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

1 Main aspects of the management of the Government Pension Fund

1.1 Background

The large revenues currently earned by the State from petroleum activities offer Norway considerable room for manoeuvre in terms of economic policy, compared to most other countries. At the same time, high and growing wealth entails considerable management responsibility. The Government will pursue a policy based on long-term management of petroleum wealth. Such management reflects a fundamental social perspective, and is an overarching priority for the Government. It implies that this wealth can benefit all generations, whilst at the same time making an important contribution to stability in output and employment.

There is broad political agreement to the effect that the Government Pension Fund shall be managed with a view to maximizing return, given a moderate level of risk. The Ministry has adopted a long-term investment strategy which ensures that the funds are invested in a broad-based portfolio of securities from many countries. This ensures a good diversification of risk on the part of the Fund.

The Government aims for the Government Pension Fund to be the best managed fund in the world, which implies that one shall seek to adopt best practice within international asset management in efforts relating to the Fund. Our management responsibility includes responsibility for ensuring that the Pension Fund is managed with a view to maximizing return, given a moderate level of risk. This enables future generations to draw the maximum possible benefit from our savings as well.

At the same time, this management responsibility implies that we, as investors, share an element of responsibility for the conduct of the companies in which the Fund invests. The Government therefore attaches considerable weight to the ownership interests in the companies in which the Fund invests being exercised with a view to promoting good and responsible conduct, showing respect for human rights and the environment. This is also in line with the long-term financial interests of the Fund.

The Government Pension Fund was established in 2006, encompassing the former Government Petroleum Fund and National Insurance Scheme Fund. The purpose of the 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. To ensure that the petroleum revenues are contributing to the stable development of the Norwegian economy, the revenues shall be phased into the economy gradually, whilst the savings shall be invested outside Norway. The Government Pension Fund – Global contributes, by investing a significant part of the petroleum revenues abroad, to a capital outflow that offsets the impact on the Norwegian krone exchange rate of large and varying foreign exchange inflows from the petroleum sector.

The savings of the Pension Fund take the form of general fund accumulation. The Fund is fully integrated with the Fiscal Budget, in order to facilitate growth in the Fund being a reflection of the State’s actual accumulation of financial assets, cf. Box 1.1. Consequently, there is no requirement that the assets of the Pension Fund shall at all times represent a certain share of the pension liabilities of the State under the National Insurance Scheme.

Textbox 1.1 The fund structure

The Government Pension Fund comprises the Government Pension Fund – Global and the Government Pension Fund – Norway. The accumulation of capital in the Government Pension Fund – Global does in large part reflect the conversion of oil and gas resources in the North Sea to financial assets abroad. Consequently, the ongoing proceeds from these petroleum activities are of a different nature than the other revenues of the State, since they partly correspond to a reduction in the petroleum wealth of the State. At the same time, the proceeds vary considerably as the result of, inter alia , fluctuations in the oil price.

Source Ministry of Finance

Figure 1.1 shows the relationship between the Government Pension Fund – Global and the Fiscal Budget. The revenues of the Government Pension Fund – Global comprise the cash flows from the petroleum activities, which are transferred from the Fiscal Budget, net financial transactions relating to the petroleum activities and the return on the investments of the Pension Fund.¹ The assets of the Fund may only be allocated to transfers to the Fiscal Budget pursuant to a resolution passed by the Storting, with the amount of such transfers being determined by the oil-adjusted budget deficit (designated “Use of petroleum revenues” in the chart). Consequently, the allocation of fund liquidity forms part of an integrated budgetary process, and renders visible the State’s use of petroleum revenues. The fund accumulation thereby reflects the actual surplus of the Fiscal Budget.

Figure 1.1 illustrates that the spending of the petroleum revenues is determined by the budget policy guidelines (the fiscal rule). The fiscal rule implies that the structural, oil-adjusted budget deficit shall over time correspond to the expected real return on the capital of the Global part of the Government Pension Fund, estimated at 4 pct. of the value of the Fund as per the beginning of the budgetary year.² The guidelines thereby facilitate predictable spending of the petroleum revenues, which is uncoupled from ongoing revenue flows. This results in the Fiscal Budget and the mainland economy being sheltered from effects of fluctuations in petroleum revenues. At the same time, the fiscal rule supports preservation of the wealth over time, in order that it may contribute to maintaining the welfare of coming generations as well. Whilst the capital of the Fund can only be spent once, the real return may fund a permanently higher level of government expenditure.

The basic capital of the Government Pension Fund – Norway originates primarily from surpluses in the national insurance accounts from the introduction of the National Insurance Scheme in 1967 and until the late 1970s. The return on the assets of the Government Pension Fund – Norway is not transferred to the treasury, but is added to this part of the Fund on an ongoing basis. Consequently, there are no transfers between the Fiscal Budget and the Government Pension Fund – Norway. Nor are there any transfers of capital between the two parts of the Government Pension Fund.

1 Section 3 of the Act relating to the Government Pension Fund defines which items are included in the cash flow and in net financial transactions relating to petroleum activities, cf. Appendix 8 to this Report.

2 The structural, oil-adjusted budget deficit provides as measure of the underlying spending of petroleum revenues over the Fiscal Budget, with the oil-adjusted budget deficit having been adjusted for fluctuations in the business cycle, transfers from Norges Bank, the net interest revenues of the State and special accounting matters, cf. Box 3.2 of Report No. 1 (2007-2008) to the Storting; the National Budget for 2008.

Under the Act of 21 December 2005 No. 123 relating to the Government Pension Fund (the “Pension Fund Act”), the Ministry of Finance has been charged with managing the Fund. The Ministry determines the general investment strategy of the Pension Fund, as well as its ethical and corporate governance principles, and follows up on its operational management. The task of carrying out the operational management of the Government Pension Fund has been delegated to Norges Bank and Folketrygdfondet, which manage the Government Pension Fund – Global and the Government Pension Fund – Norway, respectively. Both the Government Pension Fund – Global and the Government Pension Fund – Norway are subject to ethical guidelines. The main aspects of the division of responsibilities between the Storting, the Ministry of Finance, Norges Bank and Folketrygdfondet are described in Figure 1.2, illustrating, inter alia , the different roles of the Ministry. The Government Pension Fund does not have its own Executive Board or administrative staff.

Source Ministry of Finance

The Government Pension Fund is one of the largest funds in the world, and its assets are growing rapidly. The Fund is large relative to the size of the Norwegian economy, and the return on the Fund will make considerable contributions to the funding of State expenditure in coming years. Focus on the management of the Fund has increased in line with the growth in its size. This underscores the importance of ensuring that the investment strategy of the Pension Fund, and its ethical guidelines, have the firm backing of the Storting. The Ministry emphasises a high degree of openness for purposes of strengthening the credibility of, and confidence in, the Fund and the fund structure. The Storting is consulted, inter alia , through an annual report on the management of the Pension Fund, which is submitted in the spring session. Operational management performance is also reported by Norges Bank and Folketrygdfondet on a regular basis.

Norway’s handling of its petroleum revenues is often invoked as a benchmark internationally. This pertains, in particular, to the role of the Government Pension Fund as part of the frame­work for a long-term, sustainable fiscal policy, which facilitates stable economic development. The Ministry assists, through the rendering of advice in this area, several other countries in the organisation of their natural resource management. This effort takes place through bilateral cooperation, the “Oil for Development” programme under the auspices of Norad, as well as international organisations like, inter alia , the IMF, the World Bank and the UN.

This Report is organised into two Parts: Part I describes the main aspects of the management of the Government Pension Fund. In this part, weight has been attached to giving the presentation a non-technical form to the extent possible. Part II contains a more detailed analysis of themes discussed in Part I. There have also been prepared documentation memoranda of a more technical nature, containing additional information relating to certain of the issues discussed in Part II. The memoranda will be published on the Ministry of Finance’s website (www.government.no/gpf).

Part I is organised as follows: Chapter 1.2 provides an overview of management performance for the Government Pension Fund, with a special focus on performance developments during 2007. Chapter 1.3 discusses the investment strategy of the Fund, and it follows from this discussion that the Government intends to include real estate as a separate asset class for the Government Pension Fund – Global, in addition to equities and bonds. Furthermore, it intends to expand the benchmark portfolio of the Government Pension Fund – Global to include more emerging markets. It also intends to increase the limit on ownership stakes held by the Government Pension Fund – Global from 5 pct. to 10 pct. Chapter 1.4 discusses ethics and the exercise of ownership rights, and explains, inter alia , efforts relating to the ethical guidelines over the last 12 months, as well as the ownership efforts on the part of Norges Bank and Folketrygdfondet, in more detail. Chapter 1.5 concerns the efforts relating to the development and supervision of the management framework. This Report presents main aspects of a proposal for amendments to the Central Bank Act, which will subsequently be subject to a public consultation process. Chapter 1.6 provides an account of the mounting international debate concerning so-called Sovereign Wealth Funds, and the attitude of the Government to the issues raised in that debate.

Part II is organised as follows: Chapter 2 provides detailed analyses of the return and risk associated with the Government Pension Fund. Chapter 3 contains a more detailed account of the Ministry’s efforts relating to the investment strategy of the Fund and changes to the investment guidelines for the Government Pension Fund – Global. Chapter 4 discusses the interaction between ethics and the exercise of ownership rights, and also contains a description of the process of evaluating the ethical guidelines for the Pension Fund. Chapter 5 contains a more detailed discussion of the development and supervision of the management framework, with a focus on, inter alia , risk-based supervision of the management on the part of Norges Bank.

The Act relating to the Government Pension Fund, the Regulations relating to the management of the Fund, with supplementary provisions, and the management agreements are appended to this Report. The recommendations and assessments of Norges Bank, the Strategy Council and the Council on Ethics regarding the intended changes to the investment strategy of the Government Pension Fund – Global are also appended. The comments of Norges Bank to the report from Ernst & Young on the risk management and control procedures associated with the Bank’s asset management are also appended. The report from Ernst & Young is in English, and is published on the Ministry of Finance’s website (www.government.no/gpf) concurrently with the publication of this Report. An Appendix presents the key terms used in this Report. The annual reports of Norges Bank and Folketrygdfondet concerning the management of the Government Pension Fund in 2007 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.

1.2 Management performance

1.2.1 Developments in the market value of the Government Pension Fund

The total market value of the Government Pension Fund was NOK 2,136.0 billion as per yearend 2007. This represents an increase of NOK 245,4 billion in total, when compared to yearend 2006, which was caused by the inflow of new funds (313.6 NOK billion) and the return on the Fund’s investments (NOK 86.1 billion when measured in kroner). An appreciation of the Norwegian krone, as measured against the currency basket of the Government Pension Fund – Global, entailed, when taken in isolation, a reduction in the market value of the Fund (NOK 154.3 billion), but changes to the Norwegian krone exchange rate are not relevant as far as developments in terms of international purchasing power are concerned. Figure 1.3 splits the increase in the total market value of the Government Pension Fund in 2007 into various components.

Source Ministry of Finance, Norges Bank and Folketrygdfondet

The assets of the Government Pension Fund have, as illustrated in Figure 1.4, grown rapidly since the mid-1990s. The value of the Pension Fund as per yearend 2007 represented approximately NOK 1 million per household in Norway.

¹ The Government Pension Fund was created in 2006 as a general framework encompassing the Government Petroleum Fund and the National Insurance Scheme Fund. The value of the two Funds has, for purposes of illustration, been aggregated for previous years as well.

² The value of the Government Pension Fund – Global has been calculated prior to the deduction of management costs. The management costs amounted to just under NOK 1.8 billion in 2007, and are credited to Norges Bank during the 1st quarter of 2008.

Source Ministry of Finance

The market value of the Government Pension Fund – Global was 2,018.6 NOK billion as per yearend 2007. 1 This represents an increase of NOK 235.0 billion since yearend 2006. The value of the equity portfolio as per yearend was NOK 957.9 billion, whilst NOK 1,060.7 billion was invested in fixed-income securities. Total inflow to the Global part of the Pension Fund was NOK 1,756.3 billion over the years 1996–2007.

The market value of the Government Pension Fund – Norway was NOK 117.3 billion as per yearend 2007, which is NOK 10.4 billion more than at the beginning of the year. The value of the equity and fixed-income portfolio was NOK 70.1 and 47.3 billion, respectively, as per yearend. 2

1.2.2 The return on the Government Pension Fund

The real return on the Government Pension Fund is what is relevant for purposes of measuring developments in the purchasing power of the Fund. At the same time, the real return on the Global part of the Fund is a key component of the fiscal rule adopted for budget policy purposes, cf. Box 1.1. The real return (after the deduction of management costs) on the Government Pension Fund – Global was 1.05 pct. in 2007 when measured in foreign currency, as can be seen from Table 1.1, which is significantly less than the average for the period 1997-2007. The Government Pension Fund – Norway achieved a real return of 8.43 pct., which is significantly more than the average annual real return for the period 1997-2007 as a whole.

The subsequent discussion of management performance is based on nominal return data, since one seeks to compare management performance to the return on a benchmark portfolio. Not much information would have been added by adjusting the return data for inflation for this purpose. 3

The return on the Government Pension Fund – Global

The return on the Government Pension Fund – Global was 4.3 pct. in 2007, as measured in foreign currency. This is weaker than the performance for the preceding five years, cf. Table 1.2. The return on the Fund in 2007 was -3.9 pct. when measured in kroner. The nominal return on the sub-portfolios of the Government Pension Fund – Global since the beginning of 1998 is illustrated in Figure 1.5.

Source Ministry of Finance and Norges Bank

The risk associated with the Government Pension Fund – Global, as measured by the standard deviation of returns, was 3.7 pct. in 2007, when measured nominally in local currency. This is more or less in line with the level of the preceding five years, cf. Table 1.2.

Norges Bank may, in its management of the Government Pension Fund – Global, deviate from the benchmark portfolio stipulated by the Ministry, within a limit as to the permitted tracking error. The contribution from such active management is measured on an ongoing basis, by way of developments in the value of the Fund being compared to developments in the benchmark portfolio. In 2007, the return on the Global part of the Pension Fund – Global was 0.22 percentage points less than the return on the benchmark portfolio, as measured in Norwegian kroner, which corresponds to about NOK -5.2 billion. 4 This is the first time since 1998 that a negative excess return has been realised in the management of the Government Pension Fund – Global.

Last year’s results were to a significant extent influenced by the volatility of the international financial market, cf. the more detailed discussed of market developments below. Nevertheless, the fluctuations observed in the value of the Fund are well within the scope of the envisaged possibilities. The expected nominal return on the Pension Fund – Global is estimated at 6 pct., whilst the standard deviation of returns measured in the funds currency basket is estimated at 9 pct., as will be explained in Chapter 3. 5 This implies that one would expect, in one out of every three years, fluctuations in the value of the Fund outside a range from -3 pct. to +15 pct., based on an expected return of 6 pct.

The investment strategy of the Government Pension Fund – Global is based on the investments of the Fund being made in different asset classes in a broad-based portfolio of securities from many countries. Although such a strategy entails a good diversification of risk, one must nevertheless be prepared for periods of significant fluctuations in the value of the Fund. Box 1.2 discusses the risk associated with the Government Pension Fund on the basis of historical events, and it follows from the said discussion that the value of the Government Pension Fund over time appears to be relatively robust from the perspective of the type of crises that occurred over the last hundred years. One cannot, at the same time, rule out the possibility that there will in future occur crises situations where any decline in the value of the Fund cannot be recouped as swiftly in subsequent years as has been observed historically. The Ministry is of the view that it may not necessarily be appropriate to assume that developments in the international financial markets over the next hundred years will be as positive as over the last hundred years. This is also reflected in the estimates used in the modelling of the future return on, and risk associated with, the Fund in Chapter 3.

During periods of major market fluctuations, the focus is often placed on the magnitude of any change in the market value of the Government Pension Fund. Short-term fluctuations in the value of the Fund are however of minor importance to the Government Pension Fund, since the Pension Fund represents long-term savings, and it is the total return in the long run that is important. Although market volatility and increased risk premiums may lead to a reduction in the value of the Fund in the short run, it is advantageous for a long-term investor with a growing fund under management to be generously compensated for assuming risk. The equity portion is in this respect of major importance to the long-term expected return on the Fund (cf. Report No. 24 (2006-2007) to the Storting).

The return on the Government Pension Fund – Norway

The Government Pension Fund – Norway adopts a long investment horizon. The Fund is a long-term investor, and will hold a large portfolio of equities in the Norwegian market, the composition of which Folketrygdfondet must examine. In line herewith, the Ministry focuses on performance developments over time in its follow-up of Folketrygdfondet’s performance.

The return on the Government Pension Fund – Norway in 2007 was 9.8 pct., as measured in kroner. This is somewhat weaker than the average annual return for the preceding five years, but is nevertheless well above the average return for the entire period 1998-2007 as a whole, cf. Table 1.5. The nominal returns on the sub-portfolios of the Government Pension Fund – Norway are illustrated in Figure 1.6.

Source Ministry of Finance and Folketrygdfondet

The risk associated with the Government Pension Fund – Norway in 2007, as measured by the standard deviation of returns, was 6.9 pct., when measured in kroner. This is significantly higher than the level of the preceding few years, but this has to do with, inter alia, the termination of the sight deposit arrangement in December 2006. 6

In 2007, the return on the Pension Fund – Norway was 2.54 percentage points higher than the return on the benchmark portfolio. This is the highest excess return achieved in one single year over the period 1998-2007.

Market developments

Developments in the market value of the Government Pension Fund over the last few years must, all in all, be characterised as very favourable. This reflects both strong returns on the benchmark portfolio of the Fund and the generation of excess returns in the active management effort. Developments in the value of the Fund over this period should also be seen in the context of the strong growth in the world economy in recent years, caused by, inter alia , very strong growth in emerging markets like China and India. This has, together with significant easing of monetary policy in many countries during the period 2000–2003, stimulated economic growth, and enterprises have, generally speaking, registered high earnings. At the same time, inflation has remained low, cf. Figure 1.7a. This has paved the way for a broad stock market upturn since 2003, cf. Figure 1.7b. The upturn on the Oslo Stock Exchange in recent years has been particularly strong, which reflects, inter alia , high oil prices. However, in the last couple of years there has been a gradual tightening of US and European monetary policy, and bond yields have increased, cf. Figure 1.7c. The tightening of monetary policy in, inter alia , the US economy has been gradually reversed in recent months.

The return on the Government Pension Fund in 2007 may be characterised as satisfactory, despite significant volatility in the international financial markets. Such volatility was particularly pronounced in the summer of 2007, with significant fluctuations in bond and stock markets across the world, which contributed to a reduction in the return on the Fund. The volatility was triggered by problems in the US market for home mortgages with low collateral (subprime loans), which resulted in a marked increase in the compensation required by investors when investing in securities involving credit risk, cf. Figure 1.7d.

Source  EcoWin

The market fluctuations in the second half of 2007 seem less dramatic when adopting a somewhat longer time perspective. The decline in the stock prices does not seem to have been more pronounced than a number of the stock price corrections that have been observed over the last five years following a strong upturn in the stock market. Furthermore, the increase in the interest differential between secure and less creditworthy securities started from what were, in historical terms, very low levels. A certain increase in the price of risk in parts of the financial market is therefore not necessarily disadvantageous in itself. Although stock prices recovered partly during the last month of 2007, the volatility of the international bond and stock markets at the beginning of 2008 indicates that there is still considerable uncertainty as far as future developments in the financial markets are concerned.

1.2.3 Management costs

Norges Bank shall, pursuant to the management agreement entered into with the Ministry of Finance in respect of the Pension Fund – Global, be compensated for the actual management costs, up to a maximum limit, which for 2007 has been fixed at 0.10 pct. (10 basis points) of the average market value of the Fund. The maximum compensation limit is determined on the basis of, inter alia , information on the costs associated with this type of management in funds of corresponding size. The Ministry of Finance commissions the Canadian company CEM Benchmarking Inc. to prepare the analyses on which these cost comparisons are based. In addition to the reimbursement of costs up to the maximum limit, Norges Bank is compensated for such part of the fees of external managers as are incurred as a result of the excess return achieved.

Management costs for 2007, exclusive of performance-related fees, were NOK 1,514.7 million. This represented an increase of 33 pct. over 2006. The average size of the Fund increased by 24 pct., thus implying that costs measured as a share of the average portfolio increased from 0.073 pct. (7.3 basis points) in 2006 to 0.079 pct. (7.9 basis points) in 2007. Consequently, management costs exclusive of performance-related fees are well below the maximum limit. Inclusive of performance-related fees to external managers, the costs amounted to NOK 1,783.3 million, which represents 0.093 pct. (9.3 basis points) of the average market value when calculated as an annual rate.

The costs incurred by Folketrygdfondet in its management of the Government Pension Fund – Norway in 2007 represent 0.049 pct. (almost 5 basis points) of the assets under management. The management costs associated with the Government Pension Fund – Norway are not entirely comparable to the costs associated with the management of the Government Pension Fund – Global. Norges Bank has opted to use external management mandates, which when taken in isolation are more expensive than internal management. Furthermore, the asset management carried out by Norges Bank is more extensive because, inter alia , the assets of the Pension Fund – Global are spread across many more countries and companies than those of the Pension Fund – Norway. On the other hand, asset management is subject to economies of scale, and Norges Bank is amongst those benefiting therefrom.

The Ministry of Finance has for 2008 entered into a management agreement with Folketrygdfondet that lays down the principles governing the compensation to be received by Folketrygdfondet in return for managing the Government Pension Fund – Norway, cf. Appendix 8 to this Report. It is to be expected, as explained in Section 5.8, that the costs associated with the management of the Pension Fund – Norway will in future end up at a higher level than before, as the result, inter alia , of more stringent requirements as far as the measurement, management and control of risk, as well as reporting, are concerned. The Ministry aims to prepare cost comparisons as to the costs associated with this type of management on the part of funds of a comparable size, as is currently done for the Global part of the Fund.

1.3 Investment strategy

1.3.1 The basis of the investment strategy of the Fund

The Government has high ambitions for the management of the Government Pension Fund. The objective is for the Government Pension Fund to be the best managed fund in the world. This implies that one shall seek to adopt best practice within international asset management in efforts relating to the Fund. At the same time, what constitutes a good investment strategy will depend on the characteristics of the Fund, the purpose of the investments, the attitude of the owner to risk, and one’s views as to how the financial markets work.

The characteristics and purpose of the Fund

The Government Pension Fund is an instrument for general savings on the part of the State, and is not, unlike traditional pension funds, earmarked for specific liabilities, cf. Section 1.1. In view of the potential for a continuation of high petroleum revenues and a responsible fiscal policy that limits the Fund’s expenditure to the expected real return on the Government Pension Fund – Global in the long run, the Fund will be adopting a very long investment horizon. Furthermore, the assets of the Fund are funded by ongoing revenues from petroleum activities, and the State is not making any borrowings to contribute capital to the Fund. Nor is the Fund faced with much of a short-term liquidity requirement. The Fund will therefore, generally speaking, have a higher risk bearing capacity than do other funds that it would be reasonable to compare it to.

There is broad political support for the Fund to be managed with a view to achieving the maximum possible return, at a moderate level of risk, such as to enable future generations to derive the maximum possible benefit from the wealth as well. The Government Pension Fund shall therefore be characterised by a broad diversification of risk and a clear financial objective. The broad political support for the investment strategy of the Fund provides a democratic underpinning, and represents an important contribution to actually maintaining the investment strategy over time.

The objective of the Fund as a financial investor pertains to both the Government Pension Fund – Global and the Government Pension Fund – Norway. The investment universe of the Global part of the Fund is significantly wider in scope than that of the Pension Fund – Norway, which is primarily invested in the Norwegian securities market. The fact that Folketrygdfondet is, in its capacity of manager of the assets of the Fund, a large player in a relatively small capital market, may entail certain limitations as to the scope for large changes to the composition of the portfolio in the short term.

The investment strategy of the Government Pension Fund is developed with a view to maximizing the overall return on the assets of the Fund, given the attitude of political authorities to risk (hereunder market risk and operational risk), and limitations resulting from the size and characteristics of the Fund, as well as any limitations resulting from the ethical guidelines and fundamental governance principles of the Fund.

Views as to how the markets work

A robust investment strategy needs to be based on fundamental attitudes and assumptions as to how the financial markets work. The theory of efficient financial markets was generally accepted in the 1970s. This theory assumed that new information was swiftly reflected in the prices of financial assets, and that prices were generally “correct”. The theory has subsequently been challenged through studies of historical returns that have demonstrated deviations from efficient outcomes. However, it remains uncertain whether such findings can be utilised to predict future market movements such as to achieve a higher risk-adjusted return than would otherwise be realised.

The types of changes to the investment strategy of the Fund that are submitted to the Storting are subject to a lengthy decision-making process that ensures a robust strategy. The size of the Fund also limits how swiftly one can implement major adjustments to the composition of the Fund without the market impact imposing high transaction costs on the Fund. Changes to the general investment strategy of the Fund will therefore not be based on an expectation that one can identify in advance any period during which markets or segments will seem, in retrospect, “cheap” or “expensive”. At the same time, the possibility that there may exist strategies that offer profitable deviations from the benchmark portfolio is consistent with the provision for a certain degree of active management on the part of Norges Bank and Folketrygdfondet. Active management is premised, by its very nature, on the existence of erroneous pricing, and the assumption that good management can generate a return in excess of the market return.

Furthermore, it is consistent with generally accepted theory and practise to expect a higher average return on equities than on investments in fixed-income instruments, because the risk associated with equities is higher. However, the magnitude of such excess return remains uncertain.

If the returns from different markets and segments do not move in line with each other, one may achieve a better trade-off between return and risk by spreading the investments across several markets and market segments. This is the background against which the benchmark portfolio of the Government Pension Fund is spread across a broad range of geographical regions, countries, sectors and companies.

Experience shows that the selection of, and control over, the manager is of greater importance if parts of the investments are made in less liquid markets, in which it is not easy to trade securities without influencing prices. It will normally be relatively straightforward for an investor to achieve the market return in liquid markets, whilst the management performance in illiquid markets will to a significantly higher extent depend on the skills of the manager. It will therefore be necessary, when transferring parts of the Pension Fund’s investments from liquid to less liquid markets, to attach more weight to the quality of control systems and the structuring of incentives, for example in relation to fees.

1.3.2 The investment strategy of the Government Pension Fund

The Government Pension Fund is mainly invested in listed equities and investment-grade bonds. Equity investments represent ownership interests in the production of goods and services, and the value of such investments will therefore reflect, inter alia , expectations as to the future profits of businesses. Bond investments are investments in transferable loans that shall be redeemed by the issuer on a certain date together with a predetermined interest rate.

The Ministry of Finance has formulated a long-term investment strategy which implies that the portions to be invested in various asset classes and geographical regions can be determined on the basis of assessments of expected long-term returns and risks. The investment strategy is based on the premise that contributions to the diversification of the risk associated with the investments improve the risk-adjusted return. The Ministry of Finance has therefore emphasised a broad representation of the world’s stock and bond markets in the benchmark portfolio it has stipulated for the Government Pension Fund, cf. Figure 1.8. The indices making up the benchmark portfolio of the Fund include representative security samples, and developments in these reflect, in large part, market developments in the relevant countries. The benchmark index for equities of the Government Pension Fund – Global comprises almost 7,000 companies across 27 countries, whilst the benchmark index for bonds comprises more than 9,800 bonds across the currencies of 21 countries.

It follows from guidelines laid down by the Ministry of Finance that Norges Bank and Folketrygdfondet may also invest in other securities and instruments than those included in the benchmark portfolio for the Fund. At the same time, there has been established an upper limit on the permitted tracking error in active management. By making investments in securities and instruments that fall outside the scope of the benchmark portfolio, and by investing other portions of the Fund in certain securities than are implied by the benchmark portfolio, Norges Bank and Folketrygdfondet are exploiting their permitted tracking error for purposes of achieving an excess return.

Calculations in Chapter 2 show that 90-95 pct. of the return on the Government Pension Fund – Global may be attributed to the choices made by the Ministry in designing the benchmark portfolio, whilst the remaining 5-10 pct. may be attributed to the investment choices made by Norges Bank within the guidelines laid down by the Ministry. These calculations also show that about 99 pct. of the fluctuations in the return on the Government Pension Fund – Global may be attributed to the chosen benchmark portfolio, thus implying that the investment decisions of Norges Bank have hardly contributed to increasing the overall risk associated with the Fund.

¹ It has been resolved to increase the equity portion of the Pension Fund – Global to 60 pct., and it is currently being increased to that level.

Source Ministry of Finance

1.3.3 Changes to the guidelines for the Government Pension Fund – Global

The Government Pension Fund – Global has grown rapidly since the Fund received its first capital allocation in 1996, cf. Figure 1.4. Over the last decade, the Fund has grown to become one of the largest funds in the world. It is estimated, on the basis of projections in the National Budget for 2008, that its market value will be almost doubled by the beginning of 2012, to about NOK 3,500 billion. The fund capital has significantly outgrown the levels envisaged for the first few years after the initial capital allocations were made.

There has been a gradual evolvement in the investment strategy of the Government Pension Fund – Global. The Fund has invested in equities since 1998. In 2000, emerging markets were included in the benchmark portfolio for equities, whilst in 2002 the benchmark portfolio for bonds was expanded through the inclusion of non-government-guaranteed bonds (i.e. corporate bonds and mortgage-backed bonds). In 2004, new ethical guidelines were laid down for the Government Pension Fund – Global. In 2006, the investment universe was further expanded. It was decided, following the Storting’s deliberation of Report No. 24 (2006-2007) to the Storting, to include the small-cap segment in the benchmark portfolio for equities, and to increase the equity portion of the benchmark portfolio from 40 pct. to 60 pct.

The investment strategy of the Government Pension Fund – Global reflects the fact that many important strategic choices have already been made, concerning, inter alia , the allocation between equities and fixed-income instruments, the scope of the equity and fixed-income portfolios and the risk limit for active management. These decisions have established a level for the market risk associated with the Fund. The Ministry’s future efforts to evolve the investment strategy will be premised on how to achieve a further improvement in the trade-off between return and risk by further spreading the investments and better utilising the characteristics of the Fund with­out any significant changes to the overall level of risk. The investment strategy of the Government Pension Fund – Global will, in line with this, be evolved through more and smaller decisions. Some of these decisions will be of a more technical and operational nature, like issues such as the phase-in of the increased equity portion, the design and establishment of control systems for new asset classes (for example real estate), etc. Other decisions may entail minor adjustments to the investment strategy, such as the ability to invest in equities scheduled for listing (see below), but without having any material effect on the overall level of risk associated with the Fund or involving any conflict with the Fund’s ethical guidelines. The Ministry is of the view that this type of decision falls within the scope of the general management framework for the Fund as defined on the basis of deliberations by the Storting. The Storting will, in line with previous practise, be kept informed of such minor changes to the guidelines through reporting in the annual Reports on the activities of the Fund and, if applicable, in the National Budget as well. Decisions that involve more comprehensive changes to the investment strategy, and that are expected to have a material impact on the risk associated with the Fund, will be submitted to the Storting prior to the implementation of any changes.

The sources of the return on the Government Pension Fund – Global have thus far been focused, in particular, on the fact that one could reap, through the ownership of equities and bonds, returns by assuming market risk in relatively liquid markets. Furthermore, the benchmark portfolio of the Fund has been gradually expanded and made more diversified, whilst the investment universe has been expanded and additional degrees of freedom have been granted as far as active management is concerned. Excess returns have been achieved through the active management of the Fund every year since 1998, with the exception of 2007, with only a limited increase in the overall risk associated with the Fund.

It is appropriate for the future investment strategy effort to be focused on developing a strategy that utilises the characteristics of the Fund in the best possible manner. Natural types of evolvement of the investment strategy may be:

• further diversification of risk by, for example, including more countries or asset classes in the benchmark portfolio of the Fund. Reference is in this context made to the proposal in this Report for the inclusion of new emerging markets in the benchmark portfolio of the Fund for equities.

• to consider investments that benefit from the Fund’s size, creditworthiness, long-term perspective, and ability to hold less liquid assets. It is particularly appropriate to consider changes to the strategy that can provide compensation in the form of somewhat higher expected returns in exchange for reduced tradability (liquidity). Investments in unlisted real estate, as intended in this Report, may be an example of an adaptation of the strategy that delivers both an improved diversification of risk and the scope for reaping liquidity premiums over time.

Comparisons between the investments of the Government Pension Fund and those of other funds internationally show that these funds hold a lower portion of nominal bonds, and that part of their capital is invested in alternative asset classes like real estate, unlisted equities, etc. An evolvement of the investment strategy of the Government Pension Fund in line with that outlined above may result in an asset allocation that is more similar to the composition of these other funds.

A basic premise of the effort to evolve the strategy will be the need for adequate limits on other types of risk than market risk, such as operational risk. By operational risk is here meant 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. Another premise will be the need for limits on active management where desirable risk taking is stimulated on the part of the operational manager. The follow-up of the operational management shall, like at present, contribute to the interests of managers and other counterparties being aligned with the purpose of the general investment strategy of the Fund. Adherence to the ethical guidelines is also a prerequisite.

This Report intends to change the investment strategy of the Government Pension Fund – Global in relation to real estate investments, emerging markets and the limit on ownership stakes. A brief discussion of the changes is set out below, with further explanation being provided in Chapter 3.

Real estate investments

Real estate investments represent ownership interests in land, buildings or parts of buildings. Investments in real estate include, for example, office buildings, shopping centres, industrial buildings and housing. There are two methods of investing in real estate. Direct investments involve the investor acquiring real estate without intermediaries, whilst indirect investments involve the investor acquiring a share of a fund or equities of a real estate company, which then invests directly in a set of properties. An indirect investment may also be organised through a joint venture.

The quality of historical return data for the property market is inferior to the quality of those for the stock and bond markets. The findings from such analyses should therefore be interpreted with care. Available historical data show that returns on real estate investments have been somewhat higher than for bonds, but lower than for equities. Historical data also show that the risk associated with real estate investments was between the level of risk associated with equity investments and that associated with bond investments. The costs involved in the management of a real estate portfolio are higher than those involved for both equities and bonds. Nevertheless, the additional costs incurred through real estate investments are deemed to be outweighed by the positive effects such investments are expected to have on the return and risk associated with a fund. These positive effects have to do with how the returns on real estate covary with the returns in the stock and bond markets. It would be justified to claim, based on the available data, that the correlation between the return on real estate and that on equities and bonds, respectively, is limited, particularly in the short and medium term. Real estate investments may therefore contribute to an improved diversification of the risk associated with the Fund.

The Ministry intends, based on the recommendations of Norges Bank and the Strategy Council, as well as its own analyses, to invest up to 5 pct. of the capital of the Government Pension Fund – Global in real estate. The investments in real estate are offset by a reduction in the proportion of bond investments. This change is expected to contribute to an improvement in the overall return and risk profile of the Fund through an improved diversification of the risk associated with the Fund, return contributions resulting from the illiquidity of unlisted real estate investments, as well as active management.

The effects of this change on the overall risk and return profile of the Fund will depend on how the real estate investments are implemented. Observations of actual investments on the part of other large funds internationally show that their portfolios are partly comprised of investments in existing buildings with relatively predictable cash flows and partly of investments in development projects with less predictable outcomes. The return will in both cases be partly caused by developments in the underlying property market and partly by skilful active management. Another observation is that the investments are structured as equity contributions to leveraged real estate. This implies that the risk characteristics of the investment are more comparable to those of equity investments. A portfolio of leveraged real estate, through, for example, unlisted fund investments, may offer a higher contribution to the expected return on the Fund than does an unleveraged real estate portfolio. The leveraged real estate portfolio will, at the same time, contribute somewhat more to the overall risk associated with the Fund. Nevertheless, the increase in the overall risk associated with the Fund will be limited, even with a certain leveraging of the real estate included in the portfolio, given a real estate portion of 5 pct. and a limited correlation with equities and bonds.

Creating a real estate portfolio will take many years. Even a 5 pct. portion of the Fund will represent a large investment in view of the size and liquidity of the market. Considerations to do with both returns and transaction costs therefore suggest that the portfolio should be created over a period of many years. A gradual accumulation will, at the same time, reduce the risk of entering the market at a time that later turns out to have been unfavourable. Specialised skills in the management of real estate need to be developed, and it will take time to establish control systems, etc.

The majority of the investments are expected to be made through unlisted instruments. This poses challenges to do with, inter alia , the measurement of return and risk. Solutions to a number of control-related challenges need to be found before the planned real estate investments can be embarked upon. The Ministry will now be defining an investment mandate that specifies the required rate of return, risk limits and reporting requirements. Weight will be attached to finding solutions that offer the appropriate incentives for the manager, in terms of the return, risk and costs involved in the management of real estate. The Ministry envisages that the accumulation of a real estate portfolio may commence at some point during 2008 if adequate solutions have been found in these respects. The Ministry will keep the Storting informed of the progress of this effort through reporting in the National Budget and the annual Reports on the management of the Government Pension Fund.

The ethical guidelines of the Funds will also apply to investments in new asset classes like real estate. The Ministry has concluded, on the basis of a recommendation of the Council on Ethics and its own assessments, that the leasing of real estate to companies that have been excluded on the basis of the ethical guidelines will normally not qualify for exclusion from the Fund. Consequently, exclusion needs to be contemplated specifically in each individual case.

The design and operation of buildings has a major impact on the environment, and estimates show that annual CO₂ -emissions from the construction sector represent about 25 pct. of overall emissions worldwide. The Ministry intends for the real estate investment mandate to include a requirement that the manager shall participate actively in the efforts pursued internationally to accommodate special environmental considerations.

The Ministry will include, in the guidelines for investments in real estate, restrictions as to where unlisted real estate funds and companies in which the Government Pension Fund – Global invests can be incorporated. Funds and companies have to be incorporated in countries that are either OECD countries, or with which Norway has established tax treaties or other agreements that provide sufficient disclosure, or with which Norway has formed a special Tax Information Exchange Agreement (“TIEA”) based on the OECD model. In addition, the country must not be listed as a “non-cooperating jurisdiction” by OECD. This amounts to the imposition of stricter rules than apply to any other fund of which the Ministry is aware.

Extensive use of special rules may limit the availability of skilful external managers, which would impair the ability to fully utilise the return and risk characteristics associated with the real estate investments of the Fund. Ultimately, the extensive use of special rules may occasion a reconsideration of the decision to invest in real estate.

Real estate investments are discussed in more detail in Chapter 3. Reference is also made to the discussion of real estate investments on the part of the Government Pension Fund – Global in Report No. 1 (2007-2008) to the Storting; the National Budget for 2008.

Emerging markets

The equity portfolio of the Government Pension Fund – Global is broadly diversified across both regions and countries. An important purpose of such diversification is to achieve exposure to the stock markets globally, in order to attain the best possible trade-off between return and risk on the part of the Fund. The exposure of the benchmark portfolio to emerging stock markets has thus far been limited to a relatively small number of markets.

Emerging bond markets differ from emerging stock markets along several dimensions. The markets are located in low-income countries, and the size of the investable part of the market is limited relative to the Gross National Product of the country in question. There exist (listed) emerging stock markets in between 80 and 90 countries. Large index providers internationally (including FTSE, which provides indices for the Government Pension Fund – Global), define the markets in the vast majority of these countries as non-investable for international portfolio investors. The following criteria are used as a basis when assessing whether to include a country in the FTSE index universe:

• the market has to be open for direct equity investments from foreign investors;

• data (share prices, number of equities, etc.) need to be available within reasonable time limits;

• investors cannot be subject to significant exchange controls;

• there has to be significant international investor interest in investments in the market; and

• the market needs to offer adequate liquidity.

FTSE classifies the various markets into developed markets, advanced emerging and secondary emerging markets based on the following set of criteria: data quality, free flow of foreign exchange, GDP per capita, market breadth (number of limited companies), market depth (number of sectors), reliable securities price information, stock market capitalisation relative to GDP and restrictions on foreign ownership. The efficiency of settlement systems, the liquidity and maturity of the market, the total market capitalisation and the scope for corporate governance efforts are also of relevance to the classification.

The FTSE index series encompass 48 countries, and the stock markets in 24 of these countries are classified as developed (with one of these being Norway). FTSE is upgrading, with effect from the summer of 2008, the stock market in Israel to the developed market group. Five of the countries are categorised as advanced emerging markets. The stock markets in Hungary and Poland will be included in this group as from the summer of 2008. The remaining 16 markets belong to the secondary emerging market group.

The criteria adopted by FTSE for the inclusion of countries in its index universe will, when based on such criteria, contribute to objectivity, consistency and predictability. The country universe for the benchmark portfolio for equities of the Government Pension Fund – Global shall comprise the same countries that are included in the FTSE index universe. The Ministry intends, based on the recommendations of Norges Bank, the Strategy Council, the Council on Ethics and its own analyses, to expand the benchmark portfolio for equities through the inclusion of all the advanced and secondary emerging stock markets, as defined by FTSE at any given time, in the benchmark index of the Fund. This implies that all the 16 countries that are currently included in the secondary emerging market group will be included in the benchmark portfolio of the Fund. Emerging markets will then be representing a total of 10 pct. of the benchmark portfolio for equities. This change is expected to contribute to improving the trade-off between return and risk through an enhanced diversification of the risk associated with the Fund. At the same time, the expansion will contribute to the benchmark portfolio of the Fund becoming more representative as far as developments in the international stock markets are concerned. Such investments are discussed in more detail in Chapter 3.

The Ministry will embark on an evaluation of emerging bond markets at a later stage.

The limit on ownership stakes

The limit on ownership stakes stipulated in the Regulations relating to the management of the Government Pension Fund – Global imply that the investments cannot be concentrated in such a way that the Fund achieves an ownership stake in excess of 5 pct. of the voting shares of any given company. This limitation on the magnitude of ownership stakes reflects the wish of the Ministry to make it clear that the Fund is a financial investor.

The Government Pension Fund – Global has achieved a good diversification of risk through being invested in several thousand companies internationally, and its average ownership stake in the various regions is less than 1 pct. The somewhat higher limit on ownership stakes is primarily related to the need for providing Norges Bank with room for manoeuvre in its active management, aimed at generating returns in excess of the return on the benchmark portfolio stipulated by the Ministry of Finance. Even small differences in the rate of return may, because of the magnitude of the Fund, represent large amounts over time.

In the recent international debate concerning so-called Sovereign Wealth Funds, the well-defined role of the Fund as a financial investor has been a contributing factor to it having escaped significant negative attention or special initiatives that may threaten the financial interests of the Fund, cf. Section 1.6. Although the distinction between “strategic” and “financial” investors does not depend solely on their percentage ownership stake in a company, but has instead to do with the objective of the investor in making its investments and how the investor utilises, through its actions, the influence it wields, a limit on ownership stakes will in itself contribute to reinforcing the profile of the Fund as a financial investor.

The issue of determining a suitable limit on ownership stakes implies a trade-off between the concern for widespread confidence in the fact that the main objective of the Fund is to act as a financial investor and the costs incurred on the part of the Fund as the result of the ownership limit being too low, because such a low limit impairs performance. The Ministry has decided, based on a comprehensive assessment, and taking into consideration the continued strong growth in the assets of the Fund, the previously resolved changes to the investment guidelines for the Government Pension Fund – Global (i.e. the increase in the equity portion from 40 pct. to 60 pct., and the expansion of the benchmark portfolio of the Fund to include listed small-cap equities), as well as concern for the active management efforts of Norges Bank, to increase the limit on ownership stakes applicable to the equity investments of the Government Pension Fund from the current 5 pct. of the voting shares of listed companies to 10 pct.; see Chapter 3 for a more detailed discussion.

The Government Pension Fund – Global shall remain a financial investor. A limit on ownership stakes of 10 pct. in listed companies is still relatively low when compared to many other comparable funds.

Investments in pre-IPO companies

The equity investments of the Government Pension Fund – Global are currently limited to instruments listed in regulated and recognised market places. Norges Bank proposes, in a letter of 1 February 2008 to the Ministry of Finance, that one allows for investments in unlisted equities when the company has applied, or specifically plans to apply, for listing in a regulated and recognised market place. The letter is enclosed as Appendix 3 to this Report.

The intended change will not entail any material change in the level of risk associated with the overall investments of the Fund. Moreover, such a change will be based on an evaluation premised on the objectives defined for the evolvement of the investment strategy of the Fund, as discussed in more detail above.

The Ministry will now be evaluating the proposal to permit investments in the equities of companies planning a listing in a regulated and recognised market place. One may want to allow for such investments at some stage in 2008. It will in such case be appropriate to report on this as part of the regular reporting to the Storting in the National Budget for 2009 or in the annual Report on the management of the Government Pension Fund in the spring of 2009.

1.4 Ethics and the exercise of ownership rights

1.4.1 Ethical concerns in the management of the Government Pension Fund

Ethical obligations

The Government Pension Fund is owned by the Norwegian people and coming generations of Norwegians. The prosperity experienced by current generations creates obligations. The capital of the Government Pension Fund – Global originates from the oil and gas revenues of the State. The oil and gas reserves are finite. Since these resources are non-renewable, it would not be fair for the wealth to only benefit those few generations that happen to experience the extraction thereof. The wealth needs to be safeguarded for posterity. It will therefore be an important ethical responsibility to ensure that the owners of the Fund achieve a favourable return on the wealth over time. A favourable return on the Fund over time represents an important contribution to safeguarding the welfare state for the future. As an investor one also share responsibility for how the companies in which the Fund invest are conducting themselves, for what they are producing and for how they are treating their environment. The Government deems it highly important to assume such social responsibility in the management of the Government Pension Fund. This will form an important premise for the evaluation of the ethical guidelines for the Government Pension Fund – Global, which will be carried out this year.

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

The objective of the evaluation of the ethical guidelines for the Government Pension Fund – Global is to ensure that the guidelines have worked as intended, to ensure broad political support for the further development of the guidelines, as well as to strengthen the ethical profile of the Fund. Many aspects of the present system work well. A number of elements and principles should be preserved; a high degree of openness and reporting, a high quality of the decision-making process leading up to the resolutions passed, a focus on some selected areas of the active ownership effort, as well as the safeguarding of credibility and seriousness in all efforts pursued.

A main challenge is the future effort to integrate ethical and financial concerns in the management process, in order that these concerns may reinforce, and not counteract, each other. If this effort is to have an impact on other investors as well, it will both have to be based on a solid theoretical foundation and be implemented in a practicable manner.

On 16-17 January 2008, the Ministry of Finance, together with Norges Bank and the Council on Ethics, hosted an international conference in Oslo on the integration of ethical concerns in asset management, which marked the commencement of the process relating to the evaluation of the ethical guidelines. The conference shed light on a number of the issues and challenges that it would be opportune for the evaluation process to address. These include, inter alia , the issue of what products shall result in automatic exclusion from the portfolio, the active ownership effort, and how this can best be reinforced and rendered visible, as well as how this can interact with the exclusion mechanism, positive selection of investment objects based on ethical criteria, and whether and to what extent the use of such a tool is suitable for the Government Pension Fund – Global. It is appropriate for the evaluation of the ethical guidelines for the Government Pension Fund – Global to also include an assessment of the need for additional harmonisation of the ethical guidelines for the Government Pension Fund – Norway. The Ministry intends to circulate a paper on the ethical guidelines in a public consultation process. The evaluation of, and any proposals for adjustments to, the ethical guidelines, will be submitted to the Storting in the spring of 2009; see Chapter 4 for a more detailed discussion.

1.4.2 Efforts relating to ethical guidelines

The division of responsibility in the efforts relating to the ethical guidelines for the Government Pension Fund – Global

Figure 1.9 shows the division of responsibility between the Ministry of Finance, Norges Bank and the Council on Ethics in their efforts relating to the ethical guidelines for the Government Pension Fund – Global. The Council on Ethics has no formal role as far as Folketrygdfondet is concerned. The Ministry of Finance would require a Nordic company held by both the Government Pension Fund – Norway and the Government Pension Fund – Global to be removed from the investment universe of both funds if the Ministry renders a decision for the exclusion of such company.

Source Ministry of Finance

The ownership efforts of Norges Bank

Norges Bank is responsible for exercising the ownership rights of the Government Pension Fund – Global. The overarching objective of the active ownership effort is to safeguard the financial interests of the Pension Fund. The ethical guidelines are premised on favourable returns over time being dependent on sustainable development, in the financial, ecologic and social sense.

Norges Bank accords a high priority to the ownership effort, and has during 2007 increased the resources devoted to this effort. The Bank has a special focus on certain selected areas of commitment where ethics are aligned with long-term financial returns. The areas of commitment are of relevance to investors in general and to the Fund’s portfolio in particular, and these areas are suitable for dialogue with companies or regulatory bodies, which increases the prospects for real results. The commitments concern good corporate management, the rights of children and protection of the environment. Good corporate management is important to ensure favourable returns over time for the Fund, but is also absolutely essential to ensure, inter alia , that the owners are heard on the issues that are of concern to them. It is appropriate for a socially conscious investor to be concerned with the rights of children and protection of the environment, including the climate challenge, and the scope for contributing to such concerns being addressed by the companies in which the Fund is invested. The objective of the effort relating to child labour is to safeguard the rights and health of children within the value chain of the companies in which the Fund is invested. As far as the environment is concerned, the Bank has a special focus on companies’ lobbying activities in relation to legislation that may entail significant reductions in greenhouse gas emissions.

Norges Bank had as per yearend 2007 established or continued contact with about 60 companies on issues relating to social matters, with a focus on child labour and the rights of children. The Bank has prepared a document titled “NBIM Investor Expectations on Children’s Rights”, in order to highlight the position and expectations of Norges Bank in relation to the this area. The document is based on the UN Convention on the Rights of the Child, as well as the ILO conventions on child labour.

Norges Bank has during 2007 analysed more than 100 companies in the portfolio to identify those companies that are the most active when it comes to contact with government authorities on climate issues. It has approached 20 companies and held meetings with 15 of these. All of these make significant contributions to the emission of greenhouse gases, and have been identified as key lobbyists. Norges Bank has in its dialogue with the companies emphasised technology development and adaptation to new emission and tax regimes, in addition to the positions of the companies in their contacts with government authorities. Norges Bank recently joined the Carbon Disclosure Project (CDP). CDP is an independent, non-profit organisation that seeks to gather and publish information on corporate emissions of greenhouse gases, and other information relating to corporate handling of greenhouse gas issues. By being associated with the project, Norges Bank encourages more openness in the effort to cut emissions.

The ownership efforts of Folketrygdfondet

Folketrygdfondet is responsible for exercising the ownership rights of the Government Pension Fund – Norway. The overarching objective of the ownership effort is to safeguard the financial interests of the Fund.

The Executive Board of Folketrygdfondet has laid down guidelines for the exercise of ownership rights on the part of the Government Pension Fund – Norway, pursuant to which the overarching objective of the ownership effort is to safeguard the financial interests of the Fund. To ensure that the portfolio contributes, to the maximum possible extent, to promoting long-term growth, Folketrygdfondet has defined ethical principles for its investment activities as an integrated part of the guidelines for Folketrygdfondet’s active ownership effort. Good corporate governance and corporate management shall promote the rights of owners and other stakeholders as against the companies, as well as ensure that the management mechanisms of the companies work appropriately.

In order to ensure the most objective and precise assessment attainable as to the ethical attitudes and actions of the companies, Folketrygdfondet gathers information based on a combination of open sources like annual reports, the media and the Internet, and information directly from the companies through a survey of all the Norwegian companies in which the Fund holds ownership interests. In the autumn of 2006, Folketrygdfondet distributed a questionnaire to 41 Norwegian companies in which the Government Pension Fund – Norway holds ownership interests, relating to the integration and handling of environmental and social concerns. The survey and the overall assessment of Folketrygdfondet as to the ethical aspects of corporate management and practise give a generally favourable impression of the attention levels, standards and practises on the part of the companies that responded to the questionnaire.

As from 2007, Folketrygdfondet publishes a separate Ownership Report, as part of its more comprehensive reporting in relation to the active ownership effort.

Exclusion of companies

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

• negative screening to identify companies producing weapons that violate fundamental humanitarian principles in their normal use; and

• ad hoc exclusion of individual companies if an investment entails an unacceptable risk of countributing to actions or omissions that are deemed grossly unethical.

The Council on Ethics for the Government Pension Fund – Global renders recommendations on screening and exclusion, but the decision as to whether a company shall be excluded lies with the Ministry of Finance. The Ministry of Finance bases its decision on the Council’s assessment, but will also attach weight to Norges Bank’s views as to whether the Bank may, through its ownership effort, reduce the risk of complicity in grossly unethical conduct.

At present, 27 companies have been excluded from the investment universe of the Fund. 20 of the companies have been excluded because they contribute to the production of inhumane types of weapons. The remaining 7 companies are excluded to avoid an unacceptable risk that the Fund will contribute to serious or systematic human rights violations and severe environmental damage.

Issues relating to investments in Burma (Myanmar)

The Council on Ethics and Norges Bank have, in view of the deteriorating situation in Burma, taken special notice of on companies engaged in activities there. The Ministry of Finance received a letter from the Council on Ethics on 11 October 2007, in which the Council explains its assessment of the risk that the Fund may be deemed to contribute to gross or systematic violations of the human rights through its investments in companies engaged in activities in Burma. The Council on Ethics has announced possible recommendations for the exclusion of companies that form contracts for the construction of major infrastructure projects in the country. There is every reason to believe that such construction projects will entail an unacceptable risk of future contribution in human rights violations. Norges Bank has in 2007 contacted 10 companies in the portfolio to query their activities in the country. These are companies which may run a risk of contributing in human rights violations or expose themselves to other types of risk. Norges Bank is aiming for a dialogue with these companies to ensure that it has the best available information on the situation.

In the spring of 2007, the Government decided, against the background of the measures adopted by the EU and other countries against Burma, to amend the guidelines of the Fund 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. This decision supplements the arrangement for the exclusion of equities and bonds issued by specific companies. In November 2007, Norway joined expanded international measures affecting, inter alia , certain types of investments in Burma. These include a prohibition against the funding of, or new acquisitions or expansions of capital interests in, listed Burmese state-owned enterprises and a prohibition against the funding of, or investments or participation in, listed Burmese enterprises that are engaged in the extraction of timber, metals, minerals and gemstones. The prohibitions affect in excess of 1,200 Burmese enterprises. The Government Pension Fund – Global does not have, nor shall it have in future, any holdings in any of these companies.

The Government intends for the Fund to refrain from investing in companies that sell weapons and weapons technology to regimes that are included in the list of countries in whose government bonds the Government Pension Fund – Global is excluded from investing. This means that the Fund shall refrain from investing in companies that sell weapons to the Burmese regime. A preliminary review indicates that there are currently no such companies in the portfolio of the Fund. The Council on Ethics for the Fund will monitor the companies in the portfolio with a view to establishing whether the Fund may in future run the risk of holding such investments and, if applicable, render a recommendation to the Ministry of Finance for the exclusion of the relevant companies.

1.5 Development and supervision of the management framework

1.5.1 Risk-based supervision of Norges Bank’s management of the Government Pension Fund – Global

The capital of the Government Pension Fund is growing rapidly. At the same time, the investment strategy of the Fund is undergoing continuous development. This is taking place alongside major changes to the supervision of risk management in financial institutions as a result of new rules both in Europe (EU Directive) and globally (Basel II). The Ministry deems it important to ensure that the framework for the management of the Government Pension Fund is adapted to these developments on an ongoing basis.

The risk and return profile (ex ante) of the Pension Fund is largely determined by the Ministry’s investment guidelines. Norges Bank’s active management has also contributed significantly to the overall return on the Fund, but the risk assumed in active management has only to a limited degree increased the overall market risk of the Fund beyond the level implied by the benchmark portfolio. The Ministry has defined an upper limit for the risk permitted in active management. The risk limit has been defined at fund level, and the Ministry has not stipulated specific risk limits for the various sub-portfolios. The optimal allocation of the risk budget between the individual strategies and mandates is a key value driver in Norges Bank’s active management.

The Ministry of Finance resolved to expand the investment universe of the Government Pension Fund – Global with effect from 1 January 2006, cf. the discussion in the National Budget for 2006. The expansion implies more degrees of freedom for Norges Bank in its active management. An integral part of the expansion of the investment universe was the imposition of more stringent requirements on Norges Bank in relation to risk management, valuation, performance measurement and reporting. The Ministry’s requirements as to the control of risk (i.e. market, counterparty and operational risk) are based on overarching principles to the effect that Norges Bank should adhere to “best market practise” and “internationally recognised standards”.

The Ministry announced, in connection with the expansion of the investment universe, that it would introduce risk-based monitoring of Norges Bank’s asset management. In the National Budget for 2006 it is stated, inter alia , that:

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

The first due diligence project on the basis of the new requirements in the framework was implemented over the period 2006-2007. Following prior competitive tendering, the Ministry of Finance chose an international team from Ernst & Young LLP (London/Zurich/New York) to review the risk management and control procedures of Norges Bank.

The characteristics of the Pension Fund, relating to, inter alia , the fact that the Fund is an instrument for general State savings and the emphasis on broad-based political consensus as to its investment strategy, implies that the Government Pension Fund – Global differs from other large funds when it comes to the inflow of capital and the organisation of the management thereof. These differences mean that it may, generally speaking, be difficult to define a relevant reference group for the Fund.

The Ministry deems it appropriate, against the background of the degrees of freedom granted to Norges Bank in its active management and the Bank’s extensive use of international asset managers, to adopt best practice amongst large international asset managers and investment banks as a basis for the operationalisation of risk management and control requirements in the framework. This has therefore been adopted by Ernst & Young for purposes of defining an appropriate frame of reference for the evaluation of the risk management and control procedures used by Norges Bank. The report from Ernst & Young describes how risk management is organised on the part of leading financial institutions internationally, what are the main areas involved, as well as the principles for best practise within each of the main areas. This is discussed in more detail in Chapter 5.

Ernst & Young points out that Norges Bank has been charged with a highly complex task. The Bank has been instructed to develop a professional management organisation for a fund that is growing rapidly, whose investment universe is been gradually expanded, and with ever more sophisticated strategies being deployed in its operational management to achieve excess returns. The report notes that Norges Bank has delivered consistently good financial performance within the risk limit stipulated by the Ministry.

Since the purpose of the Ministry’s comparison of Norges Bank’s risk management with best market practice amongst financial institutions internationally was, inter alia, to identify areas of operational management that might deviate from best practise, the recommendations in the report are primarily focused on areas offering a potential for improvement. The recommendations in the report address five areas: I) governance; II) operational risk; III) market risk, IV) credit risk and V) valuation and performance measurement, cf. Chapter 5.

It follows from the report from Ernst & Young and the comments of Norges Bank in respect thereof, that Norges Bank has over the period 2006-2008 implemented, or is in the process of implementing, a number of projects to evolve the Bank’s risk management:

• the establishment of an Audit Committee for the Executive Board;

• the establishment of a separate internal audit department;

• strengthening of external auditing through cooperation with the firm Deloitte;

• creation of the executive positions of Chief Financial Officer and Chief Risk Officer;

• significant reinforcement of the independent risk management function RPA (Risk, Performance and Accounting); and

• new framework for operational risk, and projects for the implementation of new systems for counterparty risk and for the pricing and verification of positions independently of those who make investment decisions.

Norges Bank agrees with the vast majority of the recommendations from Ernst & Young. The Ministry has nevertheless noted that Norges Bank does not subscribe to Ernst & Young’s comment as to whether risk management has been sufficiently independent in relation to the business areas for equity and fixed-income management. As of 1 March 2008, Norges Banks asset management department (NBIM, Norges Bank Investment Management) has been reorganised, and a separate control and compliance unit directly under the head of NBIM has been established. The Ministry bases its assessment on the fact that the requirement for risk management independence therefore under any circumstance will be met through the new structure.

Norges Bank agrees that the frame of reference adopted by Ernst & Young forms a good basis for the further operationalisation of the provisions included in the framework. At the same time, the Bank points out that the principles have to be adapted to the special governance model for Norges Bank and the management of the Fund as laid down by the Central Bank Act and the Act relating to the Government Pension Fund, with appurtenant regulations and supplementary provisions. The fact that Ernst & Young has paid little heed to the Fund being managed by the Ministry of Finance and its operational management being carried out by a central bank, is caused by the Ministry emphasising, when formulating the assignment, that Ernst & Young should regard Norges Bank as a regular asset manager governed by an ordinary regulatory framework for asset management activities that are subject to mandatory supervision as practised by the Financial Services Authority (FSA) in the UK. The purpose of such formulation of the assignment was to highlight any areas in which Norges Bank’s asset management operation might deviate from the requirements normally imposed on private asset managers. To the extent that Ernst & Young’s principles for risk management on the part of private financial firms are not compatible with the current legislation governing the Pension Fund – Global and the central bank, the Ministry will examine whether adaptations should be made to the risk management principles or to the legislation.

The Ministry is of the view that the strong growth in the assets of the Fund, the increased complexity of the management of the Government Pension Fund – Global and the concern for good management control over central bank duties make it necessary to evolve the management and control structure of the Bank. The establishment of a separate internal audit department and the cooperation with the firm of auditors Deloitte concerning the external auditing of the Bank’s management of the Government Pension Fund – Global have contributed to the strengthening of the Bank’s control and monitoring arrangements. These measures have been implemented within the framework defined by the present Central Bank Act. The Ministry of Finance deems it appropriate to explore potential amendments to the accounting and auditing provisions of the Central Bank Act, thus facilitating the further strengthening of the control and monitoring arrangements. One intends to circulate the following proposed amendments to the Central Bank Act for comments:

• Replace the arrangement for a designated central bank audit department by an arrangement whereby the Supervisory Council appoints an external auditor for Norges Bank.

• Authorise to lay down regulations on what accounting principles Norges Bank should observe.

• Lay down rules on the scope of the audit and the contents of the auditors’ report or authorise the Ministry to lay down regulations thereon (at present, the Supervisory Council stipulates an audit code for the Bank).

One should in this context consider whether the auditors should, in addition to auditing of the accounts, be given a so-called certification assignment within certain areas, for example in relation to the assessment of systems for internal control.

The Ministry aims to submit a proposal to the Storting on amendments to the Central Bank Act in the autumn. Reference is made to Chapter 5 for a more detailed description.

1.5.2 New framework for the management of the Government Pension Fund – Norway

Folketrygdfondet was created as a government fund in 1967. Upon its establishment, no clear distinction was made between Folketrygdfondet as the name of the asset pool and Folketrygdfondet as the manager of such asset pool. Folketrygdfondet was established as a company by special statute on 1 January 2008, cf. the Storting’s deliberation of Proposition No. 49 (2006–2007) to the Odelsting; On the Act relating to Folketrygdfondet. This legislative amendment implies that the formal framework for Folketrygdfondet’s management of the Government Pension Fund – Norway has now been brought in line with the developed practise, with Folketrygdfondet having acquired, through a separate Act, the status of an independent legal entity.

The main principles in the former organisation of Folketrygdfondet are continued in the new Act relating to Folketrygdfondet, and no changes are intended in the activities of Folketrygdfondet or in the management of the Government Pension Fund – Norway. The new framework represents a tidying-up of the regulatory framework, which will at the same time contribute to the distinction between the asset pool designated as the Government Pension Fund – Norway and Folketrygdfondet as the entity managing such asset pool being rendered visible. The formalisation of the framework also implies a clarification of the distribution of responsibility between the Ministry and the Board of Directors of Folketrygdfondet. The Ministry stipulates general investment limits, whilst the Board of Directors of Folketrygdfondet is responsible for the operational management of the Government Pension Fund – Norway.

In the autumn of 2007, the Ministry of Finance was working on the implementation of the changes to the framework for Folketrygdfondet required under the new Act relating to Folketrygdfondet. The implementation of these changes is described in more detail in Box 1.3. Chapter 5.8 to this Report contains a more detailed description of the implications of the new framework in terms of new requirements as to, inter alia , risk management and reporting, and the handling thereof in the context of the Ministry’s supervision of the operational management effort.

1.6 Sovereign Wealth Funds

So-called Sovereign Wealth Funds (SWFs) can be characterised as government investment funds holding assets in foreign currency, with the operational management being carried out separately from official foreign exchange reserves. SWFs include funds from, inter alia , China, Russia, the Middle East and Norway. Such funds often seek to achieve a higher return on their investments by investing in other asset classes than those commonly used in the traditional management of ordinary foreign exchange reserves.

A number of Sovereign Wealth Funds have be established on the basis of revenues from the extraction of natural resources, as is the case with the Government Pension Fund – Global, whilst other funds may reflect the accumulation of foreign currency on the part of the State as the result of exchange rate policy. Uncertain estimates show that such funds hold aggregate assets of NOK 15 – 20,000 billion in total, with the Government Pension Fund – Global being one of the largest.

Sovereign Wealth Funds have recently being drawing mounting international attention. Such attention has been growing in line with the fact that certain of the funds have become relatively large, whilst the outlook ahead suggests considerable additional growth. In addition, there is the fact that some of the funds have carried out large individual transactions that have attracted attention internationally. Several financial institutions that have been hit hard by the volatility that has characterised the international financial markets since the summer of 2007 have received major capital injections from Sovereign Wealth Funds in Singapore, the Middle East and China.

Some Western countries, like the US and Germany, have expressed a certain scepticism about the investment activities of government funds and companies dominated by governmental interests. These concerns have partly to do with the possibility that the funds may be an instrument for the promotion of national interests in the markets of other countries, by way of the investments of the funds being determined by political rather than commercial objectives. Particular concern has in this context arisen in relation to the acquisition of large, strategic ownership stakes within, inter alia, infrastructure and energy supplies. Concern that certain funds are motivated by non-commercial objectives is further reinforced by the fact that, generally speaking, many of the funds disclose little information about their investment activities.

Another aspect that has been emphasised in the debate on Sovereign Wealth Funds is the potential for negative repercussions in international financial markets as the result of the funds’ size and limited openness, as the fear of unexpected, major changes to the portfolios of funds may lead to market turmoil. Lack of transparency may in this context reinforce investor uncertainty, and result in more pronounced market fluctuations.

The Government Pension Fund – Global is in this context often referred to in positive terms, and cited as a standard for other funds. Key factors in this respect are a high degree of openness, the Fund’s role as a financial investor holding non-strategic ownership stakes, an objective focused on maximizing the financial return on the Fund, a transparent and predictable set of ethical guide­lines premised on universal values, and clear lines of responsibility between political authorities and operational management.

There are large differences between the various government-controlled investment funds, in terms of their investment strategies, sizes and attitudes to openness about their operational management. A number of the funds are relatively restrictive when it comes to disclosing information about their investments, which has resulted in demands for the regulation of, and restrictions on, foreign government ownership. Protectionist attitudes have been conspicuous in the international debate, and have raised concerns that individual countries may go too far in the direction of restricting foreign government investments. The IMF and the OECD have been encouraged, in this context, to develop voluntary guidelines for best practise for government funds and recipient countries, respectively.

Increased openness about the investment activities has been emphasised by several countries as important in order to limit the danger of “financial protectionism”. It has furthermore been suggested that the Sovereign Wealth Funds should waive the right to exercise ownership rights in the companies in which they invest, although this may in principle impair the important effort to hold corporate management accountable.

It is emphasised in the debate that Sovereign Wealth Funds with considerable assets under management represent a positive contribution to international financial markets. Typical shared characteristics include long investment horizons, low or no leverage, and the absence of short-term liquidity requirements. This implies that such funds can exhibit high risk tolerance and a good ability to handle short-term market fluctuations. At times when the financial markets are strongly influenced by short-term investors, government funds can therefore have a stabilising effect and contribute to improved liquidity, including in situations characterised by financial disturbances.

The international debate on Sovereign Wealth Funds places a strong emphasis on a clear separation of roles between the owner (represented by political authorities) and the asset manager, and openness as to operational management. The management of the Government Pension Fund – Global emphasises professionalism and a high degree of openness, with the objective of generating high returns at a moderate level of risk. Openness is highlighted as a tool for building confidence in its asset management, both domestically and internationally. Moreover, openness about the management of large funds is considered to make a contribution to the stabilisation of global financial markets. The management of the Government Pension Fund – Global aims for best practise internationally, and the principles underpinning its ownership efforts are based on international standards like the UN Global Compact and the OECD guidelines on corporate governance and multinational companies.

Norway participates actively in the international debate on Sovereign Wealth Funds, and supports the efforts of the IMF and the OECD in establishing of best practise guidelines for both government funds and the countries receiving the investments. There is also an effort to promote Norway’s views in the debate vis-à-vis relevant countries. It is emphasised, in this context, that well-functioning international financial markets are in everybody’s interest, and that the equal treatment of investors, both private and public, is a fundamental principle in modern financial markets. The Government is of the view that the imposition of restrictions on investments from government funds, on top of those applicable to investors in general, is unwarranted, with the exception of those motivated by strictly limited national security considerations.