Establishment of the Ministry of Finance’s Advisory Council on Investment Strategy

The 29^th of September 2005 the Ministry of Finance’s appointed an advisory council on investment strategy for the Petroleum Fund. The Government Pension Fund Bill, no. 2 (2005-2006), states that the advisory council will continue as advisor to the Government Pension Fund – Global.

1. Background

The Government Petroleum Fund was established by Act no. 36 of 22 June 1990 to safeguard long-term interests through the use of petroleum revenues. The Act defines the Fund’s income as the government’s net cash flow from petroleum activities, the return on the Fund’s investments and the net results of financial transactions associated with petroleum activities. The Fund’s expenditure consists of an annual transfer to the Treasury pursuant to a resolution by the Storting. Upon the establishment of the Fund it was emphasised that capital transfers must be part of a coherent budget process, such that accumulation of capital reflects actual surpluses on the central government budget. In keeping with this, the annual transfer from the Fund finances the non-oil government budget deficit. The Petroleum Fund serves in this way to manifest the government’s use of petroleum revenues.

The Petroleum Fund is an important tool of central government asset management. Since payments into the Fund from petroleum activities are based on depletion of a non-renewable natural resource, they cannot be regarded as income in the usual sense. Accumulation of capital in the Government Petroleum Fund largely involves converting oil and gas resources in the North Sea into financial assets outside Norway. Receipts from the petroleum sector vary widely, for one thing in step with oil price fluctuations. However, the Petroleum Fund and the budget policy guidelines (the fiscal rule) set the stage for petroleum revenue use that is predictable and independent of current revenue flows.

The government’s net cash flow from petroleum activities is transferred in its entirety to the Petroleum Fund from the central government budget. According to the fiscal rule for budget policy, the phasing of petroleum revenues into the economy via transfers from the Government Petroleum Fund to the central government budget must, over time, be in step with the real return on the Petroleum Fund. This shields the central government budget and the economy from the effects of oil price fluctuations. Moreover, by ensuring that the Fund’s capital remains intact, it enables petroleum revenues to sustain welfare for future generations. Whereas the capital in the Fund can be used only once, the return it generates can be used indefinitely.

Since the Petroleum Fund is invested abroad it contributes to a capital outflow which countervails a sizeable and varying foreign exchange inflow from the petroleum sector. The capital outflow through the Fund promotes exchange rate stability and helps to maintain a varied industrial structure that can lay the basis for a balanced development of the Norwegian economy. Hence there are important stabilisation policy and monetary policy rationales for the fiscal rule and the petroleum fund mechanism.

The Petroleum Fund Act gives the Ministry of Finance responsibility for managing the Fund. The Ministry has delegated operational management of the Fund to Norges Bank. Norges Bank manages the Fund’s capital in accordance with provisions laid down by the Ministry of Finance. These provisions are set out in regulations, in supplementary clarifications of the regulations and in a management agreement between the Ministry of Finance and Norges Bank. Any significance changes in strategy are submitted to the Storting in appropriate budget documents. There has been a broad political consensus on the Fund’s investment strategy.

The Petroleum Fund must be managed in a prudent manner with the objective of high return subject to moderate risk. The provisions established by the Ministry of Finance reflect the Petroleum Fund’s investment strategy. Of especial importance to the investment strategy is the choice of weights for geographical regions and asset classes. These choices far and away determine expected return of the Petroleum Fund and the degree of risk attached to the investments. The strategy is enshrined in a concrete benchmark portfolio composed of broad equity and bond indices in countries with well-developed company, stock exchange and securities legislation.

The current regulations governing the management of the Petroleum Fund specify that 50-70 per cent of the Fund’s overall portfolio is to be invested in fixed income securities and 30-50 per cent in equities. Where equities are concerned, 40-60 per cent is to be invested in currencies and markets in Europe, the remainder in other regions. Where fixed income securities are concerned, 45-65 per cent is to be invested in currencies and markets in Europe, 25-45 per cent in the Americas and the Middle East/Africa and 0-20 per cent in Asia and Oceania. The benchmark portfolio’s equity portion and regional distribution correspond to the midpoints of the intervals specified in the regulations. The country distribution within the respective regions is based on market size in the individual countries.

In its operational management Norges Bank is required to adhere to the benchmark portfolio and other provisions within a risk limit set by the Ministry of Finance. The risk limit is measured in terms of “expected relative volatility”. The ministry has established a maximum expected relative volatility of 1.5 percentage points. Over time, and put somewhat simply, this means that in two out of three years the difference between the return of the Petroleum Fund and the Fund’s benchmark portfolio will not exceed 1.5 percentage points. The risk limit allows Norges Bank some leeway to engage in active management for the purpose of achieving excess return in relation to the benchmark portfolio.

In this way the benchmark portfolio serves as a risk management tool for the investment regime and as a standard of comparison for assessing Norges Bank’s performance.

The Petroleum Fund has grown rapidly since it received its first allocation in 1996. The Fund’s investment strategy has developed on a gradual basis. Investments in equities were included in 1998. In 2002 investments in fixed income securities were extended to include non-government guaranteed bonds and 2004 saw the establishment of new ethical guidelines for the investment regime.

It is important to ensure that decisions regarding the Petroleum Fund rest on a solid professional foundation. In its work with the Fund’s investment strategy, the Ministry of Finance builds on inputs from Norges Bank under an advisory agreement with the bank. The ministry also obtains advice from external bodies and in addition utilises an external consultant to review Norges Bank’s return estimates and to evaluate the bank’s results. Furthermore, an ethics council has been set up to advise the ministry on any exclusion of companies called for under the Petroleum Fund’s ethical guidelines.

As a step in strengthening the Ministry of Finance’s work on the guidelines for the Petroleum Fund, an advisory council on investment strategy is to be established to assist the ministry in shaping the Petroleum Fund’s long-term investment strategy.

2. Mandate for the Ministry of Finance’s Advisory Council on Investment Strategy

The Government Petroleum Fund was established by Act no. 36 of 22 June 1990 to safeguard long-term interests through the use of petroleum revenues. The Petroleum Fund is an important tool of central government asset management.

The act assigns responsibility for managing the Fund to the Ministry of Finance. A key aspect of the ministry’s work is to draw up guidelines for the Fund’s investments. The Ministry of Finance utilises advice from Norges Bank in its work with the guidelines for the Petroleum Fund’s investments.

The Ministry of Finance’s Advisory Council on Investment Strategy (Investment Strategy Council) will assist the ministry in the latter’s work on the long-term, overarching investment strategy for the Petroleum Fund. Key investment strategy issues are the choice of weights for geographical regions and asset classes and the inclusion of new investment alternatives. The investment strategy is reflected in the composition of the Fund’s benchmark portfolio, in the limits imposed on permitted deviations, and in the delimitation of the Fund’s overall investment universe. In shaping the guidelines, the ministry has emphasised the need for a transparent and clearly organised management regime.

The council will at the outset consider matters put to it by the Ministry of Finance. The council will on a regular basis be asked to review issues related to the long-term investment strategy. The council will be entitled to address issues on its own initiative. Decisions regarding the Fund’s investment strategy will be taken by the Ministry of Finance.

The council will base its assessments on the Government Petroleum Fund Act and on the overarching principles governing the Petroleum Fund’s investments, including the following:

The aim of the management of the Fund is to achieve high return subject to moderate risk. It is the return in terms of international currency that is relevant when gauging the Fund’s international purchasing power.

The Fund shall be invested abroad in its entirety.

The Fund shall be a financial investor and not a tool for strategic ownership of individual companies.

The Fund shall be well diversified.

A long-term investment horizon shall be applied.

In its recommendations the Council must illuminate consequences of changes for expected return and risk. Consequences of the Council’s recommendations for transparency and insight into the management of the Fund’s capital must also be illuminated, including any need for specific requirements as to monitoring and reporting that are called for by the advice given.

The council shall not make recommendations regarding the organisation of the management regime. The Ministry of Finance has delegated the operative management, including selection of external managers, to Norges Bank.

The Ministry of Finance’s Advisory Council on Investment Strategy shall not give advice regarding the Petroleum Fund’s ethical obligations. It is the responsibility of the Petroleum Fund’s Advisory Council on Ethics to consider whether investments in individual companies are contrary to the Petroleum Fund’s ethical guidelines.

The Ministry of Finance will act as secretariat to the council. The ministry fixes the remuneration to the council’s members. The council’s method of working, including meetings, deadlines etc., will be agreed between the ministry and the chairman of the council.

The council’s assessments and recommendations will only be made public after consideration by the Ministry of Finance in each case. Advice given and any changes made in the investment strategy will be described in documents to the Storting, normally before the changes are put into effect.

The Ministry of Finance will be the contractual counterparty in any agreements that the council needs to enter into with other parties.

The Ministry of Finance is entitled to make additions to or changes in this mandate.