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Innovating Sovereign Wealth Funds

By Saleem H. Ali, Gary Flomenhoft | February 17, 2011

CREDIT: Toni Lucatorto (CC).

Natural resources are often considered common human assets on a philosophical level, but there is a constant struggle to govern them in ways that benefit the population while avoiding the proverbial tragedy of the commons. One technique has been to employ some form of government resource management that allocates monetary proceeds via a common fund. This has worked particularly well for nonrenewable resources such as oil. The Alaska Permanent Fund, for example, invests 25 to 50 percent of state oil royalties in a diverse portfolio of assets that pays dividends to the citizens of Alaska—averaging around $1,500 per year.

At the national level such funds are referred to as Sovereign Wealth Funds (SWF) and they aim to capitalize on windfall profits or economic rents from natural resource unearned increments and other excess income. The goal of these funds is to stabilize revenues, save assets for contingencies, and allow for more effectively planned expenditures.

The Sovereign Wealth Funds Institute, based in Las Vegas, estimates the total value of SWF assets at $4.16 trillion. The six largest SWFs account for 75 percent of all assets held by such funds worldwide—China, Kuwait, Norway, Saudi Arabia, Singapore, and United Arab Emirates. About one-third of these funds are related to oil revenues, but there are some notable exceptions such as Singapore's fund which is largely based on government rents from the country's successful financial and manufacturing sectors. Criticism of SWFs stems from two arenas: their curtailment of cash for development needs in poor countries (saving instead of investing), and the potential for misuse of the funds by centralized authorities.

There are cases where SWFs have not had much positive impact on a nation's development, such as the fund for revenues from phosphate deposits in the Gilbert Islands (now the nation of Kiribati) set up by the British in 1956. Very poor countries often need immediate cash and for them an SWF might not be a worthwhile mechanism for initial development, plus they often need assistance managing their investment portfolios.

Some countries are also concerned about the ability of dominant funds to have influence over the workings of strategically important industrial sectors. For example, the Qatar Investment Agency's acquisition in 2009 of a 17 percent stake in the car manufacturer Volkswagen for roughly $10 billion caused major political concerns in Germany.

Such protectionist and managerial concerns aside, greater attention needs to be paid to the potential positive impacts of SWFs in reducing global inequality—which the International Monetary Fund’s delegate to the 2011 World Economic Forum deemed the "the most serious challenge for the world." For example, Alaska has the lowest Gini coefficient for household income (a measure of inequality) in the United States and has had the lowest Gini increase over the last 30 years since the dividend was initiated in 1982, according to the U.S. Census Bureau.

Elsewhere, an Alaska-style oil fund was proposed for the dispensation of Iraq's oil revenue after the U.S. invasion, but this proposal seems to have faded away. And a Niger Delta Fund has been proposed for troubled areas of Nigeria to help mitigate inequality and compensate for environmental damage due to oil extraction.

Sovereign wealth funds also may be used to create greater opportunities for human development by financing public goods such as education. For example, the Texas Permanent School Fund and the New Mexico land grant fund channel royalties from fossil fuels and minerals on public lands to public education. Alberta's Heritage Fund and the Shetland Islands oil funds have been used for economic development in Canada and the United Kingdom, respectively.

Furthermore, the SWF model has unrealized potential to create positive incentives for resource conservation by channeling rents from scarce natural assets such as water. Many governing bodies responsible for managing natural resources have applied a public trust model, especially to management of wildlife and fisheries. The resources are held in trust in perpetuity, populations are scientifically managed for sustainable yield, and users buy hunting and fishing permits to finance the whole scheme—essentially a cap and permit system where some permits are tradable.

Similar proposals have been made for management of groundwater resources and the atmospheric sink. A "Sky Trust" or "Earth Atmospheric Trust" [PDF] has been proposed to manage the use of the atmosphere as a dump for CO2 and other greenhouse gases. Sustainable levels of emissions are determined scientifically, polluters buy emission permits, and the revenues can be put in trust funds for environmental restoration and management, as well as in permanent funds that pay dividends. These concepts are being realized as cap-and-trade or cap-and-dividend schemes as exemplified by the Regional Greenhouse Gas Inititiative in the northeastern United States.

Groundwater is another scarce resource where revenue could be funneled to a trust or to a sovereign wealth fund. Commercial users such as beverage bottlers could be charged rent for groundwater extraction to finance management, monitoring, and preservation of water quality and quantity. Some funds could be shared with the public as their rightful share of common property resources.

The attraction of the SWF model is that it appeals to various shades of the political spectrum. As noted by Karl Widerquist and Michael Howard in their forthcoming book on the Alaska Permanent Fund:

A resource-financed Basic Income can further Liberal-Egalitarian and Civic Republican goals of meeting the needs of the least advantaged and protecting them from domination, but it does so using the left-libertarian strategy of taxing resources rather than income or labor.

One of the criticisms of the Alaska Permanent Fund is the incentive for exploitation of fossil fuel resources as shown by the "Drill, Baby Drill" campaign slogan of former Alaska Governor Palin's candidacy for the U.S. vice presidency. Likewise, the extremely polluting Alberta tar sands contribute to the Alberta Heritage Fund. There is certainly truth to this critique. However, consider that in countries without a SWF the government gets very little benefit from resource wealth, and the citizens get no direct benefit except in Alaska where there is a dividend. So the situation without a SWF is even worse.

A portion of resource rent should be invested in renewable replacements for the future when the resource is gone, according to the concept of weak sustainability. Extractive industries should have to pay all of the costs of pollution and depletion of the resource. Nowhere are these institutional structures to mitigate depletion of resources and pollution in place. This is not the fault of SWFs, but of the governments where the resources are located.

If rent were collected on the basis of carbon emissions rather than oil extraction in a carbon auction system, then a carbon cap could be enforced, and total revenue could be stable or even increasing. As carbon emissions are reduced the price of carbon permits could rise, offsetting the decline in quantity and maintaining funding for a SWF. This could reverse the incentive to consume more carbon-based fuels. Another option is to have wealthy countries pay poorer countries to leave resources in the ground in sensitive ecological areas, such as the proposed payment for Ecuador not to develop oil resources in Yasuní park.

Clearly there are ways in which the transparency of SWFs can be improved. As a starting point in October 2008, the international community convinced 23 countries to sign the Santiago Principles to ensure ethical and resilient practices that do not compromise the efficacy of this instrument. Vigilance over the performance of these funds must be maintained, but as we struggle to consider ways of tackling financial and ecological sustainability, sovereign wealth funds deserve far greater attention for positive adoption.

Saleem H. Ali is professor of environmental planning at the University of Vermont and director of the Institute for Environmental Diplomacy and Security (Twitter: @iedsuvm). Gary Flomenhoft is a fellow of the Gund Institute for Ecological Economics at the University of Vermont and an advisor to the Vermont legislature on natural resources policy.

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Read More: Conservation, Debt, Democracy, Development, Economy, Education, Energy, Environment, Finance, Governance, Sustainability, Canada, China, Ecuador, Germany, Iraq, Kiribati, Kuwait, Nigeria, Norway, Qatar, Singapore, Saudi Arabia, United Arab Emirates, United Kingdom, United States, Africa, Americas, Asia, Europe, Middle East

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