1 The measures of the Norwegian government aimed at the effective management of Government Pension Fund – Global during the world financial crisis. 20

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The measures of the Norwegian government aimed at the effective management of Government Pension Fund – Global

during the world financial crisis.

20 April 2009

Richard ScarboroughRoyal Norwegian Embassy, Baku

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Norwegian Ministry of Finance

Topics

The petroleum sector and the Norwegian economy

The Pension Fund and economic policy

Governance

Investment strategy

Fund performance, in particular for 2008

Corrective measures

Ethical guidelines

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-Total petroleum production in Norway, mill. Sm3 o.e.

0

50

100

150

200

250

300

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030

Crude oil Gas NGL (including condensate)

Source: Norwegian Petroleum Directorate

Oil and gas extraction in Norway

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The petroleum sector in relation to the Norwegian economy

Source: Statistics Norway, Ministry of Finance

25 % 38 % 24 % 51 %

The petroleum sector’s share of GDP

The petroleum sector’s share of state revenues

The petroleum sector’s share of total investments

The petroleum sector’s share of total exports

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Clarification 1: The Norwegian Government Pension Fund Global is a SWF, with the best of intentions for stakeholders and the financial market place

Clarification 2: The Norwegian Government Pension Fund is not really a pension fund, but a petroleum fund

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Common pitfalls in oil producing countries

1. Lack of fiscal discipline• Challenge: How to transform a windfall to a permanent income?• Overheating instead of sustained higher growth• Dutch disease

2. Bad investments• Large scale industry investments with high political prestige• Public infrastructure projects with vague/low economic return• Neglect of education

3. Loss of focus in structural policy• Main focus on how to grab a part of the oil revenues• Productivity growth in non-oil activity suffers • Labour supply falls

4. Poor governance• Resource wealth often associated with weak government institutions• Rent-seeking activities• Increased risk of corruption

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Manpower is our most important resourceNational wealth per capita in Norway. 2006

4 %8 %

3 %

85 %

Discounted petroleum rent

Capital stock

Financial assets

Discounted value of labour

Source: Ministry of Finance, NB08

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In the long run productivity is the key to welfare

Key findings in OECD’s Growth Study

• Stability-oriented macroeconomic policies (+)

• Flexible and competitive product markets (+)

• A high degree of exposure to foreign trade (+)

• Flexible labour markets (+)

• Education and training (+)

• High level of taxation (-)

• Spending on R&D (+)

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Different types of funds

• Savings fund: Aim to build up wealth for future generations Fixed inflows. Discretionary outflows.

• Stabilization fund: Aim to reduce impact of volatile revenues Inflows/outflows contingent on whether revenues “high/low”

BUT• Money is fungible. Government borrowing means fund can be

misleading (and lead to inefficient cash management)• Rigid rules on inflows and outflows may become inappropriate

• Financing fund: Aim for both saving and stabilization role Integrated with state budget. Net inflow equals overall fiscal

balance

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Return on fund investments

Fund Transfer to finance non-oil budget deficit

Revenues

Expenditures

State Budget

The Fund mechanism – integrated with fiscal policy

Fiscal policy guideline(over time spend real return of the fund,

estimated at 4%)

Petroleum revenues

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Why a “Pension Fund”? Strong increase in pension expenditure is a challenge for public finances

• Calls for a cautious fiscal policy over the next decades

• The Pension Fund has a dual purpose long term saving short- and medium term

stabilization

0

5

10

15

20

25

2006 2015 2024 2033 2042 2051 20600

5

10

15

20

25

Pensions

Expected real return of the Fund

Pension expenditure and expected real return on the Fund as share of mainland GDP

Source: Statistics Norway, Ministry of Finance

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Pension Fund - Global Governance Structure

Ministry of Finance

Regulations

Performance reports

Central Bank

(NBIM)

Norwegian Parliament

Pension Fund Act

Performance reports and strategic changes reported in National Budgets and National Accounts

Legislator

Principal

Manager

Management agreement

Office of the Auditor General

Norges Bank AuditAdvisors

Advisory / consultancy agreement

Founded on Act, regulations and separate contracts

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Asset management: Clear lines of responsibilities

• Ministry of Finance – “Owner” overall responsibility (separate asset management department) strategic asset allocation (benchmark + risk limits) monitoring and evaluating operational management ethical guidelines reports to Parliament international advisor on resource funds

• Central Bank – “Operational manager” separate entity within central bank (NBIM) implement investment strategy (benchmark) active management to achieve excess return risk control and reporting exercise the Fund’s ownership rights provide professional advice on investment strategy

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The Fund’s circumstances

• General accumulation of assets belonging to the people

• Finance minister responsible for the management and strategic asset allocation (risk & return choice)

• Strong risk bearing capacity very long investment horizon no leverage no claims for the immediate withdrawal of funds no direct link to liabilities

• Governance challenges – Decision making process (speed)

• Main risk: Political authorities lose faith in the strategy for managing the petroleum wealth

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Investment Strategy: Maximise returns

• Objective: Maximise international purchasing power, taking into account appropriate market risk appropriate operational (reputational) risk ethical guidelines principles of clear lines of responsibility (accountability),

professionalism and transparency

• Implementation: financial investor (avg. holding < 1%, max limit 10 %) passive indexation main contributor to risk active risk budget (max 1.5% tracking error) delegated to Norges

Bank

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Benchmark for the Pension Fund – Global

Equities 60 % Fixed Income 35 %

America and Africa

35 %

Asia and Oceania 15 %

America and Africa

35 %

Europe 60 %

Asia and Oceania

5 %

Equity index:

FTSE All-Cap Index, 46 countries Approx. 7700 equities

Fixed income index:

Barclay Capital’s Global Aggregate interest indices for 11 currencies. Approx. 7500 bonds

Strategic benchmark

Europe

50 %

Real estate 5 %

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The investment strategy of the Fund and peers

Source: Ministry of Finance and CEM Benchmarking Inc (2007).

Listed equities

Listed equities

Other Bonds

Bonds

BondsListed equities

Private Equity

Realestate

Realestate

0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 %

Other funds

Report to Storting 2008

Previously adopted

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Why equities?

• Diversification: Even the minimum risk portfolio has a (small) allocation to equities

• Long investment horizon• Equity risk premium• In order to harvest this risk premium, we must

tolerate fluctuations in return and fund value from year to year

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Large variations in equity returns since 1998

Real return in percent

Number of years

Annual real return in an equity portfolio similar to the Fund since 1900

Source: Ministry of Finance/Dimson, Marsh and Staunton

23 22 199221 1911 200620 1912 192519 1940 194118 1976 200417 1977 193816 1979 1923 199515 1944 1961 190814 1964 1980 190413 1969 1906 191512 1934 1978 190911 1907 1919 1960 1922 198910 1930 1965 1942 2005 1972

9 1948 1966 1939 1982 1968 20038 2001 1962 1901 1953 1955 19217 1947 1981 1950 1984 1936 1928 19856 2000 1994 1910 1971 1993 1986 19995 1929 1916 1902 1905 1997 1932 19514 2002 1990 1970 1945 1943 1991 1967 1933 19493 1920 1937 1918 1957 1900 1996 1935 1952 19582 1931 1946 1914 1913 1963 1924 1927 1926 19751 1974 1973 1917 1987 1903 1956 1998 1988 1983 1959 1954

-32 -31 to -24 -24 to -16 -16 to -8 -8 to -0 0 to 8 8 to 16 16 to 24 24 to 32 32 to 40 48

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Equities have significantly outperformed bonds in the long run

Source: Ministry of Finance/Dimson, Marsh and Staunton

Total return since 1900

0

1

10

100

1 000

10 000

1899 1908 1917 1926 1935 1944 1953 1962 1971 1980 1989 1998 2007

0

1

10

100

1000

10000

Equities Bonds

1. World w ar

Stock market crash 1929

2. World w ar

Oil price shock

Stock market crash 1987

"IT bubble" and 9.11

Financial crisis

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Our rebalancing strategy means that we buy in falling markets

Source: Norges Bank

-10

0

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20

30

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jan

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1998 1999 2000 2001 2002 2003 2004 2005 2006

Pu

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60

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120

140

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Pri

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, 97:

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Equities

Equity price

Average

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Norway’s SWF is large and still growing fast-The Fund’s market value 1996–2011. Billion USD, year end.

0

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

0

100

200

300

400

500

600

Source: Ministry of Finance, NB09

23


Cumulative return on the fund 1998-2007. NOK billion

Source: Norges Bank

24


• Annualised return rate

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2008 Results

• - 23,3 % net result, - 3,4 % net underperformance against reference portfolio

• Equity: - 40,70 % • Reference value: - 39,56• Adjustment for transaction costs: - 0,82 % net

contribution from management

• Bonds: -0,52 %• Reference value: 6,08 %• - 6,60 % net contribution from management

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2008 Results, Equity

• Reversal of recent trends (premiums for cyclical industries, commodities and emerging markets)

• 4 tools to increase yield relative to reference portfolio, all were in the red for 2008:

• Expanded indexation. Problem: rapid reduction of actors’ risk limits, illiquidity in the market

• Capital expansions: only 2 out of 6 contributed positively to the net value added of management

• Internal sector mandates. Problem: US and banking sector

• External mandates: focus on emerging markets

• Main contributors to negative result: expanded indexation and sector mandates.

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2008 Results, Bonds

• Low exposure to subprime MBS• More than 80 % of US bonds had AAA credit rating• Yet, general real estate crisis had severe impact• Increased exposure from credits on portfolio• Considerable exposure to European bank bonds• Other types of securities also affected

• General problem: considerable diversification, but limited risk reduction. Exposure to underlying, systemic risk. Positions vulnerable to rise in credit cost.

• Main remaining challenge: illiquidity in markets

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Operational corrective measures, bonds

• Acquiring internal management capability in all investment areas (including US MBS market)

• Reduction of number of operational mandates, in general and in particular against MBS

• No more credits on MBS portfolio, reducing risk exposure

• Interest swaps discontinued

• Future strategy:• Rebalance liquid parts of portfolio• Retain illiquid bonds until they mature. Yields are

good, but default risk.

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Operational corrective measures, equity

• Results of management within expectations, less need for correction

• Long term trend: more emphasis on specialised external managers in specific markets/sectors

• Low prices of shares: opportunity to buy!• Reinforced by losses reducing relative share of

equity

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Risk reduction and surveillance

• Exceeding risk limit in October 2008• Halting or delaying planned investment changes

that contribute to increased expected relative volatility (increased risk)

• Supplementing quantitative risk models with pragmatic and discretionary methods:

• Concentration analyses• Factor exposure• Liquidity exposure• Surveying counterpart risk

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Conclusions

• Main strategy remains unchanged

• More emphasis on exploiting Fund’s advantages in size and investment horizon

• Prime examples: retaining positions in illiquid papers, expanding portfolio in a low-price environment

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Ethical guidelines and corporate governance

Two main ethical obligations:

1) The obligation to ensure sound financial returns so that future generations will benefit from the petroleum wealth.

2) The obligation to respect fundamental rights for those who are affected by the companies in which the Fund invests. exercise ownership rights – corporate

governance avoid investments in companies whose

practices constitute an unacceptable risk that the Fund is or will be complicit in grossly unethical activities

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Exercise of ownership rights

• The overall objective of the ownership effort is to safeguard the (long-term) financial interests of the Pension Fund

• The principles governing the exercise of ownership rights: the UN Global Compact the OECD Principles of Corporate Governance and the OECD principles

for Multinational Enterprises

• Priority areas corporate governance children’s rights environment

• Tools for exercising ownership rights voting contact with portfolio companies contact with regulatory authorities contact and collaboration with other investors

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Exclusion of companies based on Negative screening and Ad-hoc assessment

• Negative screening (products) weapons that through their normal use may violate

fundamental humanitarian principles (e.g. cluster munitions and nuclear arms)

• Ad-hoc exclusion (production methods and conduct) serious violations of fundamental ethical norms

(human rights incl. child labour, corruption, severe environmental damage)

forward-looking assessment

• The Ministry of Finance has excluded 29 companiesas of October 2008, based upon recommendations by the Council on Ethics

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SWF- Elements of transparency

• Governance structure Lines of responsibility Guidelines and reporting Risk management systems Supervision Audit

• Investment objectives Purpose Investment horizon Rules governing allocations to and withdrawals

from the fund• Investment strategy and implementation

Fund size Risk and return Asset composition Individual holdings Rebalancing strategy Phasing-in of new investments

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Links

Ministry of Finance• www.government.no/en/dep/fin

Government Pension Fund• www.government.no/gpf

Norges Bank Investment Management• www.nbim.no

Council on Ethics• www.etikkradet.no

Contact details

Norwegian Ministry of FinanceAsset Management DepartmentP.O.Box 8008 DepNO-0030 Oslo, Norway

Visiting Address: Akersg. 40Telephone: +47 22 24 41 63Fax: +47 22 24 95 91E-mail: [email protected]

Documents

1 The measures of the Norwegian government aimed at the effective management of Government Pension Fund – Global during the world financial crisis. 20