European Affairs

Its purpose is to invest, with a view to maximize profits, the large revenue to the state generated by the Norwegian petroleum sector. The fund was established by law in 1990 as a tool to support prudent management of petroleum revenues. It has the twofold purpose of smoothing out the spending of volatile oil revenues and at the same time acting as a long-term savings vehicle to benefit future generations. Of course, oil prices have risen dramatically since then, so the fund’s size and outlook has changed. But the main principles guiding its operations have stayed the same.

Its workings were explained in a talk at The European Institute – part of a seminar on the “Growing Role of Sovereign Funds in Global Capital Markets” held on April 10, 2008. Below is Mr. Bergo’s presentation.

Today, I am slightly in the position of a man wearing two hats. Until recently, I was an official of the Central Bank of Norway, which is the manager of the Norwegian Sovereign Wealth Fund. Last week I took up a position at the International Monetary Fund, and the IMF has been charged with developing a set of best practices and guidelines for sovereign wealth funds. I will confine myself to explaining the Norwegian model, drawing on presentations that I and colleagues at the Ministry of Finance have made recently. I will not touch on possible future IMF guidelines or best practices.

The Norwegian sovereign wealth fund used to be called the “Government Petroleum Fund,” but now it is named the “Government Pension Fund – Global.” The only thing that has changed is the name: there has been no change in its objectives or in the way the fund is run. There is no direct link to the payment of pensions and the fund has no explicit liability side. It is a large fund – close to US $400 billion, which corresponds to 100 percent of Norwegian GDP. It is expected to grow substantially, perhaps to as much as 200 or 300 percent of GDP.
An early question for us was: How do you persuade the electorate in a democratic, open society like Norway to agree to save such a large proportion of GDP in a sovereign wealth fund? You have to give good answers to a lot of questions: What is the objective of the fund? Why is it there? What are the rules for accumulation of capital in the fund? And, very importantly, what are the rules for spending resources from the fund? What is guiding the investment and management of the fund – the investment strategy, the considerations regarding the risk-and-return trade-off? What is it you aim for? And then what are the actual results that are really achieved over time?

And, of course, the electorate wants to know the fund’s remuneration principles and its internal ethical guidelines. In other words, are we getting what we pay for or are some fat cats there taking most of the profits? Along with the ethical investment guidelines and the fund’s corporate governance, the people will want to know who makes the decisions. What is the governance structure of the fund and the division of responsibility among the various bodies involved in its management? Last but not least, how can we check that the fund adheres to the principles and rules that are drawn up?

Clear answers to these questions are very important for generating public support for the fund and also, I would say, for its smooth operation. The objectives of the Norwegian fund are two fold: It is a savings fund – a vehicle for transforming natural wealth into financial wealth to benefit future generations. And it also serves to protect the nation’s economy from volatile oil prices and variation in extraction rates in its oilfields.

In other words, such a fund helps make it possible to separate consumption of oil revenues from oil extraction. With the fund, we can separate spending of petroleum revenues from the current revenue stream and thus extract petroleum at a higher rate than what would be advisable if all the proceeds where to be allowed into the domestic economy on a continuous basis. So the fund helps stabilize the oil market. In Norway’s case, if there had not been such a fund, our oil extraction rate would probably have been lower.

Here are some of the answers to the earlier questions. The rules for accumulation are set in law: All cash flow to the government from activities in the petroleum sector (taxes, income from the state’s direct ownership of petroleum resources, dividends from the part-owned Statoil/Hydro oil company as well as the return on the fund’s capital and the net results of financial transactions associated with petroleum activities), shall accrue to the fund. This is specified in detail in the Pension Fund Act, and it is easy then to check that it is being adhered to.
Most important is the issue of spending the resources from the fund. Withdrawals may only be used to cover budget deficits: there is no “subversive second budget” here: The legislation effectively prohibits use of resources from the fund for purposes that are not considered important enough to be part of the ordinary budget, which is approved by parliament. This is designed to keep hands off the cookie jar.

This is how it works: All the petroleum revenue is channeled into the fund, as is all the return on the fund’s investments. Then it is possible to finance the budget deficit from the fund. And there is a fiscal rule saying that over time you should only spend the real return on the fund, which is estimated to be four percent – so four percent of the fund can be transferred to the state budget annually. And since the fund is 100 percent of GDP at present, that means that four percent of GDP can be transferred to the state budget – meaning we can run a deficit of four percent of GDP.

The decision-making structure is fairly complicated, and I’ll just give you the highlights here. The parliament sets the broad framework, but also some details such as the accumulation rules. The principal, the Ministry of Finance, fills in details but regularly chooses to consult with parliament over changes and also to have a public debate. The principal and the manager (the Central Bank) have a management agreement, a pure business agreement, on how the fund should be run. There is extensive reporting and auditing, all publicly available.
A key principle governing the fund is that it should be a financial investor, with non-strategic holdings. Currently, the amount of equity the fund may own in a single company is limited to five percent, but there is a proposal to increase that to 10 percent as the fund grows. So far this limit has been an effective constraint in only some investments in small and medium-sized companies. The average ownership share is well below one percent and would probably stay below two or three percent, even if the fund grows as we now expect.

It is an explicit aim for the fund to maximize financial returns subject to modest risk limits. Here there is a clear division of responsibility between the owner and the manager. At the bank, we know what our role is. The Ministry of Finance decides on the strategic asset allocation, the benchmark portfolio, and the risk limits; it monitors and evaluates the operational management, sets the ethical guidelines, and reports to parliament. The Central Bank as the manager implements the investment strategy and is charged with undertaking active management, within given risk limits, to maximize returns.

It has been very important to the Central Bank that our mandate is clear and that we have full freedom within the mandate to make the investments we think will give the best returns, without any political interference. The benchmark portfolio for the Pension Fund Global is set by the political authorities and expresses the preferred risk-return trade-off of the owner of the fund, or rather the representatives of the ultimate owner, the Norwegian people. The Central Bank is measured against how well we perform relative to that benchmark, that is, to what extent we achieve excess returns.

The ultimate owners should be able to check if their representatives (the Ministry) and the manager (the Central Bank) do a good job. Then you have to have transparency. There is quarterly public reporting on the results, with press conferences and numerous speeches. And there are very comprehensive annual reports.
The Central Bank also reports whether there have been any breaches of the guidelines. For instance, if we have been outside the limits for risk exposure or if we have been above five percent ownership in a single company – which could happen since we employ a number of external managers in addition to managing investments ourselves – we report it. Fortunately, there have been no very serious breaches of guidelines. But openness goes further: At year’s end, we specify every investment the fund has. You can see how many shares we have in General Electric, how many shares we have in Toyota, how many we have in Volkswagen, and what we have invested in bonds issued by different sovereigns and private companies. You can see it all there, but that is only once a year.

There are also ethical guidelines that direct the fund’s investments. These guidelines were thoroughly discussed, both in parliament and in public, before they were adopted. Since this is a fund owned by the Norwegian people, there is a need to have ethical guidelines that a broad majority can agree to; it must be felt that there is a kind of overlapping consensus on these guidelines for it to work properly.

How can we check that the principles and rules governing the fund’s activities are adhered to? I have mentioned the reporting the Central Bank does to the Ministry and to the public. Furthermore, the Ministry of Finance has reporting requirements set by parliament.
So have the questions been satisfactorily answered? Well, at least the model has survived general elections and numerous changes of government. It has been in operation now for more than 10 years and still has the support of a large majority in parliament.

Transparency has been key here, I think. It also has a disciplinary effect on the fund managers. Their performance is being measured in public, and that certainly gives them an incentive to do a good job, and we think that this openness has not compromised the financial results of the fund. But that could be different for other sovereign wealth funds. We are operating as a financial investor with financial investments in highly liquid markets. The cost of transparency could be higher if you were a strategic investor in less liquid markets.

Let me close by reiterating the official Norwegian position in the debate on the sovereign wealth funds. We support the work of the IMF in drawing up best practices for sovereign wealth funds, and we support the OECD in establishing guidelines for recipient countries. We welcome the constructive approach of the European Commission. But the Norwegian authorities really see no cause for regulations that would restrict the present investment activities of the Norwegian fund or any regulation imposing restrictions on sovereign wealth funds over and above those applying to non-sovereign wealth fund investors.

Jarle Bergo is Alternate Executive Director for the Nordic/Baltic States at the International Monetary Fund (IMF). He was previously Deputy Governor of Norges Bank, where he served since 1969 in a variety of positions, including Senior Economist and Director.

This article was published in European Affairs: Volume number 9, Issue number 3 in the Fall of 2008.