S&P INDICES|

Research Insights

December 2009
www.indices.standardandpoors.com

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

With the 2012 expiration of the Kyoto Protocol on global warming looming large, emerging markets, which have begun to surpass the U.S. as some of the largest emitters of carbon, are taking a central role in the debate over how to reduce emissions. As global attention turns to these countries, Standard & Poors has designed an index which allows for reduced carbon emission exposure in their portfolios while replicating the broad emerging market returns. Developed countries continue to lead the world in terms of per capita emissions, according to data the U.S. Energy Department's Carbon Dioxide Information Analysis Center released in 2006, the most recent numbers available. However, the largest emerging market countries are fast becoming the biggest carbon polluters1, which explains why total global emissions have risen alarmingly in the last decade. Emerging markets are polluting more for several reasons. Manufacturing services have moved increasingly to emerging markets, thirst for commodities has increased worldwide with the rapid growth of emerging market economies, and populations have exploded in developing countries, along with an attendant demand for energy, materials and infrastructure, following which environment and carbon emissions have been immediate casualties. While per capita emissions in these countries are still several notches below that of advanced economies, theyre catching up fast (see table on page 2); total emissions have already exceeded many of the developed markets.

1 Fossil fuel CO2 is one of the six green house gases identified as critical to climate change. Fossil fuel CO2 is the result of the burning of fossil fuels like coal, oil, and gas. In addition to the CO2 that already exists in the air, fossil fuel CO2 acts as a blanket trapping more of the suns energy and raising the temperature of the earth, hence the epithet global warming. Global warming induces changes in rainfall levels, daily temperatures, sea levels, and the rate of glacier melting.

Alka Banerjee
VP, Global Equities (212) 438 3536 alka_banerjee@sandp.com

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

Top 20 Carbon Emitting Countries in the World

Country National emissions (thousands of tons of carbon) 1,664,589 1,568,806 426,728 411,914 352,748 219,570 155,051 148,549 129,613 129,313 127,357 118,950 113,086 104,495 104,063 101,458 96,143 96,064 90,950 Emissions per person (tons of carbon) 1.27 5.18 2.99 0.37 2.80 2.67 2.56 4.55 2.68 2.19 1.81 1.13 2.39 1.71 4.38 4.90 0.51 2.18 0.41

CHINA (MAINLAND) UNITED STATES OF AMERICA RUSSIAN FEDERATION INDIA JAPAN GERMANY UNITED KINGDOM CANADA REPUBLIC OF KOREA ITALY (INCLUDING SAN MARINO) ISLAMIC REPUBLIC OF IRAN MEXICO SOUTH AFRICA FRANCE (INCLUDING MONACO) SAUDI ARABIA AUSTRALIA BRAZIL SPAIN INDONESIA

87,043 1.86 UKRAINE Ranking of the world's countries by 2006 total CO2 emissions from fossil-fuel burning, cement production, and gas flaring. Emissions (CO2_TOT) are expressed in thousand metric tons of carbon (not CO2). Source: Tom Boden, Gregg Marland, and Bob Andres, Carbon Dioxide Information Analysis Center, Oak Ridge National Laboratory http://cdiac.ornl.gov/trends/emis/overview_2006.html

In our view, governments alone cant fight the battle against carbon emissions. The task is too large and the scope too wide. Thus we think that a public private partnership is a must to make carbon reduction a reality. A process where stock market mechanisms reward companies that are more carbon efficient can be an effective way to deliver the eco-conscious message to the private sector. One popular approach so far has been to create equity indices and investment tools that focus on companies whose primary interest has been on producing clean technology and clean energy. This approach has its uses; it highlights the specific companies that are leading the charge in the green space and allows for focused investments that are betting on the market's ability to reward these companies.

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

However, it is an inescapable fact that fiduciary responsibility to achieve market returns dictates the flow of a large amount of institutional money. Niche investment strategies that cater to an audience of socially responsible investors havent crossed over into the mainstream market, as the relatively smaller size and liquidity of the clean companies hampers huge investments. What is required, in our view, is a broad market strategy that can meet the dual objectives of replicating a broad market and, at the same time, rewarding carbon efficiency. Pension funds, sovereign funds, and other government bodies with large assets can make a difference if they support an agenda that promotes carbon efficiency, and yet allows them to satisfy their fiduciary responsibilities at the same time.

S&P/IFCI Carbon Efficient Index Replicates the Risk Return Profile of the S&P/IFCI LargeMidCap
On the heels of the launch of the S&P U.S. Carbon Efficient Index in March 2009, Standard & Poors, under sponsorship of the International Finance Corp. (IFC), the private sector arm of the World Bank Group, began work in the area of emerging markets. The idea was to replicate the risk return profile of the S&P/IFCI LargeMidCap for emerging markets, but with an emphasis on carbon emissions. The resulting S&P/IFCI Carbon Efficient Index, which will launch on December 10, 2009 in Copenhagen, Denmark, closely tracks the investment performance of the parent index while the index constituents provide a 24% reduced exposure to carbon emissions.

There are Challenges in Working with Emerging Markets' Carbon Footprint Data
The S&P/IFCI Carbon Efficient Index, like its parent, includes 21 emerging markets and more than 800 stocks. Market weights within the index range from approximately 20% for countries like China and Brazil to less than 1% for Hungary and the Philippines. Frequently, smaller markets lack sectoral diversity, and a limited number of companies contribute nearly 100% of their emissions. Carbon footprints2, as calculated by Trucost, a company that provides comprehensive data on corporate environmental impacts, are naturally highest for companies in the utilities, energy, and materials sectors. A simple exclusion of these companies from an index provides a vast sector bias toward investing in financials and technology companies, an approach unacceptable to most investors. Carbon footprints differ greatly between emerging markets, and between sectors within the same emerging market (see table on page 4). This exponentially increases the complexity of designing an emerging market carbon efficiency index.

Trucost has partnered with Standard & Poors to provide data on carbon efficiency. Trucost calculates total greenhouse gas emissions of each company in the index based on companys resource usage, emissions, and supply chain. It then divides total emissions by total revenue dollars earned to get a normalized, comparable carbon footprint.

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

S&P/IFCI LargeMidCap Carbon Scores

Country Brazil Chile China Czech Republic Egypt Hungary India Indonesia Israel Korea Malaysia Mexico Morocco Peru Philippines Poland Russia South Africa Taiwan Thailand Turkey Grand Total
Sector Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities

Average Carbon Score 597.06 1,100.21 1,683.10 2,491.16 477.14 201.03 1,289.97 1,176.95 165.45 318.80 613.74 306.75 64.99 339.15 193.66 153.01 746.04 708.68 391.05 1,450.57 391.76 763.13
Min 15.51 62.12 25.16 4.58 57.37 17.40 16.97 97.40 13.50 24.59 Max 1,721.27 2,313.54 8,176.14 476.78 110.59 6,742.87 1,028.25 8,674.96 141.12 29,318.31 Range 1,705.76 2,251.43 8,150.98 472.20 53.22 6,725.47 1,011.27 8,577.56 127.63 29,293.72 Average 138.46 344.01 910.45 28.11 71.42 516.44 125.17 2,053.49 30.52 5,316.98 763.13

Carbon Footprint data from Trucost

How Reweighting Yields Reduce Carbon Exposure

Some market sector combinations are naturally conducive to applying some reweighting within the combination, while market sector combinations that have only one stock or stocks that are all high polluters are difficult to reweight. To reweight within a sector, we rank stocks in terms of carbon footprint using the same sectors as in the parent index. Reweighting is possible if a market sector includes both high polluters and low polluters and where the market sector combination is responsible for a significant amount of carbon emissions and reweighting will result in real emission savings. We have reweighted 21 market sectors out of the 142 in the S&P/IFCI LargeMidCap to yield a 24% savings in carbon emission exposure in the new portfolio. At all times, we kept the

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

sector and market weights of the index at exactly the same proportion as the parent index. Based on a back tested history of three years this ensures a small tracking error with the parent index.

Some Statistical Results

More than three years of back tested history gives us some interesting results. A close tracking error Tracking error of the S&P/IFCI Carbon Efficient Index to the S&P/IFCI LargeMidCap over three years was an extremely small 1.47% in the period from 2006 to 2009. In each of the three years, the tracking error ranged from .87% to 2.12%. In short, investing in the S&P/IFCI Carbon Efficient Index seems likely to assure competitive emerging market returns using a "greener" portfolio.
S&P IFCI Carbon vs S&P/IFCI Large-Mid
Tracking Error for 2006-2009 Tracking Error for 2006-2007 Tracking Error for 2007-2008 Tracking Error for 2008-2009 1.47% 0.87% 2.11% 1.14%

Index Performance comparison

175 155 135 115 95 75 55
-0 6 n0 M 7 ar -0 M 7 ay -0 7 Ju l-0 Se 7 p0 N 7 ov -0 7 Ja n0 M 8 ar -0 M 8 ay -0 8 Ju l-0 Se 8 p0 N 8 ov -0 8 Ja n0 M 9 ar -0 M 9 ay -0 9 Ju l-0 Se 9 p09 Ja N ov

MSCI EM (MXEF) (PR) S&P/IFCI Carbon Efficient (PR)

S&P/IFCI Large-Mid Cap Composite (PR)

Source: S&P Indices

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

Carbon emission exposure reduction Over the four time periods 2006, 2007, 2008, and 2009the average reduction in carbon emission exposure using our new index was in excess of 21%. In 2009, it was more than 24%.

Carbon Footprint of the Indices

CarbonFootprint of the S&P/IFCI LargeMidCap 880.80 833.57 730.90 633.87 Carbon Footprint of the S&P/IFCI Carbon Efficient 676.28 651.00 605.46 480.44

2006 2007 2008 2009

Carbon Content: S&P IFCI LargeMid vs. S&P IFCI Carbon Efficient
900 800 700 600
S&P/IFCI LargeMid

500 400 300 200 100 0 2006 2007 2008 2009

S&P/IFCI Carbon Efficient

Source: S&P Indices

Analysis of an index with deletions As an exercise to see what would happen if we designed an index without any high carbon emitters, we created a pro forma index that deleted all stocks of companies we identified as high polluters but had been included in the new S&P/IFCI Carbon Efficient Index with a lower weighting. We tested the performance of this hypothetical clean version with the S&P/IFCI LargeMidCap. The investment performance tracking error in this case ballooned to 2.6% over three years. This is important because a large tracking error introduces uncertainty over time on expected returns and can be an issue for investors that make large commitments, such as pension funds and sovereign wealth funds.

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

S&P/IFCI Clean* versus S&P/IFCI LargeMidCap

Tracking Error for 2006-2009 2.63% Tracking Error for 2006-2007 1.43% Tracking Error for 2007-2008 3.80% Tracking Error for 2008-2009 2.04% * S&P/IFCI Clean is the name of the proforma index, where we have actually deleted companies from the index who had very high carbon footprints. Source: S&P Indices

Indices can Drive Investor Attention to Carbon Efficiency

The S&P/IFCI Carbon Efficient Index is a measurement benchmark that allows investors to track the performance of stocks in a broad based emerging markets portfolio while reducing carbon exposure. The index has the same risk return profile as the parent S&P/IFCI LargeMidCap. Eventually, we expect more investors will seek a way to reduce carbon exposure, while maintaining their risk return profile. They should find that replicating a well-established index as a guide for greener investment strategies, which is what the S&P/IFCI Carbon Efficient Index does, is a useful investment tool. In order to make an impact on global warming, companies need to be motivated to perform better on the carbon efficiency scale. One of the best motivating factors for a company is the price of its stock. While indices do not drive stock market prices, they do bring attention to a specific theme, in this case investing in a reduced-carbon exposure portfolio, by giving investors insight into how to achieve their goal of balancing environmental and financial factors. While some critics argue there is a loose correlation between inclusion in an index and investor behavior, in our view indices can and do direct investor behavior. By highlighting an important issue and giving investors a way to select companies that are recognizing the importance of carbon efficiency, indices provide an essential way for the financial markets to play a role in the fight against global warming.

S&P INDICES | Research Insights

Carbon Efficient Investing in Emerging Markets as a Tool to Combat Global Warming

2009 Standard & Poor's Financial Services LLC is a wholly owned subsidiary of The McGraw-Hill Companies, Inc. All rights reserved. STANDARD & POOR'S and S&P are registered trademarks of The McGraw-Hill Companies, Inc. These materials have been prepared solely for informational purposes based upon information generally available to the public from sources believed to be reliable. Standard & Poors makes no representation with respect to the accuracy or completeness of these materials, whose content may change without notice. Standard & Poors disclaims any and all liability relating to these materials, and makes no express or implied representations or warranties concerning the statements made in, or omissions from, these materials. No portion of this publication may be reproduced in any format or by any means including electronically or mechanically, by photocopying, recording or by any information storage or retrieval system, or by any other form or manner whatsoever, without the prior written consent of Standard & Poors. Standard & Poors does not guarantee the accuracy and/or completeness of the S&P Indices, any data included therein, or any data from which it is based, and Standard & Poors shall have no liability for any errors, omissions, or interruptions therein. Standard & Poors makes no warranty, express or implied, as to results to be obtained from the use of the S&P Indices. Standard & Poors makes no express or implied warranties, and expressly disclaims all warranties of merchantability or fitness for a particular purpose or use with respect to the S&P Indices or any data included therein. Without limiting any of the foregoing, in no event shall Standard & Poors have any liability for any special, punitive, indirect, or consequential damages (including lost profits), even if notified of the possibility of such damages. Standard & Poors does not sponsor, endorse, sell, or promote any investment fund or other vehicle that is offered by third parties and that seeks to provide an investment return based on the returns of the S&P Indices. A decision to invest in any such investment fund or other vehicle should not be made in reliance on any of the statements set forth in this document. Prospective investors are advised to make an investment in any such fund or vehicle only after carefully considering the risks associated with investing in such funds, as detailed in an offering memorandum or similar document that is prepared by or on behalf of the issuer of the investment fund or vehicle. Analytic services and products provided by Standard & Poors are the result of separate activities designed to preserve the independence and objectivity of each analytic process. Standard & Poors has established policies and procedures to maintain the confidentiality of non-public information received during each analytic process.

S&P INDICES | Research Insights