If adopted by parliament, the fund would over time divest billions of dollars from oil and gas stocks, which now represent 6 percent - or around $37 billion - of the fund's benchmark equity index. The aim is to make the Norwegian government's wealth less vulnerable to a permanent drop in oil prices.

Europe's index of oil and gas shares <.SXEP> hit its lowest level since mid-October on the news and was trading down 0.27 percent at 1351 GMT.

The proposal came in a letter sent by the central bank to the finance ministry and signed by its governor, Oeystein Olsen, and the chief executive of the fund, Yngve Slyngsad, Deputy Central Bank Governor Egil Matsen said in an interview.

"Our advice is to simply remove the oil and gas sector, as it is defined in the FTSE reference index, from the fund's reference index," Matsen said.

"That would mean all companies that the FTSE has classified with the sector, should be removed from our reference index."

The fund is the world's largest sovereign wealth fund. It invests Norway's revenues from oil and gas production for future generations in stocks, bonds and real estate abroad.

It is among the largest investors in a wide range of oil companies, holding stakes at the end of 2016 of 2.3 percent in Royal Dutch Shell , 1.7 percent of BP (>> BP), 0.9 percent of Chevron (>> Chevron Corporation) and 0.8 percent of Exxon Mobil (>> Exxon Mobil Corporation).

"The risk for the oil sector is how many investment funds will downsize their exposure to extractive industries," said Jason Kenney, oil analyst at bank Santander.

The fund also held 1.7 percent of Italy's Eni (>> Eni), 1.6 percent of France's Total (>> Total) and 0.9 percent of Sweden's Lundin Petroleum (>> Lundin Petroleum), among others.

At the end of the third quarter, Royal Dutch Shell was the fund's third-biggest equity investment overall, worth around $5.34 billion and exceeded only by its ownership in Apple and Nestle (>> Nestlé).

"It clearly stands out, perhaps not surprisingly, but not obviously, that indeed there is a substantial difference ... in return between the oil and gas sector and the broad stock market in periods when the oil price changes substantially," Matsen said.

"Oil price exposure of the government's wealth position can be reduced by not having the fund invested in oil and gas stocks."

The fund could still invest in the sector if other parts of the fund's mandate are fulfilled by having some investments in some of the companies, Matsen said.

"But clearly the direction is that ... if the ministry and the politicians think it is good advice and they say yes to it, clearly the investments in the oil and gas sector will decrease over time," he added.

Green campaigners welcomed the news.

"This is a victory for common sense. We have argued this for some time and there is no reason for Parliament not to approve this," Martin Norman, Head of Sustainable Finance Campaign for Greenpeace Nordic, told Reuters.

"Bravo Norway, and let's hope it gets through because the future of fossil fuel investment is looking shaky indeed," said Rachel Kennerley, climate campaigners at Friends of the Earth.

Oil and gas stocks would be replaced by investments in other companies.

"The straight answer is that all other sectors would be weighted up in proportion ... (under) our current mandate," said Matsen.

At the end of 2016, the fund's equity investments were split between investments in the financial sector (23.3 percent), industrial companies (14.1 percent), consumer goods (13.7 percent), consumer services (10.3 percent), healthcare (10.2 percent), technology (9,5 percent), oil and gas (6.4 percent), basic materials (5.6 percent), telecoms (3.2 percent) and utilities (3.1 percent).

The timing of the coming divestments is as yet unclear. The proposal has to be reviewed by the Finance Ministry, which in turn needs to decide whether to propose it to parliament.

At the earliest, the ministry's first opportunity could come in the spring, with a vote in parliament in June.

In addition to its holdings via the fund, Norway has exposure to oil and gas via large untapped offshore hydrocarbon reserves, as well as its 67 percent stake in the national oil company, Statoil (>> Statoil).

The fund has grown so large that even though the Norwegian state is taking less than 3 percent of the fund's value every year for its fiscal budget in recent years, oil spending now accounts for one in five crowns spent by the state.

Graphic: http://tmsnrt.rs/2tskfub

(Additional reporting by Terje Solsvik in Oslo, Nina Chestney in Bonn, Stephen Jewkes in Milan, editing by Larry King)

By Gwladys Fouche