Norges Bank Investment Management. Annual Report 2006

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Feature article 2
Priority areas of corporate governance: ownership rights, children and the environment

This article presents the plans for Norges Bank's corporate governance work in the coming years. This work will concentrate on six priority areas. Four concern fundamental ownership rights: the right to vote, the right to nominate and elect board members, the right to trade shares freely, and the right to open and timely information. The other two concern social and environmental sustainability: children's rights in the value chains of multinationals, and companies' interaction with national and supranational authorities in questions related to long-term environmental changes and liabilities.

Introduction

To move mountains, you need high ambitions. Norges Bank indeed has high ambitions for its corporate governance work and aims to become known as one of the world's most prominent and professional active shareholders over the coming four-year period. The results may in many cases be difficult to gauge, not least because it will often take time for them to become apparent. Nevertheless, Norges Bank's goal is to contribute to – and be able to point to – concrete changes both in its port-folio companies and in the markets as a result of its work.

The Ministry of Finance's Ethical Guidelines for the Government Pension Fund – Global state that the primary objective for Norges Bank's exercise of ownership rights is to safeguard the Fund's financial interests. The exercise of ownership rights is to be based on a long time horizon for the Fund's investments, and broad investment diversification in the markets that are included in the investment universe. Financial, social and environmental issues must therefore all be taken into account in the exercise of ownership rights. This clearly necessitates an ambitious and wide-ranging agenda. However, for several reasons, active involvement in all potentially important issues at every one of the 3 500 or so companies in the equity portfolio would not be a reasonable goal.

Firstly, it is not possible for a single investment manager to pay full attention to all of its portfolio companies at one and the same time. External consultants, agencies and news services can contribute information, and NBIM does make active use of such information, for example in its voting (see separate article). But to go into depth and put resources into all of the matters that arise – and on which we might have an opinion – is simply not possible given the natural constraints on the time and resources available to NBIM (or any other investment manager for that matter).

Secondly, there is the delegation of duties and responsibilities between Norges Bank and the Ministry of Finance. The Ministry, acting on the advice of the Advisory Council on Ethics for the Government Pension Fund, determines which companies are to be excluded from the portfolio on the basis of the Ethical Guidelines (see section 4.1 of the 2006 Annual Report for a report on these guidelines, or see www.etikkradet.no). Norges Bank for its part follows up these same guidelines through active ownership of its portfolio companies. This means that the most serious types of breaches of human rights and fundamental ethical principles will normally be dealt with by the Council on Ethics. This does not mean that Norges Bank never addresses such issues, but it is natural for the Bank to look mainly at long-term and persistent ethical problems which do not come under the auspices of the Council on Ethics, as well as the promotion of good governance systems at companies and the safeguarding of shareholder rights.

Thirdly, Norges Bank's reputation as an active shareholder could be tarnished if its actions are viewed as arbitrary, unconsidered or politically motivated. If NBIM becomes known as a player with multiple agendas and bees in our bonnet without any common direction and prioritisation, we will lose influence and credibility as an investor.

Finally, even though the Government Pension Fund – Global is large, its holdings in each individual company are small. We cannot expect to be heard on the grounds of size or financial importance alone. The quality of our message and the credibility of our communication will also be crucial, not least if we are to secure the support of other investors.

For all these reasons, Norges Bank has decided to concentrate its corporate governance work on a small number of priority areas which are of particularly great importance for its portfolios – and so also for all of the people who stand to benefit from its returns in future generations. This does not rule out the possibility of involvement in other areas too, or of new priority areas being added as our resources and experience grow. The point is that our corporate governance work needs direction and focus, and this is something that we are hoping to achieve through the priority areas that we have chosen.

The choice of priority areas for Norges Bank's corporate governance work was based on the following criteria: they must be relevant to investors in general and our portfolio in particular; they must be suited to dialogue with companies and/or regulators and provide scope for us to make a real difference; and they must be justifiable financially, as we are acting in the capacity of an investor, not of a political player or NGO. This latter factor means that we must identify issues where ethics and long-term financial returns go hand in hand, as it is in these areas that an investor can be expected to make an impact.

The following devotes the most space to the social or ethical priority areas, but those concerning corporate governance in a narrower sense are no less important. In most cases, making a difference in these areas will be essential for engaging with companies on ethical and social issues.

Strategic priority areas

All of Norges Bank's priority areas of corporate governance, presented in more detail below, deal with owners' key interests – in other words, they relate to long-term returns and the mitigation of risk, and they concern key principles of good corporate governance, ethics or environmental protection. They can be divided into three main categories.

First, there is good corporate governance – good and legitimate management of the companies in which we have ownership interests, and of the markets of which these companies are part. Here, our most important role is to ensure that the rights of minority shareholders are protected, and that companies are governed in a way that ensures good long-term returns while observing recognised norms and laws. This area is subdivided into four parts, each of which is discussed below. Good corporate governance is essential for overall investor influence.

Second, we have ethical and social issues, not least the observance of core human rights. As an investment manager with a long-term horizon and a special interest in the potential of future generations to participate in the economy and in society, Norges Bank has decided in this context to focus on children and their welfare, particularly in relation to combating child labour and protecting child health. Children's rights in the value chain of multinationals will be especially important, as it is here that our work as an investor can be expected to have the greatest impact.

Thirdly, we have the type of long-term environmental problems that could affect the Fund's sustainability. The most high-profile of these is climate change, but there are also other problems that need to be monitored carefully and that we will increasingly be taking up with relevant portfolio companies. Norges Bank will be working particularly on the actions of portfolio companies in relation to national and supranational authorities in questions related to long-term environmental changes – including the risk of serious climate change, the destruction of ecosystems and biodiversity, and large-scale and long-term destruction of water and other natural resources. In these areas, Norges Bank will promote greater transparency and accountability when it comes to the lobbying activities of companies, so that this lobbying runs counter to Norges Bank's interests to the least possible extent.

On top of all this, NBIM also monitors other issues at company and portfolio level, including corruption, executive pay, workers' rights and companies' position in terms of violations of human rights. Matters of this kind will regularly be brought up at general meetings or be part of international campaigns which NBIM may support, together with other investors and investor networks.

Good corporate governance: director elections, voting rights, transparency and anti-takeover mechanisms

One of the single most important elements of Norges Bank's corporate governance work is holding the companies' boards of directors to account. NBIM's engagement with respect to broad ownership issues, including ethics and the environment, is therefore directed to the boards of companies. As NBIM increasingly instigates engagement processes with individual companies (which will be a key part of our activities throughout the four-year strategy period from 2007 to 2010), the chairman and key board representatives will be the most important points of contact. The board is responsible for a company's long-term strategy and is to make management accountable for its actions and communicate shareholders' views.

As part of the work to make directors more accountable, NBIM has made the nomination and election of directors one of its priority areas. This is currently a hot topic in the US, where the rights of investors to nominate candidates or vote against the candidates put forward by the company itself are strictly limited. Given that the chairman and chief executive officer are one and the same person at many listed companies in the US, it is clear that we face a governance problem. However, changes are afoot, both at individual companies and in the regulatory framework (at the Securities and Exchange Commission, for example). NBIM has been pushing for change and will work together with other investors to ensure that boards have as broad and favourable a composition as possible, with representatives who are willing to listen to their investors.

A closely related priority area is the right to vote at companies' general meetings. In many jurisdictions, especially in Europe, shares may confer limited voting rights in practice, partly because some shares carry more votes than others, and partly because trading in shares around the time of general meetings can be subject to complex restrictions which make it difficult for many funds to exercise their voting rights. NBIM is campaigning for the rules on voting rights to be made as predictable and clear as possible in all markets, and for minority shareholders to be able to have their say and exercise their voting rights at the companies of which they are the co-owners.

For voting rights to really count, and for other forms of engagement with a company to be meaningful, the information that investors receive – both ahead of general meetings and in the exercise of their ownership rights in other respects – needs to be accurate and readily available. This is far from the case at many companies. Simple things such as receiving the agenda for a general meeting in time, or having it made available in languages other than that of the country in question, can be difficult in practice at some portfolio companies. It may also be complicated and time-consuming getting answers to questions or finding out whom to approach. Not least in some Asian jurisdictions, investors struggle with this. Work on ensuring transparent reporting and information from companies is therefore a dedicated priority area for NBIM.

Another key feature of a well-functioning equity market is the ability of shareholders to sell their shares when they want to. However, the sitting management and boards of many companies place obstacles in the path of this, especially if they resist a takeover by new owners. In some cases, such obstacles may be legitimate, such as protection against takeover attempts which may in reality be a form of corruption or in some other way may not be in the interests of shareholders or the company as a whole. However, NBIM insists that such obstacles to the sale of shares and takeovers be presented openly to shareholders, and that the consent of the latter be required for both the introduction and the retention of such measures. Normally, NBIM is of the view that a free market for the buying and selling of shares with no anti-takeover mechanisms will best safeguard the interests of shareholders and the legitimacy and health of the markets. Against this background, the right to trade shares freely and the right to approve anti-takeover mechanisms has been selected as our fourth priority area.

These four priority areas are directly related to actual corporate governance: (1) board accountability and director elections, (2) the right to vote, (3) the right to good information and reporting, and (4) the right to sell and trade shares. Together, they are key prerequisites if an investor such as Norges Bank is to be able to protect its interests as an investor and exercise its ownership rights.

It is important to add that following up on these areas is not just about engaging with individual companies but also about engaging with the regulatory authorities. International organisations such as the International Corporate Governance Network play a key role here. Information from and participation in such networks are therefore important for NBIM.

Child labour and children's rights

Few topics are of such great importance ethically as the protection of children's rights. Children are normally the weakest link in conflicts and disputes, including in industry. As they cannot protect themselves, they can come to considerable harm as a result of the actions of adults. It has been established beyond doubt that some companies and sectors in our portfolios do contribute to such harm and could do more to protect children's legitimate interests and rights. The most serious breaches of children's rights will come under the auspices of the Council on Ethics and, if verified as gross breaches of human rights, lead to a recommendation on the exclusion of the relevant companies from the investment universe. In some cases, however, it may be beneficial first – before reaching a final decision on exclusion – to use Norges Bank's influence as a shareholder to enter into a dialogue with the companies in question and make sure that the companies understand the severity of the situation. There are also companies that could take action in children's interests, yet are not behaving in such a way as to qualify for exclusion. In this case, it is a matter for Norges Bank rather than the Council on Ethics.

For three important reasons, efforts to safeguard children's rights are also of financial importance and hence a natural area for an investor such as Norges Bank to take on.

Firstly, a generation lacking education and health provides a poor basis for future employment. The number of people aged 15-40 is set to grow sharply in many of the world's countries in the coming decades, because the number of women of child-bearing age is now higher than ever before (both in absolute terms and relative to the overall population), and because birth rates are still high in most developing nations. If large parts of the coming generation reach working age without skills and with their childhood wrecked by physical exploitation or inadequate social conditions, this could clearly lead to social unrest and instability, on top of the personal tragedy for the individual. On the other hand, a well-educated younger generation surrounded by stable social frameworks could be a unique resource for building a more sustainable society. Focusing on child welfare in the value chains and spheres of influence of our portfolio companies, including combating the most serious forms of child labour, is therefore a natural priority area for an investor with an investment horizon stretching forward many decades.

Secondly, corporate behaviour that harms children's health and rights distorts the market in a way that threatens the legitimacy of both individual companies and entire markets. NBIM is dependent on the credibility and legitimacy of the markets in which we operate – which, in practice, are markets all around the world, as many portfolio companies also have activities in countries where we do not have any direct investments. Serious ethical problems in the market could serve to undermine confidence not only in individual companies and sectors but in the whole of the global market economy in which NBIM participates. Measures to increase the legitimacy and morality of the market system, in the form of both general regulations and company-specific initiatives, will therefore be important for NBIM's long-term position as a global investor. In this respect, few things are as important as steps to increase the protection of children's rights within companies' spheres of responsibility.

Finally, it is natural for NBIM to assume that an unwillingness to address and combat the exploitation of children and safeguard children's rights may be indicative of a generally weak strategy at the company in question for dealing with its externalities. Working with selected portfolio companies on improving the handling of children's rights in their value chain is therefore a useful way of strengthening the ability of these companies to build a sustainable strategy for their externalities in general.

NBIM's overriding aim in this priority area is to improve the situation of children employed in, or directly affected by, the value chains of companies in NBIM's portfolio. These companies are to be encouraged to comply with the requirements of the UN Global Compact and other relevant documents on human and children's rights. They must also, where realistic, be encouraged to exceed these minimum standards in order to ensure good health and education for children within their sphere of activity and influence.

However, it should be noted that the abolition of all forms of child labour is currently unrealistic and, indeed, undesirable, given the social and familial structures that would collapse in many countries were children not able to contribute labour and income. Several international aid organisations, including Save the Children, have reached the same conclusion, even though the long-term goal is the abolition of all child labour.

Norges Bank's overriding aim of improving the situation of children is subdivided into a series of concrete objectives, all of which are in line with the UN Global Compact and the ILO Worst Forms of Child Labour Convention. These objectives require NBIM to work with relevant portfolio companies to ensure that those children who do work are not too young, and that work for the very youngest is abolished altogether; that the work that children do is not physically dangerous; that their working hours are limited; that the children are under competent adult supervision; that the children are not forcibly removed from their families; and that their work is combined with education and adequate health care. (Note that the use of the term "portfolio companies" here also includes subsidiaries and important suppliers in the supply chain, over which the companies have an influence. However, whether it is NBIM's portfolio company or companies further down the value chain which have the main responsibility for implementing these measures will vary.)

For example, large new development projects – greenfield projects – often affect whole families and local environments in ways that expose children to considerable danger and often involve child labour. NBIM will encourage companies involved in such projects to provide full reports on steps taken in line with the overriding aim and subsidiary objectives above before the projects start up. This should be developed into an international reporting standard.

To ensure that NBIM always concentrates on the most important issues, sectors and companies in this area, NBIM works with its own groups of experts who help identify the greatest problems at any one time and hold up good role models, so that the overriding aim and subsidiary objectives are implemented as realistically as possible. NBIM will also gradually involve other investors in its work on this priority area, so as to ensure the greatest possible impact, and use public communication to raise awareness of these issues. In parallel with this, NBIM has already embarked on concrete engagement processes with individual companies.

The environment and lobbying

NBIM's portfolio is global and long-term and is therefore exposed to large-scale environmental changes and environmental destruction. NBIM is therefore working to make both itself and other investors aware of the environmental factors that could impact most on the markets' long-term sustainability, and then include these in corporate governance work.

The Stern Review for the UK government published in autumn 2006 confirmed that climate change also poses a particularly serious economic threat. Unless something is done about the risk of serious climate change, there could be a decrease in global economic activity equivalent to a permanent reduction of 5-20 per cent – or more – in annual global GDP, with effects which will be noticed in the next decade. The necessary action to combat the most serious forms of climate change will themselves cost around 1 per cent of annual global GDP, according to the Stern Review. Against this background, the risk of climate change – which a clear majority of international scientists believes to be partly due to human activity and can also be combated through human activity – is a good example of the type of environmental threat that NBIM must bear in mind as an active shareholder.

However, it is important to remember that an investor's influence in this field is limited. Each individual portfolio company's emissions of carbon dioxide and other greenhouse gases are generally neither illegal nor immoral per se. It is the aggregate amount that is the problem. It is also unrealistic for companies that produce carbon dioxide and other greenhouse gases to cut their emissions without statutory requirements in this area which apply both to them and to their competitors. Companies may be able to reduce greenhouse gas emissions on their own initiative for economic reasons, in order to improve their profile and credibility, or to be better equipped to meet the more stringent statutory requirements of tomorrow. In many cases, NBIM will support initiatives to strengthen such incentives, together with the growing body of international investors expressing concern about climate change. However, it is political initiatives and market regulations, both national and international, that will be the key factor in the fight against serious climate change. This includes international solutions after the Kyoto Protocol expires in 2012 (such as more clearly expressed – and binding – targets for the total amount of greenhouse gases in the atmosphere), and national and regional tax regimes to encourage reduced emissions of greenhouse gases and increased use of alternative energy sources.

Does an investor have any influence over this at all? Can such initiatives be promoted through active share ownership? In spite of everything, we believe the answer to be yes. Some of NBIM's portfolio companies devote considerable resources to influencing national and international authorities through lobbying, both directly and through trade organisations. Lobbying per se is a legitimate and necessary part of the interaction between industry and regulators. However, it is a problem if companies actively pursue lobbying contrary to the interests of their investors. In many countries, including the US, companies (in the energy sector, for example) have employed considerable means to fight climate initiatives which would benefit NBIM and other "universal" investors, and which could also benefit the companies and sectors in question if these measures are implemented with the necessary degree of consistency and predictability. NBIM will therefore be working both with individual companies and with trade organisations to promote increased openness about the lobbying activities of companies in the environmental field, with a view to aligning investor interests on the one hand and the aims of companies in their lobbying activities on the other. NBIM wishes to highlight responsible and transparent lobbying as an area where investors can contribute to responsible environmental initiatives, in a way which serves both the long-term return on the portfolio and our interests as a financial investor in the individual company.

This same approach – openness and responsibility in lobbying the authorities on environmental initiatives – could also be significant for other environmental issues. Problem areas relevant to the portfolios include reductions in biodiversity with long-term effects on entire ecosystems, unsafe management of nuclear waste, and long-term destruction of drinking water sources and similar industrial and natural resources.

Conclusion

Norges Bank's ambition is to be a prominent and respected active shareholder that manages to combine ethical and financial considerations in a way that wins the support of other investors, companies and regulators alike. To begin with, during the four-year period from 2007 to 2010, NBIM aims to build up a solid reputation based on concrete results and changes in the market. These results may often be difficult to gauge, not least because it will often take time for them to become apparent. Nevertheless, our goal is to be able to point to increased awareness and concrete changes at portfolio companies – and in the markets – in all of our priority areas within this four-year period. Concrete information about individual companies will often have to remain confidential on account of the processes in which we are involved, but we will endeavour to report as openly as possible on the principles and priorities underlying our ownership processes, the types of resources that have been used, and the results that have been achieved. Norges Bank has also begun work on making it possible to report in even more detail on voting at company level. The publication of this material will take place with effect from the 2007 annual general meeting season in connection with the annual corporate governance report.

NBIM will also continue to promote and support good principles of corporate governance and ethics in fields outside our priority areas, through voting, participation in the public debate, publication of our ownership principles, and support for other investors' initiatives.

In this way, Norges Bank will emerge as a serious and comprehensive player with ambitious yet realistic goals.