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Consequences of introducing special ethical guidelines for the management of the Petroleum Fund

Submission to the Ministry of Finance on 22 April 1998

22 April 1998

1. Introduction

In November of last year the Norwegian government announced that it wanted guidelines for the Petroleum Fund with more emphasis on environmental and human rights issues. The press release reads: "In its forthcoming review the government must consider how the environment and human rights can be taken into account. During the spring the government will revert to the Storting on the matter of supplementing the guidelines for the investment of the capital in the Petroleum Fund". Norges Bank has been notified that in the revised National Budget 1998, the government will draft guidelines for the Petroleum Fund that take environmental and human rights issues into consideration.

The Management Agreement of 17 February 1998 between the Ministry of Finance and Norges Bank authorises procedures for amending the guidelines for the Petroleum Fund. Section 3.1 of this agreement reads: "Norges Bank shall have the opportunity to present its views before changes are made in regulations, decisions, or guidelines concerning the Fund’s management, and shall be notified in good time to enable any changes to be made in the portfolio". Against this background, Norges Bank discusses in this letter how guidelines with a stronger emphasis on the environment and human rights may affect the management of the Fund. The letter focuses on the consequences for the operational management of the Fund, given that this is Norges Bank’s area of responsibility. With such an emphasis, it has not been natural for Norges Bank to provide a general overview of the effects of introducing guidelines for the Petroleum Fund with a greater emphasis on the environment and human rights. For this reason, there has been no comprehensive discussion of the practical problems involved in drawing up an unambiguous, consistent set of rules. Nor has there been any discussion of the effect such guidelines will have on the objectives the political authorities are trying to attain with respect to the environment and human rights.

In the following, the expression "special ethical guidelines" is employed as a general term to cover guidelines which take account of the environment, human rights, or other issues of an ethical or social nature over and above what follows from national and international legislation on these issues, with which companies must comply. Studies by Norges Bank of how other managers implement ethical guidelines show that there are in principle three viable approaches to taking into account special factors of an ethical nature:

i) Establish a set of ethical criteria which are then used to determine which enterprises the Fund can invest in.

ii) Invest in unit trusts with well-documented ethical guidelines for their investment strategy.

iii) Endeavour to convince enterprises to attach importance to specific ethical issues by using the voting rights vested in their shares, but without placing restrictions on the Fund’s investment universe.

The consequences for the management of the Petroleum Fund depend, of course, on the underlying objectives of any specific ethical guidelines as well as on the actual formulation of these guidelines. Providing that the underlying policy considerations can be safeguarded, it is desirable that specific guidelines be formulated to permit cost-effective investment management with adequate control and performance measurement.

It is important that the guidelines for the Petroleum Fund are not changed too often, among other things because the Fund is so large that even small changes in the guidelines may lead to substantial transaction costs. In the view of Norges Bank, this need for stability and a long-term approach will also apply to any special ethical guidelines.

In Norges Bank’s opinion, new guidelines should not affect the clear division of responsibility established between the Ministry of Finance and Norges Bank on the management of the Petroleum Fund. Norges Bank assumes that it is the political authorities who must define the objectives of managing the Fund and an investment strategy which is consistent with these objectives. Pursuant to the Act relating to the Government Petroleum Fund of 22 June 1990, this responsibility has been delegated to the Ministry of Finance. Since ethical guidelines will depend on what objectives are desired for the Fund, it must be the responsibility of the Ministry of Finance to define such guidelines. The ministry must also assume responsibility for devising an investment strategy that is consistent with the ethical guidelines. Norges Bank’s role is to conduct the operational management in accordance with a clearly defined strategy. This is explained in greater depth below.


2 Distribution of responsibility between the Ministry of Finance and Norges Bank

The objective of the management of the Government Petroleum Fund has been to achieve the highest possible financial return (measured in foreign currency) given certain restrictions on risk taking. Taking this objective as its starting point, the Ministry of Finance has stipulated guidelines for the Fund and the benchmark portfolio for the Fund. The guidelines determine the Fund’s investment universe, by specifying the countries in which the Fund’s assets can be invested, and the types of securities that can be purchased in the individual country. The benchmark portfolio shows the investment of capital in the Fund within the investment universe that forms the starting point for the performance measurement. The return Norges Bank actually achieves will be compared with the return on the benchmark portfolio. This portfolio specifies the size of the portions that should be invested in the individual countries, and the distribution of securities invested in each country.

The Ministry of Finance also places a maximum limit on the permissible deviation from the benchmark portfolio, but within this limit it is Norges Bank’s responsibility to decide what types of deviation it wants, and how large they should be. Deviations from the benchmark portfolio may be motivated by the desire to obtain a higher return than the benchmark portfolio, or the desire for cost-effective management. These deviations are based exclusively on professional management assessments. The consequences of the deviations Norges Bank has made from the Fund's benchmark portfolio can be measured by comparing the return on the benchmark portfolio with the return on the Fund. This imposes a clear responsibility for performance on Norges Bank, and makes it possible for the Ministry and the general public to evaluate the Bank’s management. Transparency of performance is important for confidence in the management of the Petroleum Fund.

Inherent in this management model is a clear division of responsibility between the Ministry of Finance as owner and Norges Bank as manager. It is important that any ethical guidelines are not formulated in such a way that management deviates from this model. Since special ethical guidelines for the Petroleum Fund will be an expression of policy considerations and assessments, the formulation of such guidelines must be the responsibility of the political authorities. This means that the Ministry of Finance must define an investment universe and a benchmark portfolio for the Fund or, alternatively, well defined operational procedures, consistent with the ethical guidelines, for the Fund with respect to exercising the right to vote in companies it has stakes in. Responsibility for these ethical considerations cannot be left to Norges Bank. Norges Bank is not qualified to make evaluations of this nature. Moreover, deviations from the benchmark portfolio could then be due both to management-related factors (costs, return) and ethical priorities. Since it would not be possible to isolate the effects of the ethical priorities on the return on the Fund, nor would it be possible to assess the consequences of the management-related decisions made by Norges Bank.

In the management of the Petroleum Fund, it is therefore necessary to have both a precisely defined investment universe as a benchmark portfolio for the Fund, for Norges Bank to have an unambiguous responsibility for results. These issues will accordingly be prominent in the discussion concerning the possibility of introducing special ethical guidelines. In addition, emphasis will be placed on how such guidelines affect management costs, financial return and risk control. The various consequences for the management of the Petroleum Fund will be discussed in the context of each of the three possible means of incorporating ethical guidelines (selecting businesses according to ethical criteria, investing in unit trusts with ethical guidelines, and using voting rights).


3 Selection of enterprises according to ethical criteria

Selection of the enterprises to be included in the Petroleum Fund’s investment universe can take place in a number of ways. Since it is usual to classify enterprises according to industry, some managers have elected to exclude certain industries from the investment universe (for example the alcohol, tobacco or arms industries), while others have elected only to include certain types of industry in their universe (for example industries regarded as particularly environmentally friendly). One disadvantage of focusing on industry when the investment universe is to be defined is that it can result in black-and-whiting of the choice of enterprises. One reason for this is that many enterprises are involved in many industries. Thus it is becoming steadily more common to focus on individual enterprises rather than on type of industry. One drawback to this approach is that acquiring adequate information about individual enterprises can be both difficult and resource-consuming. However, there are consultancies that have specialised in gathering such information. These companies have detailed knowledge of enterprises in different countries, and they have developed software which makes it possible to select enterprises in these countries according to specific ethical criteria. Enterprises in the USA and the UK are particularly well covered by the analyses of these consultancies, but more and more countries are being covered. Enterprises can be selected either by excluding those described as being the worst in certain ethical areas, or by selecting only those enterprises regarded as being the best.

The market for investments with special ethical requirements attached to them was dominated for a long time by institutions wanting an investment strategy that was consistent with their own (ideal) objectives. This is illustrated by the fact that religious communities and hospitals have been among the dominant players in this market. In recent years, however, other types of investors have also chosen to attach ethical guidelines to their investment strategy. According to Social Investment Forum, an American interest organisation for investors wanting an ethical investment strategy, their members comprise private persons, enterprises, universities, hospitals, pension funds, religious institutions and other non-profit organisations. Social Investment Forum estimates that around 4 per cent of all asset management in the USA is subject to special ethical guidelines. The chief criteria to which weight is attached when enterprises are selected are: tobacco (84%), gambling (72%), arms (69%), alcohol (68%), contraception and abortion (50%), environment (37%), trade union rights (25%), human rights (23%), animal welfare (7%). The figures in parentheses indicate how large a share of the investments subject to ethical guidelines apply the criterion in question.

The consequences of managing the Petroleum Fund depend on how enterprises are selected, and on how strict the criteria are. The one extreme is to exclude a few specific enterprises. The other is to cross off a large number, defined, for example, as industries/sectors or types of activity. A third option is to decide that only the best-practice enterprises in each industry, or in certain industries, are to be included in the investment universe. This option may mean excluding a large number of enterprises from the universe. The effect of these options on different aspects of the management of the Petroleum Fund is examined below.

Division of responsibility between the Ministry of Finance and Norges Bank

The Ministry of Finance will have to be responsible for drawing up the ethical guidelines. It will not be sufficient to indicate general ethical preferences; specific criteria for the industries or categories of enterprise to be excluded will also have to be drawn up. In practice, deciding which category individual enterprises belong to will in many cases be a matter of discretion. For there to be a clear division of responsibility between the Ministry of Finance as owner and Norges Bank as operational manager, Norges Bank will have to be given a list of all the enterprises in which the Petroleum Fund may not (or may, as the case may be) invest.

At present the Petroleum Fund is invested in over 2000 enterprises, whereas the Fund's investment universe consists of more than 10,000 enterprises. Many of them have highly diversified activities, including subsidiaries and indirectly controlled companies. Enterprises also often change their nature over time, for example through acquisition or sale of subsidiaries. Considerable resources will be required to review the Petroleum Fund's entire investment universe with a view to excluding particular enterprises from the universe. Continuous updating of the investment universe will also be desirable, because of the constant changes in ownership structure. This will be costly. Moreover, considerations such as transaction costs suggest that the framework conditions for management of the Fund should remain fixed for long periods. All these factors point towards fairly infrequent, for example annual, revisions of the list of enterprises in which the Fund may not invest. On the other hand, the absence of continuous updating would increase the risk of the Fund actually having investments in enterprises that are at variance with the special ethical guidelines.

Construction of benchmark portfolios

The Ministry of Finance is responsible for establishing the benchmark portfolio. If, for ethical reasons, a decision is made to place restrictions on the Petroleum Fund's investment possibilities, these restrictions must be reflected in the benchmark portfolio. At present, the Fund's benchmark portfolio is composed of published, recognised market indices, the suppliers of which put a considerable amount of work into maintaining the indices (including making changes or adjustments when mergers, de-mergers or dividend payments take place). The question of whether it is possible to use the same indices as a basis when some enterprises are excluded depends on how the selection process takes place. The major index suppliers are positively inclined to tailoring an equities index for the Petroleum Fund if the selection takes place at industry level. They do this for some other investors today. It appears to be considerably more difficult to make customised indices if the customer wishes to exclude individual enterprises from the investment universe. The index supplier that the Petroleum Fund uses today (Financial Times/Standard & Poor's Actuaries World Indices) states that it is possible to develop an index from which certain enterprises have been excluded. At the same time they say it is difficult and that they have little experience of constructing such indices. The other major supplier of global shares indices, Morgan Stanley Capital International, does not offer to tailor the equities index by excluding certain enterprises.

If a large number of enterprises were to be excluded, it is possible that a customised benchmark index for the Petroleum Fund would have to be designed from scratch. Norges Bank does not know of any consulting companies that offer services of this nature. If such a system should be chosen, it is very important that decisions regarding changes in the benchmark index be taken by persons who cannot, or will not abuse this information in the market, and that decisions only be announced after Norges Bank has actually changed its investments.

One alternative to customising a special index might be to use indices developed by other institutions, the purpose of which is to select enterprises on the basis of various types of ethical criteria. There are some indices of this type, but at present little capital is invested using such indices as benchmark indices. Since the Petroleum Fund will be a major investor compared with others who follow such indices, there will be an information risk associated with changes in indices. Such information might, for example, be used to buy shares in the enterprises it is known that Norges Bank will invest in later because of the forthcoming changes in the index. Quality-assurance routines have been established for the market indices of the major investment banks to ensure that information about changes is issued simultaneously to the whole market. Another problem with using benchmark indices developed by other institutions is that one has no influence over the weight attached to individual criteria.

One disadvantage of customised benchmark indices is that it will no longer be possible to use equity futures to ensure that the Petroleum Fund has the desired market exposure at any time. This is because futures contracts are linked to broad market indices. As long as the Petroleum Fund has such indices as its benchmark portfolio, futures will be an appropriate instrument for use in managing the Fund. This is because the desired exposure in the equity markets of the individual countries can be achieved rapidly and cost-effectively using futures. This possibility is lost with customised indices which differ substantially from market indices.

It is not sufficient to have a consultancy make a customised benchmark index for the Petroleum Fund. In keeping with the purpose of the guidelines, it will probably be necessary for the whole investment universe of the Fund to be evaluated on the basis of, and in compliance with the stipulated ethical criteria. One alternative is of course to explicitly limit investment possibilities to those enterprises making up the customised index, but this will mean a substantial reduction of the Fund's investment universe.

Risk control and performance evaluation

Since Norges Bank will be measured in relation to the benchmark portfolio, a system must be devised to permit continuous measurement of the differences between the Petroleum Fund's actual portfolio and the benchmark portfolio. The resulting performance transparency is a very important part of the premises for confidence in the management of the Petroleum Fund. When customised indices are used, it is therefore important to maintain the index in order to keep constantly up to date with changes that concern the enterprises included in the index, such as mergers and de-mergers. This will probably be a resource-intensive process. The use of customised indices will also make it more difficult to evaluate Norges Bank's management, since it will no longer be natural to compare the Bank with other investors.


In drawing up the Petroleum Fund's investment strategy, great emphasis has been placed on reducing the risk by spreading the investments in each country over different industries and enterprises. Ethical guidelines can increase the risk associated with the Fund, because they may cause investments to be less diversified, particularly if it is decided to exclude many enterprises or individual industries from the investment universe.

Management costs

There are three reasons in particular why the costs of managing the Petroleum Fund may increase if ethical guidelines are introduced. First, Norges Bank is currently buying equities by entering into agreements with other investors to exchange liquid assets for existing equity portfolios (so-called crossing). This is a highly cost-effective means of investing in equities, since it eliminates transaction charges for share purchases, and at the same time the market is not affected by large share purchases. But if Norges Bank's equity portfolio needs to be substantially different from the portfolio of other managers, it will be more difficult to carry out these crossing transactions. Instead, the shares will have to be bought in the market, which will result in higher charges and increase the possibility of adverse market effects. Since large allocations can be expected to be made to the Petroleum Fund for many years to come, the costs of going into the markets may mount up.

The other reason that ethical guidelines may result in higher management costs is that in large sections of the Fund’s equity portfolio, efforts are made to replicate known market indices. Since this is a standardised management product, it has been possible to negotiate low management fees. This may be more difficult with ethical guidelines that imply customising of benchmark portfolios.

A further reason for ethical guidelines resulting in higher costs in the management of the Petroleum Fund is that over time the Fund could attain a considerable size, even in an international context. Ethical guidelines that place substantial restrictions on today’s investment universe may result in the Fund being a disproportionately large player in some segments of the stock markets. This increases the risk of adverse market effects when shares are bought or sold in these markets.

Management costs will not be strongly affected if the ethical guidelines imply that investment should be avoided in only a small number of enterprises. But if major restrictions are placed on the investment universe, costs may increase substantially.

Financial return

Some voices have maintained that the investment universe one is left with after selecting enterprises on the basis of special ethical criteria may consist of enterprises with a generally higher expected return than the average of all the enterprises. If this is the case, ethical guidelines could result in a higher return on the Petroleum Fund. Norges Bank has reviewed a number of empirical studies of how ethical guidelines affect the return on an equity portfolio. A recurrent problem in these studies is that the findings are inconclusive as a result of insufficient data. This is partly because analyses of investments subject to ethical guidelines have only been systematised in recent years. Should one nevertheless attempt to draw a tentative conclusion based on the empirical analyses, it would nevertheless be that special ethical guidelines do not seem to have any systematic impact on financial return. Since it has been pointed out above that ethical guidelines can lead to less diversification and higher management costs, the result could be a lower net return for a given risk. The size will depend on the formulation of the guidelines; a minimum solution in which a few enterprises are excluded will hardly result in any substantial impact on either net return or risk. 

4 Unit trusts with ethical guidelines

The market for unit trusts with ethical guidelines primarily consists of many small funds, with the emphasis on a wide range of ethical criteria. This reflects the fact that the investors who want an ethical unit trust are a very diverse group. One important distinction between the various unit trusts ensues from the principles used to select enterprises. Whereas it used to be most common to exclude certain types of enterprise, more and more funds now seem to be based on selection of the enterprises with best practice within particular ethical areas. This is because focusing only on best-practice enterprises makes it easier to combine ethically defensible investments with a good return. It is maintained that the enterprises selected in this way are those that will do well in the long term. Storebrand's environmental fund is one such example. This fund selects enterprises with a proactive environmental attitude because in the view of the company these enterprises operate a future-oriented business which will yield solid earnings in the longer term.

For the Petroleum Fund, the market for unit trusts with ethical guidelines is too small to be of interest at present for anything other than a very limited portion of the Fund. There are not many unit trusts that manage over USD 100m and at the same time operate according to certain ethical guidelines. By way of comparison, at the end of 1997, the Petroleum Fund's equity investments will be in the range USD 7-9bn.

Investing in ethical unit trusts implies buying two different services simultaneously. The one service is the selection of enterprises on the basis of ethical criteria. The other is analyses of enterprises' potential return in the future. Those enterprises comprising the unit trusts must satisfy the ethical criteria while at the same time being of interest with respect to return. Thus it may be difficult to know whether the result (return) is due to the ethical selection or the return analyses. This makes it difficult to know what consequences ethical guidelines in isolation have for the return on an equity portfolio.

Since the Petroleum Fund, as mentioned previously, is large compared with the size of the individual unit trusts with ethical guidelines, it is natural to work on the assumption that it will only be relevant to invest a limited part of the Fund in such unit trusts. An assessment of the consequences this could have follows below.

Division of responsibility between the Ministry of Finance and Norges Bank

Since the ethical criteria on which the various unit trusts place emphasis vary widely, deciding which funds satisfy the ethical requirements that it is felt should apply to the Petroleum Fund may be a matter of discretion. It should therefore be the responsibility of the owner (Ministry of Finance) to decide which unit trust best satisfies the ethical requirements to be complied with in the management of the Fund. Such a solution, assigning management tasks to the Ministry, must imply a similar division of responsibility for management performance. Since decisions concerning choice of unit trusts would be taken outside Norges Bank, the Bank could thus only be responsible for managing the part of the Fund that is not invested in unit trusts with ethical guidelines.

Construction of benchmark portfolios

There will not be a separate benchmark portfolio for the part of the Petroleum Fund that is placed in ethical unit trusts. In practice, one of the established market indices will probably be used as a benchmark portfolio, as most of these unit trusts do themselves. However, these indices do not constitute a relevant basis for comparison, since the ethical unit trusts cannot invest in all the enterprises comprising the market indices. A benchmark portfolio must be defined by the Ministry of Finance (as in the present situation) for the part of the Fund that is managed by Norges Bank.

Risk control and return evaluation

If investments in unit trusts are placed in a separate portfolio, the present system for evaluating the management of the (remainder of) the Petroleum Fund can be continued. Today all investment takes place in the name of Norges Bank. This gives the Bank daily information for use in risk management and return calculations. Investment in unit trusts will result in an overview of the individual (indirect) equity investments on a monthly or quarterly basis. If parts of the Petroleum Fund are invested in unit trusts, there will no longer be the same continuous overview of the Fund's overall exposure.


If investments in unit trusts with ethical guidelines are limited to a small part of the Petroleum Fund, the Fund as a whole will still be reasonably well diversified.

Management costs

The costs of investing in unit trusts are substantially higher than those associated with index management. With unit trusts, management fees will be in the range of 0.3% - 0.5%, whereas with index management they hover at around 0.02%.

Financial return

There are a number of empirical studies that compare the return on unit trusts with ethical guidelines with the return on unit trusts that do not have such guidelines. But as mentioned previously, it is difficult to draw any definite conclusions from these studies.

5 Use of voting rights

The use of ownership rights to influence the ethical profile of companies can take place at various levels and with a varying degree of commitment. One possibility is for shareholders to take direct contact with the company's management in order to discuss ethical issues. If this does not achieve results, an alternative approach is to table motions at the company's annual general meeting. A third option is to limit one's activity to voting on motions of an ethical nature which others submit at annual general meetings.

The big US pension funds, in particular, have chosen to exercise ownership rights actively instead of excluding enterprises from the investment universe, or investing in unit trusts with ethical guidelines. The line adopted by the big funds must be viewed in the light of the fact that their size makes broad diversification necessary. Index management is an important part of their strategy. When the principle of an investor is to invest in all the enterprises in the indices, it follows that the only way of improving the return is to influence the enterprises in question. Such influence naturally applies to the whole of the enterprise’s field of activities, and not only issues of an ethical nature.

If ownership rights vested in the shares in the Petroleum Fund are to be exercised, a set of ethical guidelines must first be drawn up (by the Fund’s owner). These should at the outset be as specific as possible, and mention explicitly all the activities of concern to the Fund’s owner. A mechanism is also required to translate these guidelines into active exercise of ownership rights. To the extent that active follow up of the companies is desired in the form of direct dialogue or a motion to be voted on, the activities of certain companies must be monitored with respect to the activities in question. If one limits oneself to adopting a stance on the motions of others, it will be necessary to have an ongoing overview of all relevant motions. There are consulting companies that have specialised in systematising information on which motions have been debated at the annual general meetings of enterprises. Subscribing to companies' databases, analyses and software will greatly simplify this voting. For example, by installing the Petroleum Fund's ethical guidelines in the software, it is possible to filter out the relevant shareholders' motions. Software can also be used in the administration of voting. With the current composition of the Fund, such a service would cost about USD 30 000 per annum. However, it is worth noting that whereas the USA and Europe are well covered by consulting companies of this type, the companies still have problems in acquiring information about activities in Asian enterprises.

Division of responsibility between the Ministry of Finance and Norges Bank

It is natural for the owner of the Fund (the Ministry of Finance) to be responsible for voting. The continuous monitoring of consulting companies that have specialised in this field could be used as a basis for decisions on voting.

Design of benchmark portfolios

Since the exercise of voting rights will not be a factor that influences the selection of enterprises in which the Fund can invest, it will not be necessary to change the benchmark portfolio.

Risk control and performance evaluation

Risk control and performance evaluation will be able to continue as in the past.


The portfolio will be equally well diversified.

Management costs

In the case of the Petroleum Fund, the costs will first and foremost be that the revenues from lending securities may drop. These are revenues the Fund earns from lending securities for a limited period. When voting rights are to be exercised, however, securities normally cannot be lent out. This means that this activity either has to be restricted, or that the agreements must be made more flexible, so that the securities an be recalled at short notice. Both options will probably reduce revenues somewhat.

Apart from this, the costs of exercising voting rights will be associated with the resources used to administrate this activity. However these resources will be small compared with the costs of other types of ethical guidelines.

Financial return

The Petroleum Fund’s financial return will not necessarily be affected.


6 Conclusion

It is important that in connection with decisions about any special ethical guidelines, a thorough assessment is also made of what consequences they will have for the operational management of the Fund. This letter is an attempt to shed a more general light on the consequences. It has been demonstrated that the consequences will depend on how the ethical guidelines are formulated. Whereas some types of ethical guidelines will have little impact on the management of the Fund, others could entail considerable costs and make efficient management with adequate monitoring and performance measurement more complicated. If, for example, a solution is chosen which involves excluding a large number of enterprises from the Fund’s investment universe, both management costs and the risk associated with the Fund could increase, while at the same time it could be difficult to evaluate Norges Bank’s management of the Fund.

It is crucial for Norges Bank that the introduction of ethical guidelines does not affect the clear division of responsibility between the Ministry of Finance and Norges Bank with regard to the management of the Petroleum Fund. Since the ethical guidelines will reflect policy evaluations, it is logical for the Ministry of Finance, as owner, to assume responsibility for both the general ethical weighing up of alternatives and the practical aspects of establishing the Fund’s investment universe and benchmark portfolio. This is a prerequisite for continued evaluation of Norges Bank’s management of the Petroleum Fund.

Yours sincerely

Kjell Storvik

Birger Vikøren