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The ‘Military Trophies Park’ in Baku, capital of Azerbaijan, has gained plenty of attention since opening in April. 
 
It includes 300-odd exhibits such as Armenian tanks, rocket launchers, and a wall of vehicle registration plates – all captured by Azerbaijan’s military last year when it trounced its neighbour in a war for control of a disputed mountainous region. 
 
Two stops away on the Baku Metro stands the head office of the organisation that exemplifies Azerbaijan’s real power. Sofaz, the State Oil Fund of Azerbaijan, manages the nation’s revenues from its oil and gas fields, mainly in the Caspian Sea. Over two decades its assets under management have soared 160-fold to $43.56 billion, close to the size of Azerbaijan’s economy. 
However, last year Sofaz’s oil and gas revenues halved to $4.3 billion as the Covid-19 pandemic crushed oil demand. 
 
“The outbreak of Covid-19, due to its black-swan features, had a disruptive impact for global institutional investors, including sovereign wealth funds. Sofaz also faced major challenges, as the growth in fund assets slowed down due to declining hydrocarbon revenues,” chief executive Israfil Mammadov told AsianInvestor.  
 
The collapse in deposits was offset by a 2.8% investment return in Azerbaijan’s local currency, the manat. That was mainly due to non-credit fixed income and large-cap equities. In US dollars Sofaz’s annual return was 7.8% in 2020, boosted by currency gains and a bull run in gold. 
 
CONSERVATIVE APPROACH 
 
Sofaz has a relatively conservative portfolio allocation. It invests 64% of AUM in fixed-income and money-market instruments, and just 16% in equities. A hefty 14% of its portfolio sits in gold, with the remaining 6% in property assets.
 
When deciding whether to invest via its inhouse team of not, the fund tries to balance “expertise, performance, risk and last but least the costs,” said Mammadov.
 
It manages 90% of its fixed income portfolio internally, outsourcing the rest to the likes of World Bank Treasury and DWS Group. Close to 90% of its equities, meanwhile, are managed by State Street Global Advisors, UBS, Blackrock, Mellon Capital and Sumitomo Mitsui Trust. 
 
“Our index-tracking passive fixed-income and equity strategies aim to earn a return through global diversification in a very cost-effective way,” explained Mammadov. 
 
Sofaz is looking to alternative assets. “We are constantly exploring private markets and strategies to invest in top-tier private equity and real estate funds,” he said.
 
Perhaps most notable is its heavy weighting in gold. The commodity stood at 3.4% of its assets under management in 2016 but has since more than quadrupled. The CEO argues this is a prudent investment. 
 
“Uncertainty in financial markets caused by the Covid-19 pandemic, geopolitical tensions, the low- or negative-yield environment, and loose monetary and fiscal policies, all make gold investments attractive for long-term investors like Sofaz. Gold also serves as a good tool for preserving capital and diversifying our portfolio.”
 
GOVERNANCE CHALLENGES
 
As part of its daily operations Sofaz has to contend with concerns over corruption, which abound in Azerbaijan. The country ranked 129th in Transparency International’s Index 2020, alongside Russia, Mali, Malawi and Gabon. Neighbouring Armenia stood at 60th while Georgia was in 45th spot. 
There is good reason for Azerbaijan’s low score. The family and friends of President Ilham Aliyev own controlling stakes in many of its biggest companies. Meanwhile, the former chairman of its largest bank by assets, the International Bank of Azerbaijan, is serving a prison sentence for laundering $9 billion. 
 
Sofaz is seen as an oasis of good governance relative to other Azerbaijani institutions. The government channels all revenues from exploiting sovereign oil and gas deposits into the fund. Mammadov said this ensures transparency and prevents the economy from overheating.
 
However, it has not escaped controversy, especially over withdrawals from the fund to the state budget and its own extra-budget direct spending. A 2013 joint study by the Natural Resource Governance Institute and the Columbia Center on Sustainable Investment found that government withdrawals were made “arbitrarily and vary from year to year”.
 
Azeri economist Gubad Ibadoghlu, a staunch critic of the Aliyev government who now teaches at Rutgers University, notes there are no fiscal rules surrounding transfers from Sofaz equivalent to those surrounding the Oil Fund of Norway. There, local regulations dictate that government withdrawals stay in line with the fund’s expected real annual return over time (estimated at 3%), and that large movements in the value of the fund or emergency transfers to counteract downturns are smoothed over several years. 
 
Speaking to AsianInvestor, Ibadoghlu argues that Sofaz places insufficient emphasis on generating good financial returns, instead often funding projects such as pipelines or a refinery, which should be the responsibility of general government expenditure or the oil and gas industry.
 
PANDEMIC PRESSURES
 
Mammadov argues the disparities in economic development between Norway and Azerbaijan make such comparisons flawed. 
 
“Azerbaijan inherited largely obsolete infrastructure from the communist era [when part of the former Soviet Union], and in the early years of independence [it] lacked private capital, so it is natural that fiscal policy prioritised developing modern infrastructure,” he said.
 
The government also approved a new rule in 2018 that limits how much oil and gas revenues that can be spent each year. It was due to be implemented last year, but it was derailed by the pandemic. 
 
Mammadov notes that many governments suspended their fiscal rules as the pandemic uniquely stretched economies. And falling oil revenues were a big issue for an energy-exporting nation such as Azerbaijan. He said “the rule customised to the post-pandemic period will be implemented once the economy returns to normal”.
 
TEPID ESG EMBRACE
 
Among the new realities facing Sofaz is global pressure to adopt environmental, social and governance (ESG).
 
Mammadov stresses the sovereign fund has embraced ESG. He noted that Sofaz first allocated to renewables in 2010 through private equity funds. Plus, an internal working group keeps “abreast of developments and learning best practice” in ESG. But he admits that ending dependence on fossil fuels and decarbonising is problematic for an economy and SWF based on oil and gas.
 
Sofaz is “working with external asset managers, both in private and public markets, to identify new opportunities across all climate-related sectors,” he said.
 
The vagueness of Sofaz’s ESG approach was echoed in President Aliyev’s February decree, ‘Azerbaijan 2030: National Priorities on Socio-Economic Development.’ It mentioned renewable energy only at the end of a long list of strategic and political priorities.
 
“Several laws have been drafted placing strong emphasis on renewable energy and energy efficiency to aid Azerbaijan in saving its natural gas and oil resources for export, and also meeting its greenhouse gas commitments under the Paris Agreement,” argued Mammadov. 
 
Such sentiments do not placate critics like Ibadoghlu. He had a scathing response when asked about the policy of Azerbaijan’s government to decarbonise and phase out fossil fuel investment. 
 
“What policy? There is no such policy.”

 This article was first published in the summer 2021 edition of the AsianInvestor print magazine.