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Environmental Policies and Economic Growth in Indonesia: Challenges and

Opportunities1

Paper for Friedrich Naumann Stiftung, Jakarta and National Climate Change Council
Indonesia (DNPI)
28th of October 2010

Introduction

Combating global climate change has become the dominant agenda in international
development. A large developing country such as Indonesia is both a big contributor to
global greenhouse gas emissions (GHG) and a victim of adverse impacts of climate
change. This requires Indonesian policymakers to balance two objectives. First, there is a
need to achieve high economic growth that safeguards the traditional goals of economic
development: creating wealth, jobs and income. Second, it has to safeguard the quality of
the environment in order to preserve a sustainable endowment of natural resources.

This paper argues that comprehensive environmental policies – framed within a low –
carbon economic growth strategy - is essential to achieve both objectives. The first part
explains the rationale behind a low carbon economic growth policy and how Indonesia’s
emissions profile and projection scenario determines its mitigation opportunities and
challenges. The second part looks at specific economy-wide and sector benefits and costs
if climate mitigation policies were to be implemented in Indonesia. The third part looks at
specific policy challenges arising in specific priority sectors – adaptation, forestry and
energy. The last part summarizes the main findings.

1. Indonesian development as a move towards a low carbon economy

The fight against global climate change has been put at the forefront of the international
development agenda. Virtually all major multilateral development and finance agencies
have now accepted the scientific conclusion of the Intergovernmental Panel on Climate
Change (IPCC) that climate change is happening and that human – induced
(anthropogenic) emissions are largely responsible. As the IPCC (2007 notes:

“ Warming of the climate system is unequivocal, as is now evident from observations of increases
in global average air and ocean temperatures, widespread melting of snow and ice and rising
global average sea level <….> Most of the global average warming over the past 50 years is
very likely due to anthropogenic GHG increases and it is likely that there is a discernible human-
induced warming averaged over each continent (except Antarctica) <…..> Anthropogenic
warming over the last three decades has likely had a discernible influence at the global scale on
observed changes in many physical and biological systems.(IPCC, p.72” )

1
Kurnya Roesad , RMAP/Crawford School of Economics and Government, ANU

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Recent forecasts of CO2 emissions trajectories indicate that without global collaborative
mitigation efforts, the world will face a potentially catastrophic scenario in which
temperatures would be 5 ˚ C warmer than in the pre-industrial era (IPCC 2009). The
conventional wisdom is that global greenhouse gas (GHG) emissions need to be
stabilized at 450 ppm of CO2 equivalent in order to keep global warming at a 2o Celsius,
the level at which human civilization could adapt to the worst impacts of climate change
at relatively low costs (Stern 2006, World Bank 2010c).

The physical consequences of global climate change include changed precipitation


patterns, sea level rise (amplified by storm surges), more intense and perhaps frequent
extreme weather events, increased prevalence of vector-borne diseases—and perhaps
catastrophic events, such as reversal of the Gulf Stream or melting of the Greenland ice
sheet.

The economic fallout from global warming could be substantial. The Stern Review
(2006) estimates that in a business as usual scenario (BAU) – that is if no serious climate
mitigation measures are taken – the world will need to invest 1 percent of total world
GDP per annum to mitigate the worst effects of climate change. The World Bank
estimated that about 75-80 percent of the damage costs inflicted by climate change will
be borne by the developing countries (World Bank 2010c).

The economic costs to developing countries will mainly show up as declining


productivity in the economy. Productivity losses will be especially felt in the agricultural
sector in the form of decreases in fishery production, damages in infrastructure, loss of
productive areas and settlement due to land inundation, species extinction and decline in
ecosystem integrity as life support system (Ahmad 2010). Other impacts are increased
stresses on health and water systems, changes in trading patterns and international
investment flows, financial market disruption, and altered migration patterns. All these
factors will increase the vulnerability of developing countries to sudden adverse shocks.

Thus, the costs of global climate change are real and Indonesia faces an international
environment in which major economies have embarked on a low carbon economic
growth path. Most countries, including the major developing economies, have committed
to emissions reduction goals. Despite the failure of the COP 15 in Copenhagen to agree
on a binding climate policy agreement after the Kyoto Protocol will expire in 2012, the
international community has not abandoned climate change as a major development
agenda. The Copenhagen consensus has resulted in major developing economies
formulating significant emissions reduction commitments, matching the targets of
developed economies. Most economies have also formulated ambitious renewable energy
targets in order to achieve their emissions targets.

Table 1 : Emissions and renewable energy targets in selected countries


Emissions reduction targets Renewable energy targets
Australia 5-25% below 2000 20% by 2020 from 8% in
emissions 2007

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China 40-45% below 2005 in 15% by 2020 from 8% in
emissions intensity 2006
Indonesia 26-41% below BAU 15% by 2025 (incl. nuclear)
Japan 25 % below 1990 emissions 16TwH by 2014
Korea 30% below BAU 6.08 % by 2020 from 2.7
%in 2009
Malaysia Target to be introduced in
2011
Singapore 16% below BAU
Thailand 30% below BAU 20% by 2022
Philippines 100% increase from 2005 to
2015
USA 17% below BAU No national targets, about
30 states have mandatory
targets
Vietnam 5% by 2020from 3% in2010
Source: Summaries of targets taken from various national documents, from submissions to the UNFCCC,
and from Olz and Beerepoot (2010), quoted in World Bank (2010c forthcoming)

However, commitments to emissions reductions need to be backed up by concrete


policies and to achieve these ambitious goals, economies need to adopt a low carbon
growth strategy by making production and consumption less carbon-intensive and pricing
environmental externalities.

The current emissions trends make it clear that this will be a tall order to achieve. The
point here is that emissions have to be seen as a corollary of output growth: emissions
track GDP in most countries (see Table 2). In order to reduce emissions below the BAU
scenarios, economic growth needs to some extent be de-coupled from emissions. For this
to happen, two things need to be tackled. First, production patterns need to be de-
carbonized, i.e. energy needs to be used more efficiently and directed toward using more
clean energy sources. Second, consumption behavior needs to be steered towards more
sustainable levels.

Table 2: GDP, Emissions and Energy Growth (%)


1971- 1990-
Average annual growth rates 90 2000 2000-5
World
Emissions growth 2.1 1.1 2.9
GDP growth 3.4 3.2 3.8
Energy growth 2.4 1.4 2.7

OECD
Emissions growth 0.9 1.2 0.7
GDP growth 3.2 2.7 2.1
Energy growth 1.5 1.6 0.8

Non-OECD
Emissions growth 4.2 0.9 5.5

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GDP growth 3.8 4 6.2
Energy growth 3.8 1 4.6
Source: Garnaut, Howes, Jotzo, Sheehan (2008)

A country’s low carbon growth strategy depends on its climate mitigation and adaptation
opportunities, which in turn depends on its emissions profile.

Indonesia is both a victim of and a contributor to climate change. The country’s


agricultural sector is still significant, which makes it vulnerable to extreme weather
patterns. Thus, poverty alleviation efforts will depend heavily on adaptation measures to
secure rural food production systems. On the other hand, Indonesia presides over one of
the largest remaining tropical rainforests in the world and deforestation activities are a
main case for GHG emissions.
Figure 1: Top 25 Global CO2 Emitters in 2004
Emissions trends show that Source: International Energy Agency (2007) [www.iea.org]
Mt
Indonesia belongs to the top 25 CO2/yr
emitters, if forest-based emissions
5,000
are included. Based on fossil fuel
combustion, Indonesia is among the 4,000
top 25 CO2 emitters, or ranked 16th
when counting EU as one country. 3,000 Deforestation
(estimated 2000)
However, if CO2 emissions due to 2,000
deforestation and land use change
are included, Indonesia then rises to 1,000
among the top emitters. 2 0

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Indonesia’s emissions profile shows that the land use change and land use change from
forestry (LULUCF) accounts for the largest share, followed by peat fires and energy

However, there are uncertainties regarding the emissions from forest-based sources. Recent figures from
the Min istry of Forestry indicate that the rate of deforestation may be only a third of the average rates in
the late 1990s.

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Figure 2: Sector Emissions, 2005

Energy
Peat fire 22.5%
25.7%

Industry
2.1%
.
Agriculture
4.5%

LUCF.1 % 36
Waste
9.1%

Source: Indonesia Second National Communication to the UNFCCC, 2009.

Indonesia’s CO2 emissions per capita is relatively low by international comparison,


valued at around 2t CO2 per capita. Figure 3: Annual Growth Rates of GDP, Energy Use
But this also reflects the fact that and Emission per Capita
Indonesia is still catching up on
economic growth. In fact,
Indonesia’s economic growth has
become more carbon-intensive, with
emissions per capita growing faster
than GDP per capita. The annual
growth rate of CO2 emissions per
capita has risen by 3.3 times
between 1980 and 2004. During the
same period, the growth rate of
GDP per capita has increased by 2.3
times and energy/person by 2.1 times
(Figure 3). This means that the
carbon intensity of energy use has Source: International Energy Agency (2007) [http://www.iea.org/]
increased as well.

A closer look reveals why this is the case. Table 3 shows that the increased carbon
intensity of electricity production and consumption is mainly due to rising coal use. The
industry and electricity sectors account for most of coal-based emissions.

Table 3: CO2 Emissions in Indonesia in 2006 (in million t CO2)


By Fossil Fuel Source

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Share in
Total total Emissions growth
By Consumption Group Coal Oil Gas Emissions (%) 1990-2006 (%)
Industry 50.73 23.08 22.32 96.13 29 192
Electricity 57.49 23.22 9.12 89.82 27 309
Transport 72.35 0.01 72.36 22 127
Other* 0.06 44.95 31.29 76.3 23 60
of which: Residential 0.06 25.76 0.04 25.86 8 41
Total 86.8 179.6 69.6 334.61 100
Note: * '
Other'includes unallocated auto-producers, other energy industries.
Source: IEA 2008 Annexes

Two main challenges for Indonesia arise from these emissions trends. First, in the short –
and medium-run, the main challenge is to reduce emissions from LULUCF, including
peat fires. Second, in the long-run mitigation of energy – related emissions will become
the more important issue in the future, with the added twist that the government has to
balance energy supply objectives - which could be achieved by relying on cheaper coal-
based fuel – and renewable energy targets.

Indonesia has committed to a 26 percent reduction in emissions below the BAU scenario
by 2020. Table 4 illustrates the emissions scenarios. Starting from 2005 emissions levels,
under the BAU scenario total emissions would increase from 2.12 to 2.95 giga tons (gt)
in 2020. A 26 percent reduction from the BAU level in 2020 would mean that the forestry
sector would be the biggest contributor in reducing total net emissions, followed by peat
land, waste and energy. Another 15 percent in emissions reductions could be achieved, if
substantial international assistance were provided. This is particularly true for capital-
intensive projects like geothermal development, which requires substantial foreign
investment in order to take off (Ahmad 2010a).

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Table 4: Emissions Projections in 2020 For Indonesia

Reduction Reduction
Targets targets Emissions
Emissions (Gt) (26%) (15%) Scenario
2005 BAU 2020 Giga ton % of BAU Giga ton % of BAU 26% 41%
Peat 0.83 1.09 0.280 9.5 0.057 2.03 0.81 0.75
Waste 0.17 0.25 0.040 1.6 0.030 1.07 0.2 0.17
Forstry 0.65 0.49 0.392 13.3 0.310 11.02 0.1 -0.21
Agriculture 0.05 0.06 0.008 0.3 0.003 0.11 0.05 0.05
Industry 0.05 0.06 0.001 0 0.004 0.14 0.06 0.06
Transport 0.008 0.3 0.008 0.28 -0.01 -0.02
Energy 0.37 1 0.030 1 0.010 0.36 0.97 0.96
Total 2.12 2.95 0.767 26 0.422 15.01 2.18 1.76
Source: Ahmad
(2010a)

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2. Challenges and Opportunities for Indonesian sectors

The big question now is: Could these emissions reduction be achieved without harming
the economy and welfare of the population? And what are the costs and benefits to
Indonesia’s economy from adopting a low carbon growth strategy?

Most economists would agree that environmental policies and economic growth are
mutually compatible, once proper costing of social and environmental externalities is
accounted for. Carbon pricing is seen as an essential instrument to achieve this. By
putting a price on carbon (and other greenhouse gases), incentives are changed in such a
way that individual actors have to internalize the environmental damage they are causing.
The relative price of emissions-intensive goods will be pushed up and emissions will be
reduced. First, consumer demand will now be directed towards less emissions-intensive
goods. Second, it will force suppliers to make their goods less emissions intensive, by for
instance adopting more energy efficient technologies or buy renewable electricity. Third,
it leads investors to invest in less emissions-intensive projects. Fourth, carbon-pricing
gives a financial incentive for entrepreneurs to develop new and less emissions-intensive
products (Sterner 2003, Helm and Hepburn 2009, IMF 2008)

Revenues from carbon pricing could offset economic costs of mitigation. This can be
achieved in various ways. Revenues could be used to reduce other taxes and possibly turn
a cost into a gain. This would offset at least part of the costs of pollution control, and
raise the prospect of a ‘double dividend’ from the introduction of a carbon tax (IMF
2008).

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Box 1: International experience with carbon pricing
The European Emissions Trading Scheme (ETS) is the largest GHG emissions trading scheme in
the world. Setup in 2005 in line with the GHG emissions reduction targets under the Kyoto
protocol, the ETS caps emissions of about 11,500 power and industrial installations in 25 countries
and six major industrial sectors. The ETS has been plagued by several problems, and has resulted
in volatile prices, but analysis does indicate it has helped reduce emissions (by 2-5% against
business-as-usual according to Ellerman et al., 2010).

Outside of the ETS, the Regional Greenhouse Gas Initiative (RGGI) was set up in 2005 by seven
Northeastern states to form the first mandatory cap-and-trade program for reducing CO2 in the
USA. Unlike in the EU, permits are mainly auctioned. Prices have been low starting from 1.86 USD
in 2008 to 3.51 USD for the latest allowance period (2009-2011). New Zealand has passed legislation
for an ETS in 2008 and has initiated a transition scheme starting Jul 1, 2010. In this transition
period (July 1–31 December 2012), participants in the ETS will buy emission units at a fixed price
of 25 NZ$ per unit, with energy, industrial and liquid fossil fuel sectors being able to buy at half the
price.

The global experience with carbon taxes is mainly limited to European countries. Many European
countries (notably Germany, all Scandinavian countries, France) have applied fuel taxes, energy
and emissions taxes party contingent on carbon content. Denmark imposed the World’s first
carbon tax on fossil fuels in the early 1990s, and this is held partly responsible that for the fact that
its emissions have fallen by 5% since 1990 despite annual average growth of just over 2%. Germany
has a tax on electricity. In these countries, various exemptions are typically provided for industries.
In the electricity sector, both Finland and Germany tried to impose taxes based on type and source
of electricity production, but the EU Court found this discriminated against imported energy.

Sources: World Bank (2010), Sterner (2003)

Recent macroeconomic modeling efforts have attempted to simulate the impact of certain
mitigation policies on the Indonesian economy. The Ministry of Finance in its Green
Paper (2009) has simulated the effects of a carbon tax on the Indonesian economy. A
carbon tax on fossil fuel combustion would lead to emissions reductions and at the same
time improve economic growth and poverty alleviation. Several policies need to
accompany the tax. First, the tax is passed through to consumers of electricity and fuel.
Second, revenues are used to reduce other taxes and provide cash transfers and other non-
distortive poverty alleviation measures. Specifically, revenue from the carbon tax is
recycled through a reduction in sales tax.

The carbon tax would be set at Rp80.000 per ton of CO2. It is expected to reduce
emissions from fossil fuel combustion by about 10% relative to business-as-usual.
Additional reductions can be achieved through specific sectoral policies such as
geothermal power support or the selling of carbon permit exports, estimated to yield
US$2 to US$3 billion by 2020 in export revenue per year in today’s dollars (Ministry of
Finance 2009).

Modeling efforts carried out under the Government’s and World Bank Low Carbon
Development Options Project have relied on different policy scenarios to simulate

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impacts on the economy. 3 First, several carbon prices were used to estimate the
economic and social impacts of REDD. The best outcomes in terms of Indonesia
receiving revenues from REDD using a price of 20 USD / ton of CO2 equivalent. This
assumes certain income distribution proportions between government and households,
taking account of rural-urban and Java and non-Java households. Although there is a
slightly slower national growth, growth is positive in several regions, indicating positive
distributional income flows from the centre to the regions.

Second, a policy of gradually removing fuel subsidies starting in 2010 and fully
abolishing them by 2015 yields positive growth, poverty alleviation and emissions
reduction results. This assumes a policy that ensures that 100 % of saved expenditures is
recycled back to economy via government spending.

Third, policies to increase energy efficiency – by lowering carbon intensity - in the


electricity sector can yield positive results, if the cost of technology is carried by the
government, which uses its budget to pay for the knowledge from abroad.

Fourth, increasing energy efficiency in the private manufacturing sector can also yield
beneficial outcomes under certain assumptions. If energy efficiency is increased by 10
percent from 2010 to 2015 at a cost of up to 0.5 percent of total output by 2015, then
growth, poverty and emissions reduction goals are achieved. Investment costs are
assumed to be paid to foreign investors by the government. Sectors include textile, food
and beverages, cement, basic metal and rubber.

Table 5: Results from Computable General Equilibrium (CGE) Models


Economic GDP (% relative Poverty (%) Reductions in
Modeling Studies to base case) emissions (%
relative to base
case)
MoF Green Paper 0.4 -0.6 -10.1
2009 (Indonesia 3-
E Model)
Low Carbon
Economy
Scenarios 2010
(Dynamic Inter-
Regional CGE
Model)
- REDD -0.04 -2.54 -0.32
-Gradual fuel 3.46 -7.61 -0.01
subsidy removal
- Electricity sector 0.45 -2.81 -0.02
Increase energy
efficiency
3
The following relies heavily on Ahmad (2010b).

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- Energy efficiency 0.05 -1.04 -0.06
in private sector

Source: MoF (2009), Ahmad (2010b)


Note: Best case scenarios were selected in this table.

These models illustrate the point that low carbon growth outcomes can be achieved by
different means. Various options of mixing fiscal instruments (either using carbon taxes
or energy subsidy removal) and technology – based policies (i.e. investing in
technologies to increase energy efficiency in the power and manufacturing sectors) can
result in positive economic and social welfare outcomes.

However, one insight emanating from the simulations is that each policy instrument
needs to be backed up by complementary policies to ensure social compensation and
fairer distributional outcomes. Removal of fuel subsidies needs to be accompanied by
well-targeted support for the poor. Effective REDD policies require effective
mechanisms for inter-regional fiscal transfers and strong and coherent government
forestry policies (Ahmad 2010).

The National Climate Change Council (DNPI 2009) has estimated the potential costs and
benefits of different sectors of undertaking mitigation efforts. It estimates Indonesia’s
potential to reduce GHG emissions at up to 2.3 Gt per year by 2030. This is projected to
amount to 7 percent of global emissions in 2030.

The study identified over 150 abatement opportunities in six major sectors: forestry &
peat land, cement, power, agriculture, transportation and buildings. Over 80 percent of
these abatement opportunities lie in the forestry and peat sectors. Unlike in many other
countries, the costs of abatement are estimated to be relatively low at around 3 Euros/ ton
of CO2 equivalent in 2030 (DNPI 2009). 4 Table 6 shows the abatement costs by sectors.
The point here is that Indonesia should be a very attractive target for clean energy
investors, if one looks at relative abatements costs only.

This cost estimate does not include implementation and transaction costs, which for some abatement opportunities can
be significant (DNPI 2009, p.13).

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Table 6 : Potential and costs of abatement
Average reduction
Reduction potential cost
MtCO2e/year EUR/MtCO2 e
Forestry 1100 7
Peat 700 6
Power 220 19
Agriculture 105 5
Transport 100 -80
Building 50 -38
Cement 10 -5
Source: DNPI 2009

3. Policy Challenges in Adaptation, Forestry, and Energy

Indonesia’s RPJM – the government’s main policy document for economic development
planning - has mainstreamed climate change mitigation and adaptation into
policymaking. The government’s planning document has recognized the importance of
linking economic growth and environmental issues in its long–term development agenda.
Broadly stated, environmental objectives are framed as a result of ineffective
management of natural resources. Rapid depletion of resources and pollution will have
social costs in terms of reduced quality of live, particularly in health costs and decreased
food security. Priority areas include controlling environmental degradation and pollution,
installing an early warning system to deal with large catastrophes like tsunamis, and
enhance the institutional capacity to overcome natural disasters (Bappenas 2009, p. I-45).

Adaptation challenges include the following priority sectors.5 In agriculture, the main
concern is about food security. Productivity losses – especially in rice production - are
feared due to changing weather conditions and loss of crop land due to land conversion.

The health sector needs to invest in strengthening the institutional capacity to anticipate
climate-related outbreak diseases like upper respiratory disease and viral-based diseases.
This also requires increased investment into sanitation infrastructure.

Disaster risk management needs to build up an early warning system to dealt with the
increasing risk of flooding and other climate related disasters.

Water management issues include improving watershed management and protection.


Changed rain patterns will require more efficient water planning, storage and distribution
system.

5
The following is based on the summary provided in Ahmad (2010).

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From the emissions profile and the projection scenarios discussed above, it is clear that
forestry sector and energy mitigation issues are the priority issues for Indonesia.

Accordingly, the government’s main planning document, the RPJM has prioritized the
forestry sector in its climate change platform. Policy action plans aim to strengthen the
institutional capacity and inter-agency cooperation to manage peat lands; rehabilitate
forest lands, targeted to reach 500,000 ha per year; increase policy efforts to reduce
deforestation rates and optimize funding existing mechanisms such as the IHPH (Forest
Utilization Right Fee); the PSDH (Forest Resource Fee) and the Reforestation Fund
(Bappenas 2009, p.I-56).

The Reducing Emissions from Deforestation and Forest Degradation Scheme (REDD+)
presents Indonesia with the opportunity to receive financial incentives from developed
nations to stop converting forests to prevent the release of carbon into the atmosphere.
The government is developing REDD pilot projects in the forests of Central Kalimantan,
East Kalimantan, East Java and West Nusa Tenggara provinces. The projects would
assess the drivers of deforestation, institutional and legal frameworks and the
establishment of REDD incentive mechanisms.

Indonesia has signed a new agreement with the Norwegian government to reduce
deforestation in Indonesia's forests and peat land. Norway pledged to provide US$1
billion that would be disbursed based on emission reductions in the forest sector. The
government is in the process to set up a special agency to manage the money flows from
the REDD+ and the Norwegian trust fund.

However, the question is to what extent the money from REDD schemes can be used to
empower local people and encourage them to protect forests. About 10 out of 35 million
poorest people of Indonesia live in or surrounding the forest area. About a quarter of
their incomes depend upon the forest resources, including biodiversity (Ahmad 2010).
Future REDD project designs need to balance the right of local communities to access
forest resources and the need to safeguard the carbon sequestration functions of the
forests (Ahmad 2010)

However, past and existing policies in the forestry sector have not been successful in this
regard. Policy distortions have skewed the incentives away from conservation and
sustainable harvesting. For instance, taxes and incentives were not used as

!" REDD+ could provide the


appropriate institutional framework to change the incentive structures and direction of
Indonesia’s forest management.

# $ %" &
& & & '())
provides performance-based payments to regional (mainly district)
governments, through a reformed DAK system. Payments are linked to the achievement

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of milestones and outcomes. Regional governments have full control over the design and
implementation of projects, while the central government acts as the main link to the
international and national aspects of the scheme (Ministry of Finance 2009).

The challenge in the energy sector is to secure grid expansion and increase electricity
supply, but at the same time to reduce the carbon intensity of power generation. As
previously shown, emissions and energy per capita are increasing in Indonesia, mainly
due to the increased share of coal in the energy mix. From a purely financial point of
view, coal is the most viable option, as there are sufficient reserves to be found in
Indonesia.

In addition, the reality is that that in Indonesia power outages are quite common. Firms
operate under an infrastructure constraint, which affects their decisions to invest. Power
rationing affects investment certainty and output decisions and in turn impact on
emissions outcomes. One manifestation of this uncertainty is the significant proportion of
firms investing in captive power, i.e. in own electricity generation capacities. In
Indonesia, captive power sold to PLN was estimated to be 6620 MW in 2005, compared
to PLN’s installed capacity of 22,284 MW (IEA 2008). he prevalence of captive power
in Indonesia also contributes to higher emissions rates, as most of this non-grid supply
relies on non-renewable sources.

However, the reliance on coal-based power generation only is clearly not


environmentally sustainable and Indonesia needs to make more use of its plenty non-
fossil based energy sources. These include sources like geothermal and micro hydro,
which show the most development potential. Currently, only about 2 percent of its
renewable energy potential is used. In its Energy Blueprint 2005-2025, the government
has formulated ambitious renewable energy targets. By 2025, 17 percent of total energy
use should come from renewable sources, with particular focus on promoting geothermal
energy development (IEA 2008).

The Government plans to increase the capacity of geothermal energy production from
1100 MW in 2010 to 5000 MW in 2014 (RPJM 2009). Several policy measures have
been taken to increase investment in geothermal development. First, tax incentives for
investments in geothermal and other renewable energy have been installed. Second, there
is financial support from the state budget for renewable exploration. Third, regulation on
purchasing pricing of geothermal energy supply have been issued. 6 These policies are
also accompanied by the government’s plan to tap into international climate financing
mechanisms. Loans worth US$ 400 million will be channeled to Indonesia via the CTF

6
Presidential Decree No. 4 / 2010 which assigns to PLN acceleration of power plant development using
renewable energy, coal, and gas and mandates PLN to develop and purchase power from renewable energy
resources (January 2010). MEMR Ministerial Regulation No. 32/2009 on Purchase Standard Price of
Electricity Power by PT PLN from Geothermal Electricity Power Station (December 2009). MEMR
Ministerial Regulation No31/2009 on the purchase price of electricity from renewable energy (November
2009). MOF Ministerial Regulation No. 24/2010 on tax incentives for renewable energy development was
issued in January 2010 (World Bank 2010b).

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(Clean Technology Fund) for leveraging other capital investments for geothermal
(Ahmad 2010, World Bank 2010).

However, the common theme linking all three priority areas of forestry, energy and
adaptation issues is providing investment and regulatory certainty for infrastructure
projects. Investment climate issues have been a regular concern in Indonesia. Although
Indonesia improved its rankings in the Doing Business ratings – in 2010 it ranked 122 as
compared to 129 in 2009 – there are still large concerns on the side of investors
specifically with regard to contract enforcement and regulatory issues (World Bank
2010a). Corruption is still an important obstacle, although the recent Transparency
International Index has showed a slight improvement in ratings for Indonesia (RPJM
2009). Infrastructure quality in Indonesia also ranked at relatively low levels, as seen in
Table 7(ADB, ADBI 2009).

Table 7 : Infrastructure quality, selected


countries
Country Road Rail Ports Air Electric Power Overall
World 3.8 3.0 4.0 4.7 4.6 3.8
G7 5.7 5.4 5.4 5.8 6.4 5.7
Asia 3.7 3.6 3.9 4.6 4.1 3.8
East Asia 4.7 4.8 4.8 5.1 5.3 4.6
Southeast Asia 4.2 3.2 4.3 5.1 4.7 4.2
Singapore 6.6 5.6 6.8 6.9 6.7 6.7
Hong Kong 6.4 6.2 6.6 6.7 6.7 6.3
Malaysia 5.7 5.0 5.7 6.0 5.8 5.6
Korea 5.8 5.8 5.2 5.9 6.2 5.6
Thailand 5.0 3.1 4.4 5.8 5.5 4.8
China 4.1 4.1 4.3 4.4 4.7 3.9
Indonesia 2.5 2.8 3.0 4.4 3.9 2.8
Vietnam 2.6 2.4 2.8 3.9 3.2 2.7

Score: 1 = underdeveloped, 7 = extensive, international standard


Source: ADB and ADBI (2009)

Overcoming these regulatory and policy uncertainties is particularly important for


renewable energy investment. Capital-intensive projects like geothermal development are
based on high initial fixed costs and need to be based on complex contractual
arrangements. Investors seek to receive some guarantee for their investment returns and
risk mitigation mechanisms between the involved parties need to be developed.

In addition, reducing energy price distortions matter much for providing the right signals
to investors. The existing fuel and electricity subsidies not only exacerbate wasteful
energy consumption, but also distort the incentives to invest in clean energy production.
As long as fossil fuel and coal-based electricity generation is produced at lower cost –

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that is not fully reflecting the ‘true cost of electricity’ by including environmental costs of
electricity generation – then renewable energy will not be competitive.

Given that the Indonesian government faces budget constraints, renewable energy
investment depends on private domestic and foreign investment. Improving the
investment climate is therefore essential. International subsidy mechanisms like the CTF
could provide valuable resources to kick-start large-scale renewable energy investment
and could be used to fund initial high fixed costs of renewable energy production and
assist the government in implementing social compensation programs to the poor.

Ultimately, however, political economy factors and political will are decisive in driving
the impetus for policy and regulatory reforms. Effective implementation of reforms is a
very political process involving negotiating and coordinating budget and project
implementation at different levels across agencies, between Jakarta and the regional
governments and between the government and the parliament. Controlling money and
resource flows between these different layers is a source of power and corruption. This is
especially true for low carbon development projects such as REDD and renewable energy
projects. Ensuring both transparency of money flows from international sources and
effective implementation of projects will be a key challenge for policymakers.

Conclusion

This paper looked at argues that comprehensive environmental policies – framed within a
low – carbon economic growth strategy – is essential to achieve sustainable development
objectives in Indonesia.

The first part explains the rationale behind a low carbon economic growth policy and
how Indonesia’s emissions profile and projection scenario determines its mitigation
opportunities and challenges.

The second part looks at specific economy-wide and sector benefits and costs if climate
mitigation policies were to be implemented in Indonesia. It finds that economic policy
options can be crafted to achieve growth, poverty and emissions reductions. Tackling
emissions from forestry and peat land provide the best mitigation opportunities for
Indonesia.

The third part looks at specific policy challenges arising in specific priority sectors –
adaptation, forestry and energy. The binding constraint in all three sectors is the
regulatory and investment uncertainty underlying infrastructure investment.

Indonesia’s emissions and cost abatement profile provides plenty of opportunities to tap
into international climate finance mechanisms and private investment to launch large-
scale investment into low carbon development options. However, there is still a need to
strengthen the domestic political consensus on the viability of pursuing a low carbon
development strategy. Moreover, the domestic institutional capacity – specifically with

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regard to improving the regulatory and investment climate – needs to be strengthened to
attract more private investment.

Thus, embarking on a low carbon development strategy requires a complex reform


process. It requires policy coordination in several major areas: fiscal (carbon pricing),
investment and technology policies, energy / forestry sector reforms, and broader
structural reform. Sequencing these reforms is a matter of political judgment and depends
on political economy factors driving the reform process

Specific policy recommendations

Assistance and investment from foreign donors like FNS and private investors from
Germany should flow into the key priority programs of the Indonesian government. In the
following, some of the main recommendations flowing from existing GOI policy
documents are extracted, mindful of investment opportunities for German official and
private assistance.

First, provide policy support in developing economic instruments and the regulatory
framework to support low carbon development. Currently there is still limited
capacity and expertise in adopting tax instruments to promote green growth.
Environmental taxation is still a relatively under-developed policy field in Indonesia. In
addition, with funding opportunities from carbon finance related products and services
increasing, there is a specific need to build up domestic expertise in this regard. The
Green Paper of the Ministry of Finance could serve as a good policy base, as it has
looked at various fiscal policy options to address climate financing issues. Germany has
had considerable experience with environmental fiscal policy reforms since the 1990s
and is ideally laced to provide technical assistance.

Second, invest in policy support to enhance regional analytical capacity-building.


There is a need to strengthen the overall institutional and policy framework to coordinate
climate change and environmental issues, specifically on the regional level. Regional
low carbon development growth options need to be formulated and integrated into the
national planning and budget process. Financing regional capacity-building to produce
analytical products to support the policy process is one key investment area for German
donors.

Third, invest in policy support to develop a regional financial and fiscal mechanism
for channeling REDD transfers. Implementing policy actions to mitigate emissions
from land use change and forestry sector under the REDD framework will be the main
pillar of Indonesia’s climate program in the coming years. In order to guarantee an
effective flow and monitoring of money from the centre into the regions, the government
needs to develop a regional finance mechanism to manage this process.

This mechanism should consist of two main elements. First, it needs to have an effective
inter-governmental fiscal transfer system to channel funds from national to regional
levels. Second, it needs to have a proper incentive mechanism in place to ensure that

17
REDD payments are linked to desired project outcomes. Third, the mechanism should
have an efficient framework for forest fiscal management, which includes incentives for
regional stakeholders to scrutinize REEDD transfers. Financing the study and
development of such an integrated fiscal and incentive framework is a potential area for
German funding sources.

Fourth, provide policy support and invest in strengthening the institutional and
regulatory framework for scaling up renewable energy supply in Indonesia.
Indonesia’s renewable energy potential is huge. However, take up of renewable energy
supply has been slow due to a mix of structural problems underlying the electricity
sector, investment climate issues and lack of technical expertise in promoting ‘green
energy’ sources.

Since the 1990s Germany has embarked on an ambitious program to promote renewable
energy production on a large scale. Policy advice and technical expertise could be
provided to the government to extract the main lessons for the Indonesian context. One
key area is to adopt feed in tariffs (FITs) to facilitate renewable energy projects like
geothermal energy and make them financially attractive to investors. This involves a
complex set of policy coordination and German expertise could provide valuable insights.

Fifth, share German technical expertise on small and medium enterprise


development and link it to develop rural renewable energy projects. Rural energy
supply in Indonesia will to some extent depend on non-grid small, community-based
energy producers. Germany has considerable experience in promoting the growth of
small and medium scale enterprises in Indonesia. In addition, Germany and the GTZ have
also experience in developing some micro hydropower projects. Linking these two issues
by for instance investing in the domestic financial sector’s capacity to assess and provide
green micro-finance schemes would be a valuable investment.

Sixth, provide policy support and technical assistance in building up the domestic
capacity for infrastructure financing. Infrastructure development is the key challenge
to meet mitigation and adaptation objectives. Without adequate investment into green
infrastructure – such as geothermal energy plants or mass rapid transport systems –
Indonesia will be in a bad position to adopt a successful low carbon growth path.
Guarantee and risk-sharing and - mitigation mechanisms will also be necessary to provide
investors with additional incentives to put money into projects.

These facilities can be provided by the establishment of a Low-Emission Development


Financing Facility (LEDFF), as proposed by the DNPI and UNFCCC (2009). The
Indonesia Green Investment Fund (IGIF) under the Ministry of Finance’s Government
Investment was established in 2009 to take up such a function. German technical
assistance could assist the government in leveraging private and market-based sources of
funding for low-emission development programs/projects.

Seventh, stay engaged in and provide policy support for overall economic and
governance reforms in Indonesia, based on demand driven by domestic stakeholders

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Like in many other countries, economic and low carbon development reforms are an
ongoing and continuing process. They are also very complex processes, difficult to
implement in the right sequence and thus require careful analysis. Continued transparent
and frank policy dialogues are the best means to achieve this.

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