Pensions, profits and principles: towards a sustainable financial system

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Good afternoon ladies and gentlemen,

It is a great pleasure for me to be here in this historical building, the cradle of parliamentarianism. And I’m honoured to address such a learned audience representing such a wide range of stakeholders.

“Pensions, Profits and Principles: Towards a sustainable financial system” is the title for this lecture.

Today, as we look out on the global economic landscape, we see the impact of the financial crisis: Rising unemployment, shaken financial institutions, struggling national economies, and serious consequences for the World’s poorest.

But it could have been much worse. We have seen unprecedented and internationally co-ordinated policy actions. As Mr Dominique Strauss-Kahn said in Oslo last week, global economic cooperation has been vitally important. It has saved the world economy from a much deeper downturn.

The crisis has impacted on at least three levels: the macro-economic level; the regulatory level; and the corporate governance level. Political measures from national governments and from international institutions are above all the most important factor in counteracting negative effects and in ensuring greater financial stability.

The other more long term crisis, the climate change crisis, is and must be first and foremost the responsibility for governments. But that does not mean that other stakeholders have no role to play! Investors must be ready to contribute. We cannot just ask regulators or society at large to fix the problems. Investors hold a leverage that I believe we have an obligation to use. Still, there must be a division of tasks between governments/regulatory authorities and the business community, including investors.

Allow me, before going into the responsible investment issues, to briefly go through some of the measures that my government sees as necessary to combat the financial crisis:

The international financial crisis has revealed major failures in regulation and supervision in several countries, and clear weaknesses have been brought to light in financial institutions’ risk management. Insufficient regulation and even absence of regulation are important factors behind this crisis. Improved methods are needed to monitor financial stability.

We must ensure that the entire financial sector is covered by relevant regulation and that regulation between different segments of the market is mutually consistent (based on the principle of ‘same risk, same regulation’), and therefore avoid regulatory arbitrage.

The aim should also be to foster an efficient regulatory and supervisory system. A crucial element will be to dampen the financial system’s pro cyclical mechanisms, and to require higher quality of capital. More generally Norway strongly supports all work, including work in the EU, to get better regulation and supervision.

It is also important that action is taken against non-cooperative tax havens. This will be based on OECD’s list of countries that do not comply with the international standard for exchange of tax information. As the communiqué states: “The era of banking secrecy is over.”

There is now a global consensus on enhancing sound regulations and on increasing the transparency in the financial sector. This is one of the outcomes at the G20-meetings in London in April and Pittsburgh in September. The leaders clearly stated that confidence in the financial sector will not be restored until trust in the financial system is re-established. In addition, they committed themselves to ensuring strong domestic regulatory systems as well as increasing international cooperation. In Norway’s opinion, the G20 has laid the basis for increased cooperation towards an enhanced regulatory regime.

I wanted to mention this as an important backdrop to the initiatives that should come from the investor segment, and that hopefully might compliment or contribute to necessary regulatory drivers.

I will now move on to describing the Norwegian Pension Fund, its size and structure, how we are set up, how we view our responsibilities and what kind of tools we have at our disposal. Towards the end of the lecture I will raise some dilemmas that I believe are of concern to most investors.

Overview and background of the NGPF – Global

Oil and gas extraction in Norway
As I am sure you know, the Norwegian Economy has since the 1970’s been heavily influenced by the discovery of petroleum resources – oil and gas – in the seabed of the Norwegian territory.

As you can see from the figure, the production of crude oil has peaked, and estimates tell us that the total petroleum production will peak in the near future.

But oil and gas are exhaustible resources. Up until now, and for a few more years, production will continue to rise, but then it will fall off.

The petroleum sector in relation to the Norwegian economy
This figure shows some macroeconomic indicators for the petroleum sector.

The total government take in Norway is dominated by revenues from the petroleum sector.

PFG is among the largest (and fastest growing) funds in the world
We were at 2 500 billion NOK end of September 2009 = approximately 265 billion GBP. It is one of the world’s largest funds and the biggest in Europe. We are not really a pension fund in the sense of having liabilities towards pensioners – we are more of an endowment fund. Money is saved for future expenditure – like a savings account. Based on our knowledge of demography – we know that public pension expenditure will grow much faster over the next 50 years, than the past 50 years.

Responsible investment (RI) approach of the Norwegian Pension Fund
Moving on to the responsible investment practices, let me start by giving a brief overview of the main features of the Fund, the system we have had so far, our goals ahead – in light of a review we have just undertaken – and then continue with a description of our latest practices and initiatives.

What are the main features of the Fund?
The Norwegian Pension Fund has
- high risk-bearing capacity
- a very long investment horizon, and
- broad ownership in almost 8000 thousand companies worldwide.

In light of the Fund’s special characteristics, our thinking can be summarised as follows: To quote MoF’s report in April 2009 to Parliament: “By virtue of our long-term investments in a large number of the world’s companies, we have a responsibility for and an interest in promoting good corporate governance and safeguarding environmental and social concerns.”

We fit the description of a Universal Owner (UO) – UO hypothesis: owning a cross-section of the economy = share of the entire economy = self interest in reducing unsustainable corporate practices.

Example: When one business pollutes a river, another business further down the same river may face shortages of clean water. Owning both of those companies (as we most likely do) – the problem or the cost does not disappear, it comes back to us. It is then in our interest to clean up the pollution. When one business uses child labour and prevents children from going to school, another business may face a lack of skilled labour in the future.
 
Ethical guidelines apply to all Fund investments
We have had a set of ethical guidelines for the management of the Fund in place for almost 5 years. These guidelines are at the core of the Fund’s responsible investment practices. They apply to all investments through the Fund, not just parts of it. 

The tools that are mentioned on this slide, active ownership and exclusion of individual companies, have been part of the system from day one. Still, I think it is fair to say that the exclusion mechanism has been the most visible tool and may have received the most attention. Active ownership is a broad tool that can be used both to communicate with companies, sectors and whole markets (i.e. through dialogue with regulatory authorities). This is an important leg for us to stand on. Before, when we faced specific incidents in a specific company not living up to our ethical standards, we used to ask ourselves the same question as the British punk-rock band, The Clash: “Should I stay or should I go”. Now, we try to put more emphasis on how we can best influence companies and maybe whole sectors. I will come back to examples on how we have succeeded with this. I believe the next sentence in the Clash-song goes: “If I stay there will be trouble, if I go there will be double”…

Overarching goals
The fund shall be managed with a view to achieving the maximum possible return, at a moderate level of risk. This is an ethical obligation – solidarity with future generations.

The goal of financial return is closely linked to the wish to be a responsible investor. We believe that to secure financial return in the long run, we are dependent on sustainable development - broadly speaking - and on stable financial markets. In light of this, we believe it prudent to take into consideration good corporate governance, environmental and social factors to a greater extent as relevant factors in all aspects of the management of the Fund.

We will continue to expand our active ownership efforts. We will also continue to have a tool for exclusion of companies, in combination with a new watch-list mechanism. We will use exclusion as a last resort. When there is an unacceptable risk of contributing to unethical acts in the future through the Fund’s investments - and while there at the same time is no reason to believe that it is possible for us to change the company’s unethical behaviour.

We believe that we must take widely shared ethical values into account. In some cases, the concerns of ensuring long-term financial returns and taking widely shared values into account will coincide, but not always. For example, the Fund will not invest in companies producing weapons that violate fundamental humanitarian principles or tobacco, regardless of the effect this will have on returns. 

On a more strategic level, we are launching several initiatives.

Now, let me give a quick insight into the structure and the division of roles of the Fund.

Division of roles
Ministry of Finance (MoF) = principal – responsible for the framework
Norges Bank Investment Management (NBIM) = operational manager and responsible for exercising ownership rights on behalf of the Fund
Council on Ethics = recommends exclusion of companies based on certain criteria.

Responsible investment practices: looking ahead after the review of the ethical guidelines
We have taken on a broad perspective. ESG (environmental, social and governance) issues present regulatory, market, reputational, and operational risks and opportunities shareholders need to consider to fully understand the companies in which they invest." The point is not to establish an E (environmental), S (social) or G (governance) slant for a small fraction of the portfolio. We will define sustainable strategies that can hold water across the board.

This is a long-term strategy to securing sound financial returns.

A swipe of our main RI activities:

• taking active part in international activities with the aim of following and building best RI practice
• new investment programmes: environment and sustainability in emerging markets
• collaborative research project: effects of climate change on financial markets
• active ownership: good corporate governance, climate change, water scarcity and children’s rights
• exclusion mechanism and watch-list: grossly unethical activities 

Let us look at some of these initiatives in a little more detail:

First of all the new investment programmes:
The Ministry is in the process of establishing a new investment programme for the Fund that will focus on environmental investment opportunities, such as climate-friendly energy, improving energy efficiency, carbon capture and storage, water technology, and the management of waste and pollution.

We’ve set a frame of approx NOK 20 billion for this programme and a possible investment programme aimed at sustainable growth in emerging markets.

Let me now turn to the climate change and finance research project
In April this year, we set as an aim to initiate a broad study to assess how the challenges of climate change may affect the financial markets and how investors ought to act in the light of this. Not long after, we were able to team up with twelve other large funds worldwide to embark on such a study.

The project is coordinated by the consulting firm Mercer and assisted by the Grantham Research Institute on Climate Change and the Environment at London School of Economics. The Institute is chaired by Lord Nicholas Stern. Results from the research project will be published about a year from now. The participation of the Grantham Institute on Climate Change thus brings onboard the distinguished team of economists and climate experts working with Lord Stern. This ensures a high-level scientific approach to complex questions.          

We have started this project because – as a long-term, well diversified investor – we want to have a better grasp of the risk factors we face. We cannot rely only on average-scenario analyses. This has been proven not to give sufficient answers in the past

My next point concerns active ownership through Norges Bank Investment Management:
Ownership strategies – objective and priorities
NBIM has developed a three-pronged strategy where they look at:
- governance issues
- environmental issues, in particular climate change and water scarcity, and
- children’s rights.

On Corporate Governance, NBIM puts particular emphasis on achieving fair financial treatment of all shareholders and strives to exert influence over the people who have been chosen to run the company on behalf of the shareholders.

A few recent examples:
- VW: NBIM has in a recent letter to VW questioned whether individual supervisory board members have fulfilled their fiduciary duty to the company.
- 4 US companies: challenging companies to split their chairman and chief executive roles

We (the MoF) have asked Norges Bank to detail their expectations towards companies regarding transparency and reporting on payment flows. This may help counteract use of so-called tax havens to hide illegal actions such as corruption, money laundering and tax evasion etc.

Children’s rights
NBIM has detailed its expectations towards companies also in respect of children’s rights and child labour in particular. They have targeted companies for dialogue that operate in sectors and regions where there is a high risk of child labour. As from 2008, NBIM reports on the various sector’s compliance with the bank’s expectations in this area.

Example of successful engagement: NBIM has over a few years been in dialogue with several companies operating in the cotton and vegetable seed production industry in India. This has contributed to several leading global players within the plant science industry coming together and agreeing on a common standard to combat child labour within seed production (published June 2009).

On environmental issues:
NBIM has set out its expectations towards companies’ climate change management. This document was published at the end of August. The expectations relate to corporate performance in regard to effective climate change mitigation and adaptation. This may serve as a reference point for investors and as an indicator of best business practice.

NBIM has also developed a set of expectations – similar model – on water and water scarcity. Water is an important input/output factor in many industry sectors, water scarcity carries long-term risks with financial impact, many high-risk companies lack a comprehensive water policy. 

NBIM works along several tracks, not just company dialogue, but initiatives directed at regulatory authorities etc. NBIM supports initiatives such as:

• Carbon Disclosure project
• Renewed investor call on governments and climate negotiators to highlight investor needs to get long term policy signals and predictability regarding climate change mitigation.

Saving for a better future
Ethical investment/ responsible investment/sustainable investments: these are not new concepts. Yet, there has been tremendous development in this area over the last few years.

There are signs of mainstreaming at least in parts of the investment community. We seem to be moving towards greater integration of environmental, social and governance issues based on a broader and deeper perspective. However, the big challenge remains: how to make it concrete and convincing enough to actually be implemented over the long term.

Our own thinking can be seen as having moved from “not hurting our own ethical standard” to “how can we influence the behaviour of companies”. A socially responsible investor that has negative screening of the portfolio as the only tool, can protect his own moral standards (and avoid criticism!), but probably not change irresponsible actions from companies.

Is it fair to expect that all investors take on the same responsibility?
This is a very difficult question. It is both a matter of belief and role. The most important thing might be to take a closer look at your beliefs, coupled with the particular role that you have and then define what responsibility is reasonable to take on. 

Mainstreaming of responsible investment practices is very important. But we need to be aware that investment beliefs span from “the business of business is business” (as argued amongst others by the American economist Milton Friedman) – to the more idealistic “doing well by doing good”. 

I think the truth lies somewhere between these two opposites. The term “enlightened self-interest” might be closer to where we should start.
 
The UN Principles for Responsible Investment (PRI) initiative – supported both by the MoF and our managers ( NBIM and Folketrygdfondet) – is a strong platform. It allows a certain flexibility for each asset owner and asset manager, while at the same time helping to build best practice.

To end this lecture I would like to say that we are not perfect. We are breaking new ground. When someone criticizes us for not being logical and consistent, they are probably right - sometimes! But we thought: It is better to learn by doing than to not implement ethical guidelines until a perfect system is created.

The UN is using us as adviser on responsible investments in several contexts, other funds and investors are following our exclusions and many are willing to cooperate with us when we try to influence companies or markets. This makes us proud. But of course we know that our investment strategy does not fit all. We also know that there are many investors who have more knowledge than us on many RI issues. This is why it is so important to be transparent, learn from each other and to collaborate with the aim of building best practice in this area.

Sometimes people from the financial sector criticize us for disturbing the work for maximum possible return. On the other hand NGOs very often criticize us for not acting on issues that they are particularly concerned with. Getting critique from both ends makes us believe that we are on the right track.

Our vision is to really integrate ethical principles into the entire investment strategy to secure long-term profits. A world in good shape is the best base for blooming financial markets.

As a financial and responsible investor we need to be thorough in our research and analyses. It is our aim to convince a larger part of the investment community that they need to take sustainability and stability issues into account. The more investors we have on board, the larger the impact.