Reference is made to a letter of 17 August 2001 from the Ministry of Finance regarding a draft amendment of the Regulation relating to the Management of the Government Petroleum Fund. The following comments on the draft amendment are submitted in accordance with the Management Agreement between the Ministry of Finance and Norges Bank. In the first part, the proposal is considered in relation to the advice Norges Bank has previously offered on ethical considerations in connection with the Management of the Government Petroleum Fund. In the last part, an evaluation is provided of the Ministry's proposed amendment of the Regulation.
Principles and division of responsibility
Norges Bank has discussed the ethical aspects of the management of the Government Petroleum Fund in previous submissions to the Ministry of Finance.1 In these submissions, Norges Bank has provided advice on how ethical criteria might be incorporated in the management and what implications various formulations of these criteria might have for the operational management and results thereof. Emphasis is placed in these submissions on the division of responsibility between the Ministry of Finance and Norges Bank as operational manager. See for example the letter of 22 April 1998, which states:
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 its right to vote in companies it has stakes in. Responsibility for these ethical considerations cannot be left to Norges Bank. Norges Bank is not competent to make evaluations of this nature. Moreover, deviations from the benchmark portfolio could then be due to both 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 its submissions, Norges Bank has also stressed:
- Trade-off between return and risk. With a substantial reduction of investment possibilities, the trade-off between expected return and risk would deteriorate.
- Risk management and performance measurement. The benchmark portfolio must be changed in line with changes in the universe. Customising benchmark indices instead of using publicly available indices increases the risk of error in performance and risk measurements.
- Feasibility. Sufficient information must be available to allow the criteria established to be used to identify those instruments that should be excluded.
In its submission of 16 March 1999 concerning environmental guidelines, Norges Bank pointed out that it appeared reasonable to make the same requirements of the Norwegian enterprises owned by the State as of the Petroleum Fund's investments in foreign shares. The Bank also pointed out the importance of not changing the framework conditions for management of the Petroleum Fund often. In connection with changes in the regulatory framework, for example by introducing ethical criteria in management, it is important also to consider the effects on transaction costs and the operational issues associated with management.
The exclusion mechanism now proposed by the Ministry of Finance is discussed in the Revised National Budget 2001 (RNB 01). The Ministry points out in this connection that the Government should be cautious about using the Government Petroleum Fund as an active means of promoting other political objectives, and that there should be consistency between the restrictions imposed on the Petroleum Fund and the principles implemented with respect to government commercial operations and purchases.
The Ministry concludes that the exclusion mechanism should only be used to exclude individual companies in very special situations, and subject to a close legal and factual evaluation. The criterion must be whether owning shares in such companies may be in conflict with Norway's commitments under international law. In order to maintain the Petroleum Fund's reputation as a serious investor, among other things, the Ministry points out that a high degree of probability should be required before a contention is accepted as fact. Assertions that an enterprise is engaged in a certain type of activity should therefore not be accepted as fact before they have been substantiated by closer investigations.
The exclusion mechanism, as presented in RNB 01, is consistent with the division of responsibilities agreed upon between the Ministry and the Bank. An implementation regime is described in which all decisions regarding exclusion are taken by the owner. It is not intended that the manager should take part by exercising his own discretion.
Norges Bank takes note of the owner's choice of criteria for excluding individual investments. The considerations emphasised in RNB 01 are fully consistent with the advice provided earlier by Norges Bank. If there should be question of only limited application of the exclusion mechanism, a deterioration in the trade-off between expected return and risk can hardly be invoked as an objection.
Assessment of the proposed amendment of the regulation
The first sentence of the draft new paragraph of the regulation reads: "The Ministry of Finance shall establish a council which, at the request of Norges Bank or the Ministry of Finance, shall provide an evaluation of whether the Fund's potential investments in financial instruments issued by specified issuers may be in conflict with Norway's commitments under international law."
This formulation may be interpreted to mean that Norges Bank is assigned a general responsibility for determining which investments might be in breach of the criteria issued by the Ministry of Finance. But it cannot really be expected that the criteria can be formulated so precisely that the Bank can assume such a responsibility without having to exercise discretion of a political nature. As manager, however, Norges Bank has access to information about individual investments, and will assist the Ministry of Finance when detailed information is required. In accordance with the division of responsibilities for which Norges Bank has previously argued, and which has been implemented for the Environmental Portfolio, it is proposed that the Bank's responsibility for providing information be specified as:
"When requested by the Ministry or the Council, Norges Bank shall secure factual information from the specified enterprises, and communicate this information to the Ministry."
However, such a specification shall not prevent the Bank in individual cases from submitting information that has been acquired about companies where there may possibly be breaches of the ethical criteria. As a matter of principle, such information should be submitted to the Ministry of Finance. It may also be appropriate for Norges Bank to collect information from individual companies on behalf of the Ministry of Finance and the Council. It may be an advantage for the companies only to meet one representative of the Fund's owner.
In order to make it clear that the authority to make decisions regarding changes in the investment universe lies with the Ministry of Finance, Norges Bank proposes that the order of the first two paragraphs in Section 9 be reversed. It is also proposed that in what will become the first sentence of the second paragraph, a reference be made to the first paragraph by stipulating that the Council "shall present an evaluation to the Ministry as to whether a decision should be made pursuant to the first paragraph".
The draft regulation refers to two international law conventions as being particularly relevant. In RNB 01, the Ministry writes that the exclusion mechanism is only to be used in exceptional cases. Proceeding on this assumption, the exclusion mechanism would not represent any particular drawback to operational management, and the necessary provision could be made by making adjustments in the management agreement between the Ministry of Finance and Norges Bank.
The draft amendment to the regulation discusses exclusion from the Petroleum Fund's investment options. Norges Bank assumes that financial instruments that are excluded from the range of investment options should also be excluded from the benchmark portfolio. This is important if measurement of the manager's performance is to be real.
The draft regulation specifies no deadlines for when, in the event, exclusion of financial instruments should take effect. Norges Bank wishes to point out that the Petroleum Fund's capital is invested both directly, by Norges Bank, and by external managers: At present the Petroleum Fund has more than 10 external mandates, and the number will increase in the coming year. The exclusion of financial instruments may therefore affect many mandates. Norges Bank assumes that the Bank and external managers would be given reasonable time to sell excluded instruments before the decision on exclusion is made public. The liquidity of some of the instruments that may be concerned is so limited that the managers may need time if the sale is to be accomplished without the market being influenced and the Petroleum Fund incurring a loss. This means that Norges Bank should be notified of any exclusion a reasonable period of time before it becomes effective and before it is made public.
If the number of exclusions should prove to be extensive, a time frame for the practical implementation should be agreed to take account of external managers and the measurement of the return. The costs to the Petroleum Fund in the form of a possible deterioration of the trade-off between expected return and risk will depend on the extent of the constraints applied to investment options (see Norges Bank's submission of 22 April 1998). In this submission, Norges Bank also points out that such losses will not occur if the choice is made to use voting rights as a sanction, rather than sale of securities.
1)Cf. the following three submissions:
i) "Consequences of introducing special ethical guidelines for the management of the Petroleum Fund " (dated 22 April 1998)
ii) "Implications for the management of the Government Petroleum Fund if special environmental considerations are used as a basis for the choice of investment strategy" (dated 16 March 1999)
iii) "Draft guidelines for the Environmental Fund" (dated 29 March 2000)