identify these companies. An external consultant monitors the Fund’s portfolio and the companies that have been excluded from the Fund on an ongoing basis and reports each quarter on companies that may have activities in violation of the criteria. The Council is also collaborating with other investors on a consultancy project to map which companies produce cluster munitions. The Council on Ethics investigates all the companies where there are grounds to believe that the business is actually in violation of the guidelines. Normally, the Council on Ethics contacts the companies if there is reason to believe that they are engaged in production in violation of the guidelines. However, the companies that have been excluded on the basis of tobacco production were not contacted, as the companies were classified as tobacco companies in the Fund’s benchmark, and because the companies described their tobacco production on their websites.

If a company confirms the information invoked by the Council, the Council will render an exclusion recommendation. Companies that do not reply when approached are recommended for exclusion if the Council’s documentation shows that there is a high probability that the company has products that violate the exclusion criteria.

This procedure offers a reasonable degree of assurance that companies producing products that violate the criteria in the guidelines will be excluded from the Fund. Nevertheless, it cannot be guaranteed that all companies will at all times be correctly screened by the Council’s monitoring system.

The Council on Ethics’ work on conduct-based exclusion

Whereas product-based exclusion is largely a matter of proving that a company makes a specific product, it is more difficult to determine whether the preconditions for conduct-based exclusion are met. It is also harder to find credible evidence that supports serious allegations of unacceptable aspects of a company’s operations. The Council on Ethics therefore conducts its own investigations to identify and assess companies that may be involved in human rights violations, environmental damage, corruption and other violations of ethical norms.

A number of external consultants carry out regular Internet searches for news items about all the companies in the portfolio. These searches are done in several languages, including English, Spanish, Russian and Mandarin. The Council on Ethics receives monthly reports about companies accused of complicity in human rights violations, or in corruption, severe environmental damage and other factors encompassed by the ethical guidelines. Among these, the Council selects the most serious cases for further investigation.

In its selection of cases, the Council on Ethics puts emphasis on how serious the norm violations are, whether a company is accused of several counts of unethical conduct, whether it is likely that such conduct will continue, and the scope for documenting the conduct of which the company is accused, etc. The intention is to identify companies where there is an unacceptable risk that violations of the ethical guidelines are taking place and are expected to continue. In many cases, several companies are accused of similar norm violations in the monthly reports. In order to identify the most serious norm violations, the Council on Ethics considers these cases together. In some cases, the Council on Ethics even reviews entire sectors in the portfolio.

Weight is attached to a number of factors in the more detailed assessment of a company. The degree of severity of the norm violation is reassessed, and the Council also investigates whether the violation is systematic and whether norm violations have been reported in several of the company’s activities. The Council also evaluates how serious the norm violation is compared with the conduct of other companies with similar activities and compared to other companies in the same country or region. It is essential that the norm violations can be documented and that there is factual evidence to support the accusations levelled at the company. Further, there must be an unacceptable risk that the norm violations will continue. In many cases, closer investigations reveal that the accusations are less serious than initially assumed. They may be old events that have been reported again, or the company may already have implemented measures to remedy the situation. In such cases, the Council does not pursue the matter unless new information is received suggesting that the company ought to be reassessed.

There is often a need for supplementary information to what is available from publicly accessible sources to shed more light on cases. In this work, the Council on Ethics makes use of consultancy firms, research institutions and non-governmental organisations, often based in the country where the alleged violations of norms are taking place. This may involve fieldwork and assessments of documentation. The Council attaches considerable weight to ensuring quality and confidentiality in this work. In 2009, the Council on Ethics entered into a framework agreement with a consultancy that can provide assistance in more in-depth investigations of companies.

The Council on Ethics contacts companies it believes ought to be excluded and asks them to comment on the grounds on which the exclusion recommendation is based. The companies may also be asked to answer specific questions. The Council on Ethics gives priority to describing in detail the basis for the exclusion recommendation and providing thorough documentation. Any allegations made are supported by specific source references, often from several sources. When the Council on Ethics contacts companies, the company is provided with information about the ethical guidelines and the factors that, pursuant to the criteria in the guidelines, could lead to exclusion. In several cases, the Council has had meetings with companies that have wished to provide additional information.

It is unrealistic to expect to be able at all times to identify all companies that contribute to serious violations of norms worldwide. Although the Council on Ethics has now initiated a special news search for Asian companies, there is still limited access to information about companies from these emerging markets. With a view to improving its access to information, the Council also signed a framework agreement with a consultant with the competencies necessary to evaluate companies in these markets. It is nevertheless very demanding to gather concrete, reliable documentation from countries that do not practise transparent government administration or where it may be illegal or dangerous to spread information about companies’ activities. Nor is it the case that a company can be excluded immediately on the basis of stories in the media, for example, even if they are serious and credible. It is essential that the ethical guidelines are implemented in a predictable and credible manner over time. This means that the Council on Ethics must be allowed sufficient time to complete processes and evaluations in relevant cases, and that the companies have to be given the opportunity to present their version of the matter, or to adopt the necessary measures. Only through such thorough processes will the ethical guidelines be able to have an impact on other investors, and thus make a difference beyond the direct effect on the Fund’s own investments.

4 Further development of the management framework

4.1 Introduction

The Ministry of Finance has laid down guidelines for Norges Bank’s and Folketrygdfondet’s management of the GPFG and GPFN, respectively. The guidelines describe the overarching investment limits in the form of benchmark indices and limits for active management. Furthermore, the guidelines contain qualitative provisions on risk management and reporting, along with rules for responsible investment practice. The Ministry’s guidelines are framework- and principle-based, and require the manager to set more detailed internal rules.

The overall framework for the management of the GPFG and GPFN is given in the form of parliament acts, regulations and supplementary guidelines stipulated by the Ministry. Management agreements have also been entered into between the Ministry and Norges Bank and Folketrygdfondet. The framework is available on the Ministry’s website (www.government.no/spf).

Folketrygdfondet is audited by an external auditor appointed by the Ministry. The auditor also carries out certification assignments for the Ministry. These are independent controls to see whether Folketrygdfondet complies with the GPFN management rules stipulated by the Ministry.

Norges Bank’s Supervisory Council is responsible for supervising that the rules for the Bank’s operations are adhered to, including the rules the Ministry has stipulated for managing the GPFG. The Bank’s external auditor also carries out assurance reviews. In this regard the Ministry has established a dialogue with the Supervisory Council on the preparation of such reports, see section 5.4.1 of Proposition no. 58 (2008-2009) to the Odelsting and section 3.3.2 in this report.

The Ministry works constantly to refine and develop the framework for the management of the Government Pension Fund in line with leading international practice. As explained in section 3.3 and below, several measures have been carried out over the past few years to strengthen the management of the Fund.

Section 4.2 explains the Ministry’s work on stipulating new rules for the management of the GPFG. In this connection, the Ministry’s fundamental view of the division of work and roles between the Ministry and Norges Bank is explained. Section 4.3 briefly reviews the Ministry’s plans for revising the rules for the management of the GPFN. Section 4.4 discusses alternative organisational forms for the management of the GPFG, see Recommendation no. 93 (2008–2009) to the Odelsting in which the Standing Committee on Finance and Economic Affairs stated the opinion that it would be appropriate for the Ministry to further illuminate the benefits and disadvantages of the current organisation of the operational management responsibility within Norges Bank. Section 4.5 covers the legislative process the Ministry has initiated with the aim of changing the reporting and remuneration routines for Norges Bank’s Supervisory Council, while section 4.6 presents new guidelines for responsible investment practice, see the discussion of the results of the evaluation of the ethical guidelines for the GPFG in Report no. 20 (2008–2009) to the Storting.

4.2 New rules for the management of the GPFG

4.2.1 Introduction

Report no. 20 (2008–2009) to the Storting referred to the fact that the Ministry has initiated a review of the rules for the GPFG. The aim of this review is to clarify the division of responsibilities and roles between the Ministry of Finance and Norges Bank, and place stricter requirements on regulation of the active management.

The Ministry of Finance circulated proposed new rules for comment on 31 August 2009. The proposal was largely based on the current framework, but in certain areas more detailed regulations were called for. This concerned inter alia the risk limits in active management and management, measurement and risk reporting requirements.

The new rules will gather the rules for the management of the Fund in a single document instead of being currently contained in the following documents:

• Regulation no. 1725 of 22 December 2005 regarding the management of the GPFG,

• supplementary guidelines for the management of the GPFG, and

• the management agreement of 12 February 2001 between Norges Bank and the Ministry of Finance.

Key topics in the proposed new rules circulated for comment include:

• a requirement for orges Bank to prepare a strategic plan for management of the GPFG,

• stipulation of supplementary risk-taking limits in active management above and beyond the current limit for expected relative volatility,

• limit the opportunity to use leverage,

• rules that will require Norges Bank to manage, measure and verify risk according to more parameters than is currently the case,

• a more extensive procedure for approving new instruments,

• rules for investments in real estate, and

• more extensive public reporting requirements.

The consultative comments from the Office of the Auditor General and Norges Bank revealed different views on how detailed the rules for the management of the GPFG should be. In its consultative response the Office of the Auditor General expressed the opinion that the proposed rules would mean too much delegation to Norges Bank, and queried whether the Ministry could adequately meet its control, management and follow-up responsibilities the way the proposal was designed. For its part Norges Bank argued that in certain areas the Ministry went too far in micro-managing the Bank’s management. The Bank expressed the view that in order to be able to manage the Fund in a justifiable manner, the new rules should not be so detailed so as to make the role and responsibilities of the Executive Board unclear compared with the Ministry’s exercise of ownership rights. In the Bank’s view there is a risk that the Ministry will in practice assume the role of the Executive Board if the rules are too detailed.

As stated in Report no. 16 (2008-2009) to the Storting, the Ministry of Finance planned to let the new rules for the management of the GPFG enter into force on 1 January 2010. However, the Ministry has concluded that the Storting should be given the opportunity to discuss the division of responsibilities and roles between the Ministry of Finance and Norges Bank on a more principled basis before the new rules are finally adopted.

In the following, the regulation, reporting and supervision system related to the management of the GPFG is explained first, followed by the Ministry’s fundamental view of the division of responsibilities and roles between the Ministry of Finance and Norges Bank. Section 4.2.4 outlines how the Ministry aims to specify these principles in new rules.

4.2.2 Regulation, reporting and supervision concerning the management of the GPFG

The regulation, supervision and reporting system concerning the management of the GPFG is illustrated in figure 4.1. Delegation of duties and authorisations descends through the system, while reporting of results and risks go upwards. Regulations and delegation authorisations will necessarily be more detailed farther down the pyramid. The figure also specifies the bodies that supervise the individual levels.

In the Government Pension Fund Act, the Storting has given the Ministry of Finance responsibility for managing the GPFG. At the same time, the act requires the operational management to be discharged by Norges Bank, see section 2, second paragraph of the Pension Fund Act. The act requires the Ministry to stipulate further regulations for how the management is to be implemented, without the preparatory works providing further guidelines for the division of duties between the Ministry and Norges Bank. The Ministry has laid down regulations on Norges Bank’s management of the GPFG. The Executive Board has established a separate operations area – Norges Bank Investment Management (NBIM) – to be responsible for the operational implementation of the management. The Executive Board has filled out the Ministry’s overarching regulations through the establishment of principles for risk management in investment management and mandate and position instructions for the Executive Director of NBIM. The Executive Director of NBIM in turn lays down more detailed internal and external regulations and mandates for the operational execution.

Continual reporting takes place upwards in the system. Each level in the system has its own supervisory unit that receives reporting from, and exercises supervision of, the level below. The exception from this principle is that Norges Bank’s Executive Board is subject to supervision from the Storting-appointed Supervisory Council, which also appoints the Bank’s auditor. The responsibility of the individual bodies to establish regulations and supervision, control and reporting forms is shown in Table 4.1.

Pursuant to section 2 of the Norges Bank Act, special procedures apply to the right of government authorities to make decisions about the operations of Norges Bank. Decisions may be made only by the King in Council after the Bank has had the opportunity to comment. Notice of the decision shall be sent to the Storting as soon as possible. However, this special procedure applies only to the duties governed by the Norges Bank Act, i.e. the traditional central bank duties. Pursuant to the Pension Fund Act, the Ministry of Finance is responsible for the management of the GPFG, while Norges Bank is the operating manager. When the Bank carries out duties in this manner on behalf of the Ministry, the Bank may be instructed independently of the procedure in the Norges Bank Act, see page 26 of Proposition no. 25 (1984-1985) concerning the Act on Norges Bank and the Monetary System.

In principle, there are neither content-related nor formal constraints on the Ministry’s right to instruct the Bank on how to manage the GPFG, and it becomes a practical issue of how work duties are to be divided among the organisational levels between the two. The question in the following is how the responsibilities are to be divided between the Ministry of Finance and Norges Bank’s Executive Board, see figure 4.1.

Source Ministry of Finance

4.2.3 Division of responsibility and roles between the Ministry of Finance and Norges Bank

As mentioned, the Act on the Government Pension Fund requires the operational implementation of the management assignment to be conducted by Norges Bank, in accordance with regulations set by the Ministry of Finance. However, the act and its preparatory works do not provide further guidelines for the division of assignments or further regulations for how the Ministry of Finance is to exercise its management responsibility. Hence it is for the Ministry to decide which duties are to be carried out in the Ministry, and which are to be carried out by the Bank.

The adjustment of the division of the work and roles between the Ministry and the Bank may be done in various ways.

One extreme is no or little degree of delegation, where the management is either done in the Ministry or where the Bank’s duties consist of implementing instructions issued by the Ministry in all parts of the management such as strategy, implementation of individual trades, risk management and reporting.

The Ministry has previously stated that it is neither possible nor desirable for this type of operation to be micro-managed and continually governed by the Ministry, see page 36 of Report no. 20 (2008-2009) to the Storting. This general point of departure also has broad support in the Storting. In connection with the debate on Report no. 20 (2008-2009) to the Storting, the Finance and Economic Affairs Committee unanimously stated, see page 21 of Recommendation no. 277 (2008–2009) to the Storting:

«The Committee shares in that connection the Ministry’s view that Norges Bank must have a certain degree of freedom in the execution of its management assignment, and that continual micro-management by the Ministry is neither possible nor desirable.»

Consequently, this extreme is not a real alternative.

The other extreme would be full delegation, where the Bank itself stipulates the strategy and regulations for risk management and reporting.

Current GPFG regulations may be said to lie somewhere between these extremes.

The challenge in the future remains to find the optimal balance between sufficient control and follow-up, and necessary degree of delegation. In an international context, the degree of delegation in the GPFG has been small so far. Most comparable funds have investment mandates that assign managers the task of maximising returns within more or less specific risk limits, but without, for example, issuing clear regulations for dividing the investments into various asset classes or further specification of a benchmark. A requirement for real return over time is usually set for government reserve or pension funds. Owners of the capital have consequently delegated to a far greater degree the specification of the investment strategy to managers compared with what applies to the GPFG.

The financial crisis has underlined the importance of the risk level in the GPFG being well anchored among political authorities and that there is broad support of the long-term strategy of the Fund. The regulations on the management of the GPFG should reflect a risk level in the Fund that is in line with the wishes of the political authorities. How the desired level of risk is expressed will, however, vary with the type of investment.

For listed shares and bonds the Ministry finds that there shall be a real delegation of the operational execution of Norges Bank’s management in line with the comments of the Committee. This view involves a rather large degree of freedom for the Bank to set further, specific provisions on the execution of the management assignment, including detailed provisions on measurement, management and control of risks – within overarching guidelines set by the Ministry. More micro-­managing by the Ministry would in practice imply moving parts of the ongoing responsibility for the operational implementation into the Ministry of Finance. At the same time the regulations must be designed so as to ensure that the operational management takes place in accordance with the decisions and assumptions of the Ministry and Storting. The Ministry must therefore establish certain overarching guidelines.

So far the GPFG has been invested in relative liquid markets where there are investable benchmark indices that can reflect the owner’s risk preferences. They form the basis for regulation of the risk level. A better use of the Fund’s distinctive features will mean that the investment strategy will continue to be developed in the direction of unlisted and other less tradable assets. The decision has already been made to invest in real estate, and investments in unlisted shares may be a possible investment alternative in the future. There are no investable benchmark indices for this type of investments. It is therefore not possible to distinguish between overarching strategy choices and decisions on operational execution in the same manner as for listed shares and bonds. Such investments require a different division of work between client and manager, with a larger degree of delegation. This is reflected in the regulations the Ministry has stipulated for investments in real estate, see the discussion in section 2.5.2.

The fundamental consideration of preserving confidence in the manner the Fund is managed requires a large degree of transparency about its management. This indicates rather detailed regulations on public reporting. Among other things, the Ministry aims to direct the Bank to publicise the Executive Board’s supplementary regulations for the management of the GPFG.

4.2.4 How the regulations should be formulated

The most prominent risk in a financial portfolio will be the market risk – the risk that the value of the portfolio will change as a result of movements in share prices, exchange rates, commodity prices or interest levels. The market risk of the portfolio will be a trade-off between the desired long-term expected return and risk. If a higher expected return is desired, a higher market risk must be accepted.

Today, the essential portion of the market risk in the Fund is established through the asset allocation and the Ministry’s choice of benchmark indices. The remaining risks have been determined by the active management, see discussion in chapter 3 of this report.

Under current regulations, active management is inter alia regulated in the form of a quantified limit for expected fluctuations in the return differences between the benchmark and the actual portfolio, known as expected relative volatility. In addition, the actual portfolio is required to have a good distribution of various securities. There are also requirements for internal procedures in the Bank. The framework for relative volatility can be viewed as a «risk budget» for active management from which the Bank can draw, see section 2.3.

In Report no. 20 (2008-2009) to the Storting the Ministry stated that stricter requirements would be made of Norges Bank’s active management as part of the review of the GPFG regulations. Supplemental limits on risk taking in active management were mentioned as particularly relevant measures. Furthermore, it was stated that the Ministry would assess limits for leverage and short positions, along with the actual limit for expected relative volatility.

The financial crisis has shown that it can be appropriate to set limits for market risks along more dimensions than expected relative volatility. This will make the regulations more robust. In its internal regulations the Bank has chosen to set such supplementary quantitative limits.

In principle, the Ministry of Finance can set supplementary limits for risk taking in active management along many of the same dimensions. However, it is difficult for the Ministry alone to set such supplementary risk limits without knowing the full operational consequences of such choices. A better alternative would be to direct the Bank to set limits, which in advance of their planned entry into force shall be submitted to the Ministry. Such an alternative means that the Ministry could undertake changes when needed. In this manner, the initiative for specific drafting of the regulations lies with the Bank, which is closer to the market and carries out the investments, while safeguarding the Ministry’s governance needs. Varying marketing conditions may indicate a need for a quite ongoing re-evaluation of the limits, but such a model does not pose an obstacle for quick adjustment of the limits should there be a need for it.

In line with leading international practice, it is also desirable to set overarching limits for other main categories of risks, including credit and counterparty risks.

The regulations the Ministry has stipulated for the GPFG today do not directly regulate leverage. This means that strategies that provide borrowing effects can be used as long as the qualitative and quantitative requirements the Ministry has stipulated in the overarching guidelines are met.

The Bank has used several investment strategies that provide borrowing effects. One example is lending of securities against collateral. Security in the form of cash received is reinvested and added to the Fund"s assets but is recognised at the same time as debt on the balance sheet (because it must be paid back). Another example is strategies for exploiting different levels of interest in fixed-income securities through the use of derivatives, futures contracts and repurchase agreements (an agreement to buy back a security at a pre-agreed price). Here, the sum of the Fund"s gross liabilities can exceed the value of the securities involved in the transaction. The difference is recognised as debt on the balance sheet.

The Bank recently reorganised its management substantially in these areas and issued internal regulations that limit leverage, see box in section 3.5.

In the Ministry"s view, an absolute prohibition against leverage in the GPFG is not desirable. Leverage may arise as a result of securities lending, or when various financial instruments are used for managing risk in the Fund. At the same time, in the Ministry"s view, the use of leverage to increase the Fund"s exposure to risky assets is not desirable. In the new regulations, the Ministry therefore intends to allow the use of leverage for achieving effective execution of the management assignment, but not to increase the Fund"s financial exposure to risky assets. The Bank shall establish leverage limits within this principle.

Outside the risk limits the Bank should in line with the above viewpoints be given a large degree of freedom in the operational execution of the management assignment, but the regulations should provide some general overarching requirements for the internal regulation. Through self-evaluation and external reporting requirements the Ministry can ensure that the Bank’s internal follow-up supports the overarching considerations of the management.

Moreover, in consultation with the Supervisory Council the Ministry of Finance can through assurance reviews to the Bank’s auditor ensure that the Bank complies with the guidelines set for the management of the Fund.

A key area where use of this methodology is proposed is in valuation, measurement of return and management and control of risk. Here, the Ministry proposes that the Bank shall lay down principles that at least meet internationally recognised standards and methods. The Bank will also be required to regularly evaluate its own principles and methods in these areas. Subsequently, further requirements to the Bank’s regulations in this area are specified.

Within the risk limits and the general regulations the Ministry lays down, Norges Bank shall undertake investment decisions independently of the Ministry. This has been the practice since the Fund was established, but will be formalized in the new regulations. Decisions on exclusions according to the guidelines for responsible investment practices can be viewed as an exception to this principle. Here, the Ministry decides whether the Bank shall sell its shares in a certain company. However, the ethically founded decision is made in accordance with separate public regulations and is justified in each case. There is consequently transparency surrounding why the Ministry wishes in certain cases to undertake a sell-off on the basis of broader assessments.

Norges Bank is intended to follow international accounting standards as from 1 January 2011. New accounting regulations will inter alia require disclosure of information on wages and remuneration for the leading officials in the bank. The Ministry intends to require the Bank to release the same kind of information for GPFG, as if the Fund were a separate accounting unit. In that respect, it is the Ministry’s opinion that it would be prudent to release information on wages and remuneration for the leading officials in NBIM, in accordance with international accounting standards.

4.2.5 Maintenance of the actual benchmark

In connection with the consultation on new regulations for the management of the GPFG both Norges Bank and the Office of the Auditor General noted that it should be the Ministry of Finance"s responsibility to maintain the actual benchmark. Until today, Norges Bank has performed calculations of the actual benchmark and submitted these to the Ministry of Finance for approval. Starting with the second quarter of 2010, the Ministry of Finance will undertake its own calculations of the actual benchmark independently of Norges Bank, and compare these calculations with the proposal from Norges Bank.

4.2.6 Summary

The Ministry aims to lay down new regulations that are more extensive than the three sets of regulations they are to replace. In part the Ministry aims to regulate areas not covered by current regulations and management agreement, and in part the new regulations will be more supplementary. At the same time regulation will continue to be framework-like so that Norges Bank must fill out the overarching limits and principles with more detailed internal regulations for operational management. Such a regulatory system means in practice a continuation of the current system, but by directing the Bank to publicise the Executive Board’s supplementary guidelines the overall regulations will be more easily accessible.

In line with the previous points of view the Ministry of Finance plans to lay down new regulations for the management of the GPFG according to the following overarching principles:

• New regulations for the GPFG should reflect the political authorities" attitudes to what is an acceptable risk in the Fund.

• Norges Bank shall establish supplementary risk limits for active management. They shall be presented to the Ministry of Finance before they are adopted.

• The Ministry of Finance shall establish overarching qualitative requirements related to active management risks.

• The responsibility for formulating regulations for operationalisation of the management assignment shall be delegated to Norges Bank’s Executive Board, but so that the Ministry of ­Finance’s regulations specify relevant subjects for Norges Bank’s own regulation.

• Extensive public reporting requirements about Norges Bank’s execution of the management assignment will be made.

The Ministry’s aim is for the new regulations for the management of the GPFG to enter into force from 1 January 2011.

4.3 New regulations for the management of the GFPN

The description of the division of responsibilities and roles between the Ministry of Finance and Norges Bank in sections 4.2.2 and 4.2.3 will essentially apply equally to the division of work between the Ministry of Finance and Folketrygdfondet, with the exception for the auditing and supervision system. While Norges Bank is under the supervision of the Supervisory Council and is audited by an external auditor appointed by the Supervisory Council, Folketrygdfondet is audited by an external auditor appointed by the Ministry of Finance.

Prior to the establishment of Folketrygdfondet as a special statute company from 1 January 2008, the Ministry of Finance laid down new regulations for the management of the GPFN in the form of a regulation with supplementary guidelines. A management agreement was also entered into between the Ministry and Folketrygdfondet. The regulations for Folketrygdfondet’s management of the GPFN are essentially more detailed than the guidelines that the Ministry has set for Norges Bank’s management of the GPFG, and the notified regulations that are under preparation, see the discussion in section 4.2.4. The difference between the current regulations for the GPFN and GPFG is particularly pronounced with respect to the degree of detail in the requirements for measurement, management and control of risks.

In connection with its conversion to a company created by special statute and new framework conditions for its management, Folketrygdfondet undertook material investment in new management systems. The Ministry believes that a high level of detail in the regulations for the GPFN have been necessary to clarify the Ministry’s expectations of the operational management in connection with the conversion, including the systems that were to be established. The experience with Folketrygdfondet as a company formed by special statute has in the Ministry’s view been good. Inter alia, Folketrygdfondet has invested considerable work into developing its management in line with stricter requirements than previously for measurement, management and control of the risks. In the Ministry’s view it will therefore be appropriate now to undertake a revision of the regulations for the management of the GPFN in line with the fundamental view of the division of work between capital owner and manager outlined in section 4.2.3. This does not mean that less stringent requirements will be made of measurement, management and control of risk than before, but that to a greater degree it will be the responsibility of the board of Folketrygdfondet to develop more detailed regulations for risk management within overarching limits set by the Ministry.

The Ministry’s preliminary aim is for the new regulations for the management of the GPFN to enter into force from 1 January 2011.

4.4 Organisation of the operational management of the GPFG

4.4.1 Introduction

In connection with the discussion of Proposition no. 58 (2008-2009) to the Odelsting on a new auditing system in Norges Bank etc., the Storting’s Finance and Economic Affairs Committee stated that a management structure for the GPFG of the highest international class, with clear mandates and division of roles, close follow-up and control, and sound public reporting routines, is necessary for ensuring broad trust in the actual management model, see Recommendation no. 93 (2008-2009) to the Odelsting. In this connection the Committee pointed out that it would be appropriate if the Ministry of Finance in the report to the Storting on the management of the Government Pension Fund in 2009 could discuss benefits and disadvantages of the current organisation of the operational management responsibility in Norges Bank, compared with a separate management organisation headed by a board directly appointed by the Ministry of Finance.

4.4.2 Background for the current management model

The current management model for the GPFG with operational management in Norges Bank is a continuation of the model originally selected for the Government Petroleum Fund. Proposition no. 29 (1989-90) to the Odelsting on the Act relating to the Government Petroleum Fund states:

«The Fund accordingly places its entire capital as the state’s other funds in Norwegian kroner in Norges Bank. It will not be necessary to build a separate administrative apparatus to manage the Fund’s capital. This will enable the cultivation of the Fund as an instrument of fiscal management, and not a means for managing the state"s financial assets arising as a result of a moderate use of petroleum revenues.

The return on the Fund"s investments will be determined on the basis of the same considerations underlying the determination of the return on the state"s other funds.»

The Fund was consequently emphasised as a means of fiscal management, but the Ministry had basically no investor perspective.

Due to the combination of a prolonged slump in the Norwegian economy and relatively low net petroleum revenues, funds were not set aside in the Petroleum Fund until 1996. In this regard, the Ministry of Finance laid down guidelines for management of the Fund in accordance with the conditions in the preparatory works of the Act. They were based on the guidelines for foreign exchange reserves, and meant that Norges Bank should invest the Fund’s assets in government securities with high liquidity.

In the Revised National Budget for 1997 the Ministry of Finance undertook a broader review of the guidelines. Estimates of when it would be necessary to use the Fund’s assets indicated a long time horizon. Based on an assessment that the risks associated with the value of the Fund at the time the funds are to be tapped should be emphasised, it was deemed that the risk that the Fund"s return may vary from year to year is less important. A balance between expected risk and return, as well as risk diversification considerations indicated in the Ministry"s assessment that equity investments should be permitted in the Fund, and this was done starting 1 January 1998. This took place through the establishment of a benchmark with associated deviation limits.

The Revised National Budget for 1997 also discussed the Fund"s role as investor and the management model. A relevant question was whether managers other than Norges Bank should be brought in to ensure sufficient expertise in the management of the Fund. The Ministry found that the management should be organised so that Norges Bank has overall responsibility for the Fund"s investments, but that the Bank could use external managers where this was appropriate. The Ministry stressed that equity investments would lead to increased requirements for risk management and control in Norges Bank as well as a need to evaluate Norges Bank"s management.

To improve its capacity to perform its duties as investment manager for a more complex investment portfolio, Norges Bank established from 1 January 1998 a separate unit for investment management - Norges Bank Investment Management (NBIM).

The main features of the management model drawn up in the Revised National Budget for 1997 remain unchanged. The Government Pension Fund was established on 1 January 2006 as a superstructure over the former Government Petroleum Fund and Folketrygdfondet. The arrangement of placing the funds in the GPFG in Norges Bank was continued in the new act, and in Proposition no. 2 (2005-2006) to the Odelsting concerning the Government Pension Fund the Ministry proposed that the regulations laid down for the management of the Fund in Norges Bank should be unchanged.

In the almost 14 years that have elapsed since the first transfer to the former Government Petroleum Fund, there have been major changes in the Bank"s activities in general and within asset management in particular. The capital in the Fund has grown rapidly, and the GPFG is now one of the world"s largest funds. At the same time the outlook is that the Fund will continue to grow in coming years. Moreover, the complexity of management increased significantly, and NBIM has become an essential part of the Bank"s activities. There have also been several important changes within the traditional central bank areas. In 2001, Norges Bank was given new monetary policy guidelines through a flexible inflation target. In 2008 the Bank expanded its use of policy instruments in connection with the handling of the financial crisis.

Through the lifetime of the Fund the central bank has been an important partner for the Ministry in its efforts to determine an appropriate investment strategy for the Fund. The build-up of a substantial investment management unit within the central bank"s operations also made it possible to assume that a good organisational culture would be established in the management unit.

4.4.3 Alternative management models

In the Ministry"s view, the two most appropriate management models are a further development of the current model or a model in which investment management operations in Norges Bank are spun off as a separate special statute company wholly owned by the government, equivalent to Folke­trygdfondet. One model that does not appear to be relevant in the Ministry"s view is splitting the current Fund into several smaller management units. Splitting would inter alia entail increased costs. In Sweden, an expert report recently recommended merging four of the AP funds due, among other things, to the unnecessary costs incurred by so many parallel management organisations. Analyses show that the GPFG is managed in a manner resembling passive indexing, see the discussion in chapter 14. Because there are economies of scale in passive management, many separate management environments only make sense if a variety of active strategies are desired. Even in such a case it will be difficult to avoid the overall management performance, based on many independent active strategies, being close to the index return, but with substantially higher costs. Division into several funds may also lead to an unfortunate competition between funds, with emphasis on short-term results and increased risk taking rather than competition for the most robust strategy and the best risk management.

Further development of the current model

There are international examples of large government-owned investment management operations with a business focus that have been established under central bank operations (beyond what follows from the management of foreign exchange reserves). The main impression is nevertheless that government investment management operations are organised as separate entities, and not as part of the central bank. As a rule, these units are not only responsible for ongoing management, but also stipulate the investment strategy. They consequently do not have the division between the Ministry and the manager that characterises the organisation of the GPFG. There is no reason to believe that the organisation of a state-run investment fund within a central bank violates international best practice.

In any case, organisation and division of roles will have to reflect the political institutions and traditions in each country. The deciding factor must be to have sound management principles with clear responsibilities and roles between manager and client.

As can be seen from Figure 4.1, the general rule in the management hierarchy for the GPFG is that the superior level is responsible for exercising supervision of the level just below, so that the Executive Board supervises NBIM etc. Supervision by Norges Bank’s Supervisory Council represents an exception from this. In the management of the GPFG the Executive Board is subordinate to the Finance Ministry, while the Storting-appointed Supervisory Council oversees and is responsible for auditing the Bank. This means that the scope of the Department"s management responsibility pursuant to the Government Pension Fund Act may be difficult to delimit precisely in relation to the supervisory responsibility of the Supervisory Council under the Norges Bank Act. The Ministry does not have any formal role relating to the auditor"s work on the follow-up of the Bank"s management of the GPFG.

Norges Bank"s responsibilities in monetary policy and financial stability are laid down in the Norges Bank Act. The management of the GPFG is performed according to guidelines issued by the Ministry of Finance in accordance with the Government Pension Fund Act and shall be carried out on commercial terms. This commercial activity has other characteristics than a central bank"s core tasks that are more characterised by the public exercise of authority. Experience gained through 14 years has shown that it is possible to operate such different activities under a single superstructure, but it also poses specific management challenges to the organisation, not least when it comes to requirements for expertise.

The Governor of Norges Bank has pointed out that with its organisation, discipline and work requirements the NBIM business culture has had a positive impact on the rest of Norges Bank. Synergy also exists between the Bank’s job as manager of the GPFG and its other tasks. As manager of a major international financial fortune, Norges Bank"s governing bodies must have a very good understanding of the behaviour of the capital markets. This is also significant in the performance of the Bank"s two other main tasks: monetary policy and financial stability. Regardless of the organisation of the GPFG, Norges Bank also has to manage substantial foreign exchange reserves, which requires insight into investment management.

There is also reason to believe that there has been a spill-over effect in the other direction, in that the bank"s culture of responsibility and moderation has contributed positively to the management culture of NBIM.

If monetary policy and work on financial stability is to be implemented in a proper and efficient manner, it is essential that Norges Bank enjoys broad trust in the exercise of its duties. It can be a daunting task, especially during periods of turmoil in the markets, to manage both the traditional central bank tasks and a large and complex investment management operation. Weak results or negative events in investment management may also ultimately undermine confidence in the central bank’s management of its traditional tasks, or lead to reduced capacity to implement these in a proper manner. So far this has not been the case.

Both Norges Bank and the Ministry of Finance have recently implemented a number of measures to strengthen the fund management, see the measures referred to in section 3.3.2. Among these is a substantial strengthening of the Bank"s governance structure within investment management, new auditing system with an externally appointed auditor and a new internal control regulation for Norges Bank.

Because several of these measures have been introduced relatively recently or will be introduced over the next few years, they have been in effect for a limited period. The Ministry of Finance assumes that taken together the measures will contribute to a substantial strengthening of the Fund"s management in coming years.

Although a number of measures have recently been initiated to improve the current management model, it is possible in the Ministry"s view to strengthen the model further, should there be a need for it.

Norges Bank has chosen to change the actual internal organisation related to the management of the GPFG, whereby the Executive Board and the Governor in reality operate, respectively, as board and chairman of NBIM. In contrast to the rest of the Bank, the Governor thus does not act as the general manager of NBIM – this responsibility is delegated to the Executive Director of NBIM. Since NBIM operations differ substantially from traditional central bank functions, this may be a suitable organisation. It does not, however, exempt the Governor from responsibility for the Bank"s daily operations under the Norges Bank Act. If this organisation is found to function suitably, amending the act to formalise the system will be considered. This will mean that the role of the Governor and Deputy Governor vis-à-vis NBIM is exclusively that of chairman and deputy chairman of the board.

The Ministry has considered a model in which a separate board equal in ranking to the Executive Board is created for investment management in Norges Bank. Such a model is not advisable in the Ministry"s view. It would create significant management challenges in Norges Bank in that no single body in the Bank would have overall responsibility for the Bank"s activities. There is significant operational risk also in the other areas of the Bank, and the nature of a number of issues is also such that they cover all parts of the Bank"s activities. An example of the latter is risk management and internal control, where the Ministry has recently established a regulation that applies to all of the Bank"s activities. In reality, a model with a separate board for NBIM would result in two separate organisations gathered under the same business name, with a blurred interface between the two. The Ministry is not aware of any major organisations that are governed by a model with two separate boards for different parts of operations within a single legal entity. In the Ministry"s view testing such a corporate law innovation in the country"s central bank would not be justifiable.

Should it be desirable to relieve the Executive Board of duties that would permit it to spend even more time on investment management, the creation of a separate monetary policy committee with responsibility for the conduct of monetary policy (setting interest rates) appears to be a more obvious measure. Interest rate setting is a task that is quite detached from the operational running of the Bank, and can therefore be removed from the Executive Board without impairing its overall responsibility for the Bank"s operations.

A model with an executive board and a separate interest rate committee is a parallel to the model by which the Bank of England is governed. Under such a model, the Governor would head both the monetary policy committee and the Executive Board. The Executive Board would resemble more of a traditional corporate board, with tasks aimed at the overarching issues in corporate governance. Recruitment to the Executive Board would probably be easier because it would not be necessary to put as much emphasis on macro-economic expertise among board members in addition to knowledge of investment management, financial stability and general business management. If the Board no longer made interest rate decisions this would perhaps also provide a basis for easing the current rather strict impartiality requirements. However, such a model would require a broad study, and the Ministry does not find basis at this time to proceed with such work.

Convension of the investment management operations into a company formed by special statute

As described above a number of measures that have not yet had time to work have been implemented to strengthen the organisation of the Fund, while there is also room for further improvement. Nevertheless, a model whereby investment management is spun off from the central bank into a company created by a special statute could more directly address the governance challenges pointed out above.

A company formed by special statute can establish an organisational framework which is tailored for the purpose, rather than make continuous adjustments within an organisational model that has been established for traditional central bank tasks in monetary policy and financial stability. This form of organisation was recently selected for Folketrygdfondet. The main part of a separated organisation would be the investment management unit which today is part of Norges Bank, and that through just over 12 years has built up considerable expertise and insight into the management of the world"s largest fund. It will still be difficult to find the right balance between the Ministry and manager in terms of the degree of delegation, see section 4.2.

After a possible spin-off the central bank management would be able to increase its capacity to follow up the responsibility for the conduct of monetary policy and work on financial stability. It would also remove the risk of adverse events in investment management weakening the central bank"s reputation.

Any spin-off would be a comprehensive process raising a number of sometimes complex and unresolved legal issues. Norges Bank benefits from its own central bank privileges in a number of jurisdictions. These include immunity from seizure of assets. It is not obvious that these privileges can be continued by a steward organisation detached from the central bank. A spin-off could also potentially trigger difficult tax and contract law issues. In converting an entity that for the most part operates in Norway, such as Folketrygdfondet, such issues can be effectively resolved through special legislation. Through laws, the Storting can determine that Norwegian contractual counterparties must accept the transfer of contractual obligations and that the conversion should not have tax consequences. This is not possible for an operation like NBIM, which operates internationally only.

4.4.4 The Ministry’s assessments

In the Ministry of Finance’s view the management model for the GPFG should as far possible

• facilitate professional and cost-effective management,

• specify clear lines of responsibility and predictable framework conditions,

• facilitate good communication between client and manager and between manager and the general public,

• contribute to converging interests between owner and manager,

• be well-equipped to deal with future challenges (increasingly larger funds, larger holdings in individual companies, the possible development in the direction of illiquid assets with greater management challenges etc.),

• take the role of the Fund as a fiscal policy instrument into consideration and

• take into account factors that have been important in the international debate about sovereign wealth funds, and reflect what is considered best practice internationally.

It is difficult to construct a management model that safeguards all these considerations in a proper and adequate manner. The Ministry does not assume that there is only one satisfactory model. Both a model of management within the central bank and a model of management in a separate unit outside the Bank can be designed so that these considerations are addressed. A good division of responsibility and roles between the client (the Ministry of Finance) and manager, see the discussion in section 4.2.3, is in practice an equally important question as the question of who should be manager.

In evaluating the model it must be further emphasised that the management assignment for the GPFG involves several different subassignments that require different and specialised expertise. Today, Norges Bank has five main tasks related to the management of the GPFG:

• the funds in the GPFG shall be invested in the markets at the lowest possible cost,

• the Bank shall maintain the market portfolio in a cost-effective manner,

• the Bank shall seek to achieve the highest possible return on investments within the limits the Ministry has laid down,

• the Bank shall exercise ownership, and

• the Bank shall provide the Ministry of Finance with advice on the long-term investment strategy for the GPFG.

Each of these are complex tasks, not least because of the Fund"s strong growth in combination with an increasingly complex investment universe. A robust and competent manager organisation has been built up in Norges Bank to discharge these tasks. The Ministry"s main impression is that the management of the GPFG in Norges Bank has worked well so far. Like other management environments NBIM was faced with major challenges during the financial crisis,particularly in fixed income management. As pointed out in section 3.2, it is the Ministry"s assessment that Norges Bank handled these challenges in a positive way when the crisis occurred, and there is hardly any reason to believe that another form of organisation would have reduced the challenges caused by the financial crisis.

The model with management of the GPFG in Norges Bank has in the Ministry"s view helped to create legitimacy for the structure of the Fund. Norges Bank is a highly-reputable social institution with high integrity, and there is reason to believe that the Bank"s organisational culture has contributed positively to the development of NBIM as a solid manager organisation that is highly respected internationally. In the Ministry"s view there should be weighty reasons for dismantling a well-functioning and well-regarded model.

Traditional central bank responsibilities such as monetary policy and financial stability are also highly demanding tasks. Regardless of whether Norges Bank manages the GPFG, the Bank must establish control and governance systems in line with leading international practice. The Bank also has ordinary foreign exchange reserves that in any case must be managed in a professional manner. Risk management, control and supervision are constantly evolving internationally, requiring continuous work on both the client side and within the Bank to ensure good internal systems. With the measures implemented in recent years, the Bank’s governance and control structure has been further improved, and in the Ministry"s view the organisation is well equipped to meet the challenges it faces in the future. In all essentials the current model satisfies the considerations that are highlighted above.

Any further additional potential for strengthening the management organisation and Norges Bank by separation must be weighed against the costs. A reorganisation will in any event be resource intensive, both for the Ministry and the Bank, and there is risk associated with a conversion, see discussion above. Such a process would therefore easily take attention away from important processes that are under way to improve the framework and risk management.

Taking into consideration that, all in all, the current model must be said to work well, and that it is now further strengthened, the Ministry sees no reason to separate the management of the GPFG from Norges Bank at this time. While it cannot be excluded that this rationale may be changed at some point in the future, in continuing to develop the framework of the GPFG the Ministry will work from the assumption that the model of operational management in Norges Bank remains unchanged. The Ministry will continuously evaluate the measures implemented to further improve the governance structure of Norges Bank, and will as needed make additional adjustments to continue to develop the organisation in line with best international practice.

4.5 Proposed amendments of the Norges Bank Act – Supervisory Council reporting and remuneration

Norges Bank"s Supervisory Council is appointed by the Storting and shall pursuant to the Norges Bank Act oversee the Bank"s operations. On 10 December 2009 the Supervisory Council sent a letter to the Ministry of Finance stating that the Council is in the process of formulating a strategy for further development and strengthening of the supervisory regime in the Bank. As part of this work the Supervisory Council considered the possibility of expanded and more direct reporting to Storting. Under the current system

«The annual report and the audited annual accounts, as well as the statement of the Supervisory Council on the minutes of meetings of the Executive Board and its supervision of the Bank, are sent to the ministry for submission to the King and communication to the Storting,»

see section 30 of the Norges Bank Act. The statement today is very brief.

The Supervisory Council will also have evaluated the possibility of transferring the expertise to determine the Supervisory Council’s remuneration from the King to Parliament. Today, this expertise is delegated by the King to the Ministry of Finance.

In line with input from the Supervisory Council the Ministry of Finance sent a letter on 4 February 2010 to Norges Bank"s Supervisory Council and the Executive Board in which the Ministry proposed changes to the Norges Bank Act rules for determining the remuneration of the Supervisory Council and the manner it should report to Storting. It is proposed that the Storting, which is responsible for the appointment of the Supervisory Council, should also determine its remuneration. The remuneration gives an indication of how much time the persons selected are supposed to spend on the position. It is appropriate that the body responsible for the selection through the determination of remuneration also indicate how much time and effort lies in the position.

The Ministry agrees with the Supervisory Council that having the Supervisory Council report directly to Storting will strengthen the Bank"s governance model. Direct reporting to the Storting is the scheme for all other Storting-appointed ombuds and bodies, and in the Ministry"s view there are no special considerations that indicate a different solution for the Supervisory Council. Direct reporting will help to elucidate and strengthen the Storting’s control of Norges Bank"s operations, not least when it comes to the GPFG.

For the same reasons the Ministry also finds reason to suggest minimum requirements for the Supervisory Council’s statement pursuant to the Norges Bank Act. It should, inter alia, state how the supervision has been organised and the supervision tasks that have been completed. Furthermore, the results of the supervision should be clearly evident. In regard to the GPFG’s unique position in terms of size and operational risk, the Supervisory Council should be required to provide a separate report for the supervision of investment management.

The Ministry is submitting the proposition to the Storting about changes in the Norges Bank Act simultaneously with this report.

4.6 New guidelines for responsible investments in the GPFG

4.6.1 Introduction

Ethical guidelines for the GPFG were laid down by the Ministry of Finance on 19 November 2004, based on the recommendations from the Graver Committee in NOU 2003: 22 Forvaltning for fremtiden (Management for the future).

In 2008, the Ministry of Finance carried out a broad evaluation of the ethical guidelines. The results were presented in Report no. 20 (2008-2009) to the Storting. The main conclusion of the evaluation was that the ethical guidelines had proven to be robust and many important aspects have been maintained. In addition, the Ministry announced its plans for a more comprehensive strategy for responsible investment practice in the GPFG and decided to introduce several new measures. The Storting gave its approval to the Government"s plan, see section 3.2 of Recommendation no. 277 (2008-2009) to the Storting.

An overview of the results of the evaluation of the ethical guidelines and the implementing measures is given in section 2.5.3. The contents of the two new guidelines on responsible investment practices that implement several of the proposed measures are described below.

Main features of the ethical guidelines of 2004

Point 1 of the ethical guidelines of 2004 specified the ethical obligations of the GPFG. Point 2 of the guidelines stated that the ethical obligations should be promoted through three mechanisms: active ownership, negative screening of companies on the basis of production of weapons that violate fundamental humanitarian principles through their normal use, as well as the exclusion of companies with unacceptable risk of contributing to the following conditions:

• serious or systematic human rights violations such as murder, torture, deprivation of liberty, forced labour, the worst forms of child labour and other exploitation of children,

• gross violations of individuals rights in war or conflict situations,

• severe environmental damage,

• gross corruption, and

• other particularly serious violations of fundamental ethical norms.

In 2008 it was decided that the Fund cannot be invested in government bonds issued by the state of Myanmar (Burma). It was furthermore decided that companies that sold weapons to Burma should be excluded from the Fund"s investment universe.

4.6.2 Introduction of new guidelines for responsible investment practice

As a follow-up of Report no. 20 (2008-2009) to the Storting the Ministry of Finance has laid down new rules pertaining to the work on responsible management of the GPFG. Draft new guidelines have been circulated for comment in the Council on Ethics and Norges Bank. Further consultation has not been considered necessary, in that an extensive consultation process was conducted with input from more than 50 consultative bodies in the evaluation process.

Firstly, the Ministry has laid down Guidelines for Norges Bank’s work on responsible management and active ownership . When the new regulations on the management of the GPFG are determined, see discussion above in section 4.2, these guidelines will be incorporated into the regulations as a separate chapter.

Secondly, the Ministry has laid down Guidelines for observation and exclusion from the GPFGs investment universe . The guidelines include the Ministry’s, the Council on Ethics’ and Norges Bank’s work on these issues.

These two guidelines replace the previous Ethical guidelines that were established on 19 ­November 2004.

Further details on the Guidelines for observation and exclusion from the GPFGs investment universe

The new guidelines continue the essential elements of the previous ethical guidelines. There are also several new provisions, all of which are a follow-up of Report no. 20 (2008-2009) to the Storting. Below is a description of the most important changes.

In the evaluation of the Ethical guidelines it was decided that companies that produce tobacco should be excluded from the Fund"s investment universe, see discussion on p. 127 et seq in Report no. 20 (2008-2009) to the Storting and section 3.2 of Recommendation no. 277 (2008-2009) from the Storting. Production of tobacco is therefore included as a new criterion for exclusion, see section 2, first paragraph b of the guidelines. The Ministry decided to exclude 17 tobacco producers from the Fund"s portfolio, in accordance with the Council on Ethics’ recommendation of 22 October 2009. The decision was announced in January 2010, after the sale of the shares in the companies was completed. Otherwise section 2 of the new guidelines continue the exclusion criteria from the Ethical guidelines of 2004.

The new guidelines specify several factors that the Ministry can take into consideration when assessing whether or not a company should be excluded, see section 2, fourth paragraph. Among other things, this applies to the probability of future violations of norms, the severity and extent of the norm violations, the connection between the norm violations and the company in which the Fund is invested and whether the company does what may reasonably be expected to reduce the risk of future violations of norms within a reasonable time frame. The company"s guidelines for and efforts to safeguard good corporate governance, the environment and social conditions and whether the company is making a positive contributions for those affected past or previously by its behaviour, can also be emphasised.

Moreover, it is stated that the Ministry shall consider the use of other measures before exclusion based on grossly unethical conduct is decided, see section 2, fifth paragraph. This may be relevant if other instruments may be better suited to reducing the risk of continued violations of norms, or may be more appropriate for other reasons. The Ministry may ask Norges Bank for an assessment on the case, including whether active ownership might reduce the risk of future violations of norms. The provisions are in line with section 4.3.4.4 of Report no. 20 (2008-2009) to the Storting.

Section 3 of the guidelines contains a new provision on the observation of companies. Observation of companies has been used before, but section 3 formalises the use of this instrument and is a follow-up of Report no. 20 (2008-2009) to the Storting, see the discussion in section 4.3.5.4. It is the Ministry that makes decisions to keep companies under observation, following a recommendation from the Council on Ethics. The Ministry may opt for observation both after a recommendation for exclusion and following a recommendation to put a company under observation, see section 4, fourth and fifth paragraphs of the guidelines.

Report no. 20 (2008-2009) to the Storting discusses whether or not the observation of companies is to be made public. In the Ministry"s view, disclosure should be the general rule. In some cases there may, however, be specific factors that indicate that an observation decision should not be made public, although there may be good reasons for following up a company more closely. There may be cases where disclosure of observation could be counterproductive if, for example, the company is in the process of making changes for the better at the initiative of other actors. To ensure that the application of the new guidelines is transparent, such decisions should be reported in the annual report to the Storting on the management of the Fund, possibly in anonymous form.

Section 5, third paragraph of the guidelines continues the rule that companies being considered for exclusion must be provided with the grounds so that they can comment on it. In the evaluation of the ethical guidelines of 2004, the Ministry called for giving the Council on Ethics broader opportunities for dialogue with individual companies, in addition to written correspondence, see page 126 of Report no. 20 (2008-2009) to the Storting. The Ministry stated that this could contribute to strengthening the information base as well as giving the company a better opportunity to explain the situation in question. The potential positive effects of greater predictability for companies in addition to the fact that some companies might want to change their behaviour as a result of such a dialogue, were also pointed out. At the same time the Ministry stated that it must be expected that a number of companies either will not want a dialogue, or that the dialogue will quickly show that the company has no interest or willingness to address the problems in question. In that context it was pointed out that the Council on Ethics cannot necessarily be expected to give companies specific instructions about, for example, how a company should reduce its emissions.

The provision in section 5, third paragraph permits increased dialogue between the Council on Ethics and individual companies in that it gives the companies being considered for exclusion the opportunity to provide information and opinions to the Council on Ethics early in the process. In this context, the Council shall make the factors that may form the basis for exclusion clear to the company. The provision must be understood in light of the views cited above. Increased dialogue is primarily a tool for ensuring a broader and more complete basis for decision making, and for increasing predictability for companies and their ability to submit objections. The extent of dialogue with individual companies must be weighed against the objective of good resource use. It must also be taken into consideration that it is not appropriate for the Council on Ethics to go too far into issues relating to a company"s operations, and that Norges Bank is primarily responsible for the exercise of ownership rights. If the Council decides to recommend exclusion, its draft recommendation shall as before be presented to the company for comment.

Report no. 20 (2008-2009) to the Storting called for the establishment of principles for the Council on Ethic"s selection of companies for further examination and routines for the Council"s handling of cases concerning whether a decision to exclude should be repealed. Reference is made to section 5, first and fourth paragraphs of the guidelines. The Council on Ethics is in the process of drafting these principles and routines.

An important subject in the evaluation was issues related to strengthening the interaction between the active ownership and exclusion instruments. In Report no. 20 (2008-2009) to the Storting the Ministry called for better coordination between the Council on Ethics and Norges Bank"s work in areas where there are overlapping responsibilities, see section 4.3.5.4. This has been followed up by a new provision on information exchange and coordination between Norges Bank and the Council on Ethics in section 6 of the new guidelines. Regular meetings will be held by the Ministry of Finance, Council on Ethics and Norges Bank to exchange information about work on active ownership and the Council"s monitoring of the Fund"s portfolio. The Council on Ethics and Norges Bank shall have routines to ensure that any contact with the same company is coordinated.

The Council on Ethics may ask Norges Bank for information about how cases related to specific companies are dealt with through active ownership. The Council on Ethics may furthermore ask Norges Bank to comment on other circumstances concerning companies in the portfolio. Norges Bank may also ask the Council on Ethics to make its assessments of individual companies available.

With respect to exchanging information, it is clear that Norges Bank has other and stricter confidentiality rules under the Norges Bank Act than those which apply to the Council on Ethics. This must be taken into account when applying section 6.

The area of application for the new guidelines for the observation and exclusion of companies is the entire portfolio of the GPFG’s listed investments, including real estate investments. In the case of unlisted investments, reference is made to the discussion below.

Further details on the Guidelines for Norges Bank"s work on responsible management and active ownership of the GPFG

Section 1, first paragraph of the new guidelines points out that the management of the fund assets shall be based on the goal of achieving the highest possible return, see section 2, third paragraph of Regulations no. 1725 of 22 December 2005 concerning the management of the Government Pension Fund Global. The provision assumes that a sound return in the long term is dependent on sustainable development in an economic, environmental and social terms. This is a continuation of section 1.1 in the earlier Ethical guidelines. In addition, it is specified that the highest possible return in the long term is considered to depend on «well-functioning, legitimate and efficient markets.» This is in line with the discussion in section 4.3.2 of Report no. 20 (2008-2009) to the Storting and box 4.2.

As a follow-up of the results of the evaluation, section 1, second paragraph of the guidelines requires the Bank to integrate good corporate governance, environmental and social issues in the investment activities. This is an ambitious goal, which is also in line with the UN Principles for Responsible Investment (PRI). Both Norges Bank and the Ministry of Finance endorse the PRI. Integration of such considerations shall take place in respect of the Fund’s investment strategy and role as financial manager. The second paragraph of this provision states that in executing its management assignment, the Bank shall give priority to the Fund’s long-term horizon for investments, and that the investments are broadly placed within the markets. Reference is also made in this context to the article in chapter 11 concerning the Fund as a universal owner.

The requirement in section 1, second paragraph of the guidelines about the integration of good corporate governance, environmental and social factors is formulated as a general requirement. How these considerations in practice can be integrated in investment operations will vary between investment areas and asset classes. The concrete implementation must therefore be carried out by Norges Bank. Pursuant to section 1, third paragraph, the Bank shall develop internal guidelines that indicate how said considerations are integrated into the investment activities for the various asset classes, for both the internally and externally managed parts of the portfolio. Reference is made to section 4.3.3.4 of Report no. 20 (2008-2009) to the Storting, in particular pages 109 and 112.

Section 2 of the guidelines deals with Norges Bank"s active ownership, and continues the significant parts of the contents of section 3.1 of the earlier Ethical guidelines. A new provision has been included in section 2, third paragraph, which states that major changes in the Bank"s priorities in its ownership activities are to be submitted to the Ministry before a final decision is made. The Bank’s plans shall be subject to public consultation before being submitted to the Ministry. This is a follow-up of the results of the evaluation, see page 112 of Report no. 20 (2008-2009) to the Storting. This procedure has already been implemented in connection with Norges Bank’s preparation in 2009 of two new documents detailing expectations towards companies" management of water and climate change mitigation and adaptation.

Through the management of the GPFG it is the Ministry’s ambition to contribute to the development of best practice in the area of responsible investment, see Report no. 20 (2008-2009) to the Storting and sections 2.1.1, 4.1.1 and 4.3.3.4. Section 3 of the guidelines contains a provision that the Bank shall actively contribute to the development of good international standards in responsible management and active ownership.

New requirements for transparency and reporting about the work on active ownership were announced in Report no. 20 (2008-2009) to the Storting, see page 113. Section 4 of the guidelines contains new rules for reporting on the Bank"s work in active ownership and integration of good corporate governance, environmental and social issues. The provision in section 4 is more detailed, and gives instructions for more frequent reporting, than the previous Ethical guidelines.

Unlisted investments

The new rules for the GPFG’s real estate investments allow investments in unlisted instruments, such as unlisted equities and bonds.

The exclusion mechanism is suited to listed instruments. These investments are largely determined by the benchmark. Securities are purchased without prior assessment of the company"s practices regarding environmental and social conditions. Listing of companies in the GPFG’s equity portfolio contributes to a relatively high level of public information about the company. The holdings are consistently small and the investments are liquid, so that a divestment can be accomplished without significant impact on prices and with relatively low transaction costs.

The investments in the real estate portfolio will have other characteristics. The holdings can be much larger than in the equity portfolio, and they will be far less liquid than publicly traded securities. This means that a required disposal may lead to far greater risk of loss and high transaction costs. If the holding is large, it can also be argued that it would not seem very ethical to sell the holding if there is a problem related to for instance environmental protection or labour rights. On the contrary, it can be argued that the Fund should have a good chance of influencing the situation through improvements and initiatives. Access to public information about private investments will generally be poorer than for listed ones. This makes it difficult for the Council on Ethics to monitor the portfolio. The information the Council on Ethics relies on is often based on publicly available sources.

Page 96 of Report no. 16 (2007-2008) to the Storting states:

«The ethical guidelines will, generally speaking, also apply to investments in new asset classes like real estate.»

The Ethical guidelines of 2004 have been replaced by the two new guidelines for responsible investment practices described above. The Guidelines for Norges Bank"s work on responsible management and active ownership are applicable to listed as well as unlisted investments.

With respect to the Guidelines for observation and exclusion, the particular characteristics of unlisted investments described above indicate that it would not be appropriate to let the current exclusion mechanism apply to such investments. The ethical minimum standards laid down by the Guidelines for observation and exclusion should be safeguarded in other ways for unlisted investments in the real estate portfolio. It will be particularly appropriate to call for assessments of social and environmental conditions in advance of an investment. Should problems related to specific investments arise after they are made, active ownership should be the primary instrument.

The Ministry has accordingly concluded that the Guidelines for observation and exclusion should not be applied to unlisted investments. The Ministry will return to these questions and consider whether and in which cases special regulation of such factors should be applied to unlisted investments.

4.6.3 Questions concerning government bonds

In 2007, a new provision was introduced in section 3.2 of the supplementary guidelines for the management of the GPFG concerning restrictions on investments in certain government bonds. The provision is designed to give the Ministry the option of barring Norges Bank from investing in government bonds issued by certain countries. The Ministry of Finance has decided that the GPFG is not to be invested in government bonds issued by the state of Myanmar (Burma). The reason for this emerges from section 3.4.2 of Report no. 24 (2006-2007) to the Storting:

«(...) To avoid the creation of uncertainty as to the purpose of the Fund’s investments, it is emphasised that such decisions have to reflect broad political agreement in line with the principle of «overlapping consensus» as defined by the Graver Committee. Decisions not to invest in the government bonds of individual countries should therefore primarily apply to countries in respect of which UN sanctions have been imposed, or countries that are subject to other special international measures supported by Norway. The Government intends, against the background of the measures adopted by the EU and other countries against Burma (Myanmar), to amend the guidelines in such a way as to explicitly bar Norges Bank from investing the Pension Fund’s capital in bonds issued by the state of Burma.(…)»

The Storting subsequently approved the move, see Recommendation no. 228 (2006-2007) to the Storting, which states:

«The Committee takes note of the information and the Government’s proposal to amend the guidelines so that Norges Bank is explicitly barred from investing the Pension Fund’s capital in bonds issued by the state of Burma.»

Report no. 20 (2008-2009) to the Storting discusses issues concerning the Ethical guidelines’ applicability to the Fund"s investments in government bonds. The reason for this was that some consultative bodies in the evaluation had raised the issue of whether the scope of the prohibition against investing in certain countries’ government bonds should be expanded. Other consultative bodies had raised issues related to so-called «illegitimate debt». In section 4.4.1 of Report no. 20 (2008-2009) to the Storting the Ministry stated:

«(…)Like the Graver Committee, the Ministry believes that normal foreign policy channels are a far more important instrument for influencing the authorities of other countries in the desired direction. To avoid creating uncertainty about the purpose of the investments in the Fund, such decisions should reflect broad political agreement. The decision not to invest in the government bonds of certain countries should therefore primarily apply to countries on which the UN Security Council has imposed sanctions, or countries covered by other international measures supported by Norway. On this basis it has been decided that the Government Pension Fund Global cannot be invested in government bonds issued by Burma.

The Government finds that it would represent a dramatic boycott of a country to go so far as to exclude this country’s government bonds from the investment universe. The Ministry would only take such a step if it ensued from international sanctions. It has not been Norwegian policy to introduce unilateral measures against countries engaged in war, civil war etc. It would also be perceived as a strong politicisation of the Fund and characterise it as being more of a foreign policy instrument. Another aspect of this is that in general, investments in government bonds can hardly be considered direct financing of war or conflict, but may just as well be spent on legitimate services provided by the state, such as education and health etc. Without an international anchoring as described above, using the threat of exclusion from investment as a general instrument in Norwegian foreign policy is out of the question.»

Recommendation no. 277 (2008-2009) to the Storting states:

«The majority points out that the exclusion of government bonds is conditional on the introduction, with Norwegian support, of comprehensive international sanctions against the authorities of the country concerned, and refers to the rationale for this in Report no. 20 (2008-2009) to the Storting. The majority will request that next year"s management report provide a more detailed review of opportunities for continuing to develop the Fund"s ethical guidelines also for investments in government bonds, in light of the overarching desire to avoid the unacceptable risk of contributing to environmental damage, gross corruption or other gross violations of human rights. The majority points out, however, that the Fund should not be a foreign policy tool.»

In line with the majority"s comment, the Ministry has undertaken a new review of the rules that provide an opportunity to bar the GPFG from investing in certain countries" government bonds.

Government bonds are bonds issued by states in order to fund the country"s public expenditure. Government bonds are placed on sale in the international financial markets, and may as a rule be traded on the secondary market after they are issued. The bond market is one of several financing sources that a country can use to obtain funding. Capital borrowed through the government bond market is used by the authorities of the country in question. In addition, financing can take place through direct borrowing from other states or international financial institutions such as the World Bank, the International Monetary Fund or regional development banks. Government bonds will only be suitable as a source of funding if there are buyers for the bonds. This means that the states that have low confidence in the capital markets due, for example, to weak government finances, or lack of trust in those in power, often in practice will not issue government bonds.

The Ministry holds the view that it would be extremely demanding to apply a system where the Fund as a financial investor were to take measures, including exclusion of government bonds or initiating dialogue with authorities in other states, based on an assessment of whether the country is guilty of conduct as described, for example, of environmental damage or human rights violations. First of all, the Fund would move very far into foreign policy. The GPFG is owned by the state, and it would be difficult to prevent any exclusion of other countries" government bonds from the Fund being simultaneously perceived as Norway’s official view. It will be difficult to avoid such decisions being interpreted as a unilateral boycott of the country concerned, and in that manner a strong foreign policy signal. As the majority of the Committee points out the Fund shall not be an instrument of foreign policy. Sending foreign policy signals through the Fund that are in conflict with the policy Norway otherwise pursues, for example vis-à-vis countries that are at war, civil war etc., would be highly problematic. It has not been Norwegian policy to introduce unilateral measures against countries in such a situation. Also, any exclusion on the basis of assessments related to the other states’ alleged unlawful actions could lead to difficult legal issues, both in terms of the country’s internal law and international law. The same applies to clarification of the facts.

Furthermore, owning government bonds will not be a natural starting point for a dialogue with authorities of other countries on for instance human rights issues. Neither the Ministry of Finance as the owner of the Fund nor Norges Bank as manager has a natural role in the dialogue with authorities of other countries on such issues. Such dialogue must take place through the Ministry of Foreign Affairs and in the forums that have been established for this. Bond holdings would also not be a very suitable entry point for addressing the issue of human rights in certain countries. Many of the countries where there may be the most cause for concern about human rights violations do not issue bonds. This underlines the importance of using established foreign policy channels in dialogue with other states. It provides the best basis for prioritizing efforts where the needs are greatest.

On the basis of these weighty considerations, there has been a fundamental departure since the ethical guidelines were adopted that measures directed at states are not a suitable instrument for the Fund. However, an exception has been made that applies to the system of barring investments in government bonds issued by the state of Burma. As shown in Report no. 24 (2006-2007) to the Storting, Burma has been singled out because of the scope of international measures against the country. The system of prohibition against investments in Burmese government bonds is thus based on clear and objective characteristics that are observable to others and is therefore in less danger of being perceived as a unilateral foreign policy action. Moreover, the fact is that most countries that could be included in the same category as Burma do not issue government bonds.

The current framework for the management of the Fund, supplementary guidelines section 3.2, gives the Ministry the option of barring investments in Burmese government bonds. The criteria for such a decision are not, however, contained in section 3.2. It may therefore be appropriate to formalize such an arrangement on a more general basis. Exclusion of government bonds issued by certain countries should only be decided where comprehensive UN sanctions have been adopted, or where Norway has supported other large-scale international initiatives aimed at a specific country. Only on such a basis would it be appropriate to make exceptions from the fundamental principle that the Fund shall not implement measures against states. The Ministry of Finance aims to include rules about this in its guidelines for observation and exclusion from the GPFG no later than by the end of the year.

The Ministry also points out that Norway through the Ministry of Foreign Affairs participates in international efforts aimed at arriving at an agreed definition of responsible lending and illegitimate debt and any rules that will prevent such borrowing. This work is not primarily directed at debt borrowed through government bonds, but state-to-state debt. The funds in the GPFG are not used to provide direct loans to states. Nevertheless, the Ministry of Finance will keep itself updated on the work on a general basis.