Norges Bank submitted the following letter to the Ministry of Finance on 16 March 1999
The need for applying special ethical criteria as a basis for the choice of investment strategy for the Government Petroleum Fund has been discussed on several occasions. In its letter of 22 April 1998, Norges Bank on a general basis discussed various ways of taking account of ethical factors in the management of the Petroleum Fund. Three different alternatives were discussed: (i) establishing a set of ethical criteria that are used to select those companies in which the Fund can invest, (ii) investing in unit trusts that have well documented ethical guidelines for their investment strategy and (iii) attempting to encourage companies to stress special ethical factors by using the voting rights provided by equities, but without limiting the Fund's investment universe. The submission focused exclusively on the effects of ethical guidelines on the operational management of the Fund. An important conclusion was that whereas the use of voting rights would have a limited impact on the management of the Fund, the exclusion of many companies from the Fund's investment universe might result in substantial costs and make it more complicated to engage in effective management with adequate control and performance measurement.
In the Revised National Budget for 1998, the Government discussed the possibility of introducing guidelines for the Petroleum Fund, with a stronger emphasis on the environment and human rights. The Government stated that such guidelines would have to satisfy the requirements concerning risk diversification, risk management and control and performance measurement of management. Clarity, consistency and practicability were also considered requirements if guidelines that emphasise the environment and human rights were adopted for the Fund. The Government concluded that so far it had not found ways of doing this that satisfy these requirements, but that it would continue its work to arrive at a solution whereby special environmental considerations are used as a basis for formulating the Fund's investment strategy (environmental guidelines). The Government also announced that it would consider expanding the list of countries in which the capital of the Petroleum Fund can be invested, partly because this could make a positive contribution to economic development in countries and thereby promote democracy and human rights.
In this submission, Norges Bank will discuss the consequences of introducing guidelines for the Petroleum Fund. In another submission, the Bank will look more closely at the requirements that must be met if new countries are to be included in the Fund's investment universe.
Norges Bank has two functions in relation to the management of the Petroleum Fund. First, the Bank is responsible for the operational management of the Fund. Furthermore, the Bank provides advice on how the Fund's investment strategy should be designed. If the Government decides to introduce environmental guidelines for the Petroleum Fund, this may result in changes in both the investment strategy and operational management. In this submission, we will examine how the investment strategy can be designed and how the operational management can be implemented if such guidelines are introduced for the Fund.
In the discussion below, particular emphasis is placed on the requirements set out by the Government for environmental guidelines with respect to control and performance measurement, risk diversification, clarity, practicability and consistency. Norges Bank is of the view that it is absolutely necessary to establish such requirements for these guidelines. However, as will be seen in the following, it is difficult to satisfy these requirements, partly because it is very difficult to obtain comparable environmental information on all the companies in which the Petroleum Fund can invest (around 20 000 companies in 21 different countries). Moreover, it is pointed out that environmental guidelines that limit the Petroleum Fund's investment opportunities might have a substantial impact on the Fund, partly because a tailored benchmark index for the Fund would have to be defined. This would increase the costs of management, and make it more difficult to evaluate Norges Bank's management. In addition, it would increase the Fund's risk because investments would have to be spread among a smaller number of equities. If it is decided to introduce environmental guidelines for the Petroleum Fund, it is also important to be aware of the practical problems associated with formulating clear and consistent rules. For example, environmental criteria will often require a considerable degree of discretionary assessments when selecting those companies that satisfy the criteria. Norges Bank does not possess the expertise for making such evaluations.
A key question is whether environmental guidelines for the Petroleum Fund will have positive effects on the global environment. In principle, such effects would be expected if the guidelines are relevant to the purpose and also entail that companies that do not satisfy the criteria must pay a higher price for raising equity capital than others. This would give companies an incentive to work more on environmental issues. Given the size and liquidity of international stock markets, however, it is very uncertain whether the introduction of environmental guidelines for the Petroleum Fund would have any effect. It is more likely that an effect will be seen if many investors use the same environmental criteria, but we do not know whether other investors will do so. Consequently, it is uncertain what effect a decision that limits the Petroleum Fund's investment options will have on the global environment.
In the final evaluation of environmental guidelines for the Fund, any positive environmental effects would have to be weighed against the effect on risk diversification, management costs, control and performance measurement of management. An assessment should also be made of whether there are other instruments that may be more effective for achieving the environmental objectives of the authorities. In this connection, it is also a question of whether it shall be taken into account that the public sector already has ownership interests in a large number of companies engaged in different types of business activities. It may, for example, appear reasonable to impose the same requirements on Norwegian enterprises that are owned by the state as for the Petroleum Fund's investments in foreign equities.
It is the Ministry of Finance that must assume responsibility for the work on environmental guidelines. This means, among other things, that the Ministry must define an investment universe and a benchmark portfolio for the Fund that are consistent with the environmental guidelines. A well defined investment universe and a precise benchmark portfolio are preconditions for being able to evaluate Norges Bank's management of the Fund.
It is important to avoid continuous changes in the guidelines for the Petroleum Fund, because the Fund is so large that even small changes in the guidelines might result in considerable transaction costs. In the view of Norges Bank, the need for stability and a long-term approach in the management of the Fund will also apply to environmental guidelines.
Environmental guidelines can be implemented in several ways. The guidelines can apply to a small portion of the Fund or the entire Fund, and the criteria may be used to select some companies or a large number of companies. The following discussion of principles applies irrespective of the solutions chosen, but the importance of the consequences that are discussed will naturally vary somewhat between the various alternatives.
In the following, we focus on the implications of environmental considerations for the Petroleum Fund's investment strategy and the operational management of the Fund. Most of the analyses and results that are presented, however, are generally valid even if it is found desirable to take other considerations of an ethical nature into account in the management of the Fund.
The current investment strategy
According to the Act of 22 June 1990 relating to the Government Petroleum Fund, the Ministry of Finance is responsible for the management of the Fund. Consequently, the Ministry is responsible for defining an objective for the management of the Fund and an investment strategy that is consistent with this objective. The Ministry of Finance has defined the Fund's objective as the highest possible financial return without excessive risk. In order to promote the objective of a high financial return, it has been decided to invest portions of the Fund's capital in equities. With regard to risk considerations, the Ministry has attached importance to a broad diversification of the Fund's investments. It was therefore decided to distribute the investments among 21 different countries and ensure that within each country investments were spread among a large number of equities and bonds.(1) As a result of this strategy, the Fund's capital is now invested in more than 2 000 equities throughout the world. This diversification of the Fund is also consistent with the objective that the Fund shall be a financial investor (cf [sections] 10 of the Regulation on the Management of the Government Petroleum Fund, 3 October 1997).
The Petroleum Fund's investment strategy is reflected in the benchmark portfolio that the Ministry of Finance has selected for the Fund. This portfolio has two important functions in the management of the Fund. In addition to reflecting the investment strategy, the benchmark portfolio shall also be used to assess management performance. It is therefore important that this portfolio is constructed on the basis of clear and objective criteria. The Petroleum Fund's benchmark portfolio is composed...