Bridging the Gap: Sovereign Wealth Funds and Financing for Development

This contribution is published as part of the Think Piece Series The Road To Addis and Beyond, launched to coincide with the third and final drafting session of the outcome document of this summer's Third International Conference on Financing for Development. In this Series, global experts discuss a range of topics complementary to the UNRISD research project on the Politics of Domestic Resource Mobilization on how to fund social development and raise provocative or alternative perspectives that can generate further ideas and debates. Please share your thoughts on this article in the comments space below.

Sovereign wealth funds (SWFs), government-owned investment vehicles, have become substantial players in the global financial architecture. As such, they are considered a potential source of financing for sustainable development. For the time being, however, sustainable development is not a theme that is represented prominently, if at all, in SWFs’ investment policies. That can only change if the sustainable development agenda’s cause is framed in the policy context in which SWFs operate. Three possible options come to mind: The asset owners of SWFs, that is governments, benefit from including sustainable development as an investment theme in SWFs’ investment mandates. Sustainable development could be positioned as an instrument to reduce risks to investments in less-developed jurisdictions. Sustainable development-informed investments could be tailored to meet SWFs’ financial performance objectives.

Sven Behrendt is Managing Director of GeoEconomica, a political risk management advisory firm.

SWFs are prominent players in the global financial architecture but are not engaged in sustainable development

Over the past twenty years, state-owned investment funds, also known as sovereign wealth funds (SWFs), have moved with extraordinary speed from the periphery to the centre of the global financial architecture, today controlling roughly four to five trillion US dollars. The relative success of SWFs is the result of prudent policy decisions that in many cases reach back decades. Governments of many resource-rich economies decided to save windfall incomes generated by the commodity boom to spread benefits across multiple generations and/or build financial buffers to prepare for the time when prices and revenues would come down. Others began to build a financial resource base to cover the future costs associated with an ageing population. Governments with ample foreign exchange reserves diverted some of them to generate higher returns through more diversified investments. In other words, SWFs were established under very different circumstances and with very different objectives, but always with a long-term perspective in mind.

At the same time, SWFs have not positioned themselves as a qualitatively new source of financing for sustainable development. Most of them are careful not to mix political with financial objectives. In the overwhelming number of cases, investment strategies aim at optimizing financial returns rather than social ones. Few of them are signatories to the United Nations’ Principles for Responsible Investment. This is not to say that the public interest is absent in what they are doing. Investment returns are transferred into public budgets and enable governments to finance national sustainable development policies. But, for the time being, SWFs simply allocate capital without having a sustainable development agenda in mind.

Three angles to place sustainable development on SWFs’ radar screens

Just because sustainable development has not been explicitly on the radar screen of the SWF industry in the past does not mean that it will need to remain absent in the future. In early June this year, the Parliament of Norway was considering directing the world’s largest SWF, its Government Pension Fund - Global, to divest its coal-related holdings in support of the global combat against climate change, as well as to mitigate climate risks to its portfolio. Norway’s position provides an indication that the sustainable development agenda might find its way into the SWF industry if it is able to frame its cause in the policy context in which SWFs operate. Three approaches could be promising in that regard.

First, whatever investment policies SWFs in their roles as asset managers pursue is determined by the mandates they are given by their asset owners, governments, usually in the form of a formal investment mandate. These investment mandates document government expectations and determine the criteria according to which SWFs shall operate. As such, investment mandates are based on a government’s political preferences. For the time being, governments owning SWFs have hesitated to include references to sustainable development in their investment mandates. Advocates of sustainable development seeking to increase the awareness of sustainable development in the SWF industry might therefore consider engaging with governments as the owners of sovereign assets, rather than the entities that manage them, with the objective of including sustainable development criteria in SWFs’ investment mandates. Sovereign asset managers will, and should, be relatively irresponsive to politically motivated arguments advocating the allocation of assets for sustainable development purposes. Governments that own them should not.

The second angle is to reframe and disaggregate the concept of sustainable development into risk factors that could seriously affect investment returns. SWFs, as other professional asset managers, are constantly seeking to optimize the risk/return profiles of their portfolios. The social deficits that sustainable development seeks to address—poverty, inequality, poor education, health or environmental degradation—pose considerable risks to investment returns and as such have prevented SWFs, as well as other members of the global investor community, from seeking opportunities in emerging, but socially underdeveloped markets. SWFs in general are eager to increase their exposure to frontier markets and to participate in the tremendous growth opportunities that these might have to offer. But the social risks associated with a deeper investment engagement in these jurisdictions are generally perceived as being prohibitively high. Any policies that would reduce the risk of doing business there would prompt SWFs, and other investors, to re-examine the attractiveness of less developed economies for investments. This risk-based argument suggests that the development of alternative models of risk sharing could enable SWFs to invest in a more benign risk climate and facilitate sovereign investments in sustainable development.

Third, any effort to mobilize financing for sustainable development would benefit from a careful look at the return objectives of SWFs and an assessment of the extent to which it could develop investment instruments that help SWFs meet these objectives. Such an approach might seem to be too commercial and transaction oriented. But it is realistic. And indeed, the gap between the sustainable development agenda and the investment themes that guide some SWFs’ investment decisions might not be unbridgeable. The sustainable development agenda includes the promotion of investment in infrastructure, agriculture, industrialization, science, technology and innovation. These are themes that resonate well with the investment themes that several SWFs have identified for themselves. Temasek, a SWF from Singapore, for example, seeks opportunities in transforming economies, sectors with a distinct competitive advantage, and emerging champions. The New Zealand Superannuation Fund, a pensions savings fund, has identified several investment themes that it believes will provide ample investment opportunities in the years to come, among them resource sustainability and increasing exposure to emerging and frontier markets. The gap between these investment themes and the sustainable development agenda appears not that large after all. What is needed to move SWF investments closer to sustainable development are investment products that incorporate social objectives, and offer attractive commercial returns.

SWFs already contribute to sustainable development in their own right

Beyond creating an enabling environment in which SWFs could upgrade their commitments to sustainable development, it is useful to recognize that a government’s decision to establish a SWF can be considered a contribution to sustainable development in its own right. The governments of many resource-rich countries are now in a position to finance ever-growing parts of their budgets through the revenues that SWFs generate and have become less dependent on commodity-based revenues. SWFs have served as vital fiscal buffers during the global financial crisis, and are indispensable sources of liquidity today when commodity prices are weak. The process of establishing a SWF and running it has focused public attention on their accountability and good governance arrangements. In consequence, SWFs in most cases have developed robust legal and regulatory foundations which have important and positive spill-over effects on other national public institutions. Their often rapidly growing asset base has required them to role out efficient investment programmes that often triggered the creation of small, but promising home-grown asset management and related services industries. Sovereign development funds, funds that focus on domestic opportunities rather than looking for international exposure as SWFs do, have developed investment programmes based on rigorous asset management discipline which has driven them to allocate investments more efficiently.

To conclude: SWFs have become a force in global finance, but—for the time being—their role in the global sustainable development agenda is marginal. And it will never be prominent, given their raison d'être. But it could be more substantial if smart politics bridged the gap between the worlds of sovereign wealth management and sustainable development.

ABOUT THE AUTHOR

Sven Behrendt is Managing Director of GeoEconomica, a political risk management advisory firm. He has held several positions at the World Economic Forum, the Carnegie Endowment for International Peace and the Bertelsmann Center for Applied Policy Research. He has published widely on the rise of sovereign wealth funds in the global financial architecture and other geoeconomic issues. He holds a Ph. D. in International Relations and International Public Law, and a Diploma in Public Policy and Administration from the University of Konstanz, Germany.