Green Paper MoF Indonesia

Ministry of Finance Green Paper
Economic and fiscal policy

strategies for climate change
mitigation in Indonesia
Ministry of Finance, Republic of Indonesia

Australia Indonesia Partnership
This report may be cited as follows:
Ministry of Finance (2009), Ministry of Finance Green Paper: Economic and Fiscal Policy Strategies for
Climate Change Mitigation in Indonesia, Ministry of Finance and Australia Indonesia Partnership, Jakarta.
Page ii Ministry of Finance Indonesia Green Paper on Climate Change

FOREWORD BY THE MINISTER OF FINANCE
The world has moved beyond the conventional view that economic growth objectives are
incompatible with environmental objectives. We know that left unaddressed, climate change
represents a serious threat to our economic wellbeing. On the other hand, sound economic
principles are also key to mitigating the impacts of climate change. Central to such principles is
the appropriate pricing of carbon and ensuring that climate change mitigation policies across the
board are both effective and economically efficient. This emphasizes the need for the Ministry of
Finance to play a central role in shaping Indonesia’s response to the climate change challenge
Indonesia is looking for solutions to curb greenhouse gas emissions, both through our own
domestic measures and working with the international community. To achieve this, we need to
better understand the interaction of climate change policies with our development objectives and
the broader economic reform agenda, to put sound policies in place, and to get the financing
aspects right.
Internationally, Indonesia is known as an advocate of pragmatic and effective climate policy, and
this commitment is exemplified by the recent announcement by President Yudhoyono that
Indonesia will seek to reduce its greenhouse gas emissions by 26 per cent by 2020 and up to 41
percent with international assistance. Indonesia has also played a strong and active role in the
international climate negotiations leading up to the COP15 conference in Copenhagen. Indonesia
hosted the 2007 climate conference which developed the Bali Roadmap for a new global climate
agreement, and initiated the first international meeting of finance ministers on climate change.
The Green Paper spells out a longer-term strategic framework, grounded in economic principle
and international experience, that can guide climate policymaking. Consistent with this framework,
the Green Paper sets out selected concrete strategies for fiscal and economic policies for climate
change mitigation. It focuses on the energy sector, setting out a policy package for geothermal
power; and on the land-use change and forestry sector, spelling out how regional climate change
action can be incentivized through Indonesia’s fiscal transfer mechanism.
I consider that the Green Paper will be an important part of Indonesia’s climate policy debate, and
that it will prove a solid basis for the Ministry of Finance to move toward design and
implementation of climate change mitigation policies.
Dr Sri Mulyani Indrawati

Minister of Finance
30 November 2009
Ministry of Finance Indonesia Green Paper on Climate Change Page iii

FOREWORD BY THE HEAD OF THE FISCAL POLICY OFFICE
Indonesia’s commitment to reduce greenhouse gas emissions by between 26% and 41% by
2020, compared to a business-as-usual trajectory, poses important questions for fiscal and
broader economic policies. It is crucially important to understand the interaction of climate change
policies with the development objectives and the broader economic reform agenda, in order to put
sound policies in place, and to get the financing aspects right. We want climate change mitigation
policies to be both effective and efficient.
This emphasizes the need for the Ministry of Finance to play a central role in shaping Indonesia’s
response to the climate change challenge through domestic policies, and in bringing Indonesia’s
influence to bear in international climate finance. As the Ministry of Finance’s policy function rests
with the Fiscal Policy Office the Green Paper was developed by the Fiscal Policy Office in close
collaboration with Australian experts.
This Green Paper takes the Ministry of Finance’s engagement with climate policy to a new level. It
provides a sound framework for Indonesia’s climate policy design, and it spells out a number of
concrete strategies for domestic fiscal and economic policies for climate change mitigation, and
sets out international financing strategy considerations advantageous to Indonesia.
I consider the Green Paper required reading for anyone involved or interested in Indonesian
climate change policy, and for staff in many areas of the Ministry of Finance. I expect it will be an
important part of Indonesia’s climate policy debate, and that it will prove a solid basis for moving
toward detailed design and implementation climate change policies.
Dr Anggito Abimanyu
Head, Fiscal Policy Office, Ministry of Finance
30 November 2009
Page iv Ministry of Finance Indonesia Green Paper on Climate Change

ACKNOWLEDGMENTS
This Green Paper is a joint Indonesian and Australian effort.The Green Paper was prepared by Dr
Frank Jotzo and Mr Salim Mazouz, in close collaboration with the Fiscal Policy Office of the
Ministry of Finance. The team was guided by Professor Armida Alisjahbana (prior to her taking up
the post of Minister for Development Planning). Overall project guidance was provided by the
Australian Treasury’s Government Partnership Fund program through Mr Nathan Dal Bon. The
project was funded and managed by the AusAID Technical Assistance Management Facility
through Mr Bernie Carmody. Assistance was provided by a number of experts and analysts,
including Dr James Gifford, Dr Arief Yusuf, Dr Budy P. Resosudarmo, Dr Ida A.P. Resosudarmo,
Dr Axel Michaelowa, Mr Kurnya Roesad and others.
The preparation of the study has been helped enormously by the active support and guidance at
key stages by the Minister of Finance, Dr Sri Mulyani. Valuable ongoing input and guidance was
provided by Dr Anggito Abimanyu, Head of the Fiscal Policy Office, his senior colleagues Bapak
Askolani, Director of Budget Policy and Professor Singgih Riphat, as well as FPO staff members
including Pak Amnu Fuadym, Pak Kindy Syahrir and others.
Other stakeholders that provided valuable contributions include: other Directorates of the Ministry
of Finance; Bappenas; the Ministries of Environment, Forestry, Energy and Mineral Resources;
the National Council on Climate Change and various state-owned and private sector companies,
business associations and civil society organizations.
Ministry of Finance Indonesia Green Paper on Climate Change Page v

TABLE OF CONTENTS
Foreword by the Minister of Finance iii
Foreword by the Head of the Fiscal Policy Office iv
Acknowledgments v
List of tables ix
List of figures x
Executive summary 1
Indonesia’s role in global climate change mitigation 1
The Green Paper: towards economically sound climate policy 1
The strategies in brief 2
Emissions and reduction goals 2
International carbon finance 4
Energy and carbon pricing 5
Geothermal energy 8
Regional action on land-use change, forestry and peat emissions 11
Institutional reform 14
Suggested strategy 15
1 Introduction: effective and efficient carbon policies for Indonesia 17

1.1 Indonesia’s role and commitment 17
1.2 A challenge for development and economic reform 18
1.3 Emissions profile, trajectory, and reduction scenarios 19
1.4 a pragmatic policy mix 20
1.5 Overview of the Green Paper 22
2 Carbon emissions pricing 23

2.1 The case for carbon emissions pricing 23
2.2 Principles of efficient emissions pricing 24
2.3 Complementary measures 25
2.4 Emissions trading versus a carbon tax/levy 26
2.5 An Indonesian emissions tax/levy on CO2 emissions from fossil fuel combustion 29
2.6 Modeling the economic impacts of a carbon tax/levy 35
3 International carbon finance 43

3.1 Developments in international carbon finance 44
3.2 Framing of domestic mitigation in the context of international financing options 46
3.3 International carbon market mechanisms 49
3.4 International public carbon finance 58
3.5 Financing for REDD 64
4 Policy options in the energy sector 69

4.1 Background 69
4.2 Policy considerations in the electricity sector 72
4.3 Abatement potential and costs 78
4.4 The power sector 79
4.5 Policies to deploy alternative technologies: The geothermal example 84
4.6 Energy efficiency and conservation 91
Ministry of Finance Indonesia Green Paper on Climate Change Page vii

5 A Regional Incentive Mechanism for carbon from land-use change, forestry, and peat 97
5.1 Indonesia’s forestry emissions and abatement options 98
5.2 International REDD financing and the role of intergovernmental fiscal transfers 102
5.3 Concept for a Regional Incentive Mechanism for climate change 106
5.4 Implementation of a Regional Incentive Mechanism 113
5.5 Fiscal and regulatory policies affecting land-use change and forestry 120
6 Institutions for carbon policy 125

6.1 International experience and best practice 125
6.2 Indonesia’s institutional landscape for climate policy 128
Appendix 1; Geothermal electricity 131
Appendix 2; Remarks by Professor Ross Garnaut 143
Appendix 3; Ross Garnaut: Climate change and Indonesia 147
Appendix 4; Armida Alisjahbana: Green economy 153
References 162
Page viii Ministry of Finance Indonesia Green Paper on Climate Change

LIST OF TABLES
Table 1 Average price impact of Rp 80.000 carbon price 8

Table 2.1 Technical abatement available at cost of Rp 80,000 per tonne of CO2 31
Table 2.2 Average price impact of Pr 80.000 carbon price 32
Table 2.3 Reference case assumptions 39
Table 2.4 Key modeling results 41
Table 3.1 Indonesia’s current and potential future share in carbon finance (%) 46
Table 3.2 Framing Indonesia’s reduction goals and possible NAMA policies 48
Table 3.3 Overview of potential sources for global public climate finance 61
Table 3.1 Selected abatement actions and preferred international financing options 68
Table 4.1 CO2 emissions from non-land-use change and forestry by fossil fuel source 71
Table 4.2 Steps to reform the energy market 77
Table 4.3 Components of the true cost of electricity (US cents per kWh) 84
Table 4.4 Stages in geothermal development 87
Table 4.5 Tariff and tax structures of the three schemes 88
Table 5.1 Fiscal transfers to the regions, 2009 revised budget 114
Table 6.1 Development of Australia’s emissions trading policy framework 127
Table A1.1 Location and capacity of Indonesia’s geothermal fields (MW) 132
Table A1.2 Components of the true cost of coal energy (cents per kWh) 134
Table A1.3 Probability of commercial success after various development stages 138
Table A1.4 Stages in geothermal development 140
Table A1.5 Tariff and tax structures of the three schemes 142
Ministry of Finance Indonesia Green Paper on Climate Change Page ix

LIST OF FIGURES
Figure 1 A business-as-usual scenario for Indonesia’s greenhouse gas emissions 3

Figure 2 Carbon finance needs in developing countries and financing proposals 4
Figure 3 Sequencing of the introduction of carbon pricing 7
Figure 4 Breakdown of the true cost of coal-fired electricity 9
Figure 5 Estimates of emissions from land-use change, forestry and peat for Indonesia 11
Figure 6 Payment transmission under a Regional Incentive Mechanism 12
Figure 1.1 Indonesia’s greenhouse gas emissions profile, 2005 19
Figure 1.2 Business-as-usual scenarios for Indonesia’s greenhouse gas emissions 21
Figure 2.1 Comparison of future carbon prices 30
Figure 2.2 Indonesia’s per capita emissions in the international context 31
Figure 2.3 Price pass-through of carbon tax/levy on energy prices 33
Figure 2.4 Key modeling results: % change relative to reference case, 2020 36
Figure 3.1 Carbon finance needs in developing countries and financing proposals 45
Figure 3.2 A cross-country comparison of CDM projects 51
Figure 3.3 Sectoral no-lose target: two scenarios 54
Figure 4.1 Fossil fuel emissions by energy sector, 1990 and 2006 70
Figure 4.2 Electricity capacity by source, 1995–2005 71
Figure 4.3 Economic losses due to production subsidy effects 75
Figure 4.4 Transition of subsidies to an undistorted energy sector 77
Figure 4.5 TNA’s MAC curve for abatement cost in 2025 80
Figure 4.6 DNPI’s MAC curve for abatement cost in 2030 80
Figure 4.7 Nominal cost of electricity production by technology in Indonesia 82
Figure 4.8 Illustrative comparison of true cost of energy with geothermal costs 86
Figure 4.9 PLN’s installed capacity and peak demand, 2000–2004 92
Figure 4.10 Hypothetical illustration of complementary energy efficiency measures 92
Figure 4.11 Equivalent increase in installed capacity due to negawatts 93
Figure 4.12 IEA model of future reductions in world CO2 emissions by technology area 94
Figure 5.1 Estimates of land-use change/forestry and peat emissions 99
Figure 5.2 Estimates of peat fire emissions 100
Figure 5.3 Land-use change and forestry emission reduction options 101
Figure 5.4 Peat emission reduction options: DNPI draft marginal abatement cost curve 101
Figure 5.5 Illustrative distribution of Regional Incentive Mechanism payments 108
Figure 5.6 Indonesia’s intergovernmental fiscal transfer system 114
Figure 5.7 Regional Incentive Mechanism: broad outline 116
Figure 5.8 Regional Incentive Mechanism: Three pillars of implementation 116
Figure 6.1 Evolution of Australia’s climate change institutions 127
Figure A1.1 Geothermal project development, activities, and costs 137
Page x Ministry of Finance Indonesia Green Paper on Climate Change

EXECUTIVE SUMMARY
INDONESIA’S ROLE IN GLOBAL CLIMATE CHANGE MITIGATION

Climate change is an issue of high priority for Indonesia. It is highly vulnerable to
climate change (ADB 2009), and is a significant emitter of greenhouse gases.
Therefore Indonesia has a strong stake in the global effort to limit future climate Indonesia is playing an
change. active and constructive
role in the international
Indonesia is committed to making a significant contribution to limiting global negotiations and has
greenhouse gas emissions, and to helping make a global climate change committed to making a
agreement possible. President Yudhoyono has announced a target for Indonesia strong contribution to
to reduce emissions by 26% by 2020 compared to business as usual (see Box 1), global climate change
and by up to 41% with international support. mitigation.
Indonesia has played an active and constructive role in the international climate
negotiations leading up to the Copenhagen COP15 conference. For example,
Indonesia hosted the 2007 COP13 UN climate conference, which developed the
Bali Roadmap for a new global climate agreement. Indonesia initiated the first
international meeting of finance ministers on climate change, in conjunction with
the Bali conference. In addition, Indonesia’s Ministry of Finance has been
engaged with the climate change discussions in a wide range of international
forums, including the G20 and many others.
Indonesia’s response to global climate change must be consistent with its
Meeting these
development and poverty reduction objectives. Environmental policies need to be
commitments needs to
in line with economic goals. As President Yudhoyono stated at the G20 Leaders’ be consistent with
Summit in Pittsburgh, “We must tell the world it is possible to cure the global development and
economy and save the planet at the same time.” poverty reduction
objectives, and needs
sound economic
THE GREEN PAPER: TOWARDS ECONOMICALLY SOUND policy.
CLIMATE POLICY
The Green Paper identifies economic and fiscal policy strategies for climate
change mitigation – that is, reducing emissions of carbon dioxide and other
greenhouse gases – and how to do this in the most cost effective way. It lays out
strategies for the Ministry of Finance for efficient and effective policies, both in the
short term and the long term. The paper is grounded in economic principles, and
applies emerging international experience to Indonesia’s circumstances.
Indonesia is no different to other countries in that a carbon-constrained future
presents both significant challenges and opportunities. If Indonesia can put in
place policies that enable it to grow its economy along a path of low emissions, it
will have played an important part in the solution to the threat of global climate The Green Paper
change. At the same time, by moving early to restructure its economy around low details policy
emissions, it will gain a competitive advantage relative to other nations in the approaches for cost-
effective reductions in
region, and could stand to benefit economically and financially.
greenhouse gas
The Green Paper presents strategies that can guide longer-term policy reform for emissions.
climate change mitigation, including a move toward pricing of carbon emissions. It
sets out concrete options for geothermal policy, and for creating abatement
incentives for regional governments, especially to reduce emissions from land-
use change and forestry. In these areas it illustrates how economic principles can
be used to devise efficient and effective climate policies in the short term. These
Executive summary Page 1

Principles for climate principles can be extended to other aspects of energy and land-use
policy need to be change/forestry, and to other parts of the economy such as agriculture and
reflected in mining.
implementable policies,
and as steps towards a
The Green Paper also sets out strategies to access international financing and
longer term efficient canvasses the need for further institutional development. In brief, the strategies
climate policy proposed are as follows.
framework.
THE STRATEGIES IN BRIEF

Strategy for the energy sector:
 Work towards the implementation of a carbon tax/levy on fossil fuel
combustion, in parallel with removal over time of energy subsidies. Couple
this policy with access to international carbon markets, by negotiating a “no-
lose” target with appropriate parameters.
 Introduce complementary measures to incentivize energy efficiency and
deployment of low-emissions technology, exemplified by a specific
geothermal policy strategy.
Positioning Indonesia Strategy for the land-use change and forestry sector:
for a carbon-
constrained future  Support and incentivize carbon abatement measures by regional
means early governments through the intergovernmental fiscal transfer system, working
restructuring towards a toward the creation of a Regional Incentive Mechanism (RIM) for climate
low-emissions change.
economic structure.  Work with the appropriate ministries to bring existing fiscal policy settings
into line with carbon reduction objectives.
Strategy for international carbon finance:
 Support the creation of new, broad-based carbon market mechanisms like
sectoral targets and crediting. Support new and additional sources of
international public financing. Ensure adequate returns for Indonesia’s
emissions reductions.
Strategy for institutional development:
 Strengthen capacity for climate policy analysis at the Ministry of Finance.
Support policy coordination across government especially among the
economics ministries; and advocate a review of the broader regulatory
framework that relates to climate change policy.
EMISSIONS AND REDUCTION GOALS
Emissions from land- Indonesia’s current greenhouse emissions profile is dominated by land-use
use change, forestry change, forest degradation and peat fires. However, emissions from the energy
and peat dominate sector are growing strongly as Indonesia’s economy grows. If left unchecked,
Indonesia’s emissions emissions from this sector could overtake emissions from land-use change and
profile now, but energy forestry in a few decades.
could overtake within a
few decades.
Page 2 Ministry of Finance Indonesia Green Paper on Climate Change

Figure 1 A business-as-usual scenario for Indonesia’s greenhouse gas
emissions, based on current trends, MtCO2-e/year
4000
Data
from Projection by trend extrapolation
3500
SNC
3000
2500
Peat
2000
-26%
1500
-41%
Land-use change
1000 and forestry
Other sources
500
Energy / fossil fuel combustion
0
2000 2005 2010 2015 2020 2025 2030
Data sources and notes: see Figure 1.2 in Chapter 1.
Land-based emissions provide the bulk of cost effective short to medium term
emissions reductions opportunities. But to get the energy-sector onto a longer-
An integrated policy
term lower carbon trajectory, policy directions for low-carbon energy need to be
effort across all sectors
set now. An integrated policy effort across all sectors is needed for efficient
is needed for efficient
outcomes, rather than planning for specific quantitative reductions in each sector. outcomes, rather than
A 26% reduction below the business-as-usual trajectory at 2020 could mean a planning for specific
slight reduction below current emissions levels, while a 41% cut would mean a reductions in each
sector.
significant reduction. For instance, under both DNPI projections and trend
extrapolation from current data (Figure 1), a 26% and 41% reduction relative to
business-as-usual implies a reduction of around 6% and 24% respectively below
2005 emissions levels. These are significant challenges, in the face of rapid
economic growth – but with the right policy approaches they could be achieved.
Box 1 The importance of business-as-usual scenarios

A “business as usual” (BAU) scenario is a hypothetical trajectory for future carbon
emissions in the absence of policies and other measures to reduce emissions. In contrast,
policies with other objectives – such as energy security – are included in the BAU.
Many of the proposals for developing country action that are currently discussed in
international negociations define emissions targets relative to a BAU baseline. The BAU
scenarios are therefore central to the actual effort required to achieve any emissions
reductions as part of such proposals. Fo Indonesia, the BAU concept is already central
given the announcement of a target of 26% or 41% emissions reductions relative to BAU.
There is no single objective BAU scenario, because it depends on projections of future
economic growth, structure and technological development. In agreeing emissions targets,
the underlying BAU scenario and the deviation from it are both crucial.

INTERNATIONAL CARBON FINANCE
In an increasingly carbon-constrained world, there is likely to be an expansion of
both private market and public finance to support climate change mitigation in
Indonesia could attain developing countries (Figure 2). If suitable mechanisms are put in place
a larger share of internationally and domestically, Indonesia could be a major recipient of such
international carbon finance. Indonesia currently accounts for less than 2% of the Clean Development
finance than it has to Mechanism market, but might be able to attain 10% of much larger future carbon
date. finance flows, based on its share of emissions.
Figure 2 Carbon finance needs in developing countries, financing

proposals, and the size of the Clean Development Mechanism
Attracting carbon finance inflows is not an end in itself for Indonesia. Rather,
international finance should be seen as an important factor in enabling Indonesia
to restructure its economy in readiness for a low-carbon future.
Attracting carbon
To ensure that international mechanisms are favorable to its interests, Indonesia
finance is not an end in needs to continue to engage actively with international forums such as the
itself, rather, it can UNFCCC and the G20.
assist Indonesia There is a role for both public and private carbon finance. Public finance is
prepare for a low-
particularly important in the short term, before private markets are fully functional.
carbon future.
Public finance should be used to support capacity building, institutional reform,
and the up-front financing of mitigation initiatives, and to facilitate transformational
change.
Private markets, driven by demand from developed countries’ emissions trading
schemes, could provide the mainstay of carbon finance in the medium term. More
broadly based carbon finance mechanisms, such as sectoral targets and
crediting, can assist Indonesia to benefit from this global development (Box 2).

Box 2 A shift to broad-based carbon market mechanisms
New broad-based mechanisms are under discussion for framing developing country
mitigation actions and to base carbon market financing on, for example, sectoral targets
and crediting mechanisms. These mechanisms are more comprehensive than project-
based mechanisms such as the CDM. They are likely to be preferred by the main buyers of
emissions credits, and could also be highly suitable for developing countries that
implement carbon reduction policies.
Both the carbon pricing policy and the Regional Incentive Mechanism described below are
examples of broad-based interventions in the economy intended to internalize the unpriced
externality of carbon emissions. It is in Indonesia’s interest that links to international
finance be similarly broadly based.
The cornerstones of an international carbon finance strategy, based on the

agenda of supporting longer-term economic reform and development objectives,
include the following:
 Strive for good access to international private carbon finance, by supporting
the creation of broad-based, effective new carbon market mechanisms that
match domestic policy initiatives, including a no-lose target for Indonesia’s Suitable strategies for
fossil fuel emissions. Ensure that an adequate proportion of emission Indonesia include:
reductions triggered by government policies can be sold in international proposing a no-lose
carbon markets, and are sold at market prices. target for fossil fuel
emissions; ensuring
 Strive for public carbon finance to be available to Indonesia, particularly in appropriate value is
the short term until private markets are fully functional. Ensure that it is obtained from permit
additional to existing aid and multilateral financing, that emission reductions sales; and supporting
assisted by public finance can be sold in carbon markets or count toward the creation of an
Indonesia’s target rather than other countries’, and that climate loans are REDD mechanism with
strongly concessional. Support new sources of public carbon finance, such sub-national
as a global levy on air and sea transport or the auctioning of emissions implementation
allowances in industrialized countries.
 In global developments toward the creation of a funding mechanism for
reducing emissions from deforestation and forest degradation (REDD),
support market mechanism that involve a national approach with subnational
implementation, and broad coverage of emissions sources. Secure access
to public REDD financing particularly in the start-up phase and for specific
activities like improved peat land management.
ENERGY AND CARBON PRICING

Energy is a development issue for Indonesia. Total energy demand is growing by
around 7% per year, as the transport and industrial sectors grow, and as
households become more affluent.
The electricity generation capacity is struggling to expand quickly enough to keep Significant price
up with this demand. Substantial capacity expansion programs have been put in distortions remain in
the energy sector and
place over the last few years, but the projected increases in demand will continue
climate policies
to grow strongly as Indonesia’s economy develops.
provide an opportunity
During the last decade, the emissions intensity (that is, the quantity of to enhance economic
greenhouse gas emissions per unit of energy consumed) of Indonesia’s energy efficiency in addition to
sector has been rising. This is due in large part to the increased reliance on coal reducing emissions
for electricity generation. Coal has been favored in capacity expansion because it
reduces Indonesia’s dependence on foreign oil imports, and because it is seen as
the cheapest source of electricity. However, the assumption that coal is the

cheapest source of electricity omits important economic factors that affect the
economy and the government budget.
The mainstay of efficient reform of the energy sector should be to ensure that
Introducing carbon
economic price signals are transmitted accurately through the market. This
pricing is necessary in
the medium to long
amounts to ensuring that explicit and implicit subsidies do not distort relative
term to achieve prices and induce “wrong” investment or consumption decisions. In addition, it
emissions reductions does not cost producers anything to emit carbon at present, so economic agents
at least cost. act as if emissions were free. This means that there is no pressure to reduce
emissions, and so emissions will naturally grow.
Efficient mechanisms for modifying the economy to reduce carbon emissions are
to remove energy subsidies over time and to introduce a price for carbon
emissions.
Removing subsidies will ensure that only energy that is worth more to users than
it actually costs to produce is used, reducing emissions and increasing
productivity at the same time.
Introducing a carbon price would ensure that the price of activities and goods that
involve high emissions will go up relative to low-emissions alternatives. If these
Accelerated removal of shifts in relative prices are allowed to flow through to users, they will induce a shift
energy subsidies and in activity away from high-emissions activities, toward low-emissions activities. In
the introduction of this way, the lowest-cost abatement options available in the economy are
carbon pricing are
selected and emissions abatement is achieved at least cost (see Box 3).
desirable and can be
done in parallel. Thus, both accelerated removal of energy subsidies and the introduction of
carbon pricing are desirable. However, note that introducing a carbon tax/levy is
not contingent on removing energy subsidies first, it can go hand-in-hand with
phasing energy subsidies over time. A carbon tax/levy can provide an immediate
price signal to shift to lower carbon options in power supply and industry, and
would create a forward price signal taken into account in investment decisions.
Box 3 Emissions pricing versus other policy options

Once emissions pricing is introduced, any abatement option that costs less than the
carbon price will become economically favorable, and abatement options that are more
expensive than the carbon price will remain unfavorable. The automatic selection of least-
cost abatement options through a carbon price contrasts strongly with emission reductions
achieved through specific regulatory interventions, or more piecemeal fiscal policy
interventions. These require policy-makers to single out a particular abatement option
without any guarantee that there are no lower-cost options available elsewhere in the
economy.
That said, the application of emissions pricing is limited due to the difficulty of measuring
and accounting for carbon in the agricultural and land-use change and forestry sectors. In
addition, a number of obstacles prevent the market mechanism from selecting abatement
options on the basis of price. There is therefore a legitimate and strong role for measures
to complement carbon pricing, such as providing incentives for additional energy efficiency
savings and the deployment of low-emissions technology. Measures to offset the effects
on households and businesses of price rises associated with carbon pricing also have a
legitimate role in complementing carbon pricing.
A suitable strategy is
The recommended strategy is to introduce carbon pricing through a relatively
to introduce a modest
carbon tax/levy on
modest carbon tax/levy initially. Once carbon measurement and accounting
fossil fuel combustion systems capable of supporting emissions pricing have been extended beyond
initially. fossil fuel combustion, drawing in more potential market participants, the carbon

tax/levy could be replaced by emissions trading, potentially with direct linkages to
international carbon markets. Coverage can be
expanded and the
To underpin the introduction of carbon pricing, regulations would need to be put in tax/levy replaced with
place (see Figure 3). emissions trading as
the measurement
systems are further
developed.
Figure 3 Sequencing of the introduction of carbon pricing
In the case of Indonesia, energy prices are regulated for many energy users,
which means that the carbon price signal does not get passed through to energy
and energy intensive goods. However, in order to have an effect on investment
and consumption decisions, the carbon price does need to be passed through.
As an indication of magnitude, the carbon tax/levy could start at a level of
Rp 80,000 per tonne of CO2, and rise at a rate of 5% (real) per annum to 2020.
This measure is projected to reduce emissions from the energy sector by around
10% from business-as-usual levels by 2020, assuming full carbon price pass- Carbon pricing could
through. By then it could produce a taxation/levy revenue stream of around Rp 95 yield large new
trillion per year (in today’s terms). revenues, which can
be used to assist
The revenue from a carbon tax/levy would accrue to the budget and can be used business and poor
as the government considers appropriate. That said, the suggested strategy is to households, as well as
use the revenue to assist the process of reform and help alleviate the impact of for additional climate
higher prices on the poor. change measures.
Cash transfers directed at poor households and tax reductions (of the most
distorting taxes) can improve income distribution. The revenue can also be used
to compensate businesses for losses incurred through the carbon tax/levy, either
through direct compensation or by using the revenue to promote efficiency-
enhancing reforms that make it easier for affected firms to do business (see
Table 1). The revenue from the carbon tax/levy can also be used to support
additional abatement incentives, where this is economically sound.

Table 1 Average price impact of Rp 80.000 carbon price, projected
revenue, and possible revenue uses
Price increase Tax/levy revenue Possible use of revenues
Electricity Rp 60 per kWh Revenue would rise Government free to

to around Rp 95 decide on revenue use.
Diesel/kerosene Rp 235 per liter trillion by 2020 per Proposed strategy: Offset
Gasoline Rp 190 per liter year. the impact of price rises
Additional permit on households and on
export revenue of businesses; reduce other
several billion taxes; support additional
dollars per year abatement initiatives.
may be available
Economic modeling indicates that a relatively low carbon tax/levy, implemented

while other distortions are still in existence, and with judicious recycling of tax/levy
A carbon tax or levy revenue, could yield both a small increase in GDP and a reduction in the poverty
could yield both a rate. Depending on how the revenue is used, small costs in GDP terms are also a
reduction in poverty possibility, but could be offset by exports of emissions permits to international
rates, and an carbon markets.
increase in GDP.
The proposed introduction of a domestic carbon tax/levy would allow Indonesia to
take a powerful position to the international negotiating table, and gives it a
substantial early-mover advantage. Indonesia could propose that, as part of its
26% unilateral emissions reduction, it would create a “no-lose” target for
emissions from fossil fuel combustion (see Chapter 3 for discussion of how the
“no-lose” target mechanisms would work).
The no-lose target would be set somewhat below the internationally agreed
business-as-usual emissions trajectory, and any reductions further below that
target would allow Indonesia to sell abatement units in international carbon
markets. For example, if Indonesia were to negotiate a 5% reduction below an
agreed business-as-usual trajectory, and actual emissions turned out to be 15%
below it, then Indonesia could sell 10% in international carbon markets.
A carbon tax/levy on fossil fuels would be a very credible and transparent tool to
achieve the reductions to underpin a no-lose target.
If agreed to, this kind of target arrangement would create a large new export
A no-lose sectoral
opportunity for Indonesia. Economic modeling undertaken for the Green Paper
emissions target could
yield large amounts of and various abatement cost curves for Indonesia, suggest that at an international
permit export revenue price of US$30 per tonne of CO2, reductions in Indonesia’s fossil fuel emissions in
for Indonesia, and the order of 24% from business-as-usual levels would be possible. If, for
send a strong signal illustration, a 10% reduction were agreed as the target, then such a reduction
internationally. would give rise to export revenue of US$2–3 billion per year by 2020.
The price mechanism for carbon emissions is the backbone of the emissions
reduction strategy in the energy sector. However, where obstacles prevent the
market mechanism from selecting abatement options on the basis of price, there
is a role for complementary measures to supplement the carbon tax/levy,
including providing incentives for additional energy efficiency savings and the
deployment of low-emissions technology.
GEOTHERMAL ENERGY
Geothermal energy stands out as an important opportunity for the Indonesian
economy. Indonesia is host to 40% of the world’s geothermal resources, and has
by far the largest resources of any single country. Geothermal power produces
almost zero emissions and is a renewable source of energy. As the world moves

toward a carbon-constrained future, countries that can supply low-cost, low-
emissions energy will have a strong competitive advantage and stand to gain
economically.
There is a role for
Today, only around 3% of Indonesia’s geothermal resources are developed. The regulatory and fiscal
main reason for this is that geothermal energy cannot compete with conventional measures to
energy sources, given the existing distorted price structure of the Indonesian complement emissions
energy sector. The distortions arising from explicit and implicit subsidies favor pricing. Policies to
fossil fuel generation, to the near exclusion of geothermal. incentivize geothermal
power generation
The skewed energy production mix arising from this distorted price structure provide a case in point
represents a genuine economic loss for Indonesia. Energy could be produced
more cheaply if these distortions were neutralized. There is also a substantial
danger in building energy capacity under a distorted price structure, since the
long life of investments in the energy sector mean that investment decisions
made under today’s conditions will affect Indonesia for decades to come.
The carbon tax/levy applied to fossil fuels will go some way toward unwinding the
distortions in the price structure for energy, and should make geothermal a more
attractive option to energy producers. However, the proposed carbon tax/levy is
modest compared to likely international carbon prices, and provides only a partial
answer. In addition, there are other price distortions present in the system that
need to be addressed before geothermal can compete on a level playing field.
Therefore, there is a role for complementary measures, on top of the carbon
tax/levy, to promote geothermal development in Indonesia. The need for such
measures is even more pronounced ahead of the introduction of carbon pricing.
The economic viability of a potential geothermal development can be determined
by comparing its generation costs with those of conventional technologies. It is In addition to a carbon
important to include all costs, explicit and implicit, when comparing the generation price premium for
costs of geothermal and conventional (typically coal). Many, very real costs borne geothermal power,
by the Indonesian government are not included in the simple book cost paid by geothermal tariffs need
to reflect the true cost
PLN to the independent power producers (IPPs). For instance, price pass-through
of electricity currently
arrangements for the coal generators mean that the government pays when the incurred by the
coal price rises. This amounts to an implicit subsidy (essentially a coal price Indonesian
hedge) for coal generation and must be included when comparing the costs of government.
geothermal and coal generation.
Figure 4 Breakdown of the true cost of coal-fired electricity
14
Carbon price
12
Air pollution & carbon
10 price risk cost
Fuel price risk cost

cents/kWh
6 Fuel cost
4 Operating cost
2
Capital cost
0
True cost of energy
Source: McLennan Magasanik Associates modeling for the Green Paper

By including all explicit and implicit subsidies on top of the “book price” of
electricity, the full cost of electricity generated through conventional technologies
can be calculated. In practice, calculating such costs is not straightforward,
A reasonable and suggesting a fiscally conservative approach of using a best-effort conservative
conservative estimate
value.
of the actual true cost
of electricity incurred A value of 13 cents per kWh is taken as a reasonable and conservative estimate
by the Indonesian of the true cost of electricity, using figures from McLennan Magasanik Associates
government is 13 cent (MMA) (Figure 4) and keeping in mind that geothermal in part displaces more
per kWh. expensive generation technologies such as oil based generation (see Chapter 4).
In addition, other benefits of expanding Indonesia’s geothermal capacity, such as
greater security of supply, further enhance the value of geothermal, but the “full
cost of electricity” as defined above gives a minimum price that geothermal
should fetch.
It is therefore economically reasonable for the government to pay at least 13
cents per kWh for geothermal electricity with any excess profits by operators
recouped through profit sharing arrangements.
Geothermal development is also hampered by other issues, such as high levels of
uncertainty regarding the value of the geothermal resource in a particular area
coupled with high up-front investment costs. In addition to providing better
investment conditions by providing a clear and government backed tariff, the
provision of enhanced exploration information is necessary.
The strategy for geothermal development has the following three pillars.
1. Enhancement of the existing pre-tender field survey and exploration studies,
to ensure that the geological data available before tender are of the highest
quality possible. The data gathered from surveys and exploration before
The proposed tender would ideally be added to a public geothermal database for
geothermal policy Indonesia, which will become a valuable national asset in its own right.
strategy has three Indonesia’s Clean Technology Fund bid would be well suited to supplying
pillars: enhance the the initial funding for a revolving fund to finance confirmation drilling.
information available to
potential investors; 2. Geothermal tariff. A generic power-purchasing agreement between PLN and
provide a geothermal geothermal IPPs should be created that gives IPPs the right to sell
tariff consistent with geothermal electricity at the “full cost of electricity,” as described above.
the true cost of Since this price may be higher than the price PLN is paying for conventional
electricity; and institute electricity, the Ministry of Finance should reimburse PLN for the difference.
efficient profit sharing
3. Profit-sharing arrangements, applied to the IPP’s profits after cost recovery,
arrangements.
will ensure that the government obtains a fair share of the economic profits
resulting from the geothermal resource, while maintaining the IPP’s
incentives for efficiency.
A vibrant geothermal program in Indonesia could result in healthy receipts from

the sale of emissions abatement on international markets. If Indonesia can
negotiate sectoral crediting across all fossil fuel emissions, as discussed above,
then any geothermal electricity generated will contribute directly to reducing
Indonesia’s fossil fuel emissions, and hence will generate export revenue once
the target is reached. If a comprehensive sectoral target is not achieved, then
international carbon finance could still be accessed through other avenues, and
public carbon finance can also play important complementary roles (Box 4).

Box 4 International funding models
A narrower alternative to a broad sectoral target for all fossil fuel emissions is a sectoral
crediting arrangement for abatement from geothermal resources. This would also allow
Indonesia to reap benefits from geothermal resources that are facilitated by government
policy, by selling abatement on international markets.
This would be more desirable and more applicable than project-based access to
international funding. The Clean Development Mechanism, for example, has high
administrative overheads and may not apply to investments that are made viable through
government policy actions.
Multilateral or bilateral financing in the form of grants or concessional loans is also likely to
be available, and could among other uses help to establish a revolving fund for geothermal
exploration.
REGIONAL ACTION ON LAND-USE CHANGE, FORESTRY AND

PEAT EMISSIONS
Indonesia emits large amounts of carbon from land conversion, forestry and peat
lands (Figure 5). The bulk of near-term emissions reductions in Indonesia are
expected to come from reductions in these emissions sources. Land conversion,
forestry and peat land
There are plentiful opportunities to curb carbon emissions from forestry, land-use management offer
change and peat fires, by changing land-use practices, reducing deforestation, great opportunities to
promoting reforestation, conserving peat land, and preventing fires. In many cut emissions.
cases, the technical and opportunity cost of such measures – for example to
establish a palm oil plantation on grassland rather than on forested land – would
be very low. In many cases, it can be cost-competitive with alternative abatement
actions even after taking into account implementation costs and the need for
cushioning social impacts.
Regulatory, fiscal and budgetary measures will all be important in achieving the
emissions reductions that Indonesia is aiming for. This Green Paper focuses on
ways to harness the intergovernmental fiscal transfer system for the task, which is
one important aspect of the overall climate policy package for land use change
and forestry.
Regulatory, fiscal and
Figure 5 Estimates of emissions from land-use change, forestry and budgetary measures
peat for Indonesia will all be important in
achieving emissions
2,000 reductions.
Peat decomposition
Peat fires
1,500
Land-use change & forestry
MtCO2 / year
1,000
500
-
Second National Second National IFCA, average DNPI, 2005 Comparison:
Communications, Communications, 2000–2005 Energy and other
2004/2005 average 2000- sources, SNC
2005 2005
Sources and notes: see Figure 5.1 in Chapter 5.

One difficulty is that the people, businesses, and institutions on the ground that
control land-use-change practices reap little or no direct benefit from actions to
cut carbon emissions, and so lack the incentive to pursue them. Carbon mitigation
policy also needs to heed local aspirations for development.
Many decisions relevant to land use and forestry management, and other aspects
of climate change, are under the control of local governments in Indonesia.
Hence, one avenue for promoting climate change action at the regional level is to
use the intergovernmental fiscal transfer system. Through it, the Government of
Indonesia could make payments to the regions to support and incentivize climate
The intergovernmental change action by regional governments.
fiscal transfer system
is a promising avenue The intergovernmental fiscal transfer mechanism could also be used to channel
to support regional payments for forest carbon (REDD) from industrialized countries to tropical
climate change action. developing countries. The intention is to put a financial value on the carbon stored
in forests, and thereby change land-use decisions toward lower-emission options
where this is economically sensible. REDD payments are likely to be attributed in
large measure at the national level, creating the need to transfer financial
incentives down to the regional and local levels.
This could be achieved through a Regional Incentive Mechanism, providing
payments to regional governments to support climate change mitigation action,
including payments linked to successful program implementation, and for carbon
reduction outcomes (see figure 6, where down arrows denote monetary flows and
up arrows denote emissions reductions). Regional governments would be free to
take part and have full control over the design and implementation of projects,
while the central government would choose the most cost-effective proposals for
implementation, taking into account development priorities, possibly by way of a
tendering system.
A performance based The central government would manage the national and international aspects of
Regional Incentive the scheme, including management of international finance inflows from REDD.
Mechanism is a The scheme could be revenue-neutral over time, with a share of the overall
suitable vehicle. international REDD payments to Indonesia covering the payments to regional
governments.
Figure 6 Payment transmission under a Regional Incentive Mechanism
International carbon finance, public and private market sources

National taxes and subsidies for land-use and forestry
National regulatory policies for land-use and forestry
Payments to Indonesia
Carbon emissions cuts
Central govt budget

or climate change fund
Intergovernmental
fiscal transfer mechanisms
Payments to regions
Other
Regional governments (districts and provinces)
entities

Capacity-building programs and pilot activities would be vital during the start-up
phase, and would form the initial focus of the scheme. These could be supported
through donor financing, building on existing initiatives like those under the
Indonesia-Australia Forest Carbon Partnership.
Implementation could occur through existing and emerging avenues under
Indonesia’s intergovernmental fiscal transfer system. The first vehicle for
implementation is the Special Purpose Fund (Dana Alokasi Khusus, or DAK).
Climate change funding could be channeled through existing DAK programs or
through new integrated climate change DAK programs, and could in future also Three potential
include a reward or incentive component. avenues for
implementation exist,
Another possible avenue is direct grant agreements with selected provinces or using current and
districts, for specific, agreed climate change programs and outcomes. These emerging transfer
would also allow funding to be linked directly to international inflows of carbon mechanisms.
financing.
A performance-based Regional Incentive Fund (Dana Insentif Daerah) for social
and economic performance is planned for 2010. This transfer model provides a
third option for climate change incentive payments. Payments to regional
governments would be made on the basis of performance on aggregate indicators
of outcomes, for example carbon emissions, area of deforestation or
reforestation, and incidence of peat fires.
Box 5 Regional climate change incentives beyond REDD

The Regional Incentive Mechanism could be used as a framework to incentivize and
support a wide range of locally based measures on climate change, not just forestry.
Candidate activities would include energy efficiency programs managed by local agencies,
improved waste management methods, and mitigation actions in agriculture. Fiscal
transfers could also be used to finance local actions to adapt to the impacts of climate
change, possibly through the channeling of international adaptation payments.
Support for climate change mitigation measures through intergovernmental fiscal

transfers is only one part of an overall policy platform for carbon reductions in
land-use change and forestry. There may be other channels for carbon finance to
reach the local level. Further detailed analysis is needed to design financial
systems for managing international carbon finance inflows as well as domestic
payment distribution.
Equally important components of the national policy toolbox for curbing land-use A review and reform of
and forestry are national regulatory measures, as well as the tax and subsidy fiscal and regulatory
system for land conversion, forest and agricultural industries. These regulations policies affecting land-
and policies sometimes overlap or are contradictory, and often promote high- use change and
emissions outcomes. The Ministry of Finance is currently investigating natural forestry is needed.
resource management arrangements and opportunities for fiscal and regulatory
reform, with assistance from Australia.
A systematic approach to policy review and reform – involving both the Ministry of
Finance and the relevant line ministries – is needed to ensure that carbon
reduction objectives are reflected in the fiscal policy settings for forestry and land
conversion. A suitable strategy for the Ministry of Finance is to work with the
appropriate ministries, principally Forestry and Agriculture, to bring existing fiscal
policy settings into line with carbon reduction objectives.

INSTITUTIONAL REFORM
The evolution of institutions for climate change policy overseas may provide
useful insights for Indonesia. Australia, for example, followed a pattern of
increasing climate policy integration across government, rising involvement by the
agencies of the head of government, and a central and increasing role for
economic agencies in the formulation of climate policy.
In deciding where climate policy and economic input into climate policy may best
be situated in Indonesia, a number of government agencies need to be
considered.
 The key coordinating roles in relation to climate change are shared between
the Coordinating Ministry of Social Affairs, the Coordinating Ministry of
Economic Affairs, the National Development Planning Board (Bappenas),
the Ministry of Environment, and the National Council on Climate Change
(Dewan Nasional Perubahan Iklim, or DNPI).
 The majority of the relevant policy settings continue to be determined by line
ministries and agencies, including the Ministries of Forestry, Agriculture,
Environment, Energy and Mining, Trade, Industry, Transportation, Public
Works and others.
In practice, in such a complex institutional environment, the formulation,
Effective policy coordination, and harmonization of climate change policy has proven difficult.
coordination is key to Overlapping and inconsistent formulation and implementation of policies have
successful climate hampered efforts to achieve a uniform approach to climate change. Indonesia will
policy. need stronger and more effectively integrated policy formulation, coordination,
and implementation to achieve the announced emissions targets without
impeding development goals, and to gain access to carbon finance. The new
government has an opportunity to review the existing arrangements for the
management of climate change issues to ensure a more cohesive approach to
policy formulation and implementation.
The Ministry of Finance is central to climate policy development and
implementation, not only because fiscal and budgetary instruments matter for
effective and efficient carbon policy, but more fundamentally because policies to
reduce emissions can have significant economic impacts, including on state
finances. In addition, the ministry has an important role to play in helping to
maximize access to international climate financing and channeling payments
domestically.
The Ministry of Finance will also have a key role in the allocation of funding for
climate change through the budget. As such, it will need to ensure that climate
measures are economically sensible and cost effective. A useful metric in climate
Ministry of Finance is change mitigation is the cost per tonne of emissions reductions. Furthermore, the
central to climate Ministry of Finance can assist in assuring consistency in budget allocations over
policy development time, in both medium- and long-term expenditure plans.
and implementation
Indonesia’s economics agencies more broadly – in particular the Coordinating
Ministry of Economic Affairs, Bappenas and Ministry of Finance – have a crucial
role in coordination, bringing sound economic approaches to climate policy across
government, and in safeguarding the national economic interest when policy is
contested by powerful interest groups (as has been the case in developed
countries that have implemented climate change mitigation policies).

SUGGESTED STRATEGY
1. Establish a climate policy unit within the Ministry of Finance.

This would strengthen its capacity to evaluate and contribute to the
formulation of climate change policy. It would also include efforts to ensure
consistency and effectiveness of budget allocations for climate measures. A
high-powered climate policy unit as part of its formal structure is best suited
for the task. It could consist of selected officers, drawing in experts from
across the ministry, and possibly externally.
2. Establish a working group on climate policy across the Ministry of Finance,
Bappenas, and the Coordinating Ministry of Economic Affairs.
The working group would ensure that economic considerations related to
climate change policy formulation and implementation are coordinated
across government. A coordinated approach would help to establish
mainstream economic principles in climate policy across government, and to
ensure that Indonesia’s climate policy portfolio achieves the desired
outcomes at least cost and with maximum economic benefit.
3. Encourage an interministerial review of existing legal, regulatory, and
institutional structures affecting climate change policy formulation and
implementation.
A thorough review of the impact of government rules, regulations, and
institutions on climate change policy implementation is warranted, through a
time-bound interministerial review. This could include recommendations to
fix the issues that are identified. This is essential if a national climate change
vision is to be achieved and successfully implemented.
4. Encourage the commissioning of an integrated review of climate policy.
Good policy in a new field like climate change requires systematic analysis
to explore options, scrutinize proposals, and make the latest thinking
accessible to all stakeholders and the broader community.

Page 16

1 INTRODUCTION: EFFECTIVE AND EFFICIENT CARBON
POLICIES FOR INDONESIA
Indonesia is committed to making a significant effort to curb greenhouse gas emissions, with a
goal of reducing emissions by 26–41% by 2020 relative to a business-as-usual trajectory. The
challenge is to achieve carbon reductions in a way that complements development and economic
reform objectives, and supports the transition to a long-term low-carbon development path.
Indonesia’s Ministry of Finance has an important role to play in Indonesia’s climate policy. Many
fiscal policy levers affect emissions outcomes, and climate policy can have a strong impact on
both fiscal and broader economic outcomes. Sound economics is needed in climate policy design
and implementation across government, in order to achieve emission reductions without
unnecessarily slowing economic growth. Financing for climate change mitigation action, from both
foreign and domestic sources, is likely to increase substantially in coming years, and the Ministry
of Finance will have a key role in designing financing systems and managing the flows of funds.
This Green Paper on economic and fiscal policy strategies is about climate change mitigation –
that is, reducing emissions of carbon dioxide and other greenhouse gases – and how to do this in
the most cost-effective way. It lays out strategies for the Ministry of Finance to design and
implement efficient and effective fiscal and economic policies. It is grounded in economic
principles, and applies emerging international experience to Indonesia’s circumstances.
The Green Paper presents strategies that can guide longer-term reform of climate change
mitigation policies. It sets out concrete options for geothermal policy, and for creating abatement
incentives for regional governments, to illustrate how economic principles can be used to devise
efficient and effective climate policies in the short term. It is left to future work to apply such
principles more comprehensively to other aspects of energy and land-use change and forestry,
and to other parts of the economy, such as agriculture and mining.
The Green Paper is the product of collaboration between staff at the Fiscal Policy Office of the
Ministry of Finance and an Australian team of experts supported by the Australian Treasury and
the AusAID-funded Technical Assistance Management Facility, in consultation with policy-makers
from across the government of Indonesia, and with input from other Indonesian and external
experts.
1.1 INDONESIA’S ROLE AND COMMITMENT

Climate change is an issue of high priority for Indonesia. The country is highly vulnerable to
climate change (ADB 2009), and is a significant emitter of greenhouse gases. Therefore it has a
strong stake in the global effort to limit future climate change.
Indonesia is committed to making a significant contribution to limit global greenhouse gas
emissions, and to helping make a global climate change agreement possible. This is reflected in
the target to reduce emissions by 26% by 2020 compared to business as usual (that is, a
scenario with no policy efforts to curb emissions), and by up to 41% with international support.
These goals were announced by President Yudhoyono at the G20 Pittsburgh Leaders’ Summit in
September 2009 (see Box 1.1).
Indonesia has played an active and constructive role in the international climate negotiations
leading up to the COP15 conference in Copenhagen. Indonesia hosted the 2007 COP13 UN
climate conference, which developed the Bali Roadmap for a new global climate agreement.
Indonesia also initiated the first international meeting of finance ministers on climate change, in
conjunction with the Bali conference.
Introduction Page 17

The Ministry of Finance has been involved with climate change issues, especially since the Bali
COP13 conference, in both the international and domestic policy arenas. Its international activities
have included participation and leadership on climate change financing discussions in the G20;
involvement in climate discussions in the G77, UNFCCC, APEC and ASEAN forums; and
continuing dialogue with international financial organizations, including the World Bank, the ADB
and the IMF. In the area of domestic policy development, the Ministry of Finance, through its
Fiscal Policy Office, has an ongoing work program to develop concepts and new initiatives for
climate change policies (see, for example, Fiscal Policy Office 2008a, 2008b) and to work towards
implementation through the ministry’s other directorates, and through other ministries and
government agencies. This Green Paper builds on these existing efforts and seeks to strengthen
the Ministry of Finance’s capacity to contribute to domestic and international climate policy
initiatives.
Box 1.1 Extract from President Yudhoyono’s speech to the

G20 Leaders’ Summit in Pittsburgh, 25 September 2009
“First, no matter how difficult the challenge before us, let us make history by ensuring
that Copenhagen will not fail. … As leaders, let us give a stronger mandate and a
stronger push and clearer directions to our negotiators for the success of Copenhagen.
Secondly, let us give a positive and strong signal to the world that apart from our
commitments, each of us has national goals, objectives and targets for emission
reductions, and that we have a clear and achievable timeline. We have to produce the
necessary emission cuts to reach the targets that the scientists say we must.
We are devising an energy mix policy including land use, land use change, and forestry
that will reduce our emissions by 26 percent by 2020 from Business As Usual. With
international support, we are confident that we can reduce emissions by as much as 41
percent.”
1.2 A CHALLENGE FOR DEVELOPMENT AND ECONOMIC REFORM

Climate change is now widely recognized as a core issue for development and economic
prosperity. Future climate change impacts could put Indonesia’s development achievements at
risk. Adapting to climate change impacts will be important. At the same time, the world community
must limit the extent of future climate change and the risk of catastrophic impacts, by cutting back
on greenhouse gas emissions.
Cutting carbon emissions means changing production systems and technologies throughout large
parts of the economy. This is both a challenge and an opportunity. Indonesia’s energy supply
needs to grow in order to facilitate economic growth and improve livelihoods, but this has the
potential to create enormous growth in carbon emissions. In many instances, climate change
mitigation means higher investment costs for cleaner equipment, or foregoing some profitable
high-carbon activities in favor of lower-carbon alternatives. In other cases, the shift to a lower-
carbon pathway will improve economic efficiency, even if the environmental benefits are not taken
into account.
Land conversion is important for regional economic development, but it is also a very large source
of carbon emissions. Climate policy could accelerate beneficial structural change in regional
economies without putting regional economic development at risk. At the same time, it is
expected that substantial opportunities for international financial support to reduce emissions will
become available, which could help ease the transition.
A fast-growing economy like Indonesia’s has the advantage that its economic structure is able to
change quickly as new infrastructure is added, allowing a relatively fast turnaround to a low-
carbon trajectory. On the flipside, there is the danger of lock-in to investment in high-carbon
patterns that could turn into future economic liabilities in a carbon-constrained world.

Good climate policy outcomes will often require not just specific new policies, but broader
integrated policy reform. For example, for carbon pricing policies to be fully effective in giving the
price signals for a lower-carbon energy system, energy pricing needs to be reformed. And if
carbon reductions in land-use change and forestry are to be achieved efficiently, carbon reduction
incentives need to be provided to the local level.
1.3 EMISSIONS PROFILE, TRAJECTORY, AND REDUCTION SCENARIOS

Indonesia’s emissions profile is dominated by the land-use change and forestry sector. The
country’s energy sector emissions are still low compared to Indonesia’s population, but they are
growing fast. Figure 1.1 shows two alternative estimates of Indonesia’s greenhouse gas
emissions profile in 2005, the first from the Second National Communications (SNC) to the
UNFCCC (Ministry of Environment 2009) and the other from the cost curve study by the National
Council on Climate Change (DNPI 2009).
Emissions from deforestation, forest degradation, and peat fires are estimated to account for 61%
and 84% of Indonesia’s 2005 emissions under the two datasets respectively (with large variability
between years evident in the SNC estimates). And they are large on a global scale. Indonesia has
been estimated to account for around 7% of global greenhouse gas when emissions from land-
use change and forestry are taken into account, but less than 2% when they are excluded (WRI
2009).
Figure 1.1 Indonesia’s greenhouse gas emissions profile, 2005
2500
2000
MtCO2/year
1500
Peat
1000
LUCF
other
500
Energy
0
Second National Communications DNPI
Notes: The energy category in DNPI excludes manufacturing industries, and the “Other” category excludes emissions from
waste and industrial processes. In SNC, the “LUCF” (land-use change and forestry) data are for 2004, and “Peat” includes
peat fires only, not peat decomposition.
Sources: Second National Communications (SNC) – Ministry of Environment (2009); DNPI (2009).
Consequently, if Indonesia were to significantly reduce its emissions from land-use change and
forestry relative to their business-as-usual growth path in coming years, this alone could make a
substantial contribution to the near-term global climate change mitigation effort. There are many
options to do so at a relatively low cost. However, there are also difficult institutional hurdles and
the interplay with development objectives to consider.
Energy use in Indonesia is still far below the per capita global average, and even further below
energy consumption levels in developed countries. Annual emissions from fossil fuel combustion
and industry are well below 2 tonnes of carbon dioxide per person, compared to a world average
of around 5 tonnes per person, and levels in some developed countries that exceed 20 tonnes per
person.

But Indonesia’s fossil fuel emissions are growing fast, with a growing share of energy supplied by
high-carbon coal. If left unchecked, Indonesia’s emissions profile could be dominated by
emissions from fossil fuel use within a few decades. These emissions alone would be at a
substantially higher level per person than what science tells us is the limit to avoid dangerous
climate change. The options for curbing emissions growth are to improve energy efficiency and so
use less energy to supply the same services, and to take the carbon out of the energy supply by
shifting to lower-carbon energy sources. Indonesia has plentiful opportunities to do both.
Two alternative scenarios of business-as-usual emissions growth are shown in Figure 1.2. Under
DNPI projections, total business-as-usual emissions would grow to 126% of 2005 emission levels
by 2020. In an alternative projection that extrapolates recent emission growth trends and applies
them to emission levels as estimated in the Second National Communications, total emissions
would grow by 30% between 2005 and 2020.
A 26% reduction below the business-as-usual trajectory at 2020 would mean a slight reduction
below current emission levels (around 5% below 2005 levels). A 41% cut from 2020 projected
emissions would translate into emission levels around a quarter lower than current levels.
It is not possible to determine in advance what emission reductions would occur in any particular
sector as the result of policy measures implemented. As experience is gained, there will inevitably
be surprises about the feasibility and costs of different mitigation options. Hence, policy should
not take a rigid planning approach and prescribe specific reductions in specific sectors, but aim
for a consistent effort to curb emissions across all sectors of the economy.
The guiding principle of economically efficient climate policy is to strive for equalization of the
marginal costs of abatement across all sources – that is, to strive for emission reductions at equal
cost per tonne of abatement across the economy rather than paying a higher price for abatement
in some sectors than in others. This is achieved by working towards equalized carbon prices, not
working backwards from estimated technical abatement potential or assumed sectoral reductions.
Thus, for planning and policy prioritization purposes it is important to look at the expected cost per
tonne of abatement from different sectors and policies, not merely at the estimated technical
abatement potential.
For Indonesia, emissions from the land-use change and forestry sector, together with those from
peat, present the bulk of the cost-effective short- to medium-term emission reduction
opportunities. In the longer term, however, it is the energy sector that is likely to determine
Indonesia’s overall emissions outcome. Given long investments cycles, the policy directions for
low-carbon energy need to be set now to promote reductions in the next few decades. In the short
term, significant reductions may be achieved through greater end-use energy efficiency.
A similar mitigation pattern is anticipated in Brazil, which in November 2009 announced an
emissions reduction goal comparable to that of Indonesia, namely a reduction of between 36%
and 39% below business-as-usual at 2020. The comparison with Brazil is relevant for Indonesia
because Brazil’s emissions profile is equally dominated by emissions from land-use change and
forestry. Brazil’s government anticipates that most of the reductions will be achieved through a
sharp cut-back in deforestation in the Amazon, although significant reductions would also be
achieved the agribusiness and energy sectors.
1.4 A PRAGMATIC POLICY MIX

The question for policy-makers is how to design and implement strategies and instruments to
achieve emission reductions in a way that is consistent with pro-growth, pro-poor, and pro-job
development objectives. Meeting these challenges will require an efficient carbon policy mix and a
fair and equitable transition from current policy settings.
The key principle is to apply carbon pricing widely in order to achieve the lowest-cost abatement,
by sending a carbon price signal throughout the economy. Carbon pricing, by way of emissions
trading or carbon taxes, is now being put in place in most developed countries, and is being
considered by several developing countries. It is widely seen as the backbone of efficient and

effective climate mitigation policy. In Indonesia’s case, a carbon tax or levy could go hand-in-hand
with the removal of energy subsidies over time, and could be good for both economic growth and
poverty reduction.
Figure 1.2 Business-as-usual scenarios for Indonesia’s greenhouse gas emissions
4000
Data
from Projection by trend extrapolation
3500
SNC
3000
2500
Peat
2000
-26%
1500
-41%
Land-use change
1000 and forestry
Other sources
500
Energy / fossil fuel combustion
0
2000 2005 2010 2015 2020 2025 2030
4000
No data DNPI data and projection

3500 available
in DNPI
report
3000
Peat
2500
-26%
2000
-41%
1500
Land-use change and forestry

1000
500 Other sources

Energy / fossil
fuel combustion
0
2000 2005 2010 2015 2020 2025 2030
Notes: As for Figure 1.1. Assumptions for extrapolation of DNPI data: Energy emissions growth 5% p.a., “Other sources”
1% p.a., land-use change and forestry, as well as peat, constant. For DNPI pre-2005, the same annual growth rates are
assumed as for Second National Communications. The lines labeled “-26%” and “-41%” refer to the reduction from total
projected emissions at 2020.
Sources: As for Figure 1.1.

However, it will not be possible to implement carbon pricing in all parts of the economy, and many
institutional hurdles as well as other distortionary policies will remain, at least in the short to
medium term. Therefore, regulations and budgetary measures have an important role in ensuring
that low-cost emission reductions outside the covered area contribute to the abatement effort.
Even within the sectors covered by the carbon price mechanism, it is likely that obstacles will
remain that impede the price mechanism from operating freely and prevent least-cost abatement
from taking place. Such obstacles include transaction costs, legal barriers, bureaucratic
overheads, and various “market failures,” such as a lack of information available to producers and
consumers, and benefits or costs that are not reflected in market transactions.
Finally, mitigation policy can have disproportional impacts on some sectors of the economy, so
attention needs to be paid to avoiding any negative effects on poverty reduction objectives.
Regulatory and/or budgetary intervention can address the shortcomings of using carbon pricing
alone. For example, the government can incentivize energy efficiency improvements through
information provision, minimum standards, and budgetary programs; and it can encourage the
adoption of low-emissions technologies through changes to the tariff structure and the removal of
other barriers. In the area of land-use change and forestry, there is a tremendously important role
for regulatory policy and its enforcement, in areas such as spatial planning. To ensure that the
impact of mitigation policies is fair and equitable, cash transfers and various forms of transitional
assistance can be provided to affected groups.
Such measures may have significant economic and fiscal implications, and need to be designed
with economic principles in mind. The Ministry of Finance, in conjunction with the other economics
ministries and agencies, thus has a central role in mapping out and implementing steps towards a
sound climate change policy platform for Indonesia. In policy implementation, the Ministry of
Finance has the lead role on the many fiscal policy aspects, as well as on budgetary allocations to
line ministries for climate change measures.
1.5 OVERVIEW OF THE GREEN PAPER

The Green Paper begins by setting out a strategy for emissions pricing, as the backbone of long-
term climate mitigation policy (Chapter 2). It sets out the concrete steps that would be necessary
to set Indonesia on the road towards carbon pricing for fossil fuels, presents modeling results, and
describes how carbon pricing could be paired with a strategy for attracting large-scale carbon
finance to help with the energy transition.
Chapter 3 presents a broad strategy for international carbon finance. It discusses the relationship
of Indonesia’s announced 26–41% reduction target to the current international negotiations on
carbon finance, and examines strategies for public and private-market carbon finance, as well as
specific options for financing reductions in emissions from deforestation and forest degradation
(REDD).
Selected aspects of the energy sector are considered in detail in Chapter 4. It looks at the links
between carbon mitigation policy and electricity sector reform, together with the challenges in
preparing Indonesia’s electricity sector for a carbon-constrained future. The Green Paper then
lays out a policy package for efficient development of Indonesia’s geothermal power resource,
with further detail given in Appendix 1.
The land-use change and forestry sector is discussed in Chapter 5. It details the opportunities and
sector-specific challenges in devising efficient policy, along with the need for effective
transmission of international REDD finance incentives to the local level. The chapter sets out a
strategy to support and incentivize regional climate action through Indonesia’s intergovernmental
fiscal transfer system.
The report concludes by setting out strategies for institutional development and reform
(Chapter 6). The chapter emphasizes the need to strengthen Ministry of Finance capacity in
climate change policy analysis and development, and activities that the ministry could promote
across government more broadly to help achieve sound climate policy for Indonesia.

2 CARBON EMISSIONS PRICING
KEY POINTS
 Carbon emissions pricing provides least-cost abatement and is the backbone of efficient carbon policy.
 It can be achieved either through emissions trading (as in the EU, and in preparation in Australia, the
US, Japan and other countries) or an emissions tax (as in some EU countries and South Africa, and
under consideration in China).
 A carbon tax or levy on fossil fuel combustion would provide a low-cost way of achieving the energy
sector’s contribution to Indonesia’s 26–41% emissions reduction target. It would also begin the work of
putting Indonesia on a long-term, efficient, and sustainable emissions reduction pathway in the energy
sector.
 A carbon tax/levy would broaden the revenue base and enable new spending initiatives.
 As shown by Green Paper modeling, the poverty rate could be significantly reduced as a result of carbon
pricing, and increases in GDP could be achieved especially during the period that other distortions
remain in the energy sector.
 Carbon pricing is a suitable underpinning of an international commitment that gives comprehensive
access to international carbon market finance. A target for the energy sector would give Indonesia
access to significant permit export revenue.
 Announcing its intention to introduce carbon pricing puts Indonesia among the global leaders on carbon
policy, and would give Indonesia a strong early-mover advantage in negotiating an international target
and financing.
Ministry of Finance strategy

 Prepare for emissions pricing by putting in place reliable accounting systems for carbon emissions from
coal, oil, and gas, and by reviewing the taxation system.
 Create a roadmap toward implementation of a carbon tax/levy. Investigate options for its design and
implementation, provide in-depth analysis of its economic effects, and conduct stakeholder socialization.
Aim for implementation in parallel with removal of fuel subsidies over time.
 In the international climate negotiations, indicate the possibility of an Indonesian “no-lose” reduction
target for fossil fuel emissions, underpinned by domestic policy, and enabling Indonesia to sell
abatement beyond the target on international carbon markets.
 Use of revenue from a carbon tax/levy permit export revenue is to be determined by the Indonesian
government. The suggested strategy is to use funds to offset carbon price impacts on households and
businesses, support budgetary measures for climate change, and reduce other taxes.
Parameters to frame the analysis

 Potential initial carbon tax/levy rate: Rp 80,000 per tonne of CO2 rising by 5% (real) per year.
 Possible initial coverage: all fossil fuel combustion.
 Potential domestic revenue Rp 95 trillion by 2020, potential permit export revenue around $2-3 billion.
2.1 THE CASE FOR CARBON EMISSIONS PRICING

Climate change has been coined the biggest market failure the world has ever seen (Stern 2007).
Market failures arise when some aspects of market transactions are unpriced. In the context of
climate change, damage to society caused by changes to the climate created by greenhouse gas
emissions is faced by society at large and not confined to the emitter – a classic market failure.
The magnitude of the costs imposed by climate change is so large that, if left unaddressed, it will
lead to catastrophic outcomes. Addressing this market failure is the aim of mitigation policy.
Carbon emissions pricing Page 23

At the recent G20 meeting in Pittsburgh, President Yudhoyono announced an abatement target
for Indonesia of 26% to 41% by 2020 relative to business as usual. To achieve cuts in this range,
the Indonesian government will need to put comprehensive abatement measures in place. It is
important that such measures are least cost, to ensure that they do not interfere with Indonesia’s
development goals. The case for emissions pricing follows from the ambition to achieve emission
reductions at least cost (see Box 2.1).
While emissions pricing is the main tool for achieving abatement at least cost to the economy,
especially in the long run, other complementary measures, such as standards and budgetary
measures, should also be used in parallel with carbon pricing.
The remainder of this chapter discusses theoretical aspects of carbon pricing (sections 2.2 to
2.4), a specific carbon tax/levy proposal for Indonesia (section 2.5), and the likely economic
impacts of such a tax/levy, assessed using economic modeling (section 2.6).
Box 2.1 Achieving least-cost abatement through carbon pricing

To reduce carbon emissions, it is necessary to curtail some economic activity that produces emissions or to
improve the emissions efficiency of existing economic activity. In either case, an economic cost is incurred to
achieve the abatement. The cost of abatement can be considered as a cost per tonne of emission
reductions.
There will be many opportunities to achieve emissions abatement within the economy and each abatement
option will have an associated cost. Some opportunities will be significantly cheaper than others. The
challenge for policy-makers is to find mechanisms to achieve overall abatement at least cost. If policy-
makers need to single out specific abatement actions, there is a danger that the selected actions will not be
the lowest-cost options within the economy. In this case, emissions abatement will be more expensive than
necessary.
Carbon pricing is a mechanism that can relieve policy-makers from having to make technical decisions about
precisely which economic activities should be targeted to achieve least-cost abatement, by taking advantage
of the market mechanism. The idea is that a price is put on carbon emissions, and is payable by those
producers within the economy that emit carbon. (The accounting details of how this is achieved depend on
the exact design of the scheme.) This has the effect of raising the prices of goods that have associated
carbon emissions in their production, with this price effect flowing through to all goods and services within
the economy. In this way, all prices are raised by an amount that reflects the emissions embodied in the
entire production chain, from primary materials through to final consumption.
The increased prices bring about changes to relative prices in the economy, leading to an adjustment of
economic activity away from emissions-intensive goods and services. This is because goods and services
that embody a lot of emissions will see relatively higher increases in price than goods or services that
embody few emissions. Consumers and producers will react to this price signal by switching away from
these more expensive, emissions-intensive goods and services, toward lower-emissions alternatives.
The magic of the scheme is that the economic reaction to the price signal automatically implements the
lowest-cost abatement options, without the need for policy-makers to specifically single out these options. In
fact, in principle, the effect of a carbon price is to induce all abatement options that cost less (per tonne of
abatement) than the carbon price. Any abatement option whose cost is less than the carbon price will have a
negative cost once the carbon price is applied. That is, once the carbon price is imposed, consumers and/or
producers who react to prices will be able to save money by implementing the abatement option.
Conversely, abatement options whose cost is greater than the carbon price will still have a positive (although
reduced) implementation cost, so market players will not have a price incentive to implement such options.
2.2 PRINCIPLES OF EFFICIENT EMISSIONS PRICING

When contemplating the introduction of emissions pricing, one question concerns which sectors
and gases should be covered. Ideally the coverage would include all greenhouse gases and all
sectors of the economy, since this would ensure that emissions were reduced at the lowest cost
and that distortions in resource allocation across the economy were avoided (see Box 2.1 above).
If a sector of the economy is not covered by the carbon price, then abatement options within that

sector will not be taken advantage of, since the price signal does not apply to sectors that are not
covered. This means that the price mechanism will not work to automatically select low-cost
abatement options outside the area covered by the carbon price. Thus, for a given economic cost,
less emissions abatement will be achieved than if all sectors are covered.
An additional problem with partial coverage is the possibility of activity leakage from the covered
area. For example, if a carbon price were imposed on electricity but not on other forms of energy,
the distortion in relative prices would induce a substitution away from electricity consumption in
favor of consumption of other forms of energy. This would be a source of further inefficiencies,
since less abatement would be realized at greater cost. Therefore, when considering a carbon
price with partial coverage, it is desirable that the division between the covered and uncovered
sectors reflect a “natural” economic division, with relatively little scope for substitution across
sectoral boundaries.
In practice there are significant estimation, measurement, and verification barriers to achieving full
coverage. Emissions pricing requires that parties covered by the scheme monitor and report their
emissions, and that this is done in a transparent and verifiable manner. For some sources of
emissions, such as fossil fuel combustion, the estimation of emissions is relatively straightforward,
and the existing accounting systems make it relatively easy to obtain reliable and verifiable
emissions data. For other sources, such as agricultural emissions and many aspects of land-use
change and net forestry emissions, the estimation methodologies are complex and there is
considerable debate internationally about their validity. Even for the methods that are established
and agreed, reporting and verification are fraught with problems due to a lack of existing,
compatible accounting systems.
In addition, it is important to ensure that emissions liabilities are applied to entities in a way that
minimizes transaction costs. In this light, the point of obligation – the point at which entities are
held responsible for emissions reporting and ultimately made liable for their emissions – is best
chosen so as to apply to few entities. For instance, taxes on emissions from fossil fuel combustion
could be conveniently collected from large emitters (stationary power plants) at the point of
import, or in the wholesale fuel market. For other sectors of the economy, where emissions are
distributed across a large number of small entities (such as agriculture and forestry), tax collection
is more administratively expensive.
In practice, therefore, it is reasonable to consider applying a carbon price to some sectors of the
economy but not to others. For instance, a carbon price could be applied to fossil fuels but not to
agriculture and forestry at this point in time.
2.3 COMPLEMENTARY MEASURES

Carbon pricing is the most important tool for achieving lowest-cost abatement, as discussed in
Box 2.1. However, the practical limitations of realistic carbon pricing policies mean that there is an
important role for complementary measures such as regulations and budgetary measures
designed to reduce greenhouse gas emissions.
In the face of partial coverage, regulations and budgetary measures can enhance efficiency by
ensuring that low-cost emission reductions outside the covered area contribute to the overall
abatement effort. Even within the sectors covered by the carbon price mechanism, it is likely that
obstacles will remain that impede the price mechanism from operating freely and prevent least-
cost abatement from taking place. Such obstacles include transaction costs; existing legal
barriers; bureaucratic overheads; and various “market failures,” such as the lack of information
available to producers and consumers, and benefits or costs that are external to relevant market
transactions.
These can potentially be addressed through regulatory and/or budgetary intervention. For
instance, the government can encourage energy efficiency through information provision,
introduce minimum standards and budgetary programs, and incentivize the deployment of low-
emissions technology through changes to the tariff structure and the removal of other barriers
(see Chapter 4).

Complementary measures, especially those that incentivize additional emission reductions, are
particularly desirable in the context of the proposed carbon pricing/no-lose strategy articulated in
the following section. Carbon tax/levy and international permit sale revenues can be used to
compensate those who stand to lose from the introduction of carbon pricing. If such assistance is
provided in a form that encourages further abatement, then the additional abatement can be sold
on international markets, raising further revenue. Of course this is only desirable if the cost per
tonne of abatement does not exceed the international carbon price. However, so long as the
domestic carbon price is below the international carbon price, many such opportunities should be
available.
Thus, there is an important role for complementary measures. That said, carbon pricing should
become the cornerstone of an efficient and effective carbon policy, for two reasons. Regulatory
interventions have the tendency to impose higher abatement costs on some sectors and products
than others, and thereby increase the cost of achieving a particular abatement effort compared to
emissions pricing. Secondly, regulations and budgetary measures are more prone to strategic
manipulation by interest groups, with negative effects on efficiency as well as equity. This type of
manipulation is more difficult to keep in check due to the lower levels of transparency associated
with regulations and budgetary measures relative to carbon pricing.
2.4 EMISSIONS TRADING VERSUS A CARBON TAX/LEVY

The two main mechanisms for imposing a carbon price are emissions trading and a carbon
tax/levy. Hybrid schemes which combine features of both mechanisms are also possible.
Emissions trading
In a pure emissions trading scheme, the government declares a target for annual emissions, and
distributes permits that grant the right to emit this amount. Firms that produce carbon emissions
during the year are legally obliged to surrender permits corresponding to their emissions.
The distribution of the permits from the government to producers can be achieved in a variety of
ways – through public auction, free grants, and so on. Once the permits are distributed, firms are
free to trade permits among themselves, at whatever price they see fit.
Firms that produce emissions in the course of their economic production will need to purchase
permits to cover their emissions. Firms that can implement abatement options cheaply will find it
more profitable to implement those options and avoid having to surrender more costly permits. In
this way, trading of permits creates a market price for carbon, which will be the marginal
abatement cost required to achieve the government’s emissions target.
Thus, emissions trading provides certainty over the emissions outcome (which is fixed), but it
does not provide certainty over price, since the price is allowed to float to whatever level is
necessary to achieve the emissions target. Likely values for the cost per tonne and economic
costs can be estimated but such estimates will always be uncertain, especially given the long
timeframes over which carbon policy acts.
Carbon tax/levy
In a carbon tax/levy scheme, the government declares a price that is payable per tonne of carbon
emissions. Firms that produce carbon emissions are liable to pay this price in the form of a tax or
levy.
If emissions pricing in Indonesia were implemented using a tax, then this would mean central
revenue collection through the Ministry of Finance. If it were implemented as a levy, then line
ministries – and potentially regional governments – could be in charge of revenue collection. This
Green Paper does not explore the relative merits of each option, this remains for future work.
From here on the terms “tax” and “levy” are used interchangeably for ease of exposition. This is

not to suggest that a tax is preferable to a levy, or vice versa, and does not prejudice the ability to
decide between applying the carbon price as a tax or non-tax revenue measure.
Thus, each firm has an incentive to implement any abatement options available to them at a cost
below the tax. In this way, carbon emissions are reduced throughout the economy to the point
where additional reductions would cost more per unit of abatement than the emissions tax.
A carbon tax/levy scheme provides certainty over the price per tonne of abatement. However, it
does not provide certainty over the emissions outcome, since only abatement options that have a
cost per tonne below the carbon tax are implemented and their magnitude is unknown. Likely
emissions outcomes can be estimated, but there is a high degree of uncertainty associated with
such estimates, especially given the long timeframes over which mitigation policy acts.
With carbon taxes, the government would be expected to monitor abatement outcomes and it will
be under pressure to revise tax levels depending on emissions outcomes. Conversely, with
emissions trading, the government will be under pressure to change the emissions target in light
of the cost of traded permits.
Comparison between emissions trading and carbon tax/levy

In principle, both an emissions trading scheme and a carbon tax are able to achieve emissions
abatement at lowest cost, by letting the market and the price mechanism “discover” the lowest-
cost abatement options automatically. However, there are some practical issues that differentiate
the two styles of scheme.
Administration
A carbon tax is potentially simpler to set up and administer, since it can be collected through
existing taxation institutions. A carbon tax on fossil fuels applied at wholesale levels (or at the
point of production or import) involves relatively few entities and should not impose a high
administrative burden.
An emissions trading scheme requires a new government entity to be created for its
administration. It is also desirable to establish a transparent central marketplace where permits
can be traded.
Therefore, an emissions trading scheme is more complex to set up and administer than a carbon
tax, at least initially.
Compensation and assistance

When a carbon price is imposed, firms with existing productive assets that produce emissions will
suffer an economic loss. They will argue either that they should be excluded from coverage of the
scheme or that they should be compensated for their loss.
This issue of compensation is a very controversial aspect of imposing a carbon price and will
require negotiation between the parties involved. However, regardless of the amount of
compensation issued to firms, it is important to realize that the form of compensation can have a
big impact on the economic efficiency of the carbon pricing scheme. Compensation needs to be
carefully designed so that firms still face a carbon price signal in their productive activities,
ensuring that marginal decisions about abatement are not affected.
Compensation can take many forms, including grants, lump sum transfers, and any other form of
assistance. These forms of assistance are equally available in a carbon tax scheme and a trading
scheme. However, the compensation mechanism of choice for emissions trading tends to be free
allocation of emissions permits, whereas for tax schemes the temptation is to use tax exemptions.
Firms receiving free permits can use them to offset their own emissions or sell them to other
emitters. Thus, if the allocation of free permits is based on historical emissions, industry averages,
or best practice benchmarks, the incentives to abate remain intact for the recipient firms and the
economy more generally.

In contrast, tax exemptions that preserve a carbon price signal are harder to design. Indeed, a
simple tax exemption is equivalent to removing exempt firms from the coverage of the scheme,
and a tax reduction is equivalent to only partially covering the beneficiary firm. As discussed
above, partial coverage within an economic sector is likely to produce very inefficient abatement,
since there will be substantial leakage of economic activity into the exempted subsector. Thus, tax
exemptions have the effect of muting the carbon price signal and thereby affecting the efficiency
of the scheme.
Therefore, with a carbon tax, it is important for the government to resist pressure to apply carbon
tax exemptions at a subsectoral level. Such exemptions are more economically costly than just
the value of the foregone tax revenue and increase the economy-wide costs of abatement.
A less distortive instrument for compensating businesses for losses under a carbon tax would be
grants and other non-distortive forms of assistance. These are discussed in more detail in section
2.5 on an Indonesian carbon tax.
Size and liquidity of the carbon market

An emissions trading scheme relies on market mechanisms to determine a price for carbon. If the
market has a small number of players, or is dominated by a small number of large players, the
price-setting mechanism of the market will not work efficiently. Tacit collusion among the large
players may affect the carbon price, leading to a fall in the carbon price and inefficient abatement
outcomes. Thus, when coverage is narrow and there is a relatively small number of large players
in the covered sector, a carbon tax can be preferable to emissions trading.
Linking with international markets

An emissions trading scheme is easier to link to international markets, since it naturally allows
international trade by individual firms between trading scheme regimes.
A carbon tax scheme can also be compatible with international permit trading, albeit in a
centralized way – for example, it would be possible to negotiate a no-lose target, as proposed in
the next section, whereby national abatement beyond the domestic target could be sold on
international markets.
Implementing emissions pricing through a tax/levy also allows Indonesia to more easily to
separate the domestic emissions price from the carbon price that prevails in international markets.
This could be important, especially in the early stages, to create certainty in the domestic
economy about the level of emissions pricing, by keeping the carbon tax/levy at a pre-announced
level that is likely to be below international carbon prices.
The downside of keeping the domestic price lower than the international price is that Indonesia
would need to use regulatory and fiscal measures to take advantage of abatement opportunities
that are profitable at the higher international price but not the lower domestic price. As discussed
in section 2.1 such measures are potentially less efficient than carbon pricing at reducing
emissions. Hence, over time it is desirable to allow the domestic carbon price in Indonesia to
international price levels, for example by moving to emissions trading with linkage to international
markets.

2.5 AN INDONESIAN EMISSIONS TAX/LEVY ON CO2 EMISSIONS FROM FOSSIL FUEL
COMBUSTION
Strategy
 Move toward the introduction of a carbon tax/levy on fossil fuels consumed within Indonesia.
 Consider an initial carbon price of Rp 80,000 per tonne of CO2, rising at a rate of 5% (real) to 2020.
 Ensure carbon tax/levy-related price increases are passed through the production chain and to end
users. A carbon tax/levy can co-exist with programs to remove energy subsidies over time.
 Make the scheme revenue-neutral. The tax/levy revenue can be reallocated to facilitate the transition to
a low-carbon economy, through assistance to industry and poor households.
 Subject to improved carbon-accounting systems, carbon pricing can be extended to other sectors. After
a phase-in period, a transition to an emissions trading scheme can be considered.
A carbon tax/levy for Indonesia

As outlined in previous sections, there is a strong argument for Indonesia to introduce emissions
pricing to achieve least-cost abatement, and an emissions tax on domestic fossil fuel combustion
is well suited to implementing this.
The choice of a carbon tax over emissions trading for Indonesia at this point in time is based on
the limited coverage proposed and the fact that a carbon tax can be implemented using existing
institutions, bearing in mind that a carbon tax can easily be evolved into emissions trading should
it become desirable to do so.
The choice to restrict coverage initially to emissions from fossil fuels is due to the limited carbon-
accounting and measuring systems in other sectors of the economy. In addition, it is possible to
arrange to collect the tax from a relatively small number of entities producing fossil fuel emissions
by taxing emissions from large industrial installations or upstream at the production, wholesale, or
import level.
The benefits from imposing a carbon price in the energy sector are particularly high. While fossil
fuel emissions do not currently dominate the Indonesian emissions profile, this will change in the
future as Indonesia pursues its development goals and as the strong growth in demand for energy
continues. Energy-intensive capital has a long life, typically measured in decades for stationary
energy and industrial plants. This means that it is especially important to start early with structural
reforms to this part of the economy.
For these reasons, the Ministry of Finance strategy for carbon pricing would be to:
 begin emissions pricing in the energy sector by taxing emissions from fossil fuel combustion
upstream for liquid fuels and at the point of emission for electricity generators and large
industrial installations; and
 strengthen measurement, reporting, and verification capabilities across sectors and gases to
make it possible to extend the scheme’s coverage over time.
The carbon tax on fossil fuels could be set at Rp 80,000 per tonne of CO2 and rise at a rate of 5%
(real) per year to 2020. As Figure 2.1 illustrates, this is a low carbon price relative to the prices
that have applied in the EU. It is just below the proposed minimum price for the schemes currently
before the US Congress, and significantly below the international carbon prices that would apply
under scenarios of comprehensive global action on climate change over the coming years.
Setting the initial price at this level would reduce the price shock for businesses and households
but still allow the transition to a low-carbon economy to begin. The suggested 5% (real) price
increase is in line with the rate suggested for increases in the floor price in US legislative
proposals.

Figure 2.1 Comparison of future carbon prices
Key: AUS Garnaut 25, AUS CPRS 5: scenarios modeled by the Australian Treasury (2008); EUA: 2009 prices for
European Emissions Allowances futures contracts from ECX; US ceiling and US floor: Waxman–Markey and Boxer bills;
EUA historical: historical prices for European Emissions Allowances from ECX; Indonesia: Rp 80,000 per tonne of CO2 in
2013, increasing at 5% initially and changing to international prices in 2018.
Abatement potential and benefits

Indonesia has a large and low-cost abatement potential, as illustrated by the marginal abatement
cost curves reproduced in Chapter 4 of this Green Paper. Indonesia is playing a leading and
constructive role in the international negotiations to achieve the emission reduction commitments
necessary to avoid catastrophic climate change. As part of this, Indonesia has announced a
commitment to reduce its own emissions by 26–41% by 2020 relative to business-as-usual
emissions, depending on the availability of international assistance.
Carbon pricing could reduce the cost of achieving this commitment. Indeed, modeling undertaken
for the present study indicates that a carbon tax on fossil fuel combustion could yield emission
reductions and at the same time improve economic growth and help alleviate poverty, if the tax
was passed through to consumers of electricity and fuel, and if the revenues were used to reduce
other taxes and provide cash transfers and other non-distortive poverty alleviation measures.
Modeling results show that a carbon tax set at Rp 80,000 per tonne of CO2 on its own is expected
to reduce emissions from fossil fuel combustion by about 10% relative to business as usual – a
significant but plausible amount. Beyond this, additional reductions can be made through specific
sectoral policies, for example, geothermal power support (see Chapter 4). Once the carbon tax is
raised to international levels, models indicate that the expected abatement levels will be
considerably higher. Details of the modeling results are given in section 2.6 below.
Growth trends in emissions from fossil fuels suggest that by 2020 emissions from fossil fuels
under business as usual will be around 825 million tonnes of CO2 per year. A 10% abatement in
fossil fuel emissions therefore corresponds to an abatement of 82 million tonnes per year.
Marginal abatement curves from both the DNPI and TNA support the results from the modeling.
Their MAC curves indicate that the technical abatement potential available at a carbon price of
Rp 80,000/tCO2 exceeds 82 million tonnes per year (see Table 2.1).
The abatement potential suggested by the MAC curves needs to be interpreted with some care,
since the TNA and DNPI studies quote opportunities that will be available by 2025 and 2030
respectively. Also, their abatement costs are purely technical costs, and do not count transaction
costs.

Table 2.1 Technical abatement available at cost of Rp 80,000 per tonne of CO2
Technical abatement
Source Estimate (MtCO2 per year) By year
DNPI 140 2030

TNA 105 2025
Source: DNPI 2009 and TNA 2009.
A no-lose target for access to international carbon markets

At the negotiations currently being conducted through the United Nations Framework Convention
on Climate Change (UNFCCC), there is a significant opportunity for Indonesia to propose a
concrete sectoral no-lose target for emissions from fossil fuel combustion in Indonesia (see
Chapters 3 for a detailed discussion of sectoral no-lose targets).
Indonesia could offer to commit to an emissions reduction target below a reasonable business-as-
usual trajectory. Abatement in excess of this target would be credited and sold in international
carbon markets, and Indonesia would not be liable for any penalty for overshooting the target.
This is the definition of a “no-lose” or “one-sided” target under debate in the UNFCCC talks. While
any reasonable reduction target will still imply high emissions growth from the energy sector over
the period to 2020, it is nonetheless a significant commitment given the base from which
Indonesia is starting (Figure 2.2).
While the carbon tax is initially set at a low level relative to international prices (see Figure 2.1),
abatement over and above the reduction target can be achieved through complementary
measures, including assistance for energy efficiency measures and low-emissions technologies,
and through the geothermal strategy described in Chapter 4. As the carbon tax rises and is
eventually linked to international carbon prices, such additional abatement will be induced
automatically. This would create a substantial new export market for emissions credits for
Indonesia.
Figure 2.2 Indonesia’s per capita emissions (CO2-e per person) in the international
context
20
16
12
0
Indonesia World Developing Developed United States China
average country country
average average
2006 2020 BAU 2020 BAU minus 10%

Dynamic benefits from early structural change in the economy
There are additional benefits that will accrue to Indonesia when it implements a carbon tax/levy.
In a carbon-constrained future, new economic opportunities will arise and the relative competitive
advantage of nations will change. Countries that are able to adapt their economies quickly will be
able to shift competitive advantage in their favor, while countries that are encumbered with a high-
emissions economy will find that they lose their historical competitive advantages. For instance,
countries that have historically benefited from low energy prices from fossil fuel combustion will
lose this advantage as global emissions constraints tighten. Industries will relocate to countries
with low-emissions (and hence low-cost) infrastructure. Consequently, countries that are able to
install a substantial low-emissions productive capacity will gain an international competitive
advantage.
Countries that start the restructuring process early stand to gain more from these global shifts in
competitive advantage. Because building low-emissions productive capacity takes time, early
movers will get ahead of the pack and will receive the bulk of the relocation benefits.
In addition, a commitment to emissions pricing for the long term will provide a valuable signal to
investors to take future carbon liabilities into account when they invest. This leads to more
efficient investment, and hence to a capital stock that is compatible with a carbon-constrained
future. It reduces the risk that some high-emissions assets become stranded and need to be
replaced before their planned date of decommissioning. This is particularly important for long-
lived assets in the electricity generation and industrial sectors, but it also applies to transport
where vehicles have significant life spans.
Impact on fuel and electricity prices

For a carbon tax to achieve emission reductions, the carbon price needs to be reflected in output.
This is a very important point: carbon pricing can only work by changing relative prices. If other
policy settings, such as fixed fuel and electricity subsidy arrangements, interfere with the price
signal from the carbon tax and prevent the adjustment of relative energy prices, the desired price
signal is muted or may even be removed entirely.
Thus, price rises need to be passed on to end consumers. If this is done, a carbon tax of
Rp 80,000 per tonne of CO2 would give rise to increases in the cost of fuel and electricity, as
summarized in Table 2.2.
Table 2.2 Average price impact of Pr 80.000 carbon price, projected revenue, and
possible revenue uses
Price increase Tax/levy revenue Possible use of revenues
Electricity Rp 60 per kWh Revenue would rise to Government free to decide on

around Rp95 trillion by revenue use.
Diesel/kerosene Rp 235 per liter 2020 per year. Proposed strategy: Offset the
Gasoline Rp 190 per liter Additional permit export impact of price rises on
revenue of several billion households and on businesses;
dollars per year may be reduce other taxes; support
available additional abatement initiatives.
In addition to price pass-through, it is important that the government of Indonesia adjust the
funding formulas it applies to the state electricity company, PLN, to ensure that it too faces the
cost of carbon and can take this into account when making investment decisions. Independent
power producers (IPPs) will also need to be liable for the cost of carbon consumed in their
activities, to give them an incentive to carry out fuel shifting and efficiency measures in their
production activities. Assistance measures that preserve carbon price incentives can be put in
place to absorb the impact on the bottom line of PLN and the IPPs if desired (see next section).

Coexistence of carbon tax/levy with current subsidy withdrawal program
Current fuel and electricity price subsidies in Indonesia have the effect of encouraging the use of
greenhouse gas-emitting resources and thus work against the goal of reducing emissions. There
is a strong case to replace such subsidies with cash transfers and other non-distortive means of
achieving poverty alleviation, not just from a greenhouse gas emissions perspective but also to
enhance productivity and hence economic growth in the economy more broadly. Such reforms
were started in earlier years, and Indonesia is part to a G20 nations’ commitment to remove fuel
subsidies over time. Accelerating the removal of fuel subsidies is likely to lead to improved carbon
emissions outcomes.
The introduction of a carbon tax/levy can go hand-in-hand with phasing out of fuel and electricity
subsidies. For the carbon tax/levy to achieve the desired emissions reduction results, it is
necessary for it to be passed through the production chain to end users and this can be done in
parallel with subsidy removal
To the extent that energy prices are currently fixed by the government, as is the case for example
for much of private fuel and electricity use (see Chapter 4), they need to be increased to reflect
the carbon tax/levy once it is introduced as shown in Figure 2.3. That way, the price paid by end
users will continue to move toward the production cost, but will include a component for the price
of carbon.
Figure 2.3 Price pass-through of carbon tax/levy on energy prices
Production cost
with carbon liability
Production cost
Retail price with carbon tax and
gradual subsidy withdrawal
Pri ce
Retail price without carbon tax, with
gradual subsidy withdrawal
Carbon tax introduced
Time
If the carbon price is not passed through, the carbon/tax levy would not have an impact on
consumption and associated emissions for the users whose energy supply is subject to regulated
prices.
That said, although weakened, the carbon pricing can still achieve low cost emissions abatement
even without increasing regulated electricity and fuel prices by providing the relevant price signals
to producers of electricity and to segments of the market that are not subject to regulated prices
such as industrial users and households with large grid connections. The carbon tax/levy would
create an immediate price incentive to shift to lower-carbon fuels (in particular gas) and to
renewable energy sources, and would create a forward price signal that is taken into account in
investment decisions about new plants and equipment. The carbon price would also influence
consumption decisions in those parts of energy use where prices are able to be increased in
response to higher costs associated with the carbon tax/levy.

Revenue from a carbon tax/levy and its use
On 2006 numbers, the total tax collected through these price increases would be around Rp 7
trillion per year for electricity generated from fossil fuels, or Rp 25 trillion per year for all fossil
fuels. This compares with the 2006 state budget of Rp 187 trillion for energy subsidies. Looking
forward, tax revenue could grow to about Rp 95 trillion by 2020 (given 5% real tax growth and an
annual increase in emissions of 7% to 2020).
To obtain a rough indication of the permit export potential, an international carbon price in 2020 of
US$30 per tonne of CO2 can be used. (This is conservative, below price expectations by many
market observers, and reflecting the weaker international action scenario modeled by the
Australian Treasury – see Figure 2.1 above.) This international carbon price leads to an estimated
total abatement of roughly 130–180 million tonnes of CO2 by 2020. (The DNPI/McKinsey cost
curve gives about 190 million tonnes of CO2 by 2030, the TNA about 185 million tonnes by 2025,
and the Indonesia E3 model about 200 million tonnes by 2020.)
As a hypothetical example, if Indonesia committed to reduce emissions by 60 million tonnes of
CO2 by 2020 – keeping in mind that only abatement beyond this can be sold on international
markets under the proposed sectoral agreement – a rough estimate of the permit export potential
is US$2–3 billion per year in today’s dollars (though noting that credits may be issued with a time
delay, see section 3.3).
Assistance for businesses and households

Imposing emissions pricing and allowing price pass-through has implications for households and
businesses, by raising the price of goods and services that rely on processes that generate
emissions. It may be desirable to ensure that poor households do not suffer, by compensating
them for such price increases.
Businesses with invested assets that rely on processes that generate emissions stand to lose
significantly from the introduction of emissions pricing. This is partly because the carbon price
pass-through will reduce demand for the goods they are producing, and partly because it changes
the profit-maximizing production technology away from their emissions-intensive installed assets
and toward lower-emissions technologies. Well-designed assistance can help overcome any
sudden loss of asset value, and ensure a smoother and less disruptive transition to a carbon-
constrained economy.
To ensure that emissions pricing does deliver least-cost abatement, carbon prices need to be fully
reflected in the prices of goods and services with embodied emissions. As outlined in section 2.2,
well-designed assistance and transitional measures will therefore need to preserve carbon price
incentives. From an efficiency perspective, assistance needs to be decoupled from production
and consumption decisions. This is best achieved by using lump sum transfers, or funding public-
good infrastructure improvements and other complementary measures. For instance, a business
might lose profitability because of carbon pricing but regain those losses by installing
infrastructure that is relevant to its bottom line. In other words, the firm’s profitability could remain
unchanged while its incentives to reduce emissions as a result of carbon pricing remained intact.
Similarly, low-income households could receive lump sum transfers or other non-distortive forms
of assistance that do not remove the incentives to conserve energy but avoid poverty impacts.
That said, if the carbon tax is part of the no-lose target described above, then additional
abatement would provide extra abatement for sale internationally. Thus, if a sectoral target can be
agreed (or abatement otherwise sold internationally), then assistance that encourages further
emission reductions can enhance efficiency, so long as the domestic price on carbon does not
fully reflect international carbon prices. For instance, emissions-intensive businesses could be
given assistance to install low-emissions technology and/or enhance their energy efficiency up to
the point where such assistance, per tonne of abatement, is less than the difference between the
domestic and international carbon price. This would help firms reduce their tax liabilities while at
the same time increasing international permit revenue.

Other non-distortive and possibly efficiency-enhancing uses of both tax and permit sale revenue
include measures to reduce bureaucratic red tape, to streamline regulatory structures, and to
provide better public information. Of course, one could argue that such reforms should happen
anyway, but the additional revenue might be just what is needed to make such reforms a reality.
This shows the power of using the carbon challenge to Indonesia’s advantage – rather than being
a reluctant player, Indonesia can help lead the world toward meaningful action on climate change
while not compromising its own economic development. Indeed, as seen in the next section, if
done correctly such reforms can enhance the nation’s long-run economic development.
2.6 MODELING THE ECONOMIC IMPACTS OF A CARBON TAX/LEVY
KEY POINTS
 Economic modeling shows that a carbon tax/levy of $10/tonne of CO2 could reduce emissions from
fossil fuel combustion by around 10% compared to business-as-usual by 2020, and can be achieved
without negatively affecting growth or poverty reduction aspirations.
 If revenues are used judiciously, economic gains from the introduction of a carbon tax/levy are possible.
Poverty is reduced in most carbon pricing scenarios, and could be substantially lowered if part of the
revenue is used for targeted cash transfers.
 Economic costs could be incurred at higher levels of carbon pricing and/or depending on revenue
recycling, but could be handsomely offset by permit export revenue and/or by extra efficiency gains.
Economic modeling undertaken for the Green Paper illustrates how carbon pricing for energy
sector emissions can affect emissions, economic growth and poverty in Indonesia.
The central scenario assumes
 carbon pricing of $10 per tonne of CO2 for all fossil fuel CO2 emissions, implemented as a
carbon tax/levy (or equivalently, emissions trading with full auctioning of permits to emitters),
 price increases for carbon-intensive energy passed through the production chain and to
consumers,
 all the additional revenue used to reduce sales taxes (see Figure 2.4).
Other scenarios explore variations around these assumptions. The model, assumptions and
results are discussed in more detail in Appendix 2.
Effects on emissions
The effect of a carbon tax/levy of $10/tonne CO2 at 2020 would be to reduce total emissions from
fossil combustion in Indonesia by 10% relative to the business-as-usual scenario at 2020. This
modeling result is broadly in line with results from other studies for Indonesia (see Chapter 4) and
from multi-country modeling studies.
At a higher carbon price of $30/t, in line with expectations about international carbon prices
around 2020, the aggregate emissions reductions in the modeling scenario are estimated around
25%.
Additional emissions reductions would be expected from complementary policies. These could
include policy reform to assist the deployment of renewable energy including geothermal
(Chapter 4), and extra policy measures to improve energy efficiency.
The estimated reductions of 10–25% from emissions pricing compares to underlying business-as-
usual growth in fossil fuel emissions of almost 80% from 2010 to 2020, assuming a 6% average
annual growth rate. Hence, emissions would still be substantially higher than today, but lower
than they would be without carbon pricing.

Figure 2.4 Key modeling results: % change relative to reference case, 2020
2
GDP gain
1.5 Poverty reduction
0.5
-0.5
Central scenario: $10 carbon Scenario 2: $10 carbon Scenario 3: $10 carbon Scenario 4: $30 carbon
tax/levy, revenue for sales tax/levy, revenue split tax/levy, sales tax reduction, tax/levy, without revenue
tax reduction between income transfers plus subsidy removal recycling
and sales tax reduction
Source: Indonesia E-3 model, Green Paper calibration.
Effects on GDP and poverty

In the modeling, the reductions in emissions are achieved while increasing GDP compared to the
situation without carbon pricing, for two reasons. First, a carbon tax goes some way to counteract
existing distortions in the energy sector including energy subsidies. Second, recycling revenue
from the carbon tax can provide additional economic benefits – in the central scenario it is
assumed, for illustration, that sales tax (VAT) is reduced by the same amount as the total carbon
tax revenue. Similar qualitative results can be found in the recent “Green Economy” Report
published by the Ministry of Environment (CEDS-UNPAD/Strategic Asia 2009).
The magnitude of the estimated gains is around 0.4% in GDP relative to the reference case, that
is, if implemented over a five-year time span it would translate into an increase in economic
growth of just under 0.1% per year.
In reality, revenue from carbon pricing would likely be used for a mix of purposes including
support for households and businesses, and possibly to support other climate change measures.
Whether and to what extent such expenditure improves economic efficiency depends on policy
design.
Poverty is reduced in the modeling of a carbon tax/levy, and income distribution overall would be
somewhat more equal. In the central scenario, the poverty rate is reduced by 0.5 percentage
points compared to reference case assumptions, with most of the improvement due to lower rural
poverty incidence. The reason is twofold. Firstly, increased real GDP means higher income levels
throughout the economy, lifting more people above the poverty line. Secondly, the carbon tax/levy
(and associated use of revenue) changes the relative prices in the economy – energy and
emissions intensive goods and services become more expensive, low-emissions goods and
services become relatively cheaper. In Indonesia, this would tend to favor low-income
households, whose consumption on average is skewed towards low-emissions goods and
services.
Alternative scenarios
Poverty reduction can be strongly enhanced if part of the revenue from carbon pricing is used for
targeted cash transfers to the poor, similar as the government of Indonesia did during episodes of

fuel subsidy removal in recent years. In a scenario where half of the revenue from a $10/t carbon
tax/levy is spent on cash transfers, the poverty rate is reduced by almost 2 percentage points
(scenario 2).
However, using revenue for cash transfers, rather than offsetting other distortions, reduces the
scope for gains in economic efficiency. In this scenario, the gains in GDP are about a third lower
than in the central scenario.
Removing the existing subsidies on fuel and electricity would have a strong positive effect on
efficiency and income distribution (scenario 3). Combining a $10/t carbon tax/levy with full subsidy
removal would, in the modeling, approximately double the gains in GDP and poverty reduction.
It is also possible for the gains from carbon pricing to be much smaller or a small negative,
depending what distortions remain in the energy sector, how revenue is used, and on the level of
the carbon tax/levy. As an illustration (scenario 4), for carbon pricing at $30/t and without any
revenue recycling, the model shows a small reduction in GDP relative to the reference case,
though poverty is nevertheless reduced due to a shift in relative prices.
Any such economic costs imposed by the carbon tax domestically could be more than offset by
carbon permit exports. The magnitude of such exports depends on what international target would
be negotiated, and what the international carbon price is. Potential carbon permit exports are not
modeled.
Another positive effect not captured in the modeling is that energy sector reform that supports
carbon pricing, in particular reforms that allow the pass-through of carbon price signals in the
market, could lead to strong additional gains in growth (see below).
Box 2.2 The model

The modeling uses the Indonesia E-3 model (Yusuf 2008). The model gives a representation of the input-
output structure of the Indonesian economy, including data on CO2 emissions from fossil fuel combustion.
Emissions from forestry, agriculture and some other sources are excluded. The model also provides a
breakdown of households into 200 income groups (100 urban and 100 rural), which allows an assessment of
income distribution and poverty in the different simulations.
For the Green Paper, the model was calibrated to give a representation of the Indonesian economy, energy
use and emissions at 2020, and includes more realistic representation of substitution between goods and
energy sources than previous versions of E-3.
The modeling takes into account existing policies that affect relative prices in the economy. It assumes that
carbon prices are passed through to other industries and end users. The model does not represent changes
in trade or international financial flows (including carbon finance), nor transaction costs and institutional
factors.
As with any such modeling exercise, the quantitative results need to be understood as quantitative
illustrations of economic principles, they are not meant as predictions.
Underpinnings of successful carbon policies

International experience supports the conclusion that, if played well, carbon pricing can lead to
greater prosperity. A range of European countries have already implemented broad emissions
reductions policies, creating new opportunities for their economies in the process. Many other
countries, including the United States, Australia, Japan and, increasingly, China, are in the
process of establishing comprehensive carbon mitigation policies.
If carbon pricing is implemented badly or not at all, the outcome can be a setback to long-term
economic growth. For example, if some industries are excluded from carbon pricing because of
their political influence or superior lobbying, then the sectors in which they operate will become
less efficient. The economy as a whole will be locked into some high-carbon activities, and to

achieve the same overall emissions goal, much stronger action is needed in the sectors where
policy does apply, leading to inefficiency and an unequal burden across the economy.
The upshot is that carbon pricing needs to be applied uniformly, without exemptions for particular
industries. Where there is a need to assist industries with the transition to carbon constraints, this
is better done through relief on other business taxes. It should not be done through exemptions
from a carbon tax or levy.
It is also crucial to allow markets to pass the carbon price signal through down the production
chain and to end users, so that the carbon price signal can influence decisions about investment,
processes and consumption throughout the system.
This in turn requires reform of energy pricing systems.
Details on the modeling of a carbon tax/levy
Modeling framework and reference case

The model used is a comparative-static general equilibrium model of the Indonesian economy,
based on INDONESIA-E3 model developed by Yusuf (see CEDS-UNPAD/Strategic Asia 2009).
The model gives a detailed representation of the input-output structure of the Indonesian
economy, including the energy sector, and it includes data on CO2 emissions from all types of
fossil fuel combustion. Emissions from electricity generation, transport, industrial and household
energy use are all included; emissions from forestry, agriculture and some other sources are
excluded.
For the Green Paper, the model was calibrated to give a representation of the Indonesian
economy, energy structure, and emissions at 2020. For the Green Paper, parameters for
substitution elasticities were modified to allow a more realistic representation of substitution
between goods and energy sources than in previous versions of INDONESIA-E3. This leads to
greater estimates of abatement than in previous applications, which are consistent with other
international models and with bottom-up estimates of abatement potential.
The model provides a breakdown of households into 200 income groups (100 urban and 100
rural), with their consumption bundles modeled on the basis of Indonesian data. This allows an
assessment of effects on income distribution and poverty in the different simulations.
Assumptions about GDP growth to 2020 are in line with Bappenas assumptions, and assumptions
about growth and composition of the energy sector are chosen to replicate Indonesia’s energy
development plan (2006) (see Table 2.3).
1The average annual growth rate of CO2 emissions is 5.9%, consistent with trends over recent
years and with expected future economic growth, changes in the fuel mix and in energy efficiency.
Modeling of carbon pricing

Emissions pricing is assumed to occur at a uniform rate for all emissions of CO2 from fossil fuel
combustion. In the model, carbon pricing is implemented through a carbon tax. In the context of
the model, this is equivalent to emissions pricing through a levy or indeed through emissions
trading where all permits are auctioned. This is a standard way of modeling carbon pricing.
The modeling assumes that carbon prices are passed through to other industries and end users.
Fuel and electricity subsidies are modeled as fixed subsidy rates not as flexible subsidies that
underpin a fixed price.
The model does not represent changes in trade or international financial flows (including carbon
finance), nor transaction costs and institutional factors. In all but one scenario, for modeling
purposes it is assumed that fuel and electricity subsidies continue.

Table 2.3 Reference case assumptions
Annual average growth

rate, 2003–2020
2003 2020 reference case (%)
Population (million) 209 261 1.3

GDP (Rp trillion, 2003 prices) 2,014 5,236 5.7
Energy use (million barrels 629 1,780 6.2
of oil equivalent)
CO2 emissions (Mt) 279 761 5.9
Composition of CO2 emissions by fuel (%)

Coal 25 51
Gas 16 26
Oil 59 23
Source: 2003: INDONESIA-E3 Database, 2020: model output based on assumptions by Perpres No. 5/2006, World Bank,
ADB.
Scenarios in detail
Differing assumptions are explored about
 the way government revenue from carbon pricing is used (or ‘recycled’) including through
targeted income transfers,
 the level of carbon pricing,
 subsidy removal, and
 potential additional productivity gains.
The central scenario and alternative scenarios 2 to 4 are discussed and shown in Figure 2.4 in
the main text. Table 2.4 and the text below provide further detail about numerical simulation
results, and on three additional modeling scenarios.
Scenario 2, where half of the carbon tax revenue is spent on progressive income transfers (more
money given to poorer households) shows a large decrease in poverty rates. Emissions
reductions are slightly higher than in the reference case, both because the increase in GDP is not
as large, and because more income accrues to households that have a lower propensity to spend
on high-emissions goods and services.
Scenario 3, which combines full energy subsidy removal with the introduction of a carbon tax,
shows a strong increase in GDP relative to the reference case, as price-based distortions are
removed, along with improvements in income distribution as poor households benefit from greater
national income. Emissions reductions however are not as great as in the standard scenario,
mainly because of a ‘rebound’ effect in industrial energy use. Whether this particular result is
realistic would need further detailed investigation (the emphasis in Green Paper simulations is on
carbon pricing scenarios).
Scenario 4 of a ‘high’ carbon price of $30/t coupled with no revenue recycling illustrates that it is
possible for carbon pricing in the chosen modeling framework to result in a decrease in GDP. This
scenario is however highly stylized, as it assumes that the revenue is simply ‘not used’ – in reality,
even a neutral use like reducing the budget deficit has dynamic effects such as lowering interest
payments. It is however a reasonable illustration of what might happen if the potential for
efficiency-enhancing revenue recycling is missed.
Scenario 5 shows that positive GDP impacts would be possible also at ‘high’ carbon price levels,
if revenue recycling benefits apply. Emissions reductions in scenarios of a $30/t carbon tax are
around 25% below the business-as-usual reference case.

Scenario 6 illustrates how some efficiency gains can be realized even without revenue recycling,
for ‘low’ levels of carbon pricing in the continued presence of distortions in the energy sector.
Finally, Scenario 7 illustrates how direct productivity gains in the energy sector, as a result of
energy sector reform, could yield to significant economy-wide growth gains. A one-off productivity
gain of 10% is assumed for electricity generation, in conjunction with carbon pricing, leading to a
1.5% increase in GDP.
NOTES
1 Peraturan Presiden No. 5 Tahun 2006, available at

http://www.batan.go.id/prod_hukum/extern/Perpres5_2006.pdf.

Table 2.4 Key modeling results
Reduction in poverty rate

Reduction in CO2 Increase in real (% change relative to reference case)
emissions GDP
(% change relative (% change relative Total poverty Urban poverty Rural poverty
Scenario to reference case) to reference case) reduction reduction reduction
Central scenario:
Carbon tax $10/tCO2, all revenue used to cut sales 10.1 0.37 0.56 0.30 0.78
Scenario 2: Income transfers

Carbon tax $10/tCO2, revenue split equally between
targeted income transfers and sales tax cuts 10.6 0.22 1.85 0.63 2.87
Scenario 3: Subsidy removal

Carbon tax $10/tCO2, sales tax cut, plus full removal
of subsidies on fuels and electricity 7.4 0.85 1.20 0.53 1.75
Scenario 4: High carbon price, no revenue recycling

Carbon tax $30/tCO2, no revenue recycling 25.8 -0.17 0.30 0.07 0.49
Scenario 5: High carbon price:

Carbon tax $30/tCO2, sales tax cuts 23.9 0.43 0.78 0.38 1.12
Scenario 6: No revenue recycling:

Carbon tax $10/tCO2, no revenue recycling 11.0 0.12 0.33 0.17 0.46
Scenario 7: Productivity gains:

Carbon tax $10/tCO2, sales tax cut, additional
productivity gain of 10% in the electricity sector 9.1 1.47 1.79 0.86 2.57
Source: INDONESIA E-3 model, Green Paper calibration.


3 INTERNATIONAL CARBON FINANCE
KEY POINTS
 The amount of both private market and public finance to support climate change mitigation in developing
countries is likely to expand greatly. If suitable mechanisms are put in place internationally and
domestically, Indonesia could be a major recipient of such finance.
 Carbon finance can support the transition to a lower-carbon economy, by covering additional investment
costs, compensating for economic opportunity costs, and smoothing the transition.
 New mechanisms for market-based financing that have a broader reach than the Clean Development
Mechanism (CDM) – in particular sectoral targets and crediting – are under discussion internationally. If
these mechanisms are designed correctly, they can create opportunities to support broader-based policy
action in Indonesia.
 Public climate finance mechanisms are under debate and negotiation, on both a multilateral and bilateral
basis. Key issues to be determined are the source of future international climate funding and its
allocation to recipients.
 Financing for reducing emissions from deforestation and forest degradation (REDD) is likely to start out
with public finance but will contain an increasing component of private finance over time. Indonesia’s
could get substantial REDD financing, but this depends on the design of international mechanisms and
domestic policies.

 Help secure a good strategic position for Indonesia in a post-Kyoto agreement, by continuing to engage
actively in climate financing discussions and negotiations in the UNFCCC, G20, and other forums.
 Strive for good access to international private carbon finance, by supporting the creation of broad-based,
effective new carbon market mechanisms that match domestic policy initiatives. In particular, propose a
no-lose target for Indonesia’s fossil fuel emissions. Ensure that an adequate proportion of emission
reductions triggered by government policies can be sold in international carbon markets, and are sold at
market prices.
 Strive for public carbon finance to be available to Indonesia, particularly in the short term until private
markets are fully functional. Ensure that public carbon finance is additional to existing aid and
multilateral financing, that emission reductions assisted by public finance can be sold in carbon markets
or count toward Indonesia’s target rather than other countries’, and that climate change loans are
strongly concessional. Support new sources of funding, for example, a global levy on air and sea
transport or the auctioning of emissions allowances in industrialized countries.
 Support the creation of an international REDD mechanism that involves a national policy approach and
target, and that facilitates subnational implementation.
 Examples of carbon financing by sector and type of mechanism, and recommendations, are contained in
Table A3.1 at the end of this chapter.
Indonesia has a history of strong and constructive participation in the UN climate change
negotiations, especially since the 2007 Bali climate change conference. It has also been taking a
prominent role in discussions on climate change financing in the G20, in other international
forums including APEC, the G77, and ASEAN, and in bilateral relationships.
Indonesia can build on this foundation to position itself to reap the benefits from these
international carbon finance opportunities. It can support the creation of fair, effective, and
pragmatic international climate financing arrangements, and influence the design of international
mechanisms to suit Indonesia.
This chapter starts out with an analysis of developments in international carbon finance. It then
discusses the framing of developing countries’ – in particular Indonesia’s – mitigation actions in
the context of international financing, and the options for accessing international carbon finance
International carbon finance Page 43

from private markets and public sources. The chapter closes with a discussion of financing for
activities to reduce emissions from land-use change and forestry (REDD), including peat.
Facilitating domestic economic and development goals

Carbon finance can play an important role in covering additional investment costs and providing
compensation for economic opportunity costs. It can thus facilitate the transition to an effective
climate policy platform, and in many instances will be essential to bring such a transition about.
For example, carbon finance can play a crucial role in making investment in cleaner energy
technology viable, and in providing incentives to move away from carbon-intensive land-use and
forestry practices. It may also be crucial in helping to create alternative economic structures and
livelihoods, for example where REDD is implemented through forest conservation. More
generally, it can be used to cushion any social adjustments triggered by mitigation policies.
But international carbon finance should complement domestic climate policy, not drive it. An
efficient low-carbon strategy need not rely on international financial flows in the long term. Hence,
the best strategy is to use such financing predominantly as a short to medium-term “lubricant” for
policy reform that is ultimately in Indonesia’s own self-interest. Overall government policy for
climate change should be designed with this goal in mind.
3.1 DEVELOPMENTS IN INTERNATIONAL CARBON FINANCE
KEY POINTS
 The amount of both private market finance and public finance to support mitigation in developing
countries is likely to expand greatly in coming years.
 Indonesia’s share can be substantially increased from its current level if suitable mechanisms are put in
place internationally and the right policies apply domestically.
The arithmetic of global greenhouse gas emissions shows that comprehensive involvement by
developing countries is necessary to limit future climate change to tolerable levels (Stern 2007;
IPCC 2007; Garnaut 2008). Developing countries currently account for around half of total annual
global emissions. This share is rising rapidly, as most of the incremental growth in emissions is
taking place in developing countries. Without mitigation, within a decade or two developing
countries alone will account for the total global emissions budget “allowable” under climate
stabilization. Furthermore, most of the abatement options at any given level of marginal costs are
in developing countries.
However, developing countries have much less capacity to pay for the incremental cost of climate
change mitigation, typically have more urgent calls on their scarce resources, and collectively
carry a much smaller share of the global historical responsibility for climate change. Hence,
differentiation of effort is needed, along with a phased approach to implementation.
International climate policy developments

The Bali Roadmap agreed in 2007 foreshadows a post-Kyoto Protocol global climate agreement
that contains binding quantitative emissions commitments for developed countries, actions to
reduce emissions by developing countries, and support from developed to developing countries
for climate change financing. It is expected that an in-principle agreement will be struck at the
Copenhagen COP15 conference in December 2009, or at a successor conference, with the
operational details to be worked out during further negotiations.
Finance for climate change mitigation (and also for adaptation to climate change) has emerged as
one of the two most prominent and difficult areas of the negotiations, alongside target

commitments. It is now widely accepted that developed countries need to bear part of the cost of
mitigation action in developing countries, but the extent and the form of this financing remain
contentious.
Meanwhile, most developed countries have, or are in the process of putting in place, domestic
policy platforms for mitigation. These domestic policies provide for the financing of mitigation in
developing countries, typically by allowing domestic emitters who are part of an emissions trading
scheme to buy emission reduction credits from developing countries, through the CDM or its
successor mechanisms. They may also provide for developed country governments to channel
money for mitigation to developing countries, to count toward the achievement of their own
national emissions targets, or in addition to such targets. An example is the provision in the US
Waxman–Markey climate bill for the government to purchase credits globally for avoided
deforestation to a volume of 720 million tonnes per year, more than Indonesia’s estimated annual
total (see Box 3.3 later in this chapter).
The possible magnitude of future international carbon finance

The amount of future international carbon finance available to developing countries depends on
the stringency of global and developed country commitments to reduce emissions, on the carbon
market mechanisms to be agreed, and on how much public funding developed countries are
prepared to commit.
Scenarios of stringent global climate action put developing country mitigation costs at up to
around $150 billion per year (Figure 3.1), to be met through both public and private carbon
finance. Under the EU Commission’s (2009) scenario, for example, finance requirements for
adaptation and mitigation actions in developing countries could reach roughly €100 billion per
year by 2020. Under the assumptions in the scenario, domestic private and public finance could
deliver between 20% and 40% of this and the carbon market up to around 40%. International
public finance would then help to cover the remainder.
Figure 3.1 Carbon finance needs in developing countries, financing proposals, and the
size of the Clean Development Mechanism
400
Low (or single) estimate
High estimate Proposals for financing
300
2005 US$ billion / year
Estimates of developing
country costs
200
Available
under
100 Kyoto Protocol
An international agreement at Copenhagen or later may well be less ambitious than this scenario,
and result in smaller financing flows. It is, however, highly likely that the future carbon finance
pool will be much larger than under the Kyoto Protocol. Most developed countries expect that in

future they will purchase emissions permits or credits from developing countries to help meet their
domestic emissions targets and commitments.
Indonesia’s potential share in international carbon finance

Indonesia’s share of future global carbon finance could be substantial, if an effective mechanism
for REDD is agreed and if suitable international financing mechanisms for the energy sector and
other sources of emissions can be created.
Indonesia’s share in the CDM is currently below 2%. On the basis of its magnitude of emissions
and abatement options, and assuming relatively even implementation across countries,
Indonesia’s future share in developing country abatement and credits or permits sold to
developed countries could be in the broad order of 10% (Table 3.1). Together with the substantial
scaling up of global finance for climate change, this would mean that international carbon finance
for Indonesia might be scaled up by a large factor compared to today’s situation.
Table 3.1 Indonesia’s current and potential future share in carbon finance (%)
Modeling of future abatement

CDM credits Emissions and trading
Registered Projects Excluding Including International Abatement

projects in the land-use land-use sales of permits, options below
pipeline change & change & 2020, Australian cost of €40/t,
forestry forestry Treasury 2030,
(2005) (2000) modeling McKinsey
Share 1.6 1.7 3.2 13.2 6.9 14.0

among
developing
countries
Share in 1.6 1.7 1.6 7.5 6.9 8.2
global
Source: CDM volumes: UNEP (2009); emission levels: WRI CAIT database; CPRS -15 scenario: Australian Treasury
(2008); McKinsey cost curve: Enkvist, Nauclér, and Rosander (2007) combined with DNPI (2009).
3.2 FRAMING OF DOMESTIC MITIGATION ACTIONS IN THE CONTEXT OF

INTERNATIONAL FINANCING OPTIONS
Nationally appropriate mitigation actions (NAMAs)

The Bali Action Plan speaks of “nationally appropriate mitigation actions by developing country
Parties in the context of sustainable development, supported and enabled by technology,
financing and capacity-building, in a measurable, reportable and verifiable manner.” Fine-tuning
the nationally appropriate mitigation action (NAMA) concept is one of the key tasks of the
Copenhagen negotiations.
A NAMA could be a project, a program or a policy. The policy-related proposals are distributed
along a broad spectrum. At one extreme, a policy might have other primary objectives, with
mitigation solely a side benefit. Examples are the phasing out of fossil fuel subsidies, technology
development programs to push a strategic industry, or watershed restoration projects that result in
an improvement in the plant load factor of a hydropower plant. At the other extreme, a policy
might be solely dedicated to achieving greenhouse gas mitigation. This would be the case for a
carbon tax or a domestic emissions trading system.

Between these extremes, there are many policies that have both dedicated non-climate aims as
well as some mitigation aims. They include policies to harness domestic renewable energy
resources and to increase energy efficiency, where the aim of increasing domestic energy
security also plays a key role.
There is divergence in the views of industrialized and developing countries regarding the
financing and monitoring of policies. Developing countries argue that they accepted the NAMA
concept on the understanding that NAMA policies and programs would be financed by the
industrialized countries. It is clear that the advanced developing countries should finance at least
a considerable share of those projects. In the meantime, there is an emerging consensus about
three types of NAMAs and ways of financing for them, set out below.
Under proposals currently being negotiated for making developing-country mitigation actions and
their financing operational, such as the Australian “national schedules” proposal, a country would
list:
 a headline national mitigation commitment or goal; and
 a list of mitigation actions, including policies, to achieve those targets.
In the UNFCCC negotiations, it is not expected that developing countries would put quantified
national emissions goals on the table as headline commitments. In this context, Indonesia’s 26–
41% national emissions reduction range exceeds international expectations, at least in terms of
how comprehensively the target is framed. This goal could be disaggregated into goals for
particular sectors.
Three tiers of NAMAs

Mitigation actions to achieve the targeted reductions can be categorized according to their
international carbon finance status: “unilateral” for actions or policies not supported by public or
private international carbon finance; “supported” if they use international public carbon finance;
and “market access” if reductions are sold as credits or permits are sold in international carbon
markets.
The actual way that national commitments, goals, policies, and financing are framed in a future
climate agreement could differ from the examples given here. Nevertheless, it is useful as an
illustration of the concepts.
The first tier comprises unilateral actions by host countries, without international financing
support. Examples might include tax and subsidy reform, emissions taxes, or some types of
regulatory reform. Industrialized countries stress that this tier should cover at least those policies
that provide net social benefits due to a reduction in negative externalities such as local pollution.
In general, for developing countries these “unilateral NAMAs” would be expected to have no or
very low mitigation costs; otherwise developing countries would carry too great a financial burden.
The second tier consists of direct financial support from industrialized countries, using public
carbon finance. Examples might be grants or concessional loans for cleaner energy, more
efficient plants or transport systems, technology development, improved land management, and
so forth. These have also been referred to as “conditional NAMAs.” Developing countries would
put forward proposals for up-front financing, and the international climate change funds, or
developed country governments, would choose proposals for implementation.
The third tier comprises credits that can be sold in the international greenhouse gas market. The
developing country government and/or businesses receive the international carbon market price
for their reduction credits. This allows economic rents to accrue to developing countries where the
mitigation cost is below the carbon market price. It requires that emissions are reported,
monitored, and verified, and it requires agreement on a target or baseline for emissions against
which credits are calculated.
The concept of headline commitments or goals, and NAMAs in three tiers, are illustrated in
Table 3.2, with some illustrative examples for the energy sector.

Table 3.2 Framing Indonesia’s reduction goals and possible NAMA policies: energy
sector examples
Headline commitments/goals
Reduce national emissions by 26–41% reduction below business-as-usual trajectory.
As part of the national goal: No-lose target for fossil fuel emissions at a percentage below business as
usual to be negotiated
Policy actions and financing
NAMA tiers and international Indicative mitigation actions (selected energy sector examples only).
financing support
Unilateral: Removal of fossil fuel subsidies.
not supported by public or
private international carbon
finance
Supported: Geothermal exploration kick-started using international grants and/or
using international public concessional loans; international (co-)financing for investments in
carbon finance energy efficiency programs or energy technology development,
transport systems, etc; capacity building.
Market access: Emissions pricing through carbon tax/levy on fossil fuel emissions;
credits/permits sold in additional policies such as a geothermal feed-in tariff, investing in
international carbon markets higher-efficiency power plants and industrial installations, etc.
With a no-lose target (for all fossil fuel emissions, or for a subset such
as the power sector), reductions achieved from actions under any of the
three tiers contribute to credits that can be sold in international carbon
markets, after a threshold of abatement (difference between business
as usual and target) is achieved.
Sectoral crediting mechanisms, or in their absence project offset
mechanisms, can apply in specific sectors and activities such as waste
management, gas flaring, and some industrial processes.
Which type of financing mechanism to use?

Deciding whether particular policies and other mitigation measures should be financed unilaterally
or supported through public or private market finance involves both technical and strategic
considerations.
Public finance allows mitigation actions to receive financial support without the need to define a
baseline or target for emission reductions, or to agree a quantified baseline. It also allows the
support of comparatively high-cost mitigation options – for example, investing in technology
development – that would not be affordable under unilateral actions or would not be financially
viable using carbon market finance. Public carbon finance is therefore particularly suitable to
support enabling activities, and for co-financing selected investment programs, including ones
with high abatement costs.
However, industrialized countries tend to want to avoid paying much more than the actual cost of
mitigation, to ensure that the limited amounts of public carbon finance are used most efficiently.
This runs counter to the legitimate interests of developing countries not to sell their cheapest
reduction opportunities (or “low-hanging fruit”) at discount prices, but rather at the going
international carbon price. The question comes down to whether and to what extent emission
reductions that are (to some extent) supported through international carbon finance can be sold in
international markets.
Carbon market finance has the advantage that it will generally pay for emission reductions at the
developed country market price, and therefore provide a premium over the implementation costs
of many abatement options. Developing countries can use such premiums to support the overall

transition to a lower-carbon economy, including the costs of taking unilateral mitigation actions
and cushioning social impacts.
On the other hand, emission reductions sold in markets are normally subtracted from a country’s
overall emissions budget. They do not count toward the selling country’s overall reduction target,
because they get credited to the buying country. For example, it is anticipated that CDM credits
sold in international markets will be subtracted if and when developing countries take on sectoral
or national emissions targets.
It is important to note that when using financing mechanisms that rely on overall emissions
outcomes, such as a sectoral target, it is not possible to separate out the exact effect of the
different tiers of actions. The anticipated effect of unilateral, publicly financed, and market-
financed actions can be taken into account in defining the target, but attribution of the actual
emissions outcomes will not be possible.
How to interpret supported mitigation in the context of Indonesia’s 2020 emissions goals
In Indonesia’s case, there is a question about how to align the dual reduction goal with the three
tiers of NAMAs. The government has announced that Indonesia will achieve a 26% reduction
below business as usual by itself, and up to 41% with international support.
A reasonable interpretation is that a 26% reduction will be achieved through a combination of
unilateral action and measures supported by international public finance, and that the 41% goal is
an indication of what may be achieved in terms of overall reductions, including all reductions sold
in carbon markets. In this interpretation, Indonesia’s “national target” is a 26% reduction, with
further reductions to be sold in emissions markets.
For the purpose of marked-based financing, the overall national target would need to be
disaggregated into sectoral targets. As discussed elsewhere in this Green Paper, it seems likely
that, by 2020, greater percentage reductions could be achieved in the land-use change and
forestry sectors and in peat fire emissions than in the energy sector.
Ultimately it will be up to Indonesia to determine how to account for its emissions goal, because at
present there is no obligation, or indeed even any firm expectation, for countries at Indonesia’s
stage of development to take on economy-wide emissions targets.
3.3 INTERNATIONAL CARBON MARKET MECHANISMS
KEY POINTS
 Aggregate international carbon financing mechanisms that can support policy commitments are under
discussion internationally, including sectoral targets and crediting mechanisms.
 These could be well suited to supporting climate policy action in Indonesia, and are in Indonesia’s
interest if the parameters are right.
 Indonesia could gain a strong early-mover advantage by proposing commitments such as a no-lose
target for the energy sector, along with sectoral crediting arrangements in other areas.
This section discusses existing, emerging, and likely future mechanisms and architectures for
developing country participation in global climate change mitigation policy, and suggests strategic
directions for Indonesia in securing market-based carbon finance. Potential sources of market-
based carbon finance to support emission reductions in land-use change and forestry are
discussed in section 3.5 below.
The design of market mechanisms needs to be compatible with Indonesia’s abatement options,
institutional situation, market conditions, and policy environment. In the context of Indonesian

policy development toward meeting its announced 2020 reduction goal, on the whole this means
an emphasis on more broad-based commitments and accounting, to facilitate carbon payments
that reward government policy action.
The Clean Development Mechanism

The only currently existing market mechanism covering emission reductions in developing
countries is the CDM. It is a so-called “offset mechanism,” whereby emission reduction projects in
developing countries generate credits that industrialized countries can use to meet their Kyoto
targets.
Globally, close to 2000 projects have been registered by the CDM’s executive board and another
5000 are in the pipeline. The volume of certified emission reductions (CERs) accruing until the
end of 2012 is estimated at between 1.5 and 2.5 billion. This implies total reductions of 1.5–2.5
billion tonnes of CO2-equivalent, or 0.3–0.5 billion tonnes per year, around 1% of total global
emissions. Based on the lower-bound estimate and using forward contract prices of $12 as the
basis for CER revenue, the total revenue of CDM project developers from CER sales until 2012 is
estimated at $18 billion (World Bank 2009). Taking the upper bound of CER volumes and CER
prices after issuance, which currently stand at around $18, total CDM revenues would increase to
$45 billion over five years.
Indonesia’s 26 currently registered CDM projects are expected to provide a total of around
19 million tonnes of CERs by 2012, while another 66 projects in the pipeline for validation could
produce another 26 million. They account for 1.6% and 1.7% of the global volume respectively. If
Indonesian CDM project developers forward sell CERs at $12 per tonne, the total financial value
of the CDM in Indonesia would be around $550 million by 2012, or just over $100 million per year
over the Kyoto period (2008–2012). If they finance projects themselves and sell CERs on the spot
market, then at current market prices the revenues would be around $800 million.
Figure 3.2 compares Indonesia’s CDM performance with that of some other large countries and
other countries in the ASEAN region. Indonesia’s share in the CDM is significantly smaller than its
share in emissions, even before emissions from deforestation and forestry are taken into account.
In contrast to most other countries, Indonesia has a greater amount of CDM credits still in the
pipeline (validated but not yet registered) than already registered, illustrating that it is a latecomer
to the CDM market. However, a fundamental shift to becoming a CDM powerhouse is not on the
cards.
Indonesia has a relatively broad portfolio of CDM project types, but the CDM has so far not been
able to mobilize large reductions in key sectors. It has led neither to a significant acceleration of
geothermal power development nor to an increase in the efficiency of new coal power plants. The
transport sector has been completely bypassed by the CDM.
Avoided deforestation is excluded from the CDM, and while reforestation and afforestation
activities are eligible in principle, the procedures for forestry CDM projects are very cumbersome
and not many buyers are interested in the temporary CERs from forestry projects. Therefore, only
a very few forestry CDM projects exist globally, and none in Indonesia.
Programmatic CDM
In 2007, new rules for so-called programmatic CDM were agreed, in response to complaints that
the transaction costs for project-based CDM were prohibitive for small-scale projects.
Programmatic CDM allows the bundling of an unlimited number of projects. However, due to
stringent rules only a dozen such “Programmes of Action” have been proposed globally within the
last two years, and none from Indonesia.
Waste management would lend itself to programmatic CDM, scaling up from the current approach
whereby each landfill whose methane capture is to be improved needs to go through its own CDM
approval process. For the transport and building sectors, a programmatic approach under the
CDM seems to be most promising in the short term. This approach would also be suitable for the
crediting of national actions (see below).

Figure 3.2 A cross-country comparison of CDM projects
1000
CER volume registered

800 CER volume validated
million CERs
600
400
200
0
China India Brazil Mexico Korea Malaysia Philippines Thailand Indonesia
Source data: UNEP (2009).
Voluntary carbon credit markets

Voluntary carbon credit markets also exist, driven by demand from companies, organizations, and
individuals to offset some or all of their greenhouse gas emissions. Voluntary credits are not
subject to international regulation, but a number of quality standards are competing for
acceptance. The most stringent one is the Gold Standard, which covered 12% of the market in
2008. The prices of credits from such projects can reach levels comparable to CERs.
The voluntary carbon markets reached a volume of $123 million in 2008 (Hamilton et al. 2009).
The only robust information available on Indonesia’s contributions to voluntary carbon markets is
that it ranked fifth among suppliers from Asia behind India, China, Malaysia, and Cambodia, and
that credits for a reduction of about 1 million tonnes were sold from a gas-flaring reduction project
in Sumatra that had been unable to achieve CDM validation. This shows that the voluntary market
is at best a small “add-on” and cannot finance larger mitigation actions.
A limited future for the CDM

The CDM made a start on carbon finance for developing countries, and to date remains “the only
game in town”, but it is limited in its reach and in its ability to support policy-based mitigation (see
Box 3.1).
The CDM is losing support among developed countries, who are the ones who need to pay for it.
European Commission proposals as well as US legislative drafts would restrict the CDM to the
least developed countries, plus possibly some minor sectors of developing countries’ economies
(although industries in these countries are resisting the CDM restrictions). Instead, the intention is
to support developing country mitigation through broad-based sectoral crediting mechanisms
(third-tier NAMAs) or direct funding of mitigation action (second-tier NAMAs).
If this comes to pass, then the CDM in Indonesia will largely be restricted to the continuation of
existing projects, with new abatement options financed through more broadly based market
mechanisms that are still under discussion (see below). The CDM is likely to co-exist with any
new mechanisms, but it is unlikely to be a significant option for carbon finance for Indonesia,
unless new mechanisms fail to come into existence.

Box 3.1 Limitations of the CDM
Project-based mechanisms such as the CDM are geared toward supporting private sector action. They
generally do not provide carbon finance for abatement that comes about as a result of policy or other
government actions such as better enforcement of regulations. Once mandatory regulations are in place that
require or trigger a particular kind of abatement action, a project activity can generally not claim to be
“additional” and hence is ineligible to create offsets under the CDM. However, it may be the case that
supportive policies, such as feed-in-tariffs for renewable energy, may still allow CDM projects to go ahead.
Moreover, project-based mechanisms require a highly conducive investment environment, further restricting
their reach. For example, improved landfill management is a CDM-eligible activity, but only a small
proportion of Indonesia’s landfills are under CDM projects. Anecdotal evidence suggests that this is largely
because of local institutional factors and other investment hurdles. A sector-wide mechanism that provides
international carbon payments for national policy actions to improve landfill management may have better
prospects.
Developed countries, especially the EU and the US, have become wary of the CDM. First, they want to move
away from the paradigm of full offsetting of industrialized country emissions through CDM credits, where one
unit of abatement under the CDM simply means one less unit of abatement in developed countries. Second,
doubts have been expressed about whether CDM reductions can be considered “real reductions,” given that
they are counted against a counterfactual baseline with no real proof possible that the project would not have
happened anyway (“additionality”). Third, there are concerns that CDM emission reductions by one
company, or in one location, could simply be offset by commensurate increases in emissions elsewhere
where they are not counted (“leakage”).
National interest considerations in project-based carbon finance

Where future streams of credits from CDM or other project-based mechanisms are sold to other
countries to help them comply with their obligations, these credits will start to be subtracted from a
country’s emissions budget later, when a binding national target is introduced.
Therefore, governments need to be wary of letting private companies sell future streams of credits
gained from emission reductions. The operation of private carbon credit markets essentially
grants a property right to private firms over emission reductions, but leaves the state with the
burden of complying later with any toughening of aggregate emission reduction commitments.
Hence, if and where project-based credits are created and sold in forward markets, governments
should ensure that an adequate return flows back to the country concerned.
For Indonesia, a particularly important question will be whether and in what form to allow private
carbon projects in forestry, with credits for sale in international markets. The government’s goal of
reducing emissions by 26–41% below business as usual by 2020 relies heavily on reduction
options in the forestry sector. It is unlikely that reductions that are sold in international private
markets can be acquitted against the 26% goal.
Sectoral targets and crediting

The international negotiations for the post-2012 climate policy regime have generated a number
of proposals for new market mechanisms involving developing countries. These can be seen as
ways to make third-tier NAMAs operational.
Probably the most important are mechanisms that encompass emissions from a whole sector of
an economy – for example, power generation, transport, or heavy industries – or for defined parts
of those sectors. Similar principles could be applied to a market-based mechanism for forestry, as
discussed below.
Sectoral approaches have long been discussed as a concept. For example, the Center for Clean
Air Policy (CCAP) published an overview, “proof-of-concept” study of sectoral programs in China,
Mexico, and Brazil, with parallel efforts in India and Indonesia (Helme 2009). Beyond these
conceptual discussions, there is research on the feasibility of sectoral approaches, and some

developing countries are taking steps to design sectoral programs that could be made
operational. The Ecofys consultancy has been working with China and Mexico to collect data for a
sectoral approach covering heavy industry (Ward 2008). According to CCAP, sectoral
commitments for the steel and cement industry in Mexico are under consideration.
Sectoral no-lose targets

A developing country would define an overall emissions target for a sector (defined broadly or
narrowly), with reference to its historical emissions and likely future emissions trajectory. The
target would need to be accepted by other countries, and approved under the Conference of
Parties (COP) to the UNFCCC. Any reductions below the target level could be sold in
international emissions markets, or credited directly against other countries’ emissions
commitments in exchange for payment.
The emissions target can be framed as a “no-lose” target (or, in the terminology of the 2008
Garnaut Review, a “one-sided” target). Under this arrangement, credits can be sold if actual
emissions for the sector as a whole are below the target, but no sanctions apply if emissions
exceed the target (Figure 3.3). The concept of a no-lose sectoral target is now firmly established
in the international discussion about mitigation commitments for developing countries. It is widely
seen as a suitable option to facilitate broad-based emission reduction commitments by developing
countries.
If the target is not defined as a no-lose target, then national governments would be liable for
ensuring that the agreed sectoral target was met. The regulating authorities would need to
introduce a sanctioning mechanism for cases of non-compliance (for example, the payment of
penalties or the cancellation of additional emission rights). Such sanctions are, however,
contested in the ongoing international negotiations.
Sectoral targets could also be framed in intensity terms, that is, the ratio of emissions over output
(in physical units or value). An intensity target allows the smoothing of the effects of fluctuations in
economic activity on emission levels.
Defining the target level

The agreed target level determines how easy or difficult it is to achieve a target, and how many
reduction credits a developing country is able to sell under a given emissions outcome. On the
one hand, targets need to be sufficiently attractive for developing countries to adopt sectoral
targets. This implies that the target should not lie too far below a reasonable business-as-usual
scenario. On the other hand, the view from developed countries – whose agreement to the targets
is essential, as they would be the buyers of credits – is typically that there needs to be a reduction
below business as usual before crediting sets in. Developed countries will want to maximize the
amount of “unpaid” abatement undertaken in developing countries, and to avoid the risk that the
baseline will be set above the (uncertain) business-as-usual trajectory, which would result in
credits being issued without any actual reductions (“hot air”).
The European Union (EU Commission 2009), one of the main potential buyers of credits,
suggests that the target should be set significantly below the business-as-usual emissions
trajectory, with the percentage difference between target and business-as-usual emissions
possibly linked to the level of a country’s development. The estimated business-as-usual
trajectory then becomes a key determinant of the target level, implying that national business-as-
usual scenarios may need to be reviewed by an external body.
At a time when the mechanisms and rules are still being debated, there is likely to be a strong
early-mover advantage for developing countries that are prepared to put offers on the table, to
secure both suitable modalities and favorable target levels.

Figure 3.3 Sectoral no-lose target: two scenarios
(a) Successful/“Selling” outcome:
Actual emissions below the target,
emissions credits created that can be sold.
BAU emissions
GHG emissions
(if doing nothing)
No lose
target
Actual
emissions
Emissions
credits to
sell
Time
(b) Unsuccessful /”no penalty” outcome:

Actual emissions above the target,
no credits created, no obligation to buy credits.
GHG emissions
BAU emissions
(if doing nothing) Actual
emissions
No lose
target
Time
Issuing and selling credits

The dominant view is that under a no-lose target, credits would be issued ex-post, that is, on
assessed performance against the target (Ward 2008); that performance against the target would
be averaged over a full ‘commitment period’ (expected to be five or eight years); and that any
temporary overshooting of emissions above the target trajectory would be subtracted from credits
generated in other years during the commitment period.
The implication is that credits for a no-lose target would be issued only at the end of the
commitment period, when it is clear whether and to what extent emissions in total were below the
target trajectory.

However, it would be important for Indonesia (and other developing countries) to gain access to
credit revenue during the commitment period, to support abatement investment. There are
several options how this could be achieved.
 Indonesia could negotiate for an arrangement where credits are issued in each year where
emissions are below the target trajectory, rather than averaging over the commitment period.
Any overshoot in particular years would not be netted out.
 Developed countries could provide financing ahead of the issuance of credits from the no-
lose target. This could be in the form of concessional loans, repayable only if and to the
extent that Indonesia gets issued credits at the end of the commitment period.
 International carbon markets may provide options to trade in futures (on the expectation of
future issuance of credits), akin to the CDM market that trades futures for credits at all levels
of gestation. The futures would trade at a discount to expected credit values, depending on
the perceived risk that credits will not in fact be issued. The discount could be large
especially in the early years of a commitment period.
Whichever option (or combination of options) is chosen, it is important to minimize the risk that
credits will in fact not be issued. This means avoiding to set targets at unrealistic levels, and
ensuring that mitigation policies are in fact implemented.
Link to domestic policies

A broadly defined sectoral target should give rise to the most broadly based potential carbon
finance mechanism short of a national emissions target. It is compatible with broad-based
domestic abatement policies, such as carbon pricing. A combination of carbon pricing with a
sectoral no-lose target is at the core of the strategy laid out in Chapter 2 of this Green Paper.
It would also be possible to adopt a no-lose target for more narrowly defined sectors, for example
the power sector, and link it to policy packages such as those laid out for geothermal energy in
Chapter 4.
Sectoral mechanisms are ideally suited as instruments to provide incentives for governments to
implement policies that would lower emissions in particular sectors of the economy. Under the
sectoral approach, government policy action is needed to achieve emission reductions, as there is
no direct incentive for emitters to cut back on their carbon output.
The government would receive credits for emission reductions below the target. Like revenue
from domestic carbon pricing (see Chapter 2), government revenue from the sale of sectoral
credits could be used to finance domestic climate policy measures, to assist industry (preferably
de-linked from emission levels in order not to create perverse incentives), or for other budgetary
purposes, including transfers to households.
Under a sectoral target, the government could trade on behalf of a sector as a whole, and use the
international carbon trading revenue as it sees fit. The penalty on carbon emissions in the
developing country (whether achieved through carbon pricing or other policy measures) can then
differ from the international carbon price. For example, the Indonesian government might decide
to start with a relatively low carbon price and then ramp it up over time. The advantages are
greater predictability and possibly better political manageability. The disadvantage is that a
differential between the international and domestic carbon price creates economic inefficiencies
(more abatement could be undertaken at low cost in the developing country and sold at a higher
price).
Alternatively, sectoral targets provide the possibility for domestic emitters to trade directly in
international markets, if the domestic mechanism is emissions trading. This is effectively full
emissions trading, but applying only to selected parts of the economy. Emissions allowances
would ex ante be allocated to companies owning installations that exceeded a certain level of
annual emissions. In order to avoid leakage from one installation to another, all relevant
installations within a sector would have to be covered. Emitters would be under an obligation to
acquire emissions permits equal to their actual emissions. They would obtain those permits either

by purchasing them at auction or as a free allocation from the government. To prevent
overselling, a penalty system for participants that do not surrender sufficient allowances to cover
their emissions would need to be introduced.
Sectoral crediting
A sectoral crediting mechanism also requires a sectoral no-lose target. The key difference is that
the overall baseline would not be divided into single installations to allow emissions trading.
Rather, the deviation of an entire sector’s performance below the sectoral baseline will be
credited, ex post. The requirements for reliable monitoring, reporting, and verification of emission
levels therefore apply to the covered sector as a whole.
Sectoral crediting can be seen as an entry-level sectoral commitment. It is also suitable for
sectors where it is either not feasible or not desirable for emitters to participate directly in
international emissions trading, such as transport or construction.
Sectoral crediting could coexist with the CDM, as long as CDM credits were subtracted from the
overall amount of sectoral credits. However, it is unlikely that new CDM projects would arise in a
sector covered by a sectoral crediting or target arrangement.
Policy-based crediting
The concept of supported NAMAs encompasses the possibility of financial support for policy
action by developing countries. For example, Indonesia might negotiate support for specific
policies in the energy sector. This should be seen as a fall-back position if a sectoral target is not
(yet) feasible or cannot be negotiated on acceptable terms.
Quantifying the emissions reductions from policy action could prove to be significantly more
difficult than under a sectoral target, because it is defined in terms of policy action rather than the
emission reduction outcome. As a result, it may be more difficult to gain acceptance for creating
tradable emissions credits in this way. In that case, direct financial support for policy action could
potentially be provided through public carbon finance (see next section).
Candidate sectors in Indonesia

There is a significant opportunity for Indonesia to propose a concrete sectoral no-lose target for
emissions from fossil fuel combustion within Indonesia. As described in Chapter 2, Indonesia
could introduce a carbon tax or levy, and achieve a significant reduction in emissions from fossil
fuel combustion below business as usual. Further abatement could be achieved through
complementary measures such as assistance for energy efficiency measures and low-emissions
technologies, including the geothermal strategy described in this Green Paper. These and other
policy measures would all be captured by a broad-based sectoral target.
If there is not a very broad-based sectoral target covering all fossil fuel emissions, then sectoral
targets with crediting could apply in specific sectors. Examples are the power sector and selected
emissions-intensive industries such as steel or fertilizer production.
In addition, sectoral crediting could be an attractive option in specific areas outside of fossil fuel
use, for example gas flaring in oil and gas extraction, and landfill management.
Direct support for policy implementation, either through market-based crediting or through public
carbon finance, could be attractive if no overarching sectoral target/crediting arrangement is
entered into. An example would be policies to support renewable energy or energy efficiency
policies, as discussed in Chapter 4, but also policy action in sectors not discussed in this Green
Paper, such as industrial or agricultural emissions.
Achieving adequate returns from mitigation

The UNFCCC principle of “common but differentiated responsibilities and capabilities,” and its
interpretation in the Kyoto Protocol and the current climate negotiations, implies that developed
countries will assist developing countries, financially and technically, with mitigation actions.

However, there are questions about whether developed countries should pay for all or only part of
the mitigation costs incurred by developing countries, and about the price the sale of emission
reductions might achieve. Developed countries, as the prospective buyers of emissions credits
and permits, have variously flagged that they expect developing countries to undertake part of the
total abatement effort without payment, possibly even if the totality of the reductions are to be
sold.
To ensure adequate returns from emission reductions, two conditions should be met:
 the sale of carbon reduction units needs to take place at developed-country market prices;
and
 an adequate share of emission reductions needs to be credited and become available for
sale, whether triggered by Indonesian government policies, by business action, or with the
help of international public financing.
Market prices
Where emission reductions are sold forward in international markets or sold to other
governments, these reductions could well be subtracted from any future international emissions
target that Indonesia might take on while the forward contracts are still in place. Hence, the
existence in Indonesia of “low-hanging fruit” in the form of readily accessible abatement options at
low cost does not mean that such reductions should be sold cheaply to developed countries.
The prices paid for emission reductions should be the same as the prices prevailing in developed
country emissions markets. This will generally be the case where reductions are traded in open
and unrestricted international markets. However, the involvement of developed country
governments may tend to reduce prices, through, for example, restrictions on the import of credits
or permits into buying countries, which would depress international market prices through
competition between sellers or through government-led coordination of buyers. It can also occur
under government-to-government arrangements for emission reduction trades outside the private
markets, where buying countries may see fit to make offers below the market value on the basis
that they are only willing to pay for costs.
In this context, it should be noted that the estimates of abatement costs contained in technical
studies exclude the transaction costs and premiums that may be necessary to compensate
stakeholders or facilitate development goals. (See, for example, DNPI 2009 and many similar
studies, Figures 4.6 and 4.7 in Chapter 4, and section 5.1 in Chapter 5.) In many instances,
therefore, these estimates are well below the real cost of implementing a particular option.
Adequate share of reductions credited

For the full range of reductions – including those that come about as the result of government
policy – to be able to be sold, aggregate crediting and trading mechanisms such as sectoral
targets or crediting are required.
As a counterexample, if the Indonesian government were to implement policies that resulted in
less carbon-intensive power generation or less power use, but the power sector was not covered
by sectoral crediting or trading, then the policy-induced reductions could not be sold in
international carbon markets.
To ensure that an adequate share of total emission reductions can be sold within a sector
covered by an aggregate mechanism, the targets against which credits are issued (or permits
traded) should not be too far below a reasonable business-as-usual scenario (see Figure 3.1).
Looking ahead: developing country emissions targets

The framing of emissions targets relative to historical base years (as under the Kyoto Protocol for
developed countries) or relative to medium-term business-as-usual trajectories (as foreshadowed
in the Bali Roadmap for developing countries) has problematic implications for both equity and
near-term incentives. These approaches effectively reward high emissions in the past or present.

For global climate policy to be viable in the long term, it will probably have to move toward a more
principled approach for setting targets and differentiating commitments. A promising approach is
to set equal per capita emissions entitlements (see Box 3.2). If countries’ future emissions targets
are based on external parameters such as population rather than on deviations from actual
emission levels, then abatement action undertaken now will benefit a country in the future insofar
as it takes the country onto a lower emissions trajectory.
Under current negotiation settings, which define targets and commitments relative to actual
emissions, the prudent approach for developing countries is to require financial returns for a
substantial share of abatement undertaken now.
Box 3.2 The per capita principle

The Garnaut Review proposed a modified version of the “contraction and convergence” model whereby
countries start off with emissions entitlements equal to their current emissions and converge to a common
per capita entitlement over time, with special rules for developing countries during the transition phase. This
implies rapidly falling emissions entitlements for the high per capita emitters (most developed countries) and
slow reductions (and in some cases continued increases) for most developing countries.
Countries would be able to trade emissions entitlements, to allow the global target to be met efficiently. This
would generally mean the sale of permits from developing to developed countries.
The per capita principle has received in-principle support from a range of governments, including China and
India. However they, and other developing countries, insist on also counting accumulated historical
emissions in the computation of future emissions budgets, which would give developing countries greater
entitlements.
Indonesia’s emissions excluding land-use change and forestry are substantially below the world average,
and also below the developing country average. This allows some room for further emissions growth before
a gradual decline, even under stringent global mitigation scenarios with per capita allocations. If forestry and
peat emissions are included, under per capita schemes Indonesia would be required to reduce absolute
emission levels soon and potentially at relatively fast rates. However, absolute reductions should be possible
with the right policy instruments in place, and – depending on the exact business-as-usual scenario agreed
on – are implicit in Indonesia’s 26–41% target range.
3.4 INTERNATIONAL PUBLIC CARBON FINANCE
KEY POINTS
 There is an increasing acceptance internationally that developed countries will need to make public
finance available to developing countries for climate change action, primarily for adaptation, but also for
mitigation.
 Public carbon finance has a particular role in supporting capacity building and institutional reform,
providing up-front financing of mitigation initiatives, facilitating technological change, and supporting
mitigation activities that are unsuitable for market mechanisms because of difficulties in measuring peat
fire and other emissions.
 A number of proposals for future sources of public climate finance, and arrangements for the
disbursement of funds, are on the table. The most promising ones include global levies on air and sea
transport, and the sale of a share of national emissions allocations. Other potential sources are also
available but may be difficult to establish and sustain.
 Indonesia should ensure that public carbon finance grants are additional to existing ODA and multilateral
financing, that climate change loans are strongly concessional and can be used productively according
to Indonesia’s priorities, and that emission reductions partly assisted through public finance can be sold
in carbon markets or count toward Indonesia’s own emissions reduction target.

This section gives an overview of emerging public sources of international carbon finance and
suggests strategies for Indonesia. Public financing for reductions in emissions from land-use
change, forestry and peat are discussed in section 3.4 below.
The need for public carbon finance

It has long been recognized that developing countries will need support from public financing
sources in order to deal with climate change. Until recently such support has been thought of as
applying mainly to adaptation action, which can be costly and does not create internationally
tradable credits. It is increasingly being recognized, however, that developing countries need
public finance flows for mitigation action as well.
Public finance is especially important during the early stages of mitigation programs in developing
countries when markets are not yet developed or fully functional. It also has an important role as
up-front finance, to kick-start mitigation efforts ahead of the creation of saleable emissions credits.
It can take many years for the gap between expenditure on mitigation and income from the sale of
credits to narrow. The role of public finance is crucial in situations where private capital markets
do not provide long-term risk capital. These are core applications of the concept of second-tier
NAMAs discussed in section 3.2 above.
Public finance is also vital to support capacity building and institutional reform in developing
countries, given that these are prerequisites for market mechanisms to work. Public carbon
finance should be used to support the agencies that create the information necessary to underpin
mitigation action, as proposed for geothermal energy in Chapter 4 of this Green Paper. It is also
vital for building the capacity to measure emissions, and to report and verify mitigation actions, in
particular in sectors like forestry where there are difficult technical issues to contend with.
Public carbon finance can be used to support transformational change, including mitigation
activities that have higher costs than can be covered by carbon market prices during start-up.
These would typically comprise activities whose costs are expected to fall over time as learning
effects take place, or as technologies and their deployment are perfected.
Finally, public carbon finance is essential for supporting mitigation actions that are unsuitable for
market mechanisms because of difficulties in monitoring emissions and/or setting acceptable
target levels. The stand-out example in Indonesia is emissions from peat fires (see Chapter 5).
Channels, distribution, and sources of public climate finance

There have been a number of attempts to create international financial flows to assist with climate
change action in developing countries, but actual funding has often fallen short of promises. The
large multilateral funds for climate change include:
 the Global Environment Facility (grants worth $2.2 billion allocated until 2007);
 the World Bank Climate Investment Funds, principally the Clean Technology Fund and the
Strategic Climate Fund ($6.1 billion in pledges so far); and
 the climate change funds under the UNFCCC (total donor pledges to date around $200
million, share of CDM receipts around $20 million).
It is likely that more funds will be created, and that the total funding channeled through multilateral
funds will be greatly scaled up. The G20 process in particular could encourage and support the
provision of significant public finance for climate action.
A global fund or decentralized provision

Various proposals are on the table to create a new global climate change fund, based on
contributions from developed countries and central disbursement to developing countries. This
option is being discussed under both the UNFCCC and the G20, as well as in other forums.

Invariably there will be differences in positions on the principles and formulas for paying money
into and receiving money from the fund. Governance of climate funds is both crucial and hotly
debated.
One way around these issues is to use bilateral public climate financing, possibly in a
multilaterally agreed and verified framework. This would allow donor countries to concentrate on
countries that lie within their established spheres of cooperation, and to make their on-budget
contributions more sustainable. A formula could be negotiated to determine the contributions to
be made by each high-income country, but the contributing countries would then be allowed to
decide which countries and programs their money is channeled to (Garnaut 2008).
Distribution and conditionality of funding

The distribution of public climate finance among developing countries could prove to be an
extremely contentious issue, especially if large amounts of money are channeled through
multilateral funds. Different principles could be applied to cover all the likely scenarios. They might
include a country’s development status (more money for poorer countries), its exposure and
vulnerability to climate change (more money for the countries that stand to be most affected), and
its absorptive capacity (more money for the countries that are most likely to be able to use it
productively). It will be difficult to reach global agreement on a set of indicators. It also stands to
reason that much of the funding will come with various forms of conditionality attached to its use.
Indonesia’s interest in the distribution of funding would be to maximize its own access to
international climate funding, subject to being able to put the money to good use domestically,
and subject to the money being available on favorable terms. That means an emphasis on grants
that do not carry burdensome conditionality on spending; an emphasis on loans insofar as these
are highly concessional and insofar as productive use of the funds (as determined by Indonesia)
is assured; and avoiding selling emission reduction units in return for public carbon funding below
market prices.
Sources of funding
For public climate finance from developed countries to be of real advantage to developing
countries, it needs to be additional to current financing, not merely a rededication of existing flows
from aid programs and international funds. This is of course very difficult to prove in practice.
Nevertheless, Indonesia should insist on additionality of climate finance in both multilateral forums
and bilateral relationships.
Additional funding will be difficult to secure from public budgets in developed countries, which are
likely to remain under pressure for years to come in the aftermath of the global recession and
fiscal stimulus spending. Thus, new, sustainable funding sources are needed. Key criteria are
predictability and stability of funding over time.
Proposed funding instruments can broadly be classified into proposals that rely on contributions
from national budgets; proceeds from the sale of a share of emissions permits under emission
trading schemes or national emissions allocations; and taxes/levies on global emissions or
international transport (see Table 3.3).
An evaluation of proposals
A number of proposals have been tabled in the UNFCCC negotiations (Table 3.3). Their most
important differences relate to the proposed sources of funding, as investigated below.
Other aspects, including the proposed uses of revenue and the governance of spending
decisions, are probably easier to agree and fine-tune than the basic decision about funding
sources. The proposals listed in Table 3.3 all have funding of climate change adaptation as their
major or dominant spending component. However, it would generally be straightforward to include
mitigation funding in the anticipated use of revenue as well.

Table 3.3 Overview of potential sources for global public climate finance
Source of funding Proposed/ Expected revenues Predictability and stability Additionality to existing funding Likelihood of
suggested by establishment and
functioning
National budgets G77/China Potentially very large. Likely to be unstable. Same source as aid. Reduction Unpopular with
Contributions based on share G77/China proposal: 0.5–1% Contributions can be in aid from budgets quite developed countries,
of developed country GDP of developed countries’ GNP = negotiated but no guarantee possible. unlikely to be viable.
$200–400b/year. that they will eventuate.
Countries could reduce their
National budgets Mexico Potentially very large. contributions in response to Not very likely to be
Contributions based on (Multilateral Mexican proposal > $10b/year. budgetary or political viable at high levels.
indicators including emissions, CC Fund) pressures.
GDP & population
Sale of a share of national Norway Potentially very large. Relatively predictable & stable. Additional, but has direct Difficult to establish,
emissions allowances to Depends on breadth of Money goes directly to a impacts on developed country but possible to
developed country coverage under post-2012 global authority, not through budgets (need to buy maintain once in
governments. agreement & share to be sold. developed country allowances), so aid diversion operation, if Kyoto-
governments. possible. style framework
maintained.
Auctioning of a share of European Potentially very large. Unpredictable & potentially Additional, but has direct Possible.
permits issued under domestic Commission Depends on share of permits unstable. impacts on developed country
emissions trading scheme auctioned & coverage of Revenues depend on carbon budgets (loss of domestic
emissions trading. Original EU price & on existence of auctioning revenue), so aid
estimate up to €50b/year from emissions trading & take part. diversion possible.
EU. Could combine with a “national
budgets” option.
Global carbon tax Switzerland Potentially very large. Predictable & relatively stable. Additional. Only indirect impacts Difficult to establish but
(possibly shared between (carbon Swiss proposal: $2/tCO2 with on developed country budgets, possible to maintain
national governments & tax for exemption threshold of but aid diversion nevertheless once in operation.
international contributions.) adaptation) 1.5t/person yields $50b/year. possible.
Aviation and/or maritime levy various Large. Predictable & stable. Additional. Only very indirect Likely to be possible to
(fuel levy on air tickets & Proposals $5–20b/year each impacts on developed country establish & maintain.
international shipping) for aviation & shipping. budgets.
Share of proceeds on Kyoto Existing Small. Relatively predictable & stable. Additional. Only very indirect Already exists
mechanism (e.g. 2% CDM levy mechanism Existing CDM levy impacts on developed country
for adaptation) ~$0.1b/year, ~$2b/year if budgets.
greatly expanded.
G77/China
The G77/China and Mexico have advanced proposals based on contributions from government
budgets. The G77/China proposal calls for all developed countries to pay a fixed percentage of
GNP, to the tune of $200–400 billion per year – a very large amount.
There are fundamental problems with relying on contributions from government budgets. First,
they are inherently unstable, because countries may cut or withdraw their funding contributions if
they experience domestic budgetary or political pressures in the future. The experiences with the
replenishment of World Bank funds like the Global Environment Facility, or indeed contributions to
the United Nations, are a warning in that regard. Hence, it is preferable to support proposals that
rely on new sources of funding. Direct contributions from government budgets also carry the
particular danger that countries may make compensating cuts in aid.
In the case of the G77/China proposal, an additional hurdle is that it perpetuates the dichotomy
between developed and developing countries, with a “hard” dividing line between contributors and
recipients based on country categories. It is difficult to imagine the proposal gaining support
among developed countries.
Mexican proposal
The Mexican proposal calls for contributions by all countries differentiated according to indicators
such as GDP, population, and emissions, based on a formula to be negotiated. Countries would
be eligible to draw on the fund only if they also contributed to it according to the formula.
The advantage over the G77/China proposal is that there is no hard dividing line between
developed and developing countries, but rather degrees of differentiation according to objective
indicators.
However, the reliance on government budgets as a source of funding is a major drawback, so the
chances of this proposal being adopted and sustained over time appear low. It may, however, be
possible to establish a fund on this basis if the magnitude of the funding is manageable. The
Mexican proposal calls for total annual contributions of over $10 billion. This appears ambitious
for a scheme that draws on government budgets, but it is not out of the question.
Norwegian proposal
Both Norway and the European Commission have proposed selling a share of emissions
allocations or permits to create climate change funding.
Under the Norwegian proposal, a (small) portion of national emissions allocations (“assigned
amount units,” or AAUs) under the Kyoto Protocol or a successor treaty would be auctioned by an
international body, and the remainder allocated to countries. This is in contrast to the Kyoto
Protocol, which allocates AAUs for free according to negotiated targets. It amounts to a levy in
direct proportion to the magnitude of a country’s emissions, for countries that have a binding
national target. This would provide a predictable and relatively stable source of funding,
potentially on a very large scale.
A drawback is that it relies on a continuation of the Kyoto-style system of binding national
emissions targets, and emissions allowances under a UNFCCC treaty. It is uncertain whether all
countries would want to go down this route in a post-2012 international agreement, and in
particular whether China (and indeed the United States) would agree to be part of such a system.
Furthermore, there is a direct budgetary impact, like the proposals for funding directly out of
government budgets.
EU proposal
The European Commission has suggested that a share of the permits issued under domestic
emissions trading systems be auctioned and the proceeds allocated to international climate
finance. This differs from the Norwegian proposal in that it does not rely on an international treaty
involving emissions allowances, but rather on national mechanisms.

Such a scheme could yield very large amounts of revenue, but only if countries do in fact agree to
allocate domestic revenue to international purposes. Again, this would have direct negative
impacts on developed countries’ budgets. Furthermore, the funding mechanism would apply only
in countries that have emission trading systems in place. Some advanced countries might opt for
alternatives such as emissions taxes or regulatory approaches.
A further problematic aspect is that the amount of funding would fluctuate with the carbon trading
price. This could present a formidable challenge for the financial management of the global
funding facility.
The EU proposal differs from proposals to tax the selling and buying of emissions permits or
offset credits. These would be only a comparatively minor source of revenue. For example, the
adaptation levy of 2% of CDM credits currently in place is estimated to yield only around $100
million per year.
Swiss proposal
Switzerland has proposed a carbon tax that would apply globally. It has suggested a low rate of
$2 per tonne of CO2, which would yield around $50 billion per year. The tax would be collected by
national governments, possibly at a higher rate, and $2 per tonne would be transferred for
international climate finance. A threshold level of 1.5 tonnes per person per year (in line with a
long-term global carbon constraint) would be exempt from the tax, and countries could keep a
share of the revenue, depending on their development level, for climate financing in their own
country. Countries could obviously choose to charge a higher carbon tax and keep most of the
revenue themselves.
This option could be attractive to many countries as it would give them the opportunity to levy a
carbon tax. As well as helping them to attain their mitigation objectives, for many countries it
would be a welcome revenue-raising instrument.
Again, however, this instrument relies on the implementation of a particular policy instrument,
which may not be institutionally or politically feasible in many countries.
Air and sea transport levies

Under the proposal for an “International Air Travel Adaptation Levy,” a charge would be levied on
air transport, possibly as a percentage of the ticket price or as a levy on fuel. Globally, more than
2 billion individual passenger flights are taken each year, so a levy that averaged just $5 per flight
would yield over $10 billion per year. It is easy to imagine that this could be scaled up by a factor
of five or more.
Such a levy would be highly equitable, as it is high-income people the world over who tend to fly,
and air transport is much more important in rich than in poor countries. Some European countries
already levy ticket surcharges.
Under the proposal for an “International Maritime Emissions Reduction Scheme”, a charge would
be levied on CO2 emissions from cargo ships. Based on a charge of $10 per tonne of CO2, global
annual revenue from such a scheme is estimated at around $6 billion if shipping destined for
developed countries is charged, or around $10 billion if all shipping is subject to the levy. Most of
the revenue would come from international shipping.
The main advantage of transport levies as climate financing sources is that they are completely
independent of government budgets, as well as being independent of climate change policy
regimes. Moreover, the burden is borne by many countries, without overly burdening a particular
group in society. The levies would also provide some incentive to improve fuel efficiency in
transport (if levied on emissions or fuel use) and, to a minor extent, might sway consumers’
transport consumption choices.
If there are concerns about the effects of such a scheme on developing countries, then the levies
could be applied only to international transport, and transport within developed countries.

Other options
A number of other climate finance schemes have been proposed. They include a “Tobin tax” to be
levied on foreign exchange transactions, financing through a levy on lotteries, and voluntary
contributions levied by business associations. These generally do not seem to hold much
promise.
The most promising approaches from Indonesia’s viewpoint

It will be in Indonesia’s interest for the world to create large and stable flows of international public
climate finance that are sustainable over time, and that can support adaptation and mitigation in
developing countries, including Indonesia.
An important consideration is whether Indonesia is prepared to contribute some amount of
funding to a global fund, whether directly or indirectly. Keeping in mind that Indonesia’s receipts
would almost certainly be very much larger than its contributions under any of the schemes
suggested above, the answer should be yes. This opens the way for proposals that do not double
up on commitments or mechanisms that apply in developed countries only.
Global levies on air and sea transport are highly desirable from the viewpoint of creating a large
source of revenue that is highly independent of year-to-year government decisions on budget
allocations. It appears the most promising option.
The Norwegian proposal to sell part of national emissions allocations could work well, if post-2012
international climate policy relies on emissions allowances for all major (developed) countries,
and if agreement on such a scheme can be reached for the medium to long term.
The Swiss proposal for a (low) global carbon tax holds promise in principle, but would require an
extraordinary amount of policy change in a large number of countries.
The EU proposal to auction a share of emissions trading permits could work well in countries that
have emissions trading systems and where the political will can be found to allocate a share of
permit revenue to international purposes.
If global transport levies and/or the Norwegian proposal are not possible or are not of sufficient
scale, then a possible “hybrid” way forward could be the following: determine countries’
contributions to global public climate change finance along the lines of the Mexican proposal, and
then deploy domestic carbon pricing instruments (a tax as in the Swiss proposal and/or emissions
permits sales as in the EU proposal) to provide the financing.
3.5 FINANCING FOR REDD
KEY POINTS
 International funding for REDD is likely to become available on a significant scale. Public finance from
bilateral and multilateral sources is likely to dominate in the beginning, with market mechanisms possibly
occupying a greater role over time.
 Indonesia could be a large recipient of international REDD funds, given its current emissions and its
reduction potential in deforestation, forestry, and peat land management.
 The design of domestic policy mechanisms in Indonesia needs to take account of international financing
mechanisms. At the same time there is leeway for Indonesia to influence the design of international
mechanisms to ensure they are suitable for Indonesia.
 An approach of national policy frameworks for REDD with subnational implementation holds the best
promise of success for Indonesia.
There is broad international consensus that a financing mechanism for REDD, (or indeed for
extended forms referred to as REDD+, see Chapter 5), should be agreed as part of a post-Kyoto

climate treaty. It would channel payments for forest carbon from industrialized countries to tropical
developing countries. In global terms, reducing deforestation and improving land and forest
management are seen as significant abatement options that are both affordable and relatively
quick and feasible to implement.
Public REDD finance

It is likely that REDD financing will initially be based mainly on public carbon finance. Such
financing could be used to build up the capacity to implement REDD programs, conduct trials and
pilot projects, and make a start on larger-scale activities, but without the need for comprehensive
and fully reliable emissions accounting. Public REDD financing is already available and being
deployed in Indonesia under donor-funded programs such as the Indonesia–Australia Forest
Carbon Initiative (see Chapter 5).
It is expected that government-led REDD funding and activities will be greatly scaled up in coming
years. For example, Norway has already established a large fund to support REDD activities. The
US may also emerge as a very large supporter of REDD, through both public and private
financing. Legislative proposals currently before the US Congress would also make very large
sums available for REDD. (See Box 3.3 on one of these legislative proposals, noting that passage
is not assured and that the bill’s provisions may change significantly.) The European Union’s
position has been against inclusion of credits from avoided deforestation in EU emissions
markets, but there have been suggestions that significant amounts of public carbon finance
should be made available to support REDD.
Box 3.3 The REDD provisions in the Waxman–Markey bill

The Waxman–Markey bill, approved by the House of Representatives but yet to be passed by the Senate,
signals that the US would be willing to provide massive demand for REDD emissions reductions. Revenue
from the sale of permits by the government to domestic emitters would be used to buy REDD credits. This
“Supplemental Pollution Reduction Program” would aim to buy six billion REDD credits by 2025, with annual
acquisitions to reach 720 million in 2020.
In addition, under the international offsets provision, up to 1 billion REDD credits per year could be imported
into the US, but they would have to compete with credits from other market mechanisms. Companies that
are part of the emissions trading scheme could cover up to 15% of their compliance needs through REDD
credits in 2012, increasing to 33% by 2050.
The bill employs a wide definition of deforestation. It states that the US Offset Integrity Advisory Board “may
include forest degradation, or soil carbon losses associated with forested wetlands or peat-lands within the
meaning of deforestation.” Credits from “subnational” REDD projects in countries that have not (yet)
established a national deforestation baseline may be eligible if a baseline were set at the state or provincial
level.
Australia and other countries in the Asia-Pacific region may also become large supporters of
REDD activities in Indonesia, especially once domestic climate policy regimes in these countries
are settled. Other developed and developing countries (including Japan, Brazil and Mexico) are
expected to assist with technical capacity transfer.
For Indonesia, international public finance will be essential to support the capacity building and
start-up phase of REDD programs and policies. It will also be necessary to support the building up
of institutional infrastructure for market-based financing mechanisms, and for trials of market-
based mechanisms.
There will also be instances where carbon markets do not work, even in the longer term. Thus,
public finance could become an important ongoing feature of REDD activities.
An important example in Indonesia is the prevention and reduction of emissions from peat
through peat land conservation and restoration, which may turn out to require ongoing external

financial support. Carbon markets are unlikely to be suitable sources of finance for the mitigation
of peat emissions, because there is great uncertainty around estimates of these emissions. It is
unlikely that the emission reductions from peat lands can be quantified to the degree necessary to
make them tradable in international carbon markets in the immediate term.
Private market finance for REDD

In the longer term, it is expected that private market finance will deliver a large or even dominant
share of overall REDD finance. Market finance can be ramped up as institutional prerequisites are
established in Indonesia and other tropical developing countries; as experience with market-
based mitigation activities in developing countries is gathered; and as emissions trading and other
instruments expand in developed countries, driving demand for REDD offset credits.
The design of international REDD market mechanisms is currently under negotiation. The choices
that are made will also affect the suitability of particular domestic policy approaches (see Chapter
5). The possible cornerstones of the emerging consensus on REDD market financing are as
follows (Terrestrial Carbon Group 2009).
 National-level accounting for net emissions, rather than project-level or global accounting.
 National reference emission levels (baselines or targets) on the basis of historical trends
adjusted for likely future developments, or a modeling approach, to reflect country-specific
circumstances.
 Conservation, sustainable forest management, and the enhancement of forest carbon stocks
(referred to as REDD+) to be included, possibly moving over time to more comprehensive
coverage of all agriculture, forestry, and other land use.
The tendency towards accounting and setting baselines or targets at the national in addition to
rather than solely at the project level is consistent with the desire for more verifiable emissions
reductions than could be achieved under more disaggregated, project-based mechanisms (see
Section 3.3 above). In particular, national approaches help limit the risk of intra-national ‘leakage’,
where emissions might be reduced in one local area, only to lead to an increase in another area
that is not part of the scheme.
An alternative approach, promoted principally by Brazil, is to bundle global REDD finance into a
single global fund, and provide it to tropical forested countries for mitigation action without issuing
any tradable credits (Box 3.4). This would mean that any REDD emissions reductions would be
fully in addition to developed countries’ own reduction commitments, because no offset credits are
issued. At the same time it means exclusive reliance on public sources of funding and their
efficient allocation through an administrative process, which might constrain the scale and
effectiveness of REDD.
Box 3.4 An alternative approach: The Amazon Fund

Brazil's position on REDD differs from proposals supported by other tropical forest countries, including the
Coalition for Rainforest Nations. Instead of a market-based REDD, Brazil is advocating a large fund financed
by developed countries. Contributors would not be eligible to receive carbon credits that could be used to
meet emission reduction obligations under a binding climate treaty.
In 2008, Brazil announced a plan to reduce deforestation by 70% from 1996–2005 levels, which would save
almost 5 billion tonnes of CO2 between 2006 and 2017. Details on how emissions reductions are to be
achieved are scarce, but the scheme appears to resemble development aid activities. The “Amazon Fund”
was established with the aim of paying for the program, with target financing to a total of $21 billion. Norway
has agreed to provide up to $1 billion, contingent on Brazil’s success in reducing deforestation (as opposed
to measurable carbon emission reductions), but so far no other countries have pledged money for the fund.

A REDD financing approach for Indonesia
The prospect of such a broad-based international REDD mechanism implies a need for equally
broad-based policy approaches to reduce emissions from land-use change and forestry in
Indonesia, especially as the major driver of emissions from deforestation and peat lands is
agricultural expansion.
Indonesia has pronounced regional diversity in natural resource endowment and development
and has instituted far-reaching fiscal and administrative decentralization. National and local
development objectives are important determinants of land use, but important challenges remain
in the area of governance. These characteristics are best served by an international REDD
mechanism that provides maximum flexibility in terms of what actions can be undertaken, and at
what level of government.
Putting the international and national outlook together, it appears that the best way forward for
Indonesia is national-level policy frameworks and targets (possibly supplemented by selected
regional or project approaches where applicable), with implementation of policy measures at the
subnational level. This is reflected in the principle of “national frameworks with subnational
implementation” espoused, for example, in a joint Indonesia–Australia submission to the
UNFCCC negotiations (Indonesia and Australia 2009).
A broad national approach that allows flexible implementation at the local scale provides the best
opportunity for Indonesia to attract substantial international carbon finance while pursuing its
development priorities in land-use change and forestry. Chapter 5 spells out one part of a
possible domestic policy strategy to achieve this goal.

Table 3.1 Selected abatement actions and preferred international financing options
Sector Mitigation policies and Market-based financing International public

actions financed financing
Energy sector
Preferred option: Comprehensive carbon No-lose target for all fossil Selected public finance
Full coverage of all pricing. In addition, specific fuel emissions. Credits sold support. For capacity
fossil fuel emissions, policies for the power in international markets for building, start-up
plus specific public sector (e.g. Green Paper reductions below target, financing for geothermal
financing geothermal policy package) including all fossil fuel exploration, co-financing
& energy efficiency policies emissions in a single target. of energy efficiency
for industry & households. investments, etc.
Second-best option: Carbon pricing. Greater Targets/crediting Selected public finance
Selected coverage weight on specific policies, arrangements for various support as above. In
under sectoral as listed under the sectors, for example power addition, public finance to
crediting, plus specific preferred option. generation, and for specific support specific mitigation
public financing industries. Credits sold in programs where no
international markets, for market-based crediting
each individual sector. arrangement is in place
(policy-based support).
Fall-back position: Specific policies as listed CDM, programmatic CDM, As for second-best option.
Selected coverage above. possibly policy-based
under offset crediting.
mechanisms, plus
public financing for
specific measures.
Miscellaneous emissions sources

Suitable option: Specific policies. Sectoral crediting Selected public finance
Selected coverage Examples: regulation & arrangements for various support for enabling
under sectoral enforcement of waste sectors. Credits sold in conditions & to support
crediting, plus specific management, including international markets, for specific programs where
public financing methane capture, reduction each individual sector. no market-based crediting
in venting/flaring from oil & arrangement is in place.
gas wells.
Land-use change, forestry & peat

Preferred option: Forest conservation, Forest conservation, Capacity building,
National REDD target improved forest improved forest preparation for market-
plus extensive public management, reforestation, management, reforestation, based financing
financing & afforestation, peat land & afforestation. mechanisms, start-up
conservation & Financing depends on financing across the
rehabilitation. measurability of outcomes. board, ongoing support
Use of national & for peat land conservation
subnational policies & & rehabilitation.
measures.
Second-best option: As for preferred option. Forest conservation, As for preferred option.
Subnational or project improved forest
REDD targets plus management, reforestation,
public financing & afforestation.
Financing depends on
measurability of outcomes,
dealing with leakage, &
scope for subnational policy
implementation.
Fall-back position: As for preferred option. No market financing. Capacity building,
Public financing only financing of REDD across
the board.

4 POLICY OPTIONS IN THE ENERGY SECTOR
KEY POINTS
 The energy sector is important for Indonesia’s development, but it is also a large and quickly growing
contributor to Indonesia’s greenhouse gas emissions.
 Reforms in the energy sector can deliver better economic results for Indonesia.
 The same reforms can reduce Indonesia’s greenhouse gas emissions, thereby mitigating against risks
arising from climate change, and improve Indonesia’s competitive advantage by building an efficient,
low-emissions energy sector.
 Targeted climate policy measures, including carbon pricing, regulations, and budgetary measures, can
further reduce emissions growth.
Strategy for the Ministry of Finance

 Factor the costs of externalities into market prices, using carbon taxes on fossil fuel combustion (see
Chapter 2) and other instruments such as an adjustment to geothermal tariffs.
 As a transitional measure, flatten existing subsidies to level the playing field for all technologies.
 Over time, retire all explicit and implicit subsidies as far as possible, consistent with the President’s
recent statement to the G20.
Geothermal policy
 Provide an appropriate tariff for geothermal electricity through PLN, based on the true cost of electricity
to the government of Indonesia, including any existing direct and indirect subsidies in addition to any
carbon price premium.
 Use a tender structure and profit-sharing regime based on sound efficiency principles to ensure the right
benefits accrue to the Indonesian people.
 Enhance Badan Geologi’s funding and role to include performing and/or contracting-out initial field
surveying and exploration through to confirmation drilling.
Outcomes
 Contribute to fulfilling the 26% to 41% emission reduction targets.
 Contribute to the 4,400 MW geothermal electricity expansion goal.
 Increase Indonesia’s access to international mitigation funds, enhance the security of supply, and
achieve Indonesia’s electrification goals.
4.1 BACKGROUND
The main contributors to fossil fuel-related greenhouse gas emissions are emissions from
electricity, industry, and transport. Amongst these, the electricity sector exhibits the strongest
emissions growth trend and is projected to be an increasingly dominant source of greenhouse gas
emissions in the future.
The energy sector plays an important part in Indonesia’s development. Demand for electricity is
growing quickly and the electricity supply system already has difficulty meeting current demand.
Consequently, there is much pressure to increase capacity and expand electrification in the near
future.
The Indonesian government has announced significant emission reduction targets in the energy
sector. These include the recent announcement by President Yudhoyono at the G20 meeting in
Policy options in the energy sector Page 69

Pittsburgh to reduce emissions by 26–41% relative to business as usual depending on the level of
international assistance, including by reducing emissions from the energy sector.
The requirement for emission reductions needs to be balanced with Indonesia’s development
goals and the consequent increasing demand for energy. Achieving the dual goals of increasing
electrification while reducing emissions is difficult but achievable.
This chapter provides some policy principles for efficient and effective climate policy in the energy
sector, with a particular focus on the electricity sector and, more specifically, ways of incentivizing
geothermal electricity generation. The principles set out for geothermal policy, and the electricity
sector more broadly, apply to other parts of the energy sector as well. However, beyond the
geothermal sector, detailed policy options for electricity generation and for other parts of the
energy sector are left for future work.
Growth trends in energy demand

In 2006, emissions from the energy sector were around 334 million tonnes of CO2-equivalent. The
main contributors to these emissions were the electricity, industry, and transport sectors. The
electricity sector represented 27% of Indonesia’s non-land-use change and forestry CO2
emissions, while industry and transport represented 29% and 22% respectively (see Figure 4.1).
Figure 4.1 Fossil fuel emissions by sector, 1990 and 2006, and % of total energy
emissions by sector, 2006
120
29% 1990 2006

100
27%
80 23%
22%
MtCO2
60
40
20
0
Industry Electricity Transport Other
Source: IEA (2008: Annex II.233).
Emissions from the electricity, industry, and transport sectors are all growing very strongly. As can
be seen from the emissions growth figures in Table 4.1, emissions from the electricity sector more
than quadrupled over the period 1990–2006 (growing by 309%), followed by an almost three-fold
expansion in industry sector emissions (growing by 192%) and a more than doubling in transport
emissions (growing by 127%).
This in part justifies the Green Paper’s focus on the electricity sector. Indeed, the sector’s
emissions are likely to continue to grow very strongly. For instance, despite the significant
progress made to date, Indonesia still has a relatively low electrification ratio of around 66%. The
government has announced a target to increase this ratio to 93% by 2020. This partly explains the
high forecasts for electricity demand in the National Electricity General Plan for 2006–2026,
where electricity demand is projected to grow on average by 7% annually, with higher growth
outside the Java–Madura–Bali grid. The need for a very rapid expansion in electricity supply is
underlined by the frequent power shortfalls and blackouts being experienced in Indonesia,

especially outside the Java–Madura–Bali grid. Peak demand is now close to available capacity,
with reserve margins at very low levels.
Of course, rapid electricity supply growth does not need to imply rapid emissions growth if the
emissions intensity of supply can be lowered. So far, however, capacity expansion has been
focused on coal (steam), combined-cycle, and hydro-based power (see Figure 4.2). Under the
10,000 MW “crash program” initiated by the government, an additional 10,000 MW of capacity is
to be added to the generation system by 2010. Most of this extra capacity will be supplied by coal
combustion. Coal-fired power generation is very emissions-intensive, so in fact, emissions are
likely to grow even faster than electricity demand unless there is a significant policy shift toward
high rates of penetration of renewable energies and perhaps other fuel-switching away from coal-
based electricity supply expansion.
Table 4.1 CO2 emissions from non-land-use change and forestry by fossil fuel source,
2006 (Mt)
Fossil fuel emissions source

Emissions
Share in growth
total 1990–2006
Consumer group Coal Oil Gas Total (%) (%)
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
Othera 0.06 44.95 31.29 76.3 23 60
Of which:
residential 0.06 25.76 0.04 25.86 8 41
Total 86.80 179.60 69.60 334.61 100 149
a “Other” includes unallocated auto producers and other energy industries.
Source: IEA (2008: Annex II.233).
Figure 4.2 Electricity capacity by source, 1995–2005

35000
Geothermal Gas Diesel
30000
Hydro CC (steam) Steam
25000
20000
MW
15000
10000
5000
0
1995 1997 1999 2001 2003 2005
Source: IEA (2008: 178).

4.2 POLICY CONSIDERATIONS IN THE ELECTRICITY SECTOR
Policy considerations for energy sector reform

 Achieving Indonesia’s development and poverty reduction goals will require an efficient electricity sector.
 The electricity sector needs to play an important part in helping Indonesia meet its emissions abatement
goals.
 Strong abatement in the electricity sector may be lubricated by access to international carbon finance.
 Indonesia stands to gain an early-mover advantage if it starts on a path to a low-emissions electricity
sector now.
 Leveling the playing field for energy supply technologies and using carbon price premiums are the key to
achieving the required low-cost and low-emissions growth in electricity supply.
 Electricity price reform is an important aspect of reducing emissions from electricity. Any such reforms
need to be undertaken in a way that does not disadvantage poor households.
Climate change is only one motive for energy sector reform and policy should be designed with a
bigger picture in mind. The goals of government policy in the energy sector should include the
following.
 Pursuing the government’s development goals and reducing poverty.
 Achieving energy security in a world where there is increasing competition for resources and
the domestic electricity sector is struggling to meet a rapid growth in demand.
 Creating an economically efficient energy sector, on the demand side through full cost
pricing, and on the supply side by incentivizing the lowest-cost generation technologies while
taking hidden subsidies and externalities into account.
 Mitigating the risks that arise from a carbon-constrained world.
 Taking advantage of the opportunities that arise from a carbon-constrained world to gain a
competitive advantage relative to other countries.
With good policy, these goals can work in concert and be mutually reinforcing.
Energy is a key factor in development. Since demand is growing quickly, the sector needs to
expand. Doing so at a reasonable cost will require the sector to operate efficiently. Losses due to
inefficiency in this sector represent lost opportunities for Indonesia to promote development.
At the same time, the global response to climate change is likely to change the economic
parameters of the energy industry, and Indonesia will not be insulated from this evolution.
Investment decisions made without taking this into account may well be suboptimal. The relative
costs of generation technologies will shift, and in general the costs of high-emissions technologies
such as coal will increase due to emerging carbon constraints.
The expansion of Indonesia’s power sector needs to take these future changes into account. If
the issue is ignored, the result will be a legacy of investment in expensive infrastructure and an
inefficient sector.
Another consideration is that the global response to climate change will affect the relative costs of
different economic activities, and this means that the competitive advantages of countries will
shift. This opens tremendous opportunities for countries that are able to position themselves well.
Countries that have historically enjoyed a competitive advantage due to low prices from fossil fuel
energy will lose this advantage as the price of fossil fuel generation increases.
If Indonesia is able to restructure its economy to reduce its dependency on fossil fuels, it will enjoy
a benefit relative to countries that have already invested substantially in a fossil fuel economy.
Again, achieving this will require that investment decisions are not shielded from the economic
variables (such as a price on carbon) that will drive the desired low carbon growth.

For these reasons, Indonesia stands to gain an early-mover advantage if it can reform its energy
sector toward low emissions intensity now (for more details, see Chapter 2).
The way to ensure that investment in the energy sector is efficient is through market reform, that
is, opening the market so that supply and demand are responsive to the true economic costs of
resources. Distortions in the energy market arising from subsidies bring about the opposite result
– investors do not take all economic variables into account, leading them to make distorted
investment decisions; and energy consumers (households and businesses) see only the distorted
prices of energy, leading them to make consumption decisions that are biased toward
overconsumption of energy, with too little investment in energy efficiency.
That said, ensuring consumers see the full cost of electricity and imposing carbon prices can have
deleterious effects on poor people. Indeed, energy subsidies are there to help the poor in the first
place, so removing them means finding alternative mechanisms to redistribute wealth to the poor.
Direct cash payments or investments in public infrastructure that directly benefit poor households
would provide such mechanisms. They would alleviate poverty without biasing the choice of poor
households in favor of energy- and emissions-intensive activities. In addition, poverty alleviation
mechanisms that are independent of energy consumption may be easier to target and are
therefore likely to deliver better poverty reduction outcomes for the same cost to government.
Economic losses arising from price distortions

When prices within an economy are distorted by taxes, subsidies (explicit or implicit), or unpriced
externalities, production and consumption patterns are affected and economic losses are
incurred. The best way of addressing these economic losses is to remove the price distortions
and restore the relative price levels within the economy.
The distortive effects of fuel and electricity price subsidies are well understood and will not be
repeated here. Instead this section focuses on supply distortions and their economic costs. That
is, while energy price reforms, coupled with non-distortive poverty alleviation measures, are
ongoing, there is another source of distortion and economic cost that can fruitfully be addressed.
The electricity sector suffers from structural problems that lead to inefficiencies and lost
opportunities. The worst problem is that the main buyer of electricity, PLN, is obliged to on-sell
electricity at prices below cost because of the country’s electricity subsidies. This invariably
means that PLN depends on government support each year to balance its budget. Therefore, its
decisions are not based on a full-cycle economic analysis. Instead, they are based on negotiated
and ultimately bureaucratically or politically determined relative prices. As a result, PLN is not
necessarily in a position to pursue the least-cost options for obtaining electricity in each region in
Indonesia.
There are other significant distortions that effectively subsidize some generation technologies at
the expense of others. Coal generation, for instance, involves significant costs that are not
included in the price of coal-generated electricity. These costs are borne either directly or
indirectly by the government. Some examples of these explicit and implicit subsidies are as
follows.
 Costs of the “price pass-through” arrangements whereby generators are able to pass on
rises in the price of fuel to PLN, and consequently to the government. Essentially the
government is providing a free price hedge for the generators.
 Opportunity costs arising from domestic fuel prices that are lower than export prices.
 Costs to the government and society of public infrastructure needed to support coal transport
and storage.
 Costs of the carbon emitted by coal generation. The strategy outlined in Chapter 2 to apply a
carbon tax will place a value on carbon emissions. However, as described in that chapter,
Indonesia will be well placed to negotiate access to international carbon markets for

abatement beyond a negotiated reduction target, in which case the marginal cost of carbon
will be the international carbon price.
 Costs of the carbon price risk premium. The strength and resolve of the international
response to climate change is uncertain; the costs associated with a future need to account
and be liable for carbon emissions are therefore also uncertain. If the Indonesian
government required investors to face this carbon price risk themselves, say through
contractual arrangements that explicitly passed the cost of any domestic carbon price on to
energy buyers, investors would build a (higher) carbon price risk premium into their
investment decisions. However, as matters stands, the government is carrying some of this
risk premium itself, essentially providing a free (partial) carbon price hedge.
 Costs of local pollution from coal-fired generation, and of environmental degradation from
coal mining.
These factors mean that the sale price of coal-generated electricity is below its true cost to the
government of Indonesia (and below the true economic cost more generally).
These issues are not restricted to coal-generated electricity. Indeed, since PLN operates at a loss
and depends on a distorted cost reimbursement structure, the price signals across the entire
electricity sector are distorted. Consequently, decisions about electricity production are motivated
by distorted incentives, and the mix of generation technologies in Indonesia’s energy sector will
be skewed away from the optimum.
It is, of course, possible to attempt to ameliorate this situation by regulating and setting plans for
the energy mix. However, it is extremely difficult for bureaucrats to ascertain the optimal policy
mix, since this is a function of the interaction of changing relative energy input prices and
technology development and costs. Indeed, even if one could determine this “optimal energy mix,”
it would have to be updated constantly as technology progressed and fuel prices changed.
The next two subsections provide a short discussion of two types of losses that arise from a
distorted energy sector: “static” losses that arise when electricity is not produced using the most
efficient technologies; and “ dynamic” losses that arise from structuring the economy with a bias
toward emissions-intensive technologies.
Static losses
Static economic deadweight losses arise from the failure to use an efficient production mix. The
effect of differentially subsidized technologies is that electricity is not generated using the most
efficient technology. This represents an inefficient use of resources (overuse of the subsidized
technology and underuse of the alternative) and so represents a real loss of opportunity to the
economy as a whole.
At the same time, the subsidies have the overall effect of distorting the apparent aggregate cost of
the supply of electricity. In other words, the same amount of electricity costs more to produce and
hence increases the cost to the Indonesian government of achieving the electrification goals it has
set for itself.
This is illustrated in Figure 4.3, which shows some of the economic losses that would arise from
implicit subsidies on conventional generation, to the exclusion of geothermal generation.
G C
In this figure, the S line represents the supply curve for geothermal electricity, while S
represents the supply curve for conventional electricity. The right-hand graph shows the
G C C
aggregate supply curve, S + S , alongside the conventional-only curve, S . P0 represents the
G C
supply price to produce quantity Q + Q of energy in an undistorted market.
C2 G C)
To generate the same quantity of energy using only conventional technologies (Q = Q + Q
requires a supply price of P1. The deadweight loss arising from using conventional generation
G C
rather than an optimal mix of both technologies to produce Q + Q units of energy is represented
by the two colored triangles in the right-hand diagram. The darker region represents deadweight
losses arising from the lost opportunity cost of geothermal production. The lighter region
represents the deadweight loss resulting from overproduction of conventional electricity.

Figure 4.3 Economic losses due to production subsidy effects
Dynamic losses
The electricity sector is characterized by high capital costs and long power plant lives (30–40
years). This means that allocation decisions made now will be locked into the Indonesian
economy for decades to come. Existing subsidies and other distortions in the electricity market
may induce inefficient allocation decisions, and decisions to develop new generation capacity
may have the effect of locking in economic opportunity losses for decades.
The importance of this lock-in issue is heightened by the likelihood of a global response to climate
change that includes a carbon constraint. Such a response would change the rules for electricity
generation. Nations that are able to react quickly to this changing landscape will benefit relative to
nations that are stuck with a legacy of ill-adapted or stranded infrastructure. The investments
currently going into the Indonesian power sector constitute a gamble that the climate debate will
evolve in the (increasingly unlikely) direction of carbon remaining unpriced for the life of the
assets being installed today.
When the electricity market is reformed and prices reflect the full cost of electricity, investors in
the electricity sector will make their investment decisions based on their assessment of future
conditions in the electricity market, including impacts from the world response to the threat of
global climate change. Currently, in the presence of subsidies, investors face potential gains from
their investments but are shielded from losses arising from volatility in fuel and carbon prices, the
cost of which is borne by the government.
Policy framework
Policy framework for the energy sector

 Support reforms to further enhance the openness and competitiveness of energy markets.
 Factor the costs of externalities into market prices, using carbon taxes on fossil fuel combustion as well
as other instruments such as an adjustment to geothermal tariffs.
 Consistent with Indonesia’s G20 commitment, remove explicit and implicit energy subsidies over time.
 As a transitional measure, level the electricity supply playing field by ensuring that net subsidies
available for one technology are available for other technologies.
 Ensure low-income households obtain lump sum transfers or other support to offset any losses to them
from the higher energy prices associated with energy market reform and carbon pricing.
Energy sector policy should address the distorting effects of explicit and implicit sectoral
subsidies. Removing these distortions will have substantial benefits for the Indonesian economy

just by improving the efficiency of the energy sector. Dynamically, investors will have to account
for the risk of changes in world energy markets when making decisions, and will no longer be able
to benefit from passing on the downside risks to the government. This will have the additional
benefit of making Indonesia’s energy infrastructure more “neutral” and more capable of
responding nimbly to new opportunities, particularly relative to other countries that have a high
level of existing high-emissions assets.
The overriding and long-term policy framework for energy sector reform should therefore be to
open the sector to competition and let a price-based market mechanism allocate resources where
they can best be used. Costs of externalities that are not currently priced by the market should be
addressed by government policy. Optimally, such costs would be incorporated directly into the
market price through the imposition of taxes or other pricing mechanisms. For instance, once an
Indonesian carbon market is established, it will be relatively straightforward to incorporate the
external cost of carbon emissions into energy prices.
Carbon tax/levy on fossil fuel combustion

As described in detail in Chapter 2, carbon pricing provides least-cost abatement and there is an
opportunity to introduce a carbon tax on fossil fuel combustion as a step toward comprehensive
emissions pricing in the long term. A commitment to introduce a carbon tax on fossil fuel
combustion would:
 provide a low-cost way of achieving the energy sector’s contribution to Indonesia’s 26–41%
emissions reduction target;
 allow Indonesia to make a strong positive announcement at Copenhagen, with the possibility
of linking Indonesia’s fossil fuel emissions target to a no-lose sectoral target for the energy
sector; and
 allow the Indonesian economy to begin the transition to a carbon-constrained environment
and thereby enhance its competitive position in a carbon-constrained world.
A carbon tax would also broaden the tax base, and a target for the energy sector would give
Indonesia access to significant permit export revenue. Tax and permit revenues can be used to
fund new poverty alleviation measures, support budgetary measures on climate change, and
reduce other taxes, including taxes on business.
For these reasons, a suitable strategy is as follows.
 Prepare for emissions pricing by putting in place reliable accounting systems for carbon
emissions from coal, oil, and gas, and by reviewing taxation systems, with the Directorate-
General of Taxation to collaborate with the National Greenhouse Gas Inventory team at the
Ministry of Environment.
 Create a roadmap toward implementation of a carbon tax. Investigate options for its design
and implementation, provide in-depth analysis of its economic effects, and conduct
stakeholder socialization.
The proposed initial design parameters are to set a 2020 target for reductions from business-as-
usual emissions from fossil fuel combustion, and use this to obtain agreement at Copenhagen for
a sectoral no-lose target for the energy sector. This would enable Indonesia to sell abatement
beyond the negotiated target on international carbon markets.
To provide the international community with confidence that Indonesia is serious about this target,
and to allow the country to begin harnessing the benefits of emissions pricing and set its economy
on a low carbon growth trajectory, Indonesia should commit to a carbon tax of Rp 80,000 per
tonne of CO2 rising by 5% (real) per year to 2020.
Carbon tax and permit revenues can be used to provide cash transfers to the poor to offset price
increases; to institute budgetary measures for climate change mitigation (for example, renewable
energy initiatives, energy efficiency measures, or a Regional Climate Change Mechanism); to
provide assistance and compensation packages for business; and/or to remove other taxes.

Transitional policies
Reforming the energy sector will be a slow process. Until the process is complete, transitional
policies that are compatible with this long-term goal will need to be put in place. The distorting
effect of subsidies that apply to some technologies can be partially removed by applying
compensating subsidies to the remaining technologies, in order to “flatten” the subsidy landscape
and avoid promoting overinvestment in one technology at the expense of others. However, since
the long-term policy goal is to retire all distorting subsidies as far as possible, it is critical that any
compensating subsidies be retired at the same rate as the existing subsidies.
The process of energy sector reform is visualized in Figure 4.4 and described in more detail in
Table 4.2. Section 4.5 discusses the case of geothermal energy as an example of how a
transitional policy could efficiently flatten the subsidies that are currently preventing the
development of a promising indigenous energy source.
Figure 4.4 Transition of subsidies to an undistorted energy sector

Subsidies
Alternative cost
Conventional
price
Implicit and differential Subsidies remain but Subsidies reduced to point Subsidies completely removed,

subsidies distort relative are flattened across where alternative production technologies compete
prices and give advantage technologies technologies can compete on full cost of energy.
to conventional generation without assistance.
Table 4.2 Steps to reform the energy market
Characteristics Outcome
Current situation: Many distorting subsidies. Energy sector is inefficient and costly,
Inefficient energy market. and struggles to meet expanding
demand.
Transition – first step: Subsidies flattened across Alternative technologies are able to
technologies to level the playing compete. Overall cost of energy falls.
field. Energy market open to Energy supply is diversified, reliability is
competition where possible. improved, and dependence on fossil
fuels is reduced.
Transition – subsequent Energy market fully open to Production supply efficiently meets
step: competition. Subsidies phased demand. Price signals for energy
out. Pricing mechanisms efficiency are felt by economy.
introduced for externalities.
Ideal end goal: Efficient energy markets. Price of
externalities factored into market
prices.

Other policy considerations
There are other considerations related to energy policy that might not be addressed by pure
“market” reforms. They include the following.
 Supply diversification. Supply diversification across a range of technologies can be seen as
part of a strategy to insure against the effects of, say, variations in the price or availability of
coal. Diversification also assists in ensuring the reliability and availability of supply.
 Reliability and availability of supply. Using smaller and more widely distributed power plants
may reduce the costs of improving supply reliability and availability, as an incident that
affects a single plant will have a smaller impact on supply, and so less reserve capacity will
be required in the system.
 Regional benefits. Some production technologies, such as geothermal, tend to produce
more economic activity in a region than others, such as coal (JICA 2008).
These considerations may be difficult to capture as a pure “externality cost” to be added to the
supply cost as a tax. However, the transitional measures outlined above involve removing the
biases present in the current system that promote fossil fuel-based technologies over others.
These transitional measures will lead to a greater diversification of energy sources and to a
greater dependence on “local” energy sources such as geothermal or hydroelectric energy. Local
energy sources are less exposed to risks related to dependence on foreign imports and
commodity prices, because they can only be used domestically. Therefore, the steps toward
market reform are compatible with these wider goals for the energy sector.
4.3 ABATEMENT POTENTIAL AND COSTS

Many measures can be taken to reduce greenhouse gas emissions. They comprise both demand-
side measures and supply-side measures. Demand-side measures include energy efficiency and
conservation. Supply-side measures include substituting production technologies or creating
efficiency improvements in the supply infrastructure (for example, the electricity transmission
grid).
To facilitate comparison of the different candidate measures, it is common to estimate the
“abatement cost” of each measure (in cost per tonne of avoided CO2-e emissions) and the gross
abatement potential of each measure (in tonnes of CO2-e per year). Graphing the abatement cost
against the cumulative abatement, where abatement measures are employed in increasing order
of cost, yields a marginal abatement cost (MAC) curve.
The MAC curve is a convenient conceptual device for visualizing the magnitude of emissions
abatement achievable for a given per-tonne abatement cost, assuming that abatement measures
are deployed in increasing order of cost. They can give a sense of which technologies or other
abatement opportunities are worth pursuing, on a “bang-for-buck” basis. Conceptually, to achieve
emissions abatement at the lowest overall cost to the economy, the right procedure is to deploy
the cheapest abatement measure available until its capacity to abate is exhausted, then move to
the second cheapest measure, and so on.
However, MAC curves should not be interpreted as an exact prediction of the future cost of
abatement. There are several problems with the assumptions underlying the MAC curve concept.
First, MAC curves rely on technical assumptions and relative price assumptions, which are
subject to error. But more fundamentally, even if errors are minimal, a MAC curve presents a
static snapshot of abatement costs as they stand now. Over time, relative prices will change as
technology evolves. These dynamic changes will have a large impact on abatement costs in the
future, and so the MAC curve will quickly become out of date.
Second, the calculations of abatement costs for different supply-side technologies are made on
the basis of the nominal fiscal cost of each technology, relative to the cost of the existing
“displaced” technology (the baseline). However, the existence of explicit and implicit subsidies for
older-generation technologies means that the current energy sector is very far from operating

efficiently, and nominal fiscal costs are not necessarily true economic costs. This means firstly
that the baseline will be misplaced – the incumbent technology is likely to be more expensive
economically than the nominal fiscal cost suggests – and secondly that the differential costs of
alternative technologies are likely to be miscalculated, since their deployment may reduce the
overall level of subsidies in the economy, a phenomenon that is not captured in the nominal fiscal
costs.
In addition, MAC curves do not take implementation and transitional costs into account. This
means that the real economic costs of abatement are likely to be somewhat higher than the
curves suggest.
A number of groups have produced MAC curves for Indonesia. The Indonesian Technical Needs
Assessment (TNA), produced with assistance from GTZ in March 2009, presents one such MAC
curve (see Figure 4.5). In its draft 2009 report, the National Council on Climate Change (Dewan
Nasional Perubahan Iklim, or DNPI) has produced another MAC curve for Indonesia (see
Figure 4.6).
It can be seen that the broad features of the two curves are similar. However, the details of the
marginal costs do not coincide. This is an illustration of the fact that MAC curves are more of a
conceptual device than a precise quantitative and predictive tool.
The DNPI curve includes a substantial abatement potential of 40 millions tonnes of CO2-e per
year, labeled “Demand-side management.” Demand-side management represents energy
efficiency and conservation measures, such as the use of high-efficiency appliances. Such
measures are often considered to have a negative abatement cost, because although high-
efficiency appliances are typically more expensive to purchase than less efficient ones, the total
cost of ownership is lower because of the lower energy consumption over the life of the appliance.
The reasons that these opportunities have not already been exploited include information
problems (consumers don’t know or don’t understand the implications of higher efficiency),
agency problems (the purchaser of the equipment is not responsible for paying for its operational
costs, so tends to choose the cheaper but less efficient model), or various other market failures
(such as capital constraints).
The second curve includes two technologies (supercritical coal and small hydro generation) that
also have negative abatement costs. This suggests that these technologies are currently
underdeployed in Indonesia given their nominal fiscal costs.
The cumulative abatement achievable at a given cost per tonne of abatement will depend on the
“efficiency” of the aggregate abatement measures. By ranking technical abatement opportunities
in order of increasing abatement cost, the MAC curve methodology is assuming that abatement
opportunities are deployed in order of cost. But the likelihood of this happening in practice
depends greatly on the type of policy intervention used to achieve the abatement. As described in
Box 2.1 (Chapter 2), a price mechanism will tend to deliver least-cost abatement, as compared to
more direct regulatory measures where policy-makers are required to explicitly identify areas for
intervention.
4.4 THE POWER SECTOR

Optimally, the energy market would meet demand by supplying energy using the least-cost form
of production. In a market where suppliers faced uniform prices for the supply of the good(s)
sought – in this case electricity regardless of the production technology – choosing the least-cost
technology mix would be profit maximizing and would tend to yield the right outcome
automatically. However, in Indonesia, the compensation provided to the state-owned power utility
PLN is determined administratively and is a function of technology. (For example, PLN receives a
lot more for electricity produced from diesel than for electricity produced from coal or geothermal.)
This means that PLN’s incentives are not aligned with economic cost-minimization objectives and
that the technology mix deployed is unlikely to achieve the least cost, even in expectation terms.

Figure 4.5 TNA’s MAC curve for abatement cost in 2025
Source: Technical Needs Assessment (2009).
Figure 4.6 DNPI’s MAC curve for abatement cost in 2030
Abatement cost Coal CCS

new built Onshore wind Solar PV
EUR per tCO2e Biomass
with EOR 48
50 45
40
Nuclear
30 Geothermal 26
Large hydro
20 16 Ø 19
9 10
10 Demand side
management
0
0
-10 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280
-12 Abatement potential
-20 MtCO2e per year
-30 Small hydro
-40
-50
-50
-60
Shift to coal supercritical
Source: DNPI (2009), draft cost curve.

In addition, optimally, the marginal cost of production would exactly match the marginal demand
price. In a market where consumers have to pay the full true cost of electricity, there is a tendency
for this optimal equilibrium to be reached automatically. However, the existing Indonesian energy
market does not operate in this way, since electricity consumption is subsidized according to
connection size (the smaller the connection, the higher the subsidy).This leads to many
consumers only having to pay a fraction of the actual cost of the electricity they are consuming.
The transitional strategy outlined in section 4.2 above indicates that low-emissions technologies
such as geothermal or hydroelectric generation should be assisted by introducing subsidies for
alternative energy technologies that equate to the existing subsidies for conventional
technologies. These transitional subsidies would level the playing field and result in a more
balanced energy sector, without increasing the existing net financial burden on the government.
As an example of such a transitional measure, section 4.5 describes a specific policy for the
geothermal sector. This policy could be used to efficiently remove the barriers that currently exist
to geothermal development in the period before full energy sector reform. It works by having the
government estimate the true cost of energy that the economy is currently paying (inclusive of
explicit and implicit subsidies), and offering that price to the geothermal sector through a
government-backed power purchase agreement. In order to implement such a policy, therefore, it
is important to understand and estimate the true cost of energy.
The true cost of energy should reflect all economic costs incurred by the economy in energy
production, including opportunity costs and the costs of externalities. This cost cannot be
measured directly, but it can be estimated by breaking it down into several components and either
measuring or estimating the contribution from each component.
A simple decomposition of the true cost of electricity would be:
True cost = nominal fiscal cost + cost of subsidies (explicit and implicit) + cost of externalities
Since different technologies have different relative levels of ongoing and capital costs, the
nominal fiscal cost of electricity generation is usually represented as a single “levelized” cost per
MWh defined as the ratio of total lifetime expenses to total expected outputs, expressed in terms
of the present value equivalent. The levelized cost includes a factor that takes into account the
cost of capital (as interest payments or returns on capital) spread evenly across the productive life
of the power station.
The nominal fiscal costs can be estimated by adapting standard industry costs to the Indonesian
context. Figure 4.7 shows estimates by the energy-market consulting firm McLennan Magasanik
Associates of the economic costs (not including the cost of externalities) of a range of
technologies in Indonesia.
The true cost of electricity

Indonesia’s electricity-generating capacity is currently provided mainly by a mix of oil and coal. Oil
is generally being phased out in favor of coal, although it remains the most important generating
technology in many isolated regions.
Since oil and coal are the dominant sources of electricity generation, they can be used to
establish a baseline for the current true cost of electricity. The true cost of electricity to the
Indonesian government includes the cost of subsidies and the cost of any unpriced externalities
that burden the budget in other ways (such as health costs arising from air pollution), on top of the
nominal price paid by PLN.
There are implicit and explicit subsidies for both the capital and fuel costs of electricity in
Indonesia. The prices that PLN and independent power producers (IPPs) pay for fuel are distorted
by the imposition of domestic market obligations for coal and oil and differential royalty relief for
low-grade steam coal. They are also distorted by implicit subsidies in the form of public roads
used to transport coal from mines, diesel fuel subsidies for mining equipment, and other public
infrastructure such as ports. Capital costs, too, are subsidized, through government-backed loans
to PLN for the development of coal-powered generation.

Figure 4.7 Nominal cost of electricity production by technology in Indonesia
500
400
300
$ / MWh
200
100
Source: McLennan Magasanik Associates modeling for the Green Paper.
The existence of these subsidies means that the production price that PLN incurs for electricity
generation is many steps removed from the actual cost to the Indonesian government budget.
Also, there are additional external costs – such as the air pollution cost and carbon cost – that are
not part of the current pricing model at all.
Since the presence of these subsidies clouds the interpretation of PLN’s costs, a reasonable
methodology to derive the true cost of electricity to the Indonesian government is to look at
models of international costs of generation (capital, operating, and fuel costs), adapted for
Indonesian conditions, and then quantify the costs associated with additional externalities not
included in the models.
The advantage of this top-down methodology is that it captures the economic costs of generation,
without needing to describe the structure of subsidies to PLN. However, the cost of local pollution
(air pollution) and global pollution (carbon emissions) is not counted and so needs to be counted
separately. Also, the “fuel costs” in the model are derived from spot fuel prices and therefore do
not incorporate a risk premium for fuel price fluctuations.
The international costs of coal-fired electricity generation can be used as a starting point to
describe the true cost of electricity, since it is often assumed that alternative technologies would
displace coal generation. In reality, however, coal generation is inappropriate for some Indonesian
regions, and would have difficulty expanding at a sufficient rate to keep up with fast-growing
demand. In practice, therefore, other technologies (such as oil or diesel) have been, and will
continue to be, used to fill the supply gap. Since these sources of energy are typically much more
expensive than coal, the use of the coal price as a proxy for Indonesia’s true cost of electricity is
conservative and will tend to understate the true cost (see Box 4.1).
In practice, this top-down methodology, while conceptually simple, is subject to different
decompositions of the total price and to different estimates of the cost of each component.
Considerable variation in the estimated true cost of electricity can result from using a different
breakdown of the cost, or from using different numerical parameters to represent critical inputs
such as the weighted cost of capital or average fuel prices.

Box 4.1 Cost components for externalities

Fossil fuel prices are subject to considerable volatility. This translates into a risk of rising generation costs. In
Indonesia’s case, price pass-through provisions mean that the cost of this risk is borne by the Indonesian
government and hence by the people.
The fact that Indonesia produces coal domestically and is a net coal exporter does not mean that there is no
“cost” associated with international price rises. Indeed, coal consumed locally in coal power plants is not
available for export and the cost of rising coal prices is the value of the lost export opportunity.
Recent years have shown that international coal prices can fluctuate widely. Since the fuel cost of coal
generation amounts to a sizeable proportion of the total cost at current fuel prices, changes in fuel costs
have a big impact on overall costs. Expert analysis suggests that an appropriate fuel price risk premium for
coal generation is 1 cent per kWh (McLennan Magasanik Associates 2009).
Carbon cost
The Clean Development Mechanism already provides a price for avoided carbon emissions, and other
mechanisms are likely to emerge from international climate change negotiations. Price forecasts for the
international carbon price can be seen in Figure 2.1 in Chapter 2. At a price of US$20 (Rp 200,000) per
tonne, this translates to 2 cents per kWh.
Air pollution cost, carbon price risk cost, and other externalities and co-benefits
Coal combustion produces local air pollution that is injurious to the health of local inhabitants. World Bank
studies for China, adapted to the Indonesian case, suggest a cost of between 0.5 and 1 cent per kWh for air
pollution.
The Indonesian government is currently bearing the cost of hedging against high future carbon prices. The
value of this hedge amounts to a carbon price risk cost.
Coal power requires transport infrastructure (ports, roads, railways, and so on) to move coal from mine
mouth to power station. In many cases, public infrastructure is used. This amounts to an implicit subsidy for
coal generation.
Supply diversification through the use of a mix of alternative technologies and fuels is an important way to
improve energy supply security. A component should be added to the true cost of electricity to capture the
value of diversifying the supply mix.
Regional economic benefits during the construction phase vary between technologies, but coal power plants
produce fewer regional benefits than, say, geothermal power plants (JICA 2008).
The costs associated with these externalities are difficult to quantify and further study would be required to
obtain a precise estimate. For the purposes of this Green Paper, a combined cost of 1 cent per kWh is used
to represent these externalities.
Table 4.3 shows two estimates of the true cost of electricity, the first from McLennan Magasanik
Associates (2009) and the second from the Japan International Cooperation Agency (2008).
As can be seen, the structure of the breakdown of costs and the value of cost components vary
considerably between these two sources. Some of the cost components included in the JICA
breakdown are questionable. In particular, the fuel export opportunity cost of 5.7 cents per kWh,
which is intended to represent the opportunity cost of export revenue lost to Indonesia by virtue of
burning the coal locally, appears to represent a double-counting of the cost of fuel.
The cost of capital and the cost of fuel vary substantially between the two estimates, although in
opposite directions. The difficulty here is that the cost of both capital and fuel can vary greatly
depending on the assumptions used in the model (in reality, both variables are quite volatile).
In this paper, a value of 13 cents per kWh is taken as a reasonable estimate of the true cost of
electricity, but further study should be undertaken to further refine this value.

The practical difficulties in calculating the true cost of electricity, as illustrated by the two
estimates in Table 4.3, recommend the fiscally conservative approach of using a best-effort
conservative value. In this context, it should be noted that geothermal electricity is not likely to
displace coal-fired generation alone; at the margin, it is also likely to displace some oil-based
generation, and in part is it likely to lead to fewer blackouts and brownouts.
This suggests that the “true” true cost of electricity is likely to exceed 13 cent per kWh, even in the
Java–Bali grid. Therefore, a reasonable strategy is to institute a tariff for geothermal generation of
13 cents per kWh now, and continue to refine the true cost of electricity figure – especially with
respect to geographical variation – in order to maximize the efficiency benefits of using the true
cost of electricity framework.
Table 4.3 Components of the true cost of electricity (US cents per kWh)
Cost component Levelized cost (MMA) Levelized cost (JICA)
Capital cost 5.4 2.6

Operating cost 0.7 0.7
Fuel cost 2.9 4.4
Fuel price risk cost 1
Carbon cost 2 1.9
Air pollution cost, carbon price 1
risk, and other costs
Tax cost 0.5
Tax opportunity cost 1.6
Fuel export opportunity cost 5.7
Fuel saving benefit 0.3
Total cost 13 17.7
Source: McLennan Magasanik Associates modeling for the Green Paper; JICA (2008).
4.5 POLICIES TO DEPLOY ALTERNATIVE TECHNOLOGIES: THE GEOTHERMAL

EXAMPLE
In this section the example of geothermal energy is used to illustrate the potential for government
policies to aid in the transition toward the ideal end goal of a fully efficient electricity sector in
which the least-cost technology mix is deployed and meets a demand that is fully reflective of the
true value of electricity. Background information on geothermal energy can be found in
Appendix 1.
In the short term, an appropriate transitional measure is for the government of Indonesia to
underwrite a geothermal tariff for geothermal electricity, to substitute for a true market price, as
part of a generic power purchase agreement (PPA) between PLN and geothermal power
producers.
Optimally, the tariff should be set such that the PPA sale price equals the true cost of electricity as
supplied by competing technologies in the region. This gives a baseline approach for pricing
geothermal electricity and so determining which geothermal developments should go ahead.
The cost of geothermal power generation vary significantly across work areas. However, for
illustrative purposes, Figure 4.8 compares the cost of one specific geothermal power plant with
the breakdown for the true cost of energy given in the previous section. This illustrates how a
geothermal plant that would not be viable relative to the “book” price of 9 cents per kWh for coal,

once externalities are added, the plant would become viable. Indeed in the instance chosen,
utilizing the geothermal electricity would provide a net benefit of 4 cents per kWh.
Many geothermal fields will be capable of supplying energy at a price below the price in the
geothermal PPA. It is important for the Indonesian government to capture a fair proportion of
these economic benefits, through up-front licensing fees, taxation measures, production sharing
or royalties, or a combination of these. The different instruments have different advantages and
disadvantages, as discussed below.
Investment in geothermal electricity generation is technically risky, because the characteristics of
a geothermal field vary widely and cannot be predicted with certainty before development is under
way. This translates into great uncertainty about the economic costs of development. Investors
will factor this into their valuations of projects as a risk margin at the point of bidding in a tender
process, reducing the value that investors place on a geothermal development project.
This issue can be mitigated by improving the quality and depth of geothermal exploration. The
data from the improved field exploration should be made publicly available before each field is
tendered. Optimally, the exploration should include the first successful confirmation drilling.
The strategy proposed for promoting geothermal generation is as follows.
Geothermal policy strategy

 Implement a two-phase approach to geothermal development, separating the field survey, exploration,
and confirmation drilling phase from the commercial development phase.
 Enhance Badan Geologi’s role and capacity to coordinate tenders for field exploration and initial
confirmation, and to manage the publication of exploration results.
 Institute a power purchase agreement, backed by the Indonesian government, providing a tariff for
geothermal energy that reflects the true cost of electricity. This will serve to counteract the economic
distortions that arise from existing direct and indirect subsidies for other power generation technologies.
 Design a tender structure and profit-sharing regime to obtain the best outcome for the Indonesian
people.
The tender for the development of each geothermal field should be structured as follows:
 Provide high-quality scientific data prior to the tender for the exploitation of geothermal working areas.
To this end, the quality of surface survey and other geophysical data should be enhanced and a
separate tender should be undertaken for confirmation drilling.
 The data package (including the results of confirmation drilling) and the pre-determined geothermal tariff
should be published as part of the tender documentation. A power purchase agreement that reflects the
geothermal tariff should be made available to IPPs through PLN. PLN should be funded to reflect the
geothermal tariff it is expected to underwrite (noting that the true-cost-of-electricity elements of the tariff
quantified in this study accrue to the government of Indonesia more broadly, not to PLN).
 Bids for development rights to a field should be invited from the public. Bids would be made for an up-
front, fixed license fee to be paid by the successful bidder. The bidder making the highest bid would be
selected.
 Profits after cost recovery from the geothermal project would be shared with the government using a
profit-sharing arrangement, in analogy with the existing production-sharing arrangements used for oil.
Production sharing allows a fair share of the benefits of geothermal electricity to be captured by the
government of Indonesia.

Figure 4.8 Illustrative comparison of true cost of energy with geothermal costs (cents
per kWh)
14
Carbon price
12
10 Air pollution & carbon price risk cost
8 Fuel price risk cost

cents
6 Fuel cost
4
Operating cost
2
Capital cost
0
True cost of energy Geothermal
Comparison with other structures

Other policy combinations could also be proposed to encourage geothermal development. It is
worth comparing the features of the different combinations to see their relative merits. For the
sake of comparison, the following combinations are considered.
 Green Paper model (GP model). As described above, this involves a fixed geothermal tariff
set on the basis of the true cost of electricity; bidding through an up-front license fee; and a
higher rate of taxation (production sharing). High-quality field data from publicly funded
exploration are provided at the time of tender.
 Bid FIT. In this model, developers bid on the basis of a feed-in-tariff (FIT) and the bidder with
the lowest FIT bid is awarded the license. Field survey data are made available at the time of
tender but no additional public exploration is done.
 Fixed FIT + tax concessions. In this model, an FIT is offered based on the price PLN
currently pays for coal-generated electricity, plus some additional margin to help bridge the
gap between that low price and the cost of geothermal energy. Additionally, tax concessions
are provided to make geothermal development relatively more attractive. Field survey data
are made available at the time of tender but no additional public exploration is done. This is
essentially the scheme recommended in JICA’s (2008) study on fiscal incentives for
geothermal electricity.
In addition to these models, many other models to incentivize geothermal development exist. One
worth mentioning here, even if it is not part of the comparisons below, is the internal rate of return
(IRR) guarantee. In this model, the government pays developers an FIT or supplemental subsidy
so as to ensure that a specific IRR (say 16% or 17%) is achieved for the project. This is
essentially a cost-plus model. Some have suggested that an IRR guarantee model could be
combined with a bid FIT. However, any initially agreed FIT is rendered meaningless by an IRR
guarantee, since the guarantee ensures a specific IRR on the basis of cost regardless of the FIT.
(In the case where the FIT is adjusted to ensure the guaranteed IRR, this is obvious; in the case
where other forms of payment are used it is less obvious, but still in practice equivalent to
adjusting the FIT post hoc.)
A key problem with cost-plus models generally, including the IRR guarantee model, is that there is
no incentive for firms to operate efficiently. The only advantage of the IRR guarantee is that it
removes project risk for the project proponents, but this comes at enormous cost. The
government of Indonesia shoulders that risk instead – that is, it is no longer on the project
proponents’ books but it is still being paid for as a liability to the government of Indonesia. What is
worse is that an IRR guarantee shields the project proponents from the consequences of their

own decisions, introducing additional costs and removing incentives for firms to operate
efficiently.
Geothermal development stages

The stages in geothermal development and the relationship with the government of Indonesia and
the IPPs are illustrated in Table 4.4.
Table 4.4 Stages in geothermal development

Fixed FIT + tax
GP model Bid FIT concessions
Surface surveys Government of Government of Government of

Indonesia Indonesia Indonesia
Exploration drilling Government of IPP IPP
Indonesia
Resource assessment & feasibility IPP IPP IPP
study
Development & production drilling IPP IPP IPP
Production IPP IPP IPP
The question of who should conduct each stage of a geothermal development requires
discussion. At one extreme, the government of Indonesia could conduct the entire project itself,
from initial survey through to production. However, it is difficult for state-run businesses to operate
efficiently, and the government may not have access to suitable capital for the development.
Therefore, there is a preference to persuade the private sector to conduct as much of the
development as possible. On the other hand, there are substantial problems with getting IPPs to
take over all stages of development. The main problem is that, at the beginning, the value of the
geothermal resource is unknown, so it is difficult for the government and IPPs to negotiate a
reasonable licensing arrangement.
As surveying and exploration take place, more information about the field is known and it
becomes easier to estimate its economic value. However, if the surveying and/or exploration are
performed privately by an IPP, the government will suffer from the disadvantage of asymmetric
information when negotiating with the IPP. It would be possible to invite all potential investors to
perform their own surveys and exploration, but this would involve unnecessary and costly
duplication of effort and permitting.
Therefore, the Green Paper suggests an intermediate position, with the government conducting
the early stages of development before handing a project over to the private sector through a
competitive tender. The government should conduct exploration to the point of the first successful
confirmation drilling (the first well that produces commercial-grade steam).
While the GP model remains the best option even if the tender is conducted prior to exploration
drilling, having confirmation drilling data available at the time of the bid will substantially improve
the accuracy of the bidders’ reservoir models and hence substantially reduce the risk premium
that bidders need to apply to their economic models. It will also allow the government to select
bidders at a point where much is known about the resource, reducing the need to renegotiate
elements of the bid after the bidder is selected.
Tariff and tax structures and the management of excess profits

Development of productive geothermal fields will yield positive economic benefits. The structure
of tariff and tax arrangements influences who receives those benefits. The three schemes
distribute the benefits differently, as the comparison of the three models’ tariff structures in
Table 4.5 demonstrates.

Table 4.5 Tariff and tax structures of the three schemes
Fixed FIT + tax

Form of electricity Fixed, based on the true Set through bidding. Based on cost to PLN of
sale price cost of electricity. coal plus a margin.
Management of Competitive up-front fee Managed through the bid Not managed. Tax
excess profits captures the ex-ante level of the FIT. No concessions mean
expected profits. mechanism apart from supernormal profits are
Production sharing of normal income tax to potentially taxed even less
profits after costs reduces accommodate than for other industries.
supernormal profits in supernormal profits in
case the field turns out to case of higher than
be more productive than expected productivity.
anticipated.
Distortions on Minimal. Fields with Managed through the bid Large. The FIT is fixed
investment before expected positive returns FIT. However, due to and not able to reflect
tender given the true cost of significant uncertainty at local cost structures.
electricity and profit- this stage, risk premiums Fields with costs above
sharing arrangements may be very high, implying the fixed FIT remain
should attract bids, unacceptably high FIT unexploited even if they
allowing development. bids. are below the true cost of
electricity.
Distortions on Minimal. As field Large. Activities only Large. As with the Bid FIT
activities after characteristics are proceed where the cost is scheme, activities do not
tender discovered, the full less than the FIT set at proceed where the cost
economic price of tender. This may result in exceeds the FIT. Setting
conventional generation is underinvestment by the the FIT uniformly across
available, with taxation developer. Field is never regions or plants will
applied only to profits after exploited to full economic exaggerate this effect.
costs. potential.
Risk for investors Lower. Technical risk Higher. Technical risk not Lower. Higher technical
mitigated by pre-tender mitigated. If managed risk is counterbalanced,
exploration and through post-tender because excess profits
confirmation drilling. negotiations, asymmetric are retained by the IPPs.
information becomes an
issue. Also, provides
incentives for firms to bid
a low FIT and then
renegotiate.
In the strategy proposed here, investors compete by tendering bids for an up-front fee. In
principle, investors will estimate the current net present value (NPV) of the project, and be willing
to offer an amount up to that as their bid. Therefore, in a competitive bid, any excess profits from
operating the field and selling under the geothermal tariff will be absorbed by the initial bids.
In the strategy proposed here, production profits are shared between the government and the IPP
through a production-sharing arrangement, similar to the way it is done now in the oil and gas
sectors. The effects of this are two-fold. First, since an IPP receives only a pre-determined
fraction of the profits from an operation, it will scale down the NPV for the project. This means that
the size of the license fee required for competitive bidding will be reduced. This is desirable, since
it reduces the amount of up-front capital that a developer needs in order to be able to compete in
the bid and hence will allow a wider range of participants to tender. Second, production sharing
helps capture profits in case the geothermal field turns out to be more profitable than was
expected at the time of tender. This helps overcome credit constraints.

One criticism of production-sharing arrangements is that firms have an incentive to inflate their
costs. This is a real issue present in any arrangement where costs are reimbursed. Thus, profit-
sharing arrangements are not a panacea; they also introduce some problems. In comparison with
other models, however, these problems are modest. In other words, while firms can claim some
costs that are not “real” at the margin, they still have a strong incentive to contain costs because
they have a profit share, unlike in models that guarantee a fixed rate of return. Overall, therefore,
profit-sharing arrangements, while not perfect, offer the best compromise to ensure that any
excess profits accrue to the Indonesian people while minimizing economic waste associated with
other forms of managing excess profits.
In the Bid FIT model, investors compete by bidding on the level of the FIT. Again, competition
should drive bidders to estimate the NPV of the project and reduce their bids for the FIT to the
point where the NPV approaches zero. However, if the project later turns out to be more profitable
than expected, there are no measures in place for the government to share in these benefits
beyond the normal company income tax.
In the Fixed FIT + tax concessions model, there is no bidding process to eliminate the expected
part of the NPV, and tax concessions mean that unexpected profits would be taxed at even lower
than normal rates.
Distortions on activities before tender

A well-designed tender will minimize the distortions it imposes on investment decisions made by
developers. One way to measure the distortions introduced by different tender arrangements is to
consider the effect on marginally viable development projects – that is, projects with an expected
NPV close to zero. Ideally all projects that are able to deliver geothermal electricity for less than
the true cost of electricity should proceed and projects than cannot deliver electricity at this price
should not proceed.
It should be noted that the taxation of IPPs’ profits means that the NPV of projects for IPPs is less
than the NPV for the economy at large. Since none of the schemes considered here involve
removing the taxation of profits for geothermal projects, this effect will render some marginally
viable projects unviable. This is an inevitable effect of the existing taxation arrangements for
company income.1
In the GP model, the NPV of projects is further reduced by the profit-sharing arrangements. This
means that some projects that are marginal without the scheme will become inframarginal with
the scheme, and will not proceed. However, the magnitude of this impact is modest, since the
IPPs receive an input tariff equal to the true cost of electricity on all sales, but profit sharing
applies only to profits after costs.
In the Bid FIT model, the government has to impose a cap on the price that it is willing to accept,
since otherwise all tendered projects will proceed (possibly with a very high FIT) regardless of
NPV.
The least distortive cap that can be imposed on a Bid FIT tender is the true cost of electricity. With
this cap in place, IPPs will not submit bids for marginal projects. In the absence of uncertainty, the
IPPs can submit bids close to the true price of electricity for marginal projects, Thus, the Bid FIT
scheme would not introduce additional distortions before tender if project costs were certain.
However, because the costs of actual geothermal development projects are subject to
considerable uncertainty, a developer will have to add a substantial risk premium to the FIT
submitted. The risk premium will need to be large, because the bid-for FIT will apply to all units of
electricity sold by the IPP, and the IPP needs to build a sufficient margin into the FIT to ensure
that the uncertain costs do not exceed the bid-for FIT.
This produces a large pre-tender distortion. Marginally viable projects will not proceed under the
Bid FIT model, because the risk premium that developers need to add to the FIT to insure against
high costs will yield bids above the cap.

In the Fixed FIT + tax concessions model, the pre-tender distortions are largest. The Fixed FIT
does not reflect per-field cost structures, and fields with costs above the Fixed FIT level will
remain unexploited.
Distortions on activities after tender

Another characteristic of a well-designed tender is that it will avoid introducing distortions that
might lead to underinvestment or overinvestment in fields once they are under development. The
strategy proposed here offers the full true cost of electricity as the geothermal tariff. The
advantage of this is that geothermal fields will be developed to the point where the marginal cost
of geothermal electricity equals the marginal benefit. As the characteristics of the geothermal
resource are revealed through development and operation, the IPP always has an incentive to
develop the resource to the optimal point.
In the Bid FIT model, investors compete by bidding the FIT down. This means that, even without
the issue of technical uncertainty, geothermal fields will not be developed to their optimal
economic potential. The problem is worse when technical uncertainty is considered: if the field
turns out to be less profitable than expected at the time of tender, the IPP may not be able to
recoup its costs through the FIT and may stop development altogether.
In the Fixed FIT + tax concessions model, the fixed FIT will be less than the optimal true cost of
electricity. The distortions will therefore be large, since many otherwise worthwhile geothermal
developments will not be profitable under the fixed FIT.
Fiscal impacts
The cost of preliminary exploration, borne by the government of Indonesia, is estimated at
approximately US$2.8–3 million per field. Noting that some fields may not become viable, the cost
per successful field is likely to be around US$4–5 million. Initially this should be funded by budget
measures, potentially supplemented by international financing. But once the scheme is
operational, the license fees collected from the winning bidders through the tender process can
be used to recover exploration costs.
The fiscal cost to the Ministry of Finance of exploration and the geothermal tariff will be offset by
several factors:
 Money received through up-front fees from successful bidders.
 Reduced coal price risk and increased diversification of supply as the ministry reduces its
current exposure to fuel (coal and oil) price fluctuations.
 Reduced infrastructure requirements for coal. Insofar as infrastructure is built using public
money, the avoided costs accrue to the line ministries and hence to the Ministry of Finance.
 Lower spending on illness caused by airborne pollution, reducing the budgetary pressure on
the public healthcare system.
 Improved reliability and availability of supply. By operating a more efficient system, PLN’s
costs will fall, reducing its dependence on subsidies from the Ministry of Finance.
 Regional benefits from construction. Improving the local economy increases incomes and
reduces pressure on the Ministry of Finance to provide electricity and other subsidies for
low-income earners.
Policies to deploy other alternative technologies

The transitional policy presented here for geothermal energy can be adapted to other
technologies. The key features of the transitional policy that should be retained are as follows.

Strategy: Key features of transitional policy to deploy alternative technologies
 The true cost of energy, as determined by the current production-mix and subsidy landscape,
should be used to determine electricity tariffs for alternative technologies. Care should be
taken to ensure that externalities related to the alternative technology are accounted for.
 Rights to develop can be tendered to private developers, who will then receive the tariff for the
electricity they produce. The tender needs to be structured to ensure that all bidders have
adequate and equal information, in order to obtain the most accurate and competitive price. If
possible, tendering should be on the basis of bidding for an up-front fee for the license to
develop.
 Profits obtained from the exploitation of domestic resources should be shared with the
Indonesian people using production-sharing arrangements.
4.6 ENERGY EFFICIENCY AND CONSERVATION

This section provides a brief overview of the benefits from energy efficiency and conservation and
a description of Australia’s National Framework for Energy Efficiency. It leaves the task of
determining concrete policy options for Indonesia to future work.
Demand for electricity is growing rapidly, and Indonesia’s electricity system will have difficulty
expanding rapidly enough to meet the demand. Energy efficiency and conservation is an
important tool to address this problem. There is scope for significant savings in energy
consumption in the electricity, transport, and industry sectors.
Because energy has historically been underpriced, the incentives for energy efficiency and
conservation are not strong. Consequently, much energy consumption is inefficient or
unnecessary. This situation could be improved at very low cost. Energy is not a final good in its
own right, but rather an intermediate good that is consumed in order to generate services that are
of genuine value to consumers. This means that energy-saving measures can translate into
reduced costs and lower carbon emissions without any reduction in the quality of the final
delivered service.
Energy efficiency in the electricity sector

The significance of energy efficiency and conservation measures in the electricity sector is that
they have the potential to serve multiple goals at once. By improving energy efficiency, the
demand imposed on the electricity network to deliver a given level of service to the community is
reduced. At the same time, the capacity to deliver services from the existing generation system is
improved. Instead of adding megawatts to the installed capacity, one can talk of installing
“negawatts” (megawatts of saved consumption) of energy efficiency.
Figure 4.9 shows installed capacity and peak demand in Indonesia for the years 2000–2004. In
those years, consumer demand increased steadily in line with economy-wide growth in Indonesia;
peak demand approached the installed capacity; and reserve margins became increasingly slim.

Figure 4.9 PLN’s installed capacity and peak demand, 2000–2004
30000
Capacity Demand
25000
20000
MW
15000
10000
5000
0
2000 2001 2002 2003 2004
As an illustration of how energy efficiency and conservation measures can complement capacity
expansion by adding negawatts to the installed supply, one can consider a scenario where
increasing demand for electricity services is complemented by such measures (Figure 4.10). The
growth in demand for electricity services is maintained, but by reducing the energy intensity of the
economy, the services are delivered using less energy.
Figure 4.10 Hypothetical illustration of complementary energy efficiency and

conservation measures
30000
Capacity Demand EEC demand
25000
20000
MW
15000
10000
5000
0
2000 2001 2002 2003 2004
The effect of reducing the energy intensity of the economy is in many ways equivalent to
increasing the installed capacity, but with zero greenhouse gas emissions and with the best
supply security available. In our hypothetical scenario, the equivalent expansion is illustrated in
Figure 4.11, where the effective capacity of the system has grown through energy efficiency and
conservation measures from 21,000 MW to the equivalent of 25,000 MW.

Figure 4.11 Equivalent increase in installed capacity due to negawatts
35000
Effective capacity Capacity Demand
30000
25000
20000
MW
15000
10000
5000
0
2000 2001 2002 2003 2004
Capacity building with “negawatts” is an attractive way for Indonesia to pursue its policy goals of
development and poverty alleviation, for the following reasons.
 Negawatts can be a very cheap way of expanding the capacity of the network. Many
analysts put a negative cost on a significant number of energy efficiency measures. This
means that the savings in energy costs outweigh any investment required to achieve those
savings. The reason that these opportunities are not already exploited relates to information
problems and situations where the person or firm making equipment purchasing decisions
does not face the running costs (as in the case of landlords). These can be ameliorated
through targeted government policy.
 Increasing the capacity of the electricity network to deliver services through energy efficiency
and conservation improves the robustness of the network. Capacity is extended at the same
time as the strain on the transmission grid is reduced. This reduces the size of the power
plants required to meet demand.
 Dependence on fossil fuels and foreign imports is reduced.
 Energy efficiency and conservation measures result in avoided greenhouse gas emissions
as well as energy cost savings. Avoided emissions can be sold in international carbon
markets. But even if they are not, emissions savings from energy efficiency and conservation
will help Indonesia achieve its 26–41% emission reduction goals and may attract other forms
of international finance.
There is considerable scope for energy savings and emission reductions through energy
efficiency and conservation. The DNPI abatement cost curve (DNPI 2009) indicates an abatement
of 40 million tonnes of CO2-e per year. This is equivalent to replacing 6 billion tonnes of coal
generation capacity with a zero emissions technology. The International Energy Agency (IEA
2006) estimates that, worldwide, end-use energy efficiency and conservation measures could
account for 45% of emissions abatement by 2050 (see Figure 4.12).
With the current distorted energy prices in Indonesia, end users with low connection capacities do
not have a financial incentive to implement energy conservation measures even though these
would result in net savings. For instance, in the domestic sector, a consumer may elect to
purchase a relatively inefficient but cheap domestic appliance because (depending on the size of
the connection to the grid) the consumer is liable for only a fraction of the cost of the energy
consumed by the appliance over its lifetime.

Figure 4.12 IEA model of future reductions in world CO2 emissions by technology area
Source: IEA (2006).
Electricity market reforms, including the imposition of a carbon tax and the gradual withdrawal of
electricity subsidies, will mean that end users do see the full price of electricity, and so will have
better incentives to conserve electricity. However, experience in other countries shows that
consumers often do not take up energy conservation measures, even when energy prices are
closer to their true values and there is a financial incentive to implement the conservation
measure.
The failure to take up conservation measures that yield a positive financial saving can be
explained by a combination of factors. Often the root cause is a lack of information – end users
simply do not know or do not understand the energy costs implied by their purchases. In some
cases the issue is compounded by problems of agency. For instance, builders may lack the
incentive to install (relatively more expensive) energy-efficient appliances in new houses because
the potential purchasers are not aware of their benefits, and discriminate against such builders in
their purchasing decisions.
This has led to a proliferation of regulatory and fiscal measures in most developed countries. The
following subsection provides a description of Australia’s National Framework for Energy
Efficiency.
Australia’s National Framework for Energy Efficiency

The Australian experience in pursuing energy efficiency objectives illustrates some of the
measures that can be implemented by governments and some of the benefits that can be
obtained. The National Framework for Energy Efficiency (NFEE) is the main umbrella framework
covering a range of Australian commonwealth government programs. Phase 1 of this framework,
implemented between 2004 and 2007, consisted of eight measures:
 residential and commercial building standards;
 an Energy Efficiency Opportunities program (mandatory energy assessments for large
energy consumers);
 demonstration projects showing the benefits of energy efficiency;
 appliance labeling requirements and minimum energy performance standards;
 government energy efficiency measures;
 trade and professional training and accreditation;

 a consumer awareness campaign; and
 a financial sector awareness campaign.
NFEE measures are designed to yield both economic and energy efficiency benefits. The
designed payback period is four years. The results of phase 1 have been analyzed in a regulation
impact statement. It estimated the following savings by 2015.2
Australia’s National Framework for Energy Efficiency – phase 1 results

 GDP benefits: A$380 million (US$295 million) per year
 Greenhouse gas emissions savings: 7.8 million tonnes per year
Phase 2 of the NFEE proposed further measures:

 more minimum energy performance standards;
 a strategy to promote high-efficiency heating/ventilation and air conditioning systems;
 the phasing out of incandescent lighting;
 government leadership on green leases; and
 a national hot water strategy.
The Energy Efficiency Opportunities program

Under the NFEE’s Energy Efficiency Opportunities (EEO) program, large consumers of electricity
are required to perform energy audits and report to government. Companies are not under any
obligation to pursue the efficiency measures identified in their audits. However, in many cases the
energy audits reveal large potential energy savings and the companies have an economic interest
in applying the changes.
The top 200 companies account for 60% of Australia’s energy consumption. Many companies
have reported large savings from measures identified by energy audits under the EEO program.
For instance, Orica reported a 6% reduction in energy use and savings of A$1 million per year.
The payback period for measures identified in the EEO program is four years or less.
Commercial building standards

The NFEE introduced changes to the Building Code of Australia for commercial buildings and
major refurbishments, to encourage energy-efficient buildings. The estimated benefit–cost ratio of
the standards is 4:1.3
Opportunities for Indonesia

The Australian experience highlights the substantial greenhouse gas abatement opportunities
offered by energy efficiency measures, at low or often negative cost and with concordant benefits
for the economy. These can be characterized as “win–win” measures. It is very likely that there
are similar or even more dramatic greenhouse gas reduction opportunities available within
Indonesia. However, because of the different structure of the Indonesian energy sector and the
presence of substantial government subsidies for energy, different incentives may be needed to
realize these gains.
The Indonesian government has already demonstrated an interest in pursuing energy efficiency
measures. Under its National Energy Policy, the following roadmap for energy conservation policy
and regulation is in place.
 2006: Presidential Decree No. 5/2006 (National Energy Policy): Aims to reduce energy
elasticity to less than unity.

 2007: Law No. 30/2007 on Energy: Government, energy producers, and energy consumers
are responsible for the implementation of energy conservation. Government will provide
incentives for energy efficiency and conservation implementation.
 2008: Presidential Instruction No. 2/2008 on Energy and Water Saving: Government offices
instructed to increase the efficiency of energy and water consumption; and to establish task
forces to monitor implementation.
 2009: Draft government regulation on energy efficiency: places an obligation on large energy
consumers to conduct energy audits and designate an energy manager; Application of
energy efficiency labeling for home appliances.
The steps in this roadmap are consistent with the Australian NFEE and provide an excellent
foundation. The challenge is to implement effective and efficient policies to achieve the outcomes
sought. To this end, it is important to study the relative cost per tonne of abatement likely to be
achieved by the different energy efficiency measures and to implement policies that promise to
deliver abatement at costs below what can be achieved through other means.
NOTES
1 Schemes to tax the economic rents from natural resource exploitation without creating a distortionary
effect have been proposed, and are in use in some jurisdictions, including Australia and Papua New
Guinea. A resource rent tax is one such alternative taxation scheme. An early description of this scheme
appears in Garnaut and Clunies Ross (1983).
2 See http://www.ret.gov.au/Documents/mce/energy-eff/nfee/_documents/e2wg_nfee_stag.pdf, retrieved
15/5/2009.
3 Discussion paper on phase 2 of the NEEF, p. 8, retrieved from
http://www.ret.gov.au/Documents/mce/_documents/Natinal_Framework_On_Energy_Effeciency(NFEE)_
Stage2_Consultation20070904133959.pdf, 21/5/2009.

5 A REGIONAL INCENTIVE MECHANISM FOR CARBON
FROM LAND-USE CHANGE, FORESTRY, AND PEAT
KEY POINTS
 Indonesia has very large emissions from land-use change, forestry, and peat. There are plentiful
opportunities to reduce these emissions. An international scheme for reducing emissions from
deforestation and degradation (REDD) could provide substantial amounts of financing.
 Many decisions relevant to climate change, and REDD in particular, are under the control of regional
governments, and local governments are also often best placed to tailor climate measures to local
conditions and development aspirations.
 As part of the policy mix for REDD, mechanisms will be needed to transmit incentives from international
carbon finance and to channel payments for REDD from the international community to the local level.
 Broader national fiscal and regulatory policies for land-use change, and land and forestry management,
often tend to go against carbon reduction objectives. Policy and regulatory reform will be necessary,
including in the area of land-use planning, with analysis left for further work.

 Work toward a Regional Incentive Mechanism (RIM) that uses intergovernmental fiscal transfers to
incentivize and support climate change action by regional governments, starting with REDD. The RIM
can use three existing and emerging avenues in Indonesia’s fiscal transfer system.
 The Special Allocation Fund (Dana Alokasi Khusus, or DAK) could be used to fund broad-based climate
change programs. An incentive component could possibly be introduced into the DAK system.
 Direct grant agreements could be made for specific agreed climate change programs and outcomes.
Funding could be linked directly to international inflows of carbon financing.
 A performance-based Regional Incentive Fund (Dana Insentif Daerah, or DID) could be established, with
payments to be based on carbon outcomes, in similar fashion to the DID to be introduced in 2010 to
improve the financial, economic, and social performance of regional governments.
 Ministry of Finance to conduct detailed analysis and move toward establishing financial systems for
managing international carbon finance inflows and domestic payment distribution.
 Fiscal policy settings affecting land-use change and forestry need to be brought into line with Indonesia’s
carbon reduction objectives. The Ministry of Finance would work toward this with the appropriate
ministries, principally Forestry and Agriculture. Reform of fiscal policies needs to recognize the
importance of regulatory settings for land zoning and enforcement in particular.
The conversion of forests to other uses releases carbon dioxide, through the loss of biomass from
both trees and soils. Globally, deforestation is estimated to contribute 12–20% of total annual
greenhouse gas emissions. Slowing the rate of deforestation, together with reforestation and
better management of forests and soils, is considered a key component of global climate change
mitigation (Stern 2007).
Indonesia is possibly the largest global emitter of carbon from land-use and land-based activities,
if emissions from peat and peat fires are counted. This poses a challenge for Indonesia as it
attempts to meet its responsibilities toward the international community. However, it also offers a
golden opportunity for Indonesia to reduce its aggregate greenhouse gas emissions.
Reducing emissions from land-use change and forestry, including peat fires, is the cornerstone of
Indonesia’s goal to reduce national emissions by 26–41% by 2020 compared to business-as-
usual levels.
The forestry sector and a Regional Incentive Mechanism Page 97

Substantial financial support from developed countries could become available under an
international scheme for REDD. The question is how best to implement REDD activities to
achieve carbon outcomes that are consistent with development objectives, and that attract
international financing. Specific questions for the Ministry of Finance are what fiscal policies can
be used to incentivize and support REDD and how to design them to achieve efficient outcomes,
and how to channel international REDD financing to local entities.
The two most prominent options for fiscal policy are;
 to use Indonesia’s intergovernmental fiscal transfer system to incentivize and support REDD
at the local level; and
 to reform the tax and subsidy system as it applies to land use-change (including plantation
establishment) and forestry.
This chapter focuses on the first of these two options, and finishes with a brief overview of the
issues to be considered on the second.
Regulatory policies such as land-zoning regulations and their implementation will have a central
role to play in an effective REDD framework, including and in particular for peat lands. Regulatory
policies that affect land use and forestry have important economic implications. These will need
thorough consideration if an overall effective and efficient policy framework is to be achieved.
They are not covered in the Green Paper.
5.1 INDONESIA’S FORESTRY EMISSIONS AND ABATEMENT OPTIONS
KEY POINTS
 Indonesia has very large emissions from land-use change, forestry, and peat. Although measurement
and baselines are uncertain, it is clear that Indonesia’s emissions will remain high in the future if no
abatement action is taken.
 There are plentiful technical opportunities to reduce these emissions at relatively low technical cost. But
in practice the carbon payments needed to effect action will typically be above the estimated pure
opportunity and implementation costs.
 Low-emission alternatives to business-as-usual land conversion need to bring development benefits to
local communities.
Indonesia’s forest and peat emissions

High rates of forest conversion and the widespread incidence of peat fires – a problem almost
unique to Indonesia – mean that emissions from Indonesia’s forest lands are very large (see
Figure 5.1). Estimates in Indonesia’s Second National Communications (SNC) under the
UNFCCC (Ministry of Environment 2009) have net emissions from land-use change and forestry
and peat accounting for 61% of the nation’s total greenhouse gas emissions during 2005.
Alternative estimates by Indonesia’s National Council on Climate Change (DNPI 2009) put
emissions from deforestation and forest degradation at around 1100 million tonnes and emissions
from peat fires and peat decomposition (the latter is not included in SNC estimates) at around 800
million tonnes, to give a combined share of 84%. Differences in estimated levels can be explained
by differences in estimation methodologies and coverage of emissions sources. There is also
great variability in estimated levels between years.
These emissions are globally significant in their magnitude. Indonesia is thought to account for
almost 20% of global annual deforestation (measured by area), second only to Brazil; and global
emissions from deforestation are estimated to account for 12–20% of total greenhouse gas
emissions. Importantly, Indonesia is the largest global source of emissions from peat, through
fires and decomposition. Indonesia is estimated to have around half the world’s tropical peat

lands, to contribute almost half of global carbon emissions from peat decomposition, and to be the
world’s largest source of emissions from peat fires.
Figure 5.1 Estimates of land-use change/forestry and peat emissions
2,000
Peat decomposition
Peat fires
1,500
Land-use change & forestry
MtCO2 / year
1,000
500
-
Second National Second National IFCA, average DNPI, 2005 Comparison:
Communications, Communications, 2000–2005 Energy and other
2004/2005 average 2000- sources, SNC
2005 2005
Note: SNC provides no data for land-use change and forestry emissions in 2005, using the 2004 estimate instead.
Sources: Second National Communications (SNC): Ministry of Environment (2009); IFCA (Indonesian Forest Climate
Alliance): IFCA (2008); DNPI: DNPI (2009); Comparison: Second National Communications (emissions from energy,
agriculture, and waste).
The main source of deforestation emissions is forest conversion to croplands and plantations, and
to a lesser extent conversion to grassland. Net carbon emissions also arise from forest production
land, where regrowth is below the rate of logging. There is large year-on-year variability in net
land-use change and forestry emissions, and there are also uncertainties in estimation related to
the extent of forest conversion, the extent and speed of vegetation regrowth, and the carbon
density of forests.
Emissions are strongly concentrated in some regions of Indonesia. The Indonesia Forest Climate
Alliance estimates that the province of Riau accounted for one-third of Indonesia’s emissions from
deforestation during 2000–2005 (IFCA 2008). Four more provinces (Central Kalimantan, South
Sumatra, Papua, and East Kalimantan) accounted for a further third.
Emissions from peat fires are even more locally concentrated, uncertain, and variable over time.
The extent of peat fires depends heavily on seasonal weather patterns, with fires more frequent
and intense in El Niño years. Estimating the extent of emissions from peat is even more difficult
than for deforestation. Estimates of Indonesia’s peat emissions in the literature vary by a factor of
10 between years, and they vary substantially between studies (see Figure 5.2).
Future trajectories and baselines

Reference emission levels and baselines for future trajectories are crucial for establishing the
amount of reductions that are deemed to have occurred – deemed reductions are calculated as
the difference between the reference emission levels (or “baselines”) and the actual, measured
emissions in the future. As discussed in Chapter 3, the emerging international consensus is to
use historical trends in emissions as a basis, but to adjust these for likely future developments in
the absence of REDD financing (see, for example, Ashton 2009).

Figure 5.2 Estimates of peat fire emissions
4,000
3,500 Heil et al.

van der Werf et al.
3,000
MtCO2/year
2,500
2,000
1,500
1,000
500
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Source: Heil, Langmann, and Aldrian (2007); van der Werf et al. (2007).
A typical baseline assumption is that emissions from land-use change and forestry as well as peat
will remain at current levels in future years, or increase slightly over time (see, for example, DNPI
2009).
But deforestation and peat land emissions are much less predictable than fossil fuel emissions. A
multitude of market, institutional, and policy factors drive the processes that result in land and
forest carbon emissions, and there is less inertia in the system than for the energy sector. For
example, the rate of land conversion depends on demand for timber and plantation-grown
commodities (especially palm oil), and may respond to changes in policies and institutions. A
large share of emissions depends on land management practices, in the case of peat fires in
particular. Defendable alternative assumptions can result in significantly higher or lower
baselines. In the longer term, it is clear that the baseline emission levels would fall, as less and
less forested land is available for conversion.
Although any particular baseline for future emissions is debatable, it is indisputable that forest
carbon emissions will remain at high absolute levels for some time to come, unless targeted
policy action is taken to curb them.
It is likely that Indonesia will not be able simply to determine its own baseline. Rather, it will need
to justify its proposed baseline, and possibly negotiate it both with the countries providing REDD
finance and with other developing countries in the REDD market. It will be important for Indonesia
to put up a credible baseline and to arrive at an agreed baseline that is a reasonable reflection of
likely future emissions trends. If the baseline is set too low, this would short-change Indonesia. On
the other hand, a very high baseline might be viewed as inflating the accounting of Indonesia’s
emission reductions and therefore be unacceptable to other countries.
Abatement potential and cost

Many options are available to reduce Indonesia’s carbon emissions from land-use change and
forestry. They include preventing peat fires, establishing new plantations on degraded rather than
forested lands, improving forest management, and extending the level of forest protection.
Different options carry vastly different implementation costs and opportunity costs (that is, the
profit foregone if land is not converted), and differ in their practicality.
The Indonesian Forest Climate Alliance has estimated the opportunity cost of converting primary
forest to oil palm plantations, and selling the timber, at around $4000 per hectare (IFCA 2008:
129). This implies a break-even carbon price of around $6 per tonne of CO2.

These estimates of opportunity costs can be described as the monetary one-off payment that
would be needed to compensate for future expected profits from land conversion.
By contrast, the opportunity costs and break-even point for conversion of primary forest to crops
such as cassava is much lower, estimated at $500 per hectare or $0.70 per tonne. Conversion of
degraded forest has a lower opportunity cost because the revenue from timber is lower or zero,
but carbon savings may also be lower per hectare. Abatement costs will further vary between
locations, depending on accessibility, soil characteristics, and existing vegetation.
However, as discussed below, these estimates do not include transaction costs and
implementation costs, and therefore tend to be underestimates of the true costs of reducing
emissions.
It seems that there is very large potential for abatement at costs below the prices currently paid in
international carbon markets. The DNPI study has estimated the total abatement potential in
forests and peat at more than 1.3 billion tonnes per year (well over half of assumed business-as-
usual emissions), at a cost of up to €6 per tonne, less than half the current carbon price in EU
markets (see Figures 5.3 and 5.4).
Figure 5.3 Land-use change and forestry emission reduction options: DNPI draft
marginal abatement cost curve
Abatement cost
EUR per tCO2e Forest sector
30 Agriculture sector
Total emisions from peat by 2030
in the business as usual trajectory Water Fire
25 is 1,227 Mt CO2e manage- managem
ent on Re-wetting
ment palm of non- REDD –
REDD – Marginal oil plantation existing
REDD – Reforest
20 smallholder land plantations used land Intensive
Timber ation Water plantations
agriculture afforest- REDD –
ation extraction palm oil
manage- Intensive
15 ment plantations
pulpwood pulpwood
plantation
10
0
0 100 200 300 400 500 600 700 800
Abatement potential
MtCO2e per year
Figure 5.4 Peat emission reduction options: DNPI draft marginal abatement cost curve
Abatement cost
EUR per tCO2e
30
Total emssions from Forestry REDD –
sector by 2030 in the business Cropland Forest REDD – Intensive
25 as usual trajectory is 0.8 GtCO2e afforest- manage Intensive plantation –
ation -ment plantation - palm oil
pulpwood 20
20
15 15
11
10 REDD – small- Marginal land Reforest- REDD –
holder agriculture afforestation ation timber 7
extraction 6
5 4 4
1
0
0 200 300 400 500 600 700 800 900 1,000 1,100 1,200
Abatement potential
MtCO2e per year

Practical constraints and extra costs
Many of the opportunities for abatement would involve additional costs over and above the pure
opportunity costs. For example, the conversion of forests to plantations is often accompanied by
local development benefits such as new roads, better communications, and improved health
infrastructure, all of which are valued highly by local communities. To make forest conservation
attractive to local communities, additional compensation may be required. Other factors that could
significantly increase the actual cost of implementing REDD activities, compared to the pure
opportunity cost, include administration and transaction costs, as well as the overheads and taxes
charged by different levels of government.
As a result, international REDD payments may in many cases need to substantially exceed the
opportunity cost of abatement options as estimated in studies such as DNPI (2009), in order for
these to be viable in practice.
Other factors likely to reduce the abatement potential below the theoretically possible level
include institutional constraints that may preclude the implementation of cost-effective REDD
activities and other policies that provide counterincentives. These are discussed further below.
5.2 INTERNATIONAL REDD FINANCING, INCENTIVE TRANSMISSION AND THE ROLE

OF INTERGOVERNMENTAL FISCAL TRANSFERS
From a fiscal and economic perspective, key aspects of REDD are to create a policy platform that
provides reasonably uniform incentives across all the different abatement options, and that
transmits the financial incentives for abatement created by the international community down to
the level of governments, businesses, and other groups that make the actual decisions about
land-use, land management and forestry practices.
In the theoretical ideal, policies would be designed such that, across all the different REDD
activities, the incentives result in abatement costs at the margin that are equal to the carbon price
(the payments that can be received per tonne of emissions avoided) plus or minus any other
externalities. Where the cost of reductions is far below the carbon price, these profits can then be
shared between the private sector and the government, or between different levels of
government. This is along the same lines as the “true cost of energy” and geothermal policy
framework laid out in Chapter 4.
In practice, this will be far harder to achieve in the land-use change and forestry sector than in the
energy sector, for a number of reasons. These include difficulties in measuring emission
reductions, the large number of emissions sources, the inability to apply pricing instruments in
many areas, and the possibility that international public REDD finance could vary greatly in terms
of the payment per tonne of emission reductions. Nevertheless, equalizing marginal costs across
abatement options, subject to other externalities and development objectives, should be the
guiding principle in designing REDD policies.
Form of international REDD financing and implications for Indonesia

The international community is intent on creating an international financing mechanism for REDD
that would channel payments for forest carbon from industrialized countries to tropical developing
countries. The intention is not to stop particular forms of forest use or land conversion, but to put a
financial value on the carbon stored in forests, and thereby bias land-use decisions toward lower-
emissions options where it is economically viable.
Public versus market finance

As set out in Chapter 3, it seems likely that international REDD financing will be dominated at the
start by public carbon finance to build up capacity and kick-start abatement efforts. Donor-
financed efforts along these lines are already under way, including in cooperation with Australia,
the United Kingdom, Germany, and other countries.

Over time, however, it is expected that private carbon markets will play an increasingly important
role in financing REDD, where adequate systems for measurement and verification can be
implemented. From the developed countries’ perspective, this model has the advantage that there
are no budgetary costs insofar as private industry buys REDD credits to fulfill their carbon
reduction obligations, and that all of the reductions that are financed can be credited against
international commitments. Its advantage from the developing countries’ viewpoint is that they are
likely to receive greater amounts of REDD payments, because the payment per unit of reduction
is likely to be larger than under public financing.
The private market model requires reliable systems for monitoring, reporting, and verifying
emission levels, which may take some time to establish. It also requires agreement with potential
buyers on baselines/targets. This relates back to the difficulty of establishing what a credible
scenario for future emissions might be, as discussed above. The model may also turn out not to
be suitable for certain kinds of mitigation activities, chief among them reductions in emissions
from peat fires. They may remain impossible to measure accurately, with the baselines for future
emissions likely to be especially contentious. In such areas, an important role for public finance
will remain.
Importance of national approaches

Buyers of REDD credits will want to ensure that emission reductions are “real,” and are not overly
compromised by the risk of inflated baselines or leakage (an increase in emissions in areas not
covered by a reduction scheme). As explained in Chapter 3, this points to national accounting
approaches and national-level baselines or targets for emissions.
A national-level REDD approach would suit Indonesia, as it would allow the greatest scope to
apply a broad variety of government policy instruments and allow maximum flexibility in how to
achieve overall emission reductions, including the use of very different approaches in different
parts of the country. It would also permit the central government to play a valuable role in financial
management of the REDD regime, including aggregation of low-cost with high-cost and low-risk
with high-risk REDD activities, and the smoothing of financing flows over time.
In Indonesia’s case, province-level approaches may also have a role to play, as provincial
boundaries in many cases are useful delineations in both geographical and political terms, and
because the provinces cover areas with large amounts of emissions.
In terms of coverage of sources of emissions, it is generally in Indonesia’s interest for a REDD
mechanism to be as broad as possible, in order to cover as much as possible of the spectrum of
Indonesian abatement options. Ideally this would include avoided deforestation, reforestation,
peat land and fire management. The international discussion is increasingly focused on a so-
called “REDD+” mechanism, which explicitly includes conservation and sustainable forest
management. An expanded future mechanism that would include agriculture and carbon from any
kind of land use is also under consideration. Expansion of the scope for REDD could go hand in
hand with the development of monitoring and payment delivery methods (Terrestrial Carbon
Group 2009).
Role of project-based approaches and Ministry of Finance REDD regulations

In principle, project-based approaches to REDD could also be accommodated under an
overarching national approach. This would potentially introduce substantial complexity in
emissions accounting and administration. Still, it might be worthwhile in certain instances where
large businesses are in a favorable position to deal directly with international buyers of emission
reductions.
The Ministry of Forestry has already issued several regulations concerning the implementation of
REDD activities, focused on a project-level approach (see Box 5.1). One of these regulations
includes detailed provisions on revenue sharing. This is an area under the authority of the Ministry
of Finance, not an issue to be addressed through line ministry regulations.

This instance can be seen as an illustration of the need for the Ministry of Finance to be engaged
across government in the design and development of climate change policy, and for sound
economic analysis to guide carbon policy. REDD revenue-sharing formulas would have important
implications for the viability of different kinds of emission reduction activities, and for the overall
effectiveness and efficiency of the scheme.
For example, if, for a certain type of project, 30% of the revenue accrued to private developers
and the rest to governments and communities, but the costs and risks lay with the developer, then
this would amount to a 70% tax on REDD finance. In turn, if the international carbon price
available were $10 per tonne of CO2, then only activities up to a cost of $3 per tonne would be
implemented by the developer. Many economically viable options might exist at costs between $3
and $10 per tonne but they would remain unused. On the other hand, allocating 60% of REDD
revenues to developers of low-cost project options might entail large windfall profits. The optimal
policy settings might in many cases not involve revenue sharing in fixed proportions, but tendering
or profit-sharing arrangements. Judicious economic judgment and consistency across different
sectors of the economy are therefore needed in carbon policy.
Box 5.1 Ministry of Forestry REDD regulations

To date the Ministry of Forestry has promulgated three regulations concerning REDD.
Decree 68 of 2008, issued on 11 December 2008, concerns the approval of REDD demonstration activities.
The aim is to experiment with and assess REDD methodologies, technologies, and institutions, and consider
how they can be carried out, evaluated, and transferred to real activities in the future.
Decree 30 of 2009, issued on 1 May 2009, concerns the mechanisms for REDD. It regulates procedures for
the implementation of REDD, including the requirements that should be fulfilled by developers, verification
and certification procedures, and terms and conditions for REDD implementing bodies.
Decree 36 of 2009, issued on 22 May 2009, concerns the procedures for issuing permits for carbon projects
in production and protection forests, across a range of different settings. It also specifies the sharing of
revenues from REDD projects, setting out the shares to accrue to government (10–50% depending on the
type of forest where a project takes place), communities (20–70%), and private developers (20–60%),
though revenue-sharing provisions fall in the remit of the Ministry of Finance.
The need for effective transmission of domestic incentives

REDD credits essentially need to be seen as a new commodity that can be “produced” and sold in
international markets, and whose production typically entails extra costs, both direct and
opportunity.
An efficient national response requires that local actors have financial incentives to implement
carbon-saving strategies in line with the incentives that Indonesia as a whole receives through an
international REDD mechanism. The challenge is therefore to achieve effective transmission of
incentives from the international to the national through local levels.
The guiding principle for incentive transmission in the forestry sector is the same as for other
sectors of the economy: where it can be created, a broad-based price signal similar to the carbon
price in international markets, complemented by regulatory and fiscal policies that result in a
similar marginal cost of abatement, while taking into account other policy objectives and societal
preferences.
Measuring carbon emissions and enforcing pricing policies at the micro level tend to be much
more difficult for REDD than for fossil fuel emissions. This is because the sources of emissions
and the economic actors responsible for them are much more dispersed, and because systems
for monitoring and charging are either absent or geared toward other purposes, for example log or
palm oil production rather than carbon emissions. (In the energy sector by contrast, there is a
relatively small number of distribution points for fossil fuels, the amount of fuel distributed is
monitored reasonably well, and fuel amounts can be translated almost directly into carbon

emissions.) Hence, for REDD, regulatory and broader fiscal measures are likely to play a
relatively greater role than direct emission-pricing instruments.
As a further challenge to achieving efficient abatement outcomes, policies and management
decisions on land-use change and forestry will tend to be subject to non-economic objectives
such as local development and social objectives. The interests and preferences of local actors
and communities need to play a central role for REDD strategies to be sustainable.
Using intergovernmental fiscal transfers for climate change action

Intergovernmental transfer systems are already being used in several countries to provide
incentives for local governments to achieve environmental outcomes. For example, Brazil and
Portugal have implemented fiscal transfer programs for biodiversity conservation, and India and
some European countries are considering similar programs (Irawan and Tacconi 2009).
In Indonesia, incentive payment systems have recently been introduced into the
intergovernmental fiscal transfer system, in particular in the area of education (see Section 5.4
below).
Indonesia’s system of administrative and fiscal decentralization allows the provincial, and
especially district, governments to take their own decisions about spending, to accommodate
local circumstances and preferences. Creating incentives for the regions to engage in REDD is
particularly important, because in Indonesia forest conservation and management outcomes are
to a significant extent determined at the local level. Similar arguments apply for other options to
reduce greenhouse gas emissions at the local level.
The role of regional governments

Regional governments are in the best position to manage the social impacts of changes to land-
use policies. For example, district governments are usually in the best position to compensate the
potential “losers” from carbon abatement policies, where that is a prerequisite for changes in land-
use and forestry practices.
Environmental benefits, such as improved watershed management and reduced air pollution, also
accrue to a large extent at the local and regional levels. Hence, if regional governments are
allowed to decide the nature and extent of change in land and forest management, they can tailor
their interventions to take account of the environmental co-benefits of their actions.
Many local and regional options for policy, regulatory, and management reform exist. A few
examples of actions that regional governments could consider include, among many others, the
following:
 issuing fewer permits for conversion of forest land to plantations (and/or issuing permits for
plantations on grassland instead of forest land, or on degraded rather than natural forest);
 enforcing more strongly forest management regulations, including requirements for
replanting after logging;
 ensuring that protection forests are not logged or cleared;
 supporting fire prevention measures, especially in peat land; and
 building new roads in areas covered by grassland or degraded forest rather than areas
covered by natural forest.
However, regional governments do need external incentives for reducing carbon emissions,
because the benefits of reduced climate change accrue to all nations of the world, over very long
time spans. This is where REDD payments come in. If introduced, they would represent an effort
by the international community to internalize the global externality, by way of rich countries paying
for forest carbon emission reductions in tropical developing countries.

The role of the central government
The central government has an important intermediary role to play between international carbon
markets and other governments as sources of REDD revenue on the one hand, and regional
governments as implementers and recipients of funds on the other. Its role includes:
 overall financial management of the national REDD system and the interface with
international funding channels;
 facilitating up-front investment where needed;
 setting up institutional structures and systems for measurement and monitoring;
 helping build local capacity for the identification and implementation of mitigation options;
 coordinating donor activities; and
 helping to prioritize the most cost-effective options, and ensuring that overarching national
development objectives are met.
As discussed in Chapter 3, international REDD funding from carbon markets could become
available on a large scale, but mostly for proven results in the form of demonstrable emission
reductions. This outcomes-based payment framework at the international level needs to be
replicated at the regional level, so that the central government can transmit the incentives it
receives from the international community to the local level.
5.3 CONCEPT FOR A REGIONAL INCENTIVE MECHANISM FOR CLIMATE CHANGE
KEY POINTS
 A Regional Incentive Mechanism (RIM) for climate change would use the intergovernmental fiscal
transfer system to support and incentivize climate change action by regional governments.
 Payments would be made from the central government to regional (mainly district) governments, linked
to the achievement of milestones and outcomes in activities to reduce emissions, or to actual emission
reductions.
 Payments to regional governments could exceed implementation costs and opportunity costs. Some
parts of the program would be tied to specific spending purposes, while the rest would be in the form of
reward payments for successful implementation, with regional governments free to make their own
spending decisions.
 Participation in RIM programs by regional governments would be entirely voluntary, and regional
governments would have full control over the design and implementation of projects.
 The central government would choose the most cost-effective proposals for implementation, taking into
account development priorities. This could take the form of a tendering system whereby regional
governments would submit bids for actions, anticipated outcomes, and payments.
 The central government would have carriage of the international, national, and overall financing aspects
of the scheme, including management of international finance inflows from REDD.
 The RIM could be revenue-neutral over time, with a share of the overall international REDD payments to
Indonesia covering the payments to regional governments.
 Capacity-building programs and pilot activities would be the initial focus of the scheme. These could be
supported through donor financing.
 Over time, the emphasis would shift from program-oriented spending to outcomes-based reward
systems that pay for a region’s aggregate carbon reduction outcomes regardless of how they are
achieved.
 The RIM concept could be used for objectives other than REDD, including other climate change
mitigation or adaptation actions at the local level.
Based on the considerations set out above, the Green Paper has developed a concept for a
Regional Incentive Mechanism (RIM) for climate change. This section lays out the features of

such a mechanism. The following section provides an initial exploration of how it could be
implemented under Indonesia’s existing intergovernmental fiscal system.
Performance-based payments to regional governments

The RIM would provide performance-based payments to regional governments. The majority of
payments would be made to district governments, which could then channel them to lower
administrative levels (including the village level), but payments to provinces would equally be
possible.
Payments would be provided principally on the basis of the achievement of agreed milestones
and outcomes. There could also be a component to pay for the cost of implementing agreed
measures, as part of an overall package to be negotiated between the central and each regional
government. Participation by regional governments would be entirely voluntary.
The ideal way of defining RIM programs is through payments for measurable carbon outcomes,
for example, actual carbon emissions evaluated against an agreed district-level carbon baseline.
This would transmit the incentives received from the international level, and hence maximize
Indonesia’s access to and benefit from international carbon funding. It would also align local
governments’ incentives with those of the central government, and promote efficient action at the
local level.
However, in many instances it will be necessary to provide milestone-based payments, to support
activities where carbon outcomes are difficult to measure (as in the case of peat fires), or to avoid
long delays between action and payment.
In other instances, it will be appropriate for the central government simply to pay for the
implementation of climate change-related measures and programs at the local level. This may
include capacity building and the establishment of the basic physical or institutional infrastructure
necessary to underpin REDD activities.
The RIM would start out using mostly milestone-based payments, and transition over time toward
greater reliance on outcomes-based payments. This would be in line with the expected shift in
international REDD finance from public to private market finance, which implies a rising emphasis
over time on measurable, reportable, and verifiable outcomes.
Scope of programs
Any activity that served REDD objectives would in principle be eligible for funding. In the case of
reforestation activities, projects already receiving funding from the Reforestation Fund (Dana
Reboisasi, or DR) would not be eligible for RIM funding.
Programs proposed by regional governments could range from specific local activities (such as
directing a proposed new plantation away from natural forest and onto grassland) to highly
aggregated outcomes (such as a carbon baseline for an entire forestry operation in a district over
a period of time).
To guide district governments in developing proposals, a sample list of actions could be prepared,
together with an indication of typical implementation and opportunity costs. During the start-up
phase, the sample list and cost guide could be used as a positive list and default payment
schedule.
There is no need in principle to restrict eligibility for the RIM to certain provinces or districts.
However, it may be practical to phase in the program, starting with a relatively small number of
districts and provinces. The obvious candidates are those with the largest and most promising
abatement options and the greatest interest in participating in REDD.

Conditionality of payments
A successful RIM will often involve compensating districts for not doing something, for example,
choosing not to convert an area of natural forest. Consequently, there cannot be conditionality on
the spending of RIM payments insofar as these relate to opportunity costs, or represent a
premium above costs.
Expenditure conditionality would apply only during the early implementation phase of programs,
when and where up-front financing is provided by the central government for putting particular
measures in place at the local level. The composition, conditionality, and payment schedule for
this kind of tied funding would be defined as part of each agreement between the central
government and a district government. Depending on the project, the share of tied funding could
range from zero to 100% of the total funding.
For the remainder of the payments, performance conditionality would apply, with payments to be
made on the achievement and verification of agreed milestones and/or specified outcomes.
Payment distribution
Payments under the RIM can and should exceed local implementation costs and opportunity
costs. “Profits” will generally be needed to make REDD actions attractive to regional
governments. This is because deviating from business-as-usual practices will often entail not only
opportunity costs (from a reduced timber harvest, for example) and implementation costs (such as
the cost of enforcing regulations), but also local social and political consequences that need
buffering.
At the same time, the central government should also be paid out of REDD revenue for the
functions it fulfils, such as administration and financial risk management – at least over time.
However, care must be taken not to “tax” REDD revenues at unnecessarily high rates at the
central government level, as this would weaken the incentive for, and reduce the supply of, REDD
actions. For example, if international REDD payments of $10 per tonne of CO2 avoided were
available, and the central government kept 50%, then the effective incentive at the local level
would only be $5 per tonne, and any higher-cost options would not be implemented even though
they might still be profitable from an overall national perspective (see Figure 5.5).
Figure 5.5 Illustrative distribution of Regional Incentive Mechanism payments
REDD payment from international

sources to central government
Portfolio risk (international market price)
buffer, profit
sharing
Central govt
costs Payment to regional government
Local transition
programs &
admin costs
Local
opportunity
cost &
implementation
cost

For some activities, there could be a large difference between, on the one hand, the payments
needed to compensate and provide incentives to regional governments plus the costs incurred by
the central government, and, on the other hand, the revenues from international REDD payments.
Such additional revenue from specific activities would be needed to pay administrative costs at
the central and regional levels, to cover the costs of programs to support social and economic
transition at the local level, and to balance out any losses incurred in other parts of the REDD
portfolio. Any remaining profits could be used to support climate change activities outside the
REDD portfolio, or shared between governments.
The role of regional governments

Regional governments would have full control over the design and implementation of projects.
They would propose programs of action; determine the milestones and outcomes for judging
performance; propose the payments and payment schedule they required to implement a
program; and be responsible for implementing the chosen measures so as to achieve the agreed
milestones and outcomes.
These functions would require them to implement local-level political, economic, and
administrative decision-making processes, consult with the local population and businesses, and
involve experts to assess the benefits and risks of proposed carbon reduction actions.
District governments will generally be best placed to negotiate the various economic, social, and
environmental interests that apply at the local level, and to determine what level of financial return
is needed to make programs attractive. They can strike deals with individual businesses and
villages where required.
However, they will generally need assistance in the evaluation of mitigation options, especially
regarding the likely effect on carbon emissions, and in putting together a proposal or tender (see
below). The central government, together with donors, has an important role to play in advising
and building up local capacity on these issues.
The role of the central government

The central government has responsibility for all aspects of the scheme other than design and
implementation of local measures. Crucially, this includes the interface with the international
REDD regime, fiscal functions, and the coordination of overlap with other policies and national
objectives. An indicative list of central government functions with regard to the RIM includes the
following:
 decide a national REDD baseline;
 negotiate international REDD commitments and finance;
 carry responsibility for any national commitments;
 coordinate donor activities;
 provide up-front finance to regional governments;
 pool the risks of performance across projects;
 decide the overall distribution of payments between the central and regional governments;
 manage overlaps, synergies, and conflicts with other policies;
 select projects according to cost effectiveness and national development priorities;
 develop tools for measurement, reporting, and verification;
 create national-level institutions; and
 support local institutions and capacity building.

A tender system for project selection and payment distribution
Once sufficient experience had been accumulated, a tendering system could be implemented to
select RIM programs for implementation.
Tendering would allow the central government to choose the most cost-effective proposals and
screen them for national development benefits. It would also encourage competition between
districts and allow maximum flexibility for the types of commitments and actions that district
governments may want to undertake.
In a tendering system, districts would nominate specific activities and outcomes, and the
payments they seek for implementing them. For example, a district may wish to limit the issuance
of permits for land conversion, with the outcome defined in terms of the total area converted
against an agreed baseline, and possibly an estimate of the carbon emissions saved.
The central government would conduct a ranking of tenders received at a specific point in time
according to their cost effectiveness. It would accept the best offers, up to a defined total amount
each year and/or up to a threshold cost-effectiveness ratio, assessed in rupiahs per tonne of CO2.
This would allow for differentiation in funding according to costs without impeding incentives, and
would allow the most cost-effective options to be prioritized.
The central government would also have the opportunity to formally take development priorities
into account when evaluating the tenders. This could take the form of upward or downward
adjustment in the ranking of tenders depending on whether the proposed program supports or
countervails the national development agenda.
A practical example of the types of tendering already taking place in some other countries is given
in Box 5.2, which describes Australia’s Bush Tender program.
Box 5.2 Australia’s Bush Tender program

Australia has experimented with programs to improve local land management to achieve better
environmental outcomes, using performance-based payments to landholders determined on a tendering
system. The original program was designed and tested in the state of Victoria. Various other schemes have
since been created along similar lines.
These programs support landholders to identify options for improved environmental management of their
land, using a team of specialists employed by a state government agency. Landholders are then free to
submit a proposal containing specified actions – setting aside some land for conservation, planting trees,
eradicating weeds, and so on. Along with the proposal, they submit a bid for the payment to be received in
exchange for implementing the program. Landholders can align this bid with the expected cost, bid above
cost if they want to make a profit, or bid below cost if they are willing to bear part of the cost themselves.
The government agency receives the bids and assesses them using a metric that compares the different
types of outcomes. The bids are ranked according to their cost effectiveness, and the most cost-effective
bids are chosen for implementation (usually on the basis of a fixed overall budget to be distributed).
Landholders are generally paid the agreed sums on successful and verified implementation of the agreed
measure, but up-front finance may also be made available.
Fiscal implications
International REDD finance would be the principal source of funding. Payments would come from
an international REDD scheme, from multilateral funds, and/or from individual countries that had
agreed to support REDD in bilateral arrangements. Until REDD is operational internationally, the
main source of funding is likely to be donor initiatives and multilateral funds.
The Indonesian government may need to smooth funding over time, as the time profile of
emission reduction actions in the regions may not match the time profile of international
payments. In order to kick off substantial emission reductions in the future, the government may

need to provide some up-front financing, which it could expect to recoup later through REDD
inflows. In addition, the government may choose to supplement the funds it receives from the
international community to help it achieve its national carbon objectives.
The RIM can become revenue-neutral over time, by balancing financial inflows from developed
countries for REDD with transfers to the regions. Alternatively, depending on revenues, costs, and
government preferences, the RIM could provide a net cash flow to the central government, or be
“subsidized” by the central government in order to achieve greater emission reductions and/or
greater payments to the regions.
A domestic REDD fund?

An important question yet to be resolved is whether the RIM for REDD would be financed from a
dedicated REDD fund that would pool international payments. A REDD fund could be allowed to
borrow money from the state budget or accrue surpluses, and would in principle provide
accounting clarity for Indonesia’s REDD program. It would receive donor funds, trade in REDD
credits on behalf of the government, pay for the RIM, and pay for the necessary institutional
infrastructure. Strong governance arrangements would be needed.
The alternative would be to fund the RIM directly out of the annual state budget, and let
international REDD payments flow into consolidated government revenue. This could be an
attractive option if and when a market-based mechanism with country-level trading on a national
REDD target comes into being.
Phased introduction and capacity building

The RIM would start with selected programs in a limited number of locations covering a set menu
of mitigation options. Milestone-based payments would be financed from the available funding
from donors and international funds, and possibly Indonesian budgetary resources.
As experience is gathered and more external finance becomes available, the RIM could rapidly be
scaled up in scope and scale to encompass more locations and a broader range of activities, and
shift to more outcomes-based funding.
Capacity building is another essential aspect of the start-up phase. Regional governments will
need to strengthen their expertise to assess the actions they are considering, the effect those
measures would have, and the payments they seek in return. Teams of assessors and educators
should be made available to the regions on request, to advise them on their options and help
them build local capacity.
Donor assistance has a very important role in the start-up phase of the RIM, and is likely to be
available immediately. Donor involvement is likely to be especially beneficial in developing
technical measurement tools and identifying mitigation options. These activities could evolve
seamlessly from current donor programs to support REDD “readiness” for Indonesia. Pilot
programs trialing financial incentive mechanisms, such as those under the Indonesia–Australia
Forest Carbon Partnership and other donor programs (Box 5.3), will also yield valuable lessons
for the design of a RIM mechanism. Donor support for capacity building and the implementation of
enabling activities at the local level will be important.
Applications beyond REDD
Intergovernmental fiscal transfers could be used to provide incentives for, and finance, other
climate change actions at the regional and local levels. In the case of carbon emission reductions,
candidate activities include energy efficiency programs administered by district governments,
improved management of landfills, and mitigation actions in agriculture. Fiscal transfers can also
be used to finance local actions to adapt to climate change, possibly by channeling international
payments for adaptation through the central government to the local level.

Box 5.3 Donor financed REDD activities:
The Indonesia–Australia Forest Carbon Partnership
The Indonesia–Australia Forest Carbon Partnership is a donor-sponsored activity on REDD, as part of
Australia’s A$200 million International Forest Carbon Initiative.
Key areas of the partnership, agreed between the two governments in 2008, are policy development and
capacity building to support participation in international negotiations and future carbon markets; technical
support for Indonesia to develop its national forest carbon-accounting and monitoring system; and
development of large-scale demonstration activities, including the provision of enabling assistance, to trial
approaches to REDD.
The program includes a $A30 million contribution to the Kalimantan Forest Carbon Partnership, which aims
to cut greenhouse gas emissions from the deforestation, drying, and burning of peat lands by up to 700
million tonnes of CO2-equivalent over 30 years. It hopes to achieve this by preventing the deforestation of up
to 70,000 hectares of standing forest, rehabilitating 200,000 hectares of degraded peat land, and reforesting
up to 70,000 hectares of rehabilitated peat land. A second project area is in preparation, possibly focusing on
the protection of natural forests.
Lessons from the reforestation fund

The Reforestation Fund (Dana Reboisasi, or DR) is a significant component of the
intergovernmental fiscal transfer system. Its mandate is to support reforestation and the
rehabilitation of degraded lands and forests. Hence, it might be thought of as a potential vehicle
for REDD financing. In practice, however, the DR operates more as a mechanism for sharing
forestry revenue than for supporting reforestation (see Box 5.4).
Box 5.4 The Reforestation Fund (DR) and its use in the regions
The DR is an instrument for raising revenue through a volume-based levy on timber. Sixty percent of DR
revenue is allocated to the national government and 40% goes to the district governments, according to the
amount of levies received from each district, and the requirements for forest rehabilitation.
The DR’s mandate is to support reforestation and the rehabilitation of degraded lands and forests. However,
revenue has often not been used as mandated. The Supreme Audit Board found that the central and
regional governments had consistently underspent the funds allocated to reforestation and forest
rehabilitation. In the early years of fiscal decentralization, misuse of funds was reportedly rampant at the
regional government level.
Reforms instituted between 2004 and 2006 aimed to improve the implementation of the DR. The regional
government share of DR is no longer treated as part of the Special Purpose Fund (DAK-DR) but included in
the natural resource-sharing allocation (DBH SDA-DR), and all regional funds are allocated directly to district
(not provincial) governments. Spending remains tied to reforestation and land rehabilitation, in multiyear
programs. There are, however, no sanctions for non-compliance with spending rules, nor are allocations
linked to past performance.
The restrictive conditions on the use of the monies have meant that districts themselves must finance the
required administrative and logistical support activities, drawing on other budget resources. Experience with
the DR indicates that reforestation and rehabilitation are not a priority for district governments.
Tighter financial management and greater accountability might reduce the diversion of funds to non-eligible
purposes, but it would also tend to discourage spending of DR funds on the intended activities. In many
cases, improved financial accountability mechanisms have simply choked off DR spending altogether.
A fundamental problem in the incentive design is that district governments often have little interest
in spending the DR money they receive, because reforestation and rehabilitation are a low priority
for them. In the absence of rewards for spending the funds in the way intended, it can be more
attractive for district governments to redirect the funding to other activities. Where this is

precluded by effective enforcement of spending rules, the most attractive option is often not to
spend DR funds at all and instead to concentrate administrative efforts elsewhere.
The experience with the DR provides clear pointers for the design of a fiscal mechanism to
support carbon abatement measures at the regional level. These inform the strategy outlined
above, which relies heavily on positive incentives and gives regional government maximum
flexibility in the design and implementation of climate change programs.
5.4 IMPLEMENTATION OF A REGIONAL INCENTIVE MECHANISM IN THE

INTERGOVERNMENTAL FISCAL TRANSFER SYSTEM
KEY POINTS
 Implementation of a Regional Incentive Mechanism for climate change could use existing and emerging
vehicles under Indonesia’s intergovernmental fiscal transfer system. There are three main prospective
channels.
 The DAK could be used to pay for a number of broad-based climate change programs. Additional
funding to reward successful implementation could be provided, and funding under other DAK programs
could be made contingent on good performance on climate change programs.
 Direct grant agreements (governed by regulation PP 57/2005) could be struck with selected provinces or
districts, for specific, agreed climate change programs and outcomes. Funding could be linked directly to
international inflows of carbon financing, especially for REDD.
 A performance-based Regional Incentive Fund (Dana Insentif Daerah, or DID) could be established.
Payments to regional governments would be made on the basis of performance on aggregate indicators
of carbon emissions or related indicators like area of deforestation or reforestation, and incidence of peat
fires.
 The Ministry of Finance could conduct detailed analysis of options and move toward establishing
financial management systems for carbon finance, in particular REDD.
The intergovernmental fiscal transfer system

Under decentralization, Indonesia’s regional governments have assumed wide-ranging authority
and responsibility to manage their own budgets. Transfers from the central government to the
regions comprise almost a third of Indonesia’s central government budget. Fiscal decentralization
is determined by Law No. 25/1999 and Law No. 33/2004. The implementation of these laws is
assisted by various regulations.
The aims and purposes of Indonesia’s intergovernmental fiscal transfer system include:
 reducing the fiscal imbalance between the central and local governments, and between
regions (that is, reducing vertical and horizontal fiscal imbalances);
 increasing the revenue base of local governments;
 supporting regional activities that would help to achieve national development priorities;
 improving the quality of local public services; and
 developing regional infrastructure.
Figure 5.6 and Table 5.1 give an overview of the different components of the fiscal transfer
system, and their size.
A significant part of the regions’ revenue comes from the central government’s Balancing Fund
(Dana Perimbangan). The bulk of overall payments to the regions comes from block grants
provided under the General Allocation Fund (Dana Alokasi Umum, or DAU), which is a formula-
based fiscal equalization scheme, and from natural resource revenue sharing.

Figure 5.6 Indonesia’s intergovernmental fiscal transfer system
DBH for tax
Revenue Sharing
Fund (DBH) DBH for natural resources
DAU by formula
General Allocation
Balancing Fund
Fund (DAU)
DAU for teachers’ incentives
Specific Allocation
Fund (DAK) 14 programs under line ministries
Special Autonomy Fund Special Autonomy

and Adjustment Fund Fund Additional incentive fund for teachers
Adjustment Fund Performance-based incentive fund (DID)

Direct grants
under PP 57/2005
Table 5.1 Fiscal transfers to the regions, 2009 revised budget
Amount Share of total central

(Rp trillion) government budget
Total transfers to regions 303 31%

Fiscal balancing funds 279 28%
Revenue-sharing funds (DBH) 68 7%
General Allocation Fund (DAU) 186 19%
Special Allocation Fund (DAK) 25 3%
Special Autonomy and Adjustment Funds 24 2%
Special Autonomy Fund 9 1%
Adjustment Fund 15 2%
Source: State Budget Summary, Fiscal Policy Office.
An implementation strategy for RIM

Based on the analysis below of potential avenues of climate finance under Indonesia’s
intergovernmental fiscal transfer system, an implementation strategy for an overall Regional
Incentive Mechanism for climate change is sketched here. (For details, see the following section.)
There are three main prospective channels of finance: the DAK; direct grants governed by
regulation PP 57; and a Regional Incentive Fund for climate change.
1. The DAK could be used to pay for a number of programs related to climate change. The
costs of physical investments could be covered as per standard DAK practice, but possibly
using a linked “climate change” DAK spanning several line ministries. To cover local
opportunity costs and to provide incentives, extra funding could be made available under the
same DAK. Also, funding under other DAK programs could be made contingent on good
performance on climate change programs. The DAK would the mainstay of climate change
funding in the fiscal transfer system at least during the start-up phase.

2. Direct grant agreements (governed by regulation PP 57) could be struck with some
provinces or districts for the implementation of specific, agreed climate change programs,
and possibly for the achievement of specified outcomes. In the case of large-scale projects,
funding could be based on the submission of tenders by regional governments. Funding
could be linked directly to international inflows of carbon financing, especially for REDD.
3. A performance-based Regional Incentive Fund (DID) could be established. Payments to
regional governments would be made on the basis of performance against aggregate
indicators of outcomes. The initial set of criteria could include indicators like the area of
deforestation or reforestation, and the incidence of peat fires. Over time, however,
performance would be assessed in terms of estimated carbon emissions relative to agreed
baselines. The total amount of money to be distributed to districts and provinces would be
linked to REDD and other carbon finance available to Indonesia from both public and private
market sources.
In each of the three pillars, the same principle applies: the central government provides the
interface with international carbon finance, carries out the financial management functions, and
helps choose and prepare carbon abatement actions at the local level. Regional governments are
mainly (and in many instances fully) in charge of program design and implementation. Payments
from the central to a regional government depend to a significant extent (in some instances fully)
on outcomes.
This model requires significant involvement by the Ministry of Finance in the financial
management of carbon finance, including channeling money from the international community to
regional governments, providing up-front financing and risk aggregation functions, and
determining the basis of revenue sharing, especially where the international carbon payments
exceed local costs.
To prepare for this task, the Ministry of Finance would need to conduct detailed analysis of the
options, and move toward establishing financial management systems for carbon finance, in
particular for REDD.
The broader policy context

It is important to remember that a Regional Incentive Mechanism is only one part of an overall
policy platform for carbon reductions in land-use change and forestry. Regulatory policies
including land-use planning and their effective enforcement are of primary importance for
achieving Indonesia’s emission reduction objectives.
National fiscal policy settings – in particular the taxation and subsidy system for land conversion
and forestry as well as agricultural businesses – are also of great importance (see Section 5.5
below).
Sound economic principles that facilitate emission reduction objectives need to apply in the
regulatory and overall fiscal policy framework. Some aspects of fiscal policies are discussed in the
following section, but an in-depth treatment is beyond the scope of this Green Paper.
Finally, it should be noted that the intergovernmental fiscal transfer system may not be the only,
or necessarily the largest, channels for REDD financing. There may be REDD transactions
between businesses and international investors or the central government, and transactions
between regional governments and the international community.
A schematic representation
The implementation of the Regional Incentive Mechanism in the context of other policy and
financing areas is represented in Figure 5.7, while Figure 5.8 gives more detail on the three
possible pillars of implementation within Indonesia’s intergovernmental fiscal transfer system.

Figure 5.7 Regional Incentive Mechanism: broad outline
National taxes and subsidies for land-use and forestry

Payments to Indonesia
Central govt budget

Intergovernmental
fiscal transfer mechanisms
Payments to regions
Other
entities
Figure 5.8 Regional Incentive Mechanism: Three pillars of implementation
Payments /carbon cuts Payments /carbon cuts Payments /carbon cuts National taxes and subsidies for land-use and forestry

on-granting Central govt budget
Central govt budget on-lending
Central govt budget
Funding for specific programs, Funding for broad programs,

Purely outcomes-based funding
actions and outcomes with incentive components
Direct grant agreements (PP 57) DAK for climate change mitigation Regional Incentive Fund
Agreed Disburse- Rewards Funding Penalties
Allocation of funds
measures ment of for good for specific for bad
in line with
and funds perfor- climate perfor-
performance on
outcomes on proven mance: change mance:
carbon emissions
performance payments invest- cut back
indicators
above costs ments other DAK
allocations
Payments /carbon cuts Payments /carbon cuts Payments /carbon cuts

Special Purpose Fund (DAK) for climate change
The Special Purpose Fund (DAK) aims to support selected local governments to provide services
infrastructure, and to help with the achievement of regional and national development priorities.
The DAK system ties transfers to specific spending purposes – typically physical investments – in
a variety of sectors. The Ministry of Finance as fiscal regulator has the job of allocating DAK
funding based on the prescribed criteria, working with the line ministries.
Indonesia currently has 14 different DAK programs, which are administered by the relevant line
ministries. The largest category is education (spending on the construction of school buildings,
libraries, and so forth), which accounts for almost 40% of total DAK funding. It is followed by
health (mainly medical facilities and equipment) and transport infrastructure, which together
account for another 35%.
The existing DAK programs that would be of most directly relevance for climate change mitigation
are those for environment and forestry. They are relatively small, at Rp 351 billion and Rp 100
billion respectively (with forestry funding increasing to Rp 250 billion in 2010), together accounting
for around 2% of overall DAK funding. To date the environment DAK has been focused mainly on
water management, and the forestry DAK on protection against natural disasters, including
flooding and landslides.
The DAK under the Ministry of Environment has been entered in the government work plan (RKP)
under the priority area “Improvement of natural resource management and climate change
mitigation,” providing the basis for future climate change financing under this vehicle.
Thus far, the utilization of the DAK has been limited indirectly by a number of factors, including a
lack of implementation capacity at the local level; a mindset of funding projects rather than
implementing broader programs, and hence a tendency for lack of follow-up; and broader issues
related to the integration of DAK funding with other local government activities.
However with some adjustments, the DAK system could be made to perform for climate change
mitigation.
Peat fire example

Existing proposals to extend the environment DAK could serve to reduce emissions through
locally based actions. For example, programs to rehabilitate drained peat lands and reduce the
incidence and severity of peat fires, in the relatively small number of locations where peat fires
are a big issue, could be accommodated under the DAK system. If implemented successfully,
they could lead to large reductions in carbon emissions and yield substantial benefits for air
quality in Indonesia and neighboring countries.
However, it stands to reason that district governments and the villages in question would have
little incentive to implement peat fire reduction measures if they were reimbursed only for the
costs of the required physical investment. This would leave them facing the additional costs of
labor and administration, and possibly the cost of a lost economic opportunity, for example where
fires arise from land-clearing activity. The benefits in terms of carbon emission reductions and
improved air quality, meanwhile, would accrue almost exclusively at the national and international
levels. In other words, the local level shoulders the costs but does not reap the rewards. Hence,
additional rewards and incentives will be needed.
Reward and incentives under a climate change DAK

Because of these externalities in climate change mitigation, local governments would need to be
offered additional reward and incentive payments for the successful implementation of measures
where core financing is provided under the DAK.
This could be done by providing additional payments under the DAK, on top of the costs of
physical investments. This would be a departure from the predominant current practice, and could
be investigated as part of an ongoing process of evaluation and reform of the intergovernmental
fiscal transfer system.

Another approach to bring performance criteria into the DAK system would be to link the
disbursement of DAK funding in areas that are of genuine interest to regional governments
(possible examples being health or transport infrastructure) to their performance in implementing
climate change-relevant actions supported by the DAK. For example, the funding of a new road
under the DAK could be made contingent on successful implementation of a program for peat fire
prevention agreed and funded in the previous year. There could be extra DAK funding as a
reward for good climate performance, or a cut-back in funding for poor performance. This is
consistent with a broader move under consideration, to make DAK allocations partly dependent
on past performance in the use of DAK funds.
Integration of climate change-relevant DAK funding across line ministries may also be desirable,
given the cross-cutting nature of many aspects of climate change. At present, for example, peat
fire mitigation could potentially fall under the DAK programs of the Ministry of Environment,
Ministry of Public Works, Ministry of Agriculture, or Ministry of Forestry. Again, this would require
a shift from current practice whereby any DAK activity is administered by one specific line
ministry.
The DAK could also be used to support climate change measures without any institutional reform,
instead using additional fiscal transfer mechanisms to provide incentives for the implementation of
measures whose core funding comes from the DAK. The options in this area are explored in the
following two sections.
It should be noted that the DAK system as it stands could be a suitable instrument to support
adaptation to the impacts and risks of climate change – as opposed to climate change mitigation
through greenhouse gas reduction, which is the topic of this Green Paper. Such actions will often
require substantial physical investments, but they will generally be in the direct interest of local
communities and governments, so incentive payments may not be needed.
Funding for DAK climate change measures would generally come from the central government
budget, with possible offsetting inflows to the budget from REDD or other international climate
change finance.
Direct grant agreements (PP 57/2005) for climate change

Government Regulation (PP) No. 57/2005 sets out a general policy on the provision of grants
from the central government and international sources to regional governments. According to PP
57, the central government must consider certain criteria when providing grants and document the
grants through an agreement (naskah perjanjian hibah daerah) signed between the central
government (represented by the Minister of Finance) and the head of a regional government. The
disbursement of the grants themselves would again be subject to certain conditions.
Grants from international (bilateral or multilateral) sources should be received by the central
government and documented through the signing of a grant agreement between central
government and the foreign donor. The money would then be channeled to the relevant local
government(s), after the signing of a grant agreement between the Minister of Finance and the
head of the local government.
In other words, the regulations allow “on-granting” and “on-lending” of international funds to
regional governments with the central government as the intermediary, with conditions open to
determination in each case.
The Minister of Finance has enacted two ministerial decrees to strengthen the implementation of
regional grants policy, PMK No. 168/2008 on Regional Grants and PMK No. 169/2008 on
Procedures for Grants Disbursement to Local Government.
Performance-based payments and the channeling of funds

PMK No. 169/2008 clearly accommodates a performance-based grants system. Grants stipulated
under PMK 168 and PMK 169 are not part of the block grants system. Rather, they are linked to
certain activities defined by the central government, and they are managed under a specific grant

agreement. In order to request funds disbursement from the Minister of Finance, local
governments must have completed the agreed work or project and submit a progress report for
the activity. Implementation is assessed by the relevant line ministry of the central government,
which then gives a disbursement recommendation to the Ministry of Finance.
This assessment or verification process by the line ministry is a very important stage in the grants
system under PMK 168 and PMK 169, since it differentiates this type of grants from those
provided under other parts of the existing intergovernmental financing system. Direct grant
agreements under PP No. 57/2005 and its implementing regulations could thus play a significant
role in bringing about regional climate change action in Indonesia, because the system can be
designed specifically to finance climate mitigation activities at the local level.
To date, three programs have been designed to channel foreign grants to local governments
under this system. They are:
 the Mass Rapid Transit system for Jakarta (2009);
 the Local Basic Education Capacity program, under which the European Union and the
Dutch government while provide grants to 50 local governments (2009–2012); and
 the Water and Sanitation Initiative planned by the Australian government (2010–2011).
Applying direct grants to climate change

The direct grants system could be used to finance and incentivize the implementation of specific
climate change mitigation programs in specific locations, possibly on a large scale. Examples in
the REDD sphere might include:
 agreements for effective protection of large areas of forest (possibly at the provincial level, to
link up with the interest some provincial governors, including those of Papua and Aceh, have
already expressed in setting aside forest land in exchange for payment);
 reforestation of degraded lands; or
 flooding of drained peat swamps and other measures relating to peat lands.
The sources of financing would be the Indonesian central government (which could expect to be
reimbursed from international REDD revenue); the general budget or a climate change fund, as
discussed in the previous section; or international carbon finance. A tender-based system would
be another possibility, as discussed in the previous section.
Performance-based Regional Incentive Fund (DID) for climate change

Starting in 2010, the central government will provide a Regional Incentive Fund (Dana Insentif
Daerah, DID) to reward districts for good performance in the areas of economy, social welfare,
and good governance. The aim is to spur local governments to improve their performance.1 The
DID comes under the Adjustment Fund, and is expected to disburse Rp 1.3 trillion in 2010.
Under this program, district governments will be assessed on a set of financial, economic, and
social performance criteria, including the locality’s tax effort, auditing qualifications, economic
growth and poverty rate. A total of nine provinces and 45 districts will be awarded between Rp 18
billion and Rp 38 billion each, and will be free to use the money as they see fit. There is a fixed
total amount to be handed out, so it is good performance relative to other regional governments
that will be rewarded. Another incentive fund with a similar design exists in the education sphere
to reward good teaching performance.
Applying the DID to climate change

In similar fashion, a Regional Incentive Fund could be established to provide incentives for
climate change mitigation. Regional governments would be assessed on be a small set of
indicators that proxied the outcome of mitigation activities. The widest aggregate indicator, fully
compatible with international REDD incentives, would be carbon emissions performance. Under
the model, each participating district (or province) would be assigned its own emissions baseline,

developed in consultation with the central government, and in line with Indonesia’s overall
national baseline. (The regional baselines together would need to add up to the national
baseline.) Performance would be judged in terms of the difference between actual emissions and
the baseline: those regions that reduced their emissions the most beneath their baselines would
receive the largest amount of money. This approach requires a robust system of emissions
estimation and baseline setting that applies at the regional level. The development of such a
system will take some time to achieve.
In the meantime, other readily available indicators could be used: the rate of deforestation in each
region compared to historical rates (rewarding regions where deforestation slows at the highest
rate); the rate of successful reforestation of logged lands; or the incidence of forest and peat fires
in each district relative to other districts.
Payments would need to come from the Indonesian state budget, and it is expected that they
would be offset over time through international REDD finance inflows to the government.
5.5 FISCAL AND REGULATORY POLICIES AFFECTING LAND-USE CHANGE AND

FORESTRY
KEY POINTS
 Many national regulatory and fiscal policies affect land-use change and forestry, often promoting high
carbon emission activities, or creating conflicting incentives. Often these policies are motivated by, or
intersect with, national and local development objectives.
 A systematic approach to policy review and reform – involving both the Ministry of Finance and the
relevant line ministries – is needed to ensure that carbon reduction objectives are reflected in the fiscal
policy settings for forestry and land conversion.
This section sketches some of the challenges associated with broader national fiscal and
regulatory policies affecting land-use change and forestry, and their impact on carbon emissions.
It argues the case for harmonization of policy approaches, taking into account Indonesia’s
national carbon reduction objectives.
Development goals and environmental co-benefits

The options for carbon emission reductions in land-use change and forestry need to be seen in
the context of Indonesia’s development goals. At the national level, in the interest of food security
Indonesia has been aiming for self-sufficiency in food crop production, and policies related to this
objective are an important driver of land conversion. At the local level, rural economic
development (for example, through road building) and social improvements (for example, through
job creation) are important objectives that can be met through forest conversion to plantations.
On the other hand, conservation and land management actions that lead to lower carbon
emissions also have environmental co-benefits at the local and regional levels, such as reduced
air pollution from fires and improved water quality and flood protection. Air pollution has a
transboundary dimension in that any improvements benefit both Indonesia and its neighbors (in
particular to the north).
Agricultural expansion
The expansion of agriculture has been a major cause of deforestation in Indonesia (in particular in
Sumatra, West Kalimantan, and Sulawesi), as it has been in other countries (such as Brazil).
The Indonesian government is intensifying its efforts to expand agricultural activities in the outer
islands, including Papua where most of the remaining natural forests are. Palm oil production is

the main target, with the aim being an expansion to over 9 million hectares under oil palm by
2020, compared to 7 million hectares currently.
A variety of regulatory and fiscal policies support the establishment of plantations for agricultural
commodities, foremost among them palm oil. For example, under the Food Crop Resilience and
Renewable Energy Development Credit Program (Program Kredit Ketahanan Pangan dan
Pengembangan Energi Terbarukan), the government provided over Rp 600 billion in interest rate
subsidies in 2009.
The Ministry of Forestry and local governments are facilitating the release and conversion of large
areas of land, including non-productive forest land, for biofuel crops. The licensing processes of
both levels of government are streamlined. Demand for biofuel is also being boosted through
regulatory means, through the requirement for transport and industrial fuels to contain a share of
biodiesel. The motivations include achieving self-sufficiency in the production of strategic
commodities; boosting exports of marketable commodities; and expanding biofuel production,
which is seen as a hedge against oil price volatility.
The effect of land-use change on carbon emissions depends on the policy and its implementation,
but in the majority of cases existing policy interventions are likely to push emissions up.
Intensification of production on existing plantations could reduce rates of land conversion. But
accelerated plantation establishment typically runs counter to the objective of reducing carbon
emissions, insofar as it involves the conversion of natural forests to agricultural plantations.
A particularly important issue is the conversion of peat forests to agricultural land. Draining peat
swamps exposes the peat to oxidization and carries the risk of peat fires (including during the
clearing process, which is sometimes conducted by fire). This can release extremely large
amounts of carbon. The ambition to expand palm oil production has tended to lead to less
stringent environmental criteria. For example, in February 2009 the Ministry of Agriculture issued
guidelines on establishing oil palm plantations on peat lands.2 According to this regulation, oil
palm plantations can be developed in peat lands with a peat depth of less than 3 meters.
The interplay between agriculture, biofuel production, deforestation, and peat land degradation is
crucial. Integrated land-use planning is therefore a key part of the solution, and policy
coordination between ministries, as well as between the national, provincial, and local levels, is
essential.
The government has been attempting to revitalize the forest industry – sometimes perceived as a
“sunset” industry – by promoting investment and relaxing the regulations governing the sector.
Various policies are in place to promote forest timber plantation (HTI) development. The effect on
carbon emissions depends primarily on whether such plantations are established on natural forest
land, where they are a negative for the carbon balance, or on degraded land, where they can
mean a net sequestration of carbon. An efficient REDD policy framework would provide incentives
for timber plantation establishment where it means a net carbon saving, and disincentives where
it means net carbon emissions.
Policies for downstream processing industries are also important drivers of carbon emissions. For
example, Indonesia’s pulp and paper industry expanded thirteen-fold from 1987 to 2007. This
expansion in processing capacity was not matched by an increase in the supply capacity of timber
plantations. As a result, the pulp and paper industry now depends on natural forests for its raw
materials, and this is a major cause of deforestation.
Ineffective policy coordination and the lack of a supportive regulatory framework are among the
causes of the supply and demand imbalance. Issuing permits for the pulp and paper industry is
the domain of the Ministry of Industry, while the Ministry of Forestry is in charge of issuing permits
for, and regulating, timber plantations. The industry’s processing capacity has been allowed to
grow without due consideration to the sustainability of the raw materials on which it depends.
Consideration is being given to new regulations that would increase forestry-derived non-tax
government revenue and at the same time curb deforestation. The idea is to require developers to
pay for the value of standing timber stock in natural forests when these are cleared for timber and

crop plantations, and to provide compensation for the use value of the land that is to be cleared.
These requirements would apply to every conversion of forests for commercial purposes. They
would help ensure that land is not cleared just for the profit to be made from logs but that
plantation development actually takes place. They would also help to insure that conversion
projects that are fundamentally uneconomical do not take place.
Such regulations could thus result in lower carbon emissions. However, to contribute efficiently to
the overall climate change objective, carbon should also be priced directly into the value of the
standing timber stock, at a rate comparable to carbon prices in international markets. In this way,
commercial forest conversion would face the correct carbon price signal.
Options for cutting carbon emissions

A number of strategic management interventions could be employed to lower carbon emissions
(see, for example, IFCA 2008). These include:
 the development of a revised national forest conservation strategy;
 better enforcement of laws against illegal logging and the fostering of alternative sources of
log supply;
 incentives for better management practices in production forests;
 changes to regulatory settings in the pulp and paper industry;
 regulations to improve the management of oil palm plantations, including zero burning and
more intensive production; and
 regulatory measures to improve the management of peat lands, including measures to
prevent further draining and conversion of peat swamp land, and to prevent fires.
In many instances these strategies would involve regulatory interventions. Nevertheless,
economic principles should be applied to their design: where regulations are aimed at curbing
emissions, the cost of complying with them, per unit of emissions saved, should roughly
approximate the carbon price that Indonesia could achieve in international markets.
In other instances, these strategies would involve fiscal policy interventions.
Need for a policy review

The alignment of fiscal and economic policies affecting land-use change and forestry with carbon
objectives is at its core an economic issue. In Indonesia, it will require the involvement of the
Ministry of Finance, working with the relevant line ministries on the basis of established
frameworks for forest land use.
As sketched out above, Indonesia has a number of existing policies that could be refined to
improve resource-use efficiency in land use and forestry, and reduce carbon emissions. To do
this, the Ministry of Finance needs to work with the appropriate ministries, principally Forestry and
Agriculture, to bring existing fiscal policy settings into line with Indonesia’s carbon reduction
objectives.
Some of the areas that would be covered by such a review are as follows.
1. Incentives for activities that lead to deforestation (for example, low-interest loans for timber
and oil palm plantations) and their role in encouraging deforestation beyond the level
justified by the economic benefits those activities generate.
2. Taxation of land allocated to timber and oil palm concessions. The objective would be to
ensure that concessionaires pay an appropriate level of taxes relative to the REDD benefits
that could be derived from forest conservation.
3. Incentives for afforestation and reforestation (including amount and management processes)
and their suitability to stimulate effective and efficient private sector initiatives. Indonesia has
a long history of attempting public reforestation programs and subsidizing private sector
activities with limited success, often at a relatively high cost.

4. Taxation of forest concessions and other options to promote sustainable forest management
in logging concessions and reduce forest degradation, including levels of taxation.
5. Options to align the timber-processing capacity of existing and planned industries, especially
pulp and paper and sawmills, with the existing and planned timber supply capacity from
plantations and the legal conversion of natural forests.
6. Policy development and coordination across ministries, and the legal and regulatory
framework covering ministries, agencies, and subnational ordinances.
NOTES
1 Remarks by the Finance Minister at a stakeholder gathering on the provision of regional achievement
awards, Jakarta, 2 November 2009.
2 Ministry of Agriculture Decree No. 14/2009 on the Guidelines for the Utilization of Peat Lands for Oil
Palm Establishments.


6 INSTITUTIONS FOR CARBON POLICY
KEY POINTS
International experience suggests that effective climate policy requires strong policy coordination and
integration across portfolios. To ensure that climate policy does not needlessly impinge on economic
outcomes, economic input needs to be central.
Strategy for the Ministry of Finance

 Establish an internal, high-powered climate policy unit within the Ministry of Finance consisting of
selected officers, including experts from across the ministry. The unit would be under the direction of the
head of the ministry’s Fiscal Policy Office.
 Propose the establishment of a working group on climate policy across the Ministry of Finance, the
National Development Planning Board (Bappenas), and the Coordinating Ministry of Economic Affairs.
 Encourage an interministerial review of existing legal, regulatory, and institutional structures affecting
climate change policy formulation and implementation.
 Suggest the commissioning of an independent, integrated review of climate policy for Indonesia.
6.1 INTERNATIONAL EXPERIENCE AND BEST PRACTICE
The need for whole-of-government policy coordination

Effective climate change policy requires action across many different portfolios. For an efficient
response to be possible, these policy actions need to be coordinated and harmonized. Without
proper coordination, policy action in one portfolio may be negated or distorted by action in another
portfolio. There is also a danger that the level of stringency of policy-making may differ greatly
across sectors. This may lead to an inefficient abatement outcome overall as substantial efforts
and costs are incurred in some parts of the economy while comparatively low-cost emission
reduction opportunities in other sectors remain underutilized. Lack of coordination also hampers
efforts to secure international carbon finance.
Carbon abatement policy requires the involvement of most or all of the sectors that contribute
significantly to emissions, or are potential sources of reductions. In Indonesia this encompasses,
at a minimum, the Ministries of Forestry, Agriculture, Energy and Mineral Resources, Industry,
Transportation, and Public Works. (Other line ministries should also be closely involved in climate
change adaptation policy, but this is not considered in this report.)
In addition, several cross-cutting agencies are involved in climate policy-making and
implementation. Apart from the National Council on Climate Change (Dewan Nasional Perubahan
Iklim, or DNPI), these comprise principally the National Development Planning Board (Bappenas),
the Ministry of Finance, the Ministry of Environment, the Ministry of Foreign Affairs, the
Coordinating Ministry of Economic Affairs, the Ministry of Trade, the Ministry of Home Affairs, and
the Ministry of Research and Technology.
Policy coordination across all these portfolios is an exceptionally difficult task, especially as the
interests of line ministries and cross-cutting agencies often diverge, and may not be in line with an
overall national objective.
Coordination across government is also needed on climate change financing. Consistent with the
desire to have an overall, cohesive climate policy framework, the Indonesian government needs
to take a consistent approach to climate change finance from multilateral agencies, and from
donors. A limited survey of the current donor programs on climate change suggests that,
collectively, donor programs have both large overlaps and large gaps, and may actually make
Institutions for carbon policy Page 125

coordination between government agencies more difficult. Hence, there is scope for better
coordination of donor activities on climate change, including aligning donor activities with
Indonesia’s interests.
A crucial role for the economics agencies

Climate change mitigation policy is at its heart an issue of economic reform, to facilitate lower-
carbon economic growth and change the structure of the economy toward lower carbon
emissions. While addressing technical issues in each sector is central to dealing with the
challenge, an overall national strategy for climate change is essentially an economic question, as
it affects the relative prices of goods and services throughout the economy.
Core questions for a climate change strategy include what mix of policies will achieve a desired
outcome at least cost, how growth and development can be supported through climate policy,
what effects policies will have on income distribution and poverty (and how these effects can be
alleviated), and how climate change measures can be financed.
Economic instruments are central to an effective and efficient carbon policy. Emissions pricing
policies, fiscal policies, budgetary measures, and regulatory measures with significant economic
and fiscal implications are the mainstay of carbon policy. In addition, international finance is
increasingly becoming a focal issue for climate change policy.
Three ministries in particular have a major role with respect to economic climate change policy.
The Ministry of Finance is crucial in ensuring the fiscal sustainability of budgetary measures, in
safeguarding overall economic objectives, and in establishing mechanisms to facilitate the
movement of funds (see Figure 6.1). The role of the Coordinating Ministry of Economic Affairs is
to bring together the various line ministries to ensure that sectoral policies are designed in an
economically sound way, and work effectively to achieve the common national goal of a low-
carbon environment. Finally, Bappenas is in charge of coordinating planning across the various
ministries. Given the need to plan long-, medium- and short-term strategies to achieve the
transition to a low-carbon environment, Bappenas is another crucial element in economically
sound climate change policy-making.
Ultimately, the economics agencies are the guardians of the economic interests of the country as
a whole when policy is contested by special interest groups. Effective carbon policy may involve
the redistribution of very large opportunities for economic and financial gain between sectors and
industries. Low-carbon industries and activities will flourish, while high-carbon industries face
pressures for change.
The experience in all countries that have instituted, or are in the process of instituting,
comprehensive carbon policies is that there are strong calls for special exemptions from policy
and regulations, and for special assistance through subsidies or other preferential treatment.
Huge amounts of money can be at stake, resulting in equally huge lobbying of government. In
such circumstances, the economics ministries are best placed to put the longer-term interest of
the nation ahead of particular special interests and, where necessary, find ways of providing
assistance in the forms that are least harmful to economic efficiency.
Lessons from Australia’s experience

The evolution of climate change policy institutions in Australia provides a useful case study for
Indonesia. Australia followed a pattern that in its broad outlines is quite typical of other (in
particular developed) countries, of increasing policy integration and rising central government
involvement in climate change policy-making. The most recent step to elevate climate change to a
separate powerful ministry was a world first, but it would not be surprising to find such ministries
created in other countries as climate change continues to gain in importance. The evolution of
Australia’s climate change institutions is represented in Figure 6.1.

Figure 6.1 Evolution of Australia’s climate change institutions
1998 2004 2007
Responsibilities Australian Australian Department of

distributed across Greenhouse Office Greenhouse Office Climate Change
departments Separate whole-of- brought within established as part
`
(Environment, Industry, government agency. Environment of PM’s portfolio,
Foreign Affairs). Not well No minister. Department. with separate
integrated across Coordination Coordination cabinet minister.
portfolios. problems. problems persist.
Limited Treasury involvement Strong Treasury involvement
Policy framework: States, Task Group, Garnaut Review, Green/White Paper
One important feature of climate policy development during this period has been the use of high-
powered teams with strong links to the Prime Minister – such as the Prime Ministerial Task Group
on Emissions Trading – to formulate broad policy parameters. It is interesting to note that the
head of the task group’s Secretariat was a Deputy Secretary at the Australian Treasury at the
time, and later became the Secretary of the Department of Climate Change, which in turn
recruited heavily from senior treasury ranks.
As Australia’s proposed mitigation policies became stronger, and hence were expected to have a
larger impact on economic activity, the government increasingly sought advice on economic
impacts and efficient mitigation policy design from the Treasury itself. In addition, the economics
agencies naturally became more centrally involved in policy-making as Australia began to
contemplate significant action on climate change, particularly the use of carbon pricing in the form
of an emissions trading scheme. The Treasury expanded its climate change capacity by bringing
together a dedicated team of over 20 experts, and produced a major and influential report on
emissions trading based on perhaps the largest modeling exercise ever undertaken in Australia
(Australian Treasury 2008). The development of Australia’s emissions trading policy framework is
shown in Table 6.1.
Table 6.1 Development of Australia’s emissions trading policy framework
Activity Date
Australian Greenhouse Office releases emissions trading discussion papers March 1999
Emissions trading proposal put before cabinet 2003
Final report of the Prime Ministerial Task Group on Emissions Trading released May 2007
Final report of the National Emissions Trading Taskforce (a multistate taskforce) December 2007
released
Discussion paper by the National Emissions Trading Taskforce on the design of a August 2006
national emissions trading scheme released
Climate change Green Paper released July 2008
Garnaut Climate Change Review (final report) presented September 2008
Treasury report released: Australia's Low Pollution Future: The Economics of October 2008
Climate Change Mitigation
Climate change White Paper released December 2008
Carbon Pollution Reduction Scheme legislation introduced to parliament May 2009

6.2 INDONESIA’S INSTITUTIONAL LANDSCAPE FOR CLIMATE POLICY
Legal and regulatory aspects

In Indonesia, laws tend to be expressions of principle. Their role is generally to establish an
institutional framework and provide broad direction. With the laws themselves containing little
detail, implementing provisions are usually deferred to a regulation-making phase once the law is
passed.
This is an important aspect of Indonesia law-making, as the length of time from a policy initiative
to a new law may be 3–5 years, followed by further time for implementing regulations to be
formulated. For instance, the Indonesian parliament passed a Mining Law in December 2008, but
key details concerning implementation of some aspects of the law are still waiting on regulations
(due by January 2010).
A new law on a specific subject will usually replace an earlier law on the same subject. In these
circumstances, implementing regulations (Government Regulations) and ministerial decrees
(formerly Ministerial Decrees, now Ministerial Regulations) issued under the repealed law remain
in effect until new ones are issued, unless they conflict with the new law. This can lead to a lack of
clarity until the new regulations or decrees are promulgated.
With respect to climate change legislation, the following points need to be kept in mind.
 There have been only a few regulations that directly implement climate change policy within
Indonesia. However, the increasing attention being paid to climate change issues suggests
that regulatory action on climate change is likely to gather momentum.
 It can take a long time to effect legal change in Indonesia through legislation. On the other
hand, operational matters can be delegated to regulations, which are quicker to bring into
effect. To some extent, this offsets the slow pace of legal change.
 Given these characteristics of governance in Indonesia, in the short term the most effective
way to foster change may be to engage in an interministerial effort to reform existing
regulations. In the medium term, however, there may be a need for specific climate change
legislation.
Institutions responsible for policy development, coordination, and implementation
Ministry of Environment
The Ministry of Environment is a key player in climate change developments in Indonesia.
Pursuant to Law No. 32/2009, the Ministry of Environment has responsibility for environmental
affairs. With regard to climate change, its main responsibilities include: determining eco-region
zoning in coordination with the relevant agencies; establishing a National Plan on Environmental
Protection and Management (RPPLH) that considers the effects of climate change and contains
mitigation efforts; and generally to carry out and coordinate the government’s environmental
responsibilities, including developing a national climate change policy.
DNPI
In 2008, the DNPI was established to “coordinate the control over climate change and to
strengthen the position of Indonesia in international forums on climate change” (Presidential
Decree 46/2008, official translation, section 2). The DNPI’s tasks, as set out in section 3 of the
decree, are: formulating national policies, strategies, programs, and activities to control climate
change; coordinating activities to control climate change, including adaptation, mitigation,
technology transfer, and funding activities; formulating mechanisms and procedures to facilitate
carbon trade; monitoring and evaluating the implementation of policies to control climate change;
and strengthening the position of Indonesia to encourage developed countries to be more
responsible for controlling climate change.

Bappenas
The general coordinating role and tasks of Bappenas are outlined in National Development
Planning Minister Regulation No. Per. 005/M.PPN/10/2007. In addition, Decree No. 204/10/2008
specifically establishes a National Coordination Team within Bappenas to develop a national
program and formulate activities on climate change. The duties of its steering committee include
making policy/strategy recommendations to integrate climate change issues into the National
Development Plan; and developing policy/strategy recommendations and guidelines to facilitate
the implementation of climate change programs and activities funded by foreign loan or grant
schemes.
Bappenas is already making a significant contribution to the climate change debate through its
macroeconomic planning role and its soon to be released Roadmap on Climate Change. It is an
integral part of the economics ministry framework, often working in partnership on climate change
matters with the Ministry of Finance through, for example, development of the Annual Budget.
Coordinating Ministry of Economic Affairs1

The functions of the Coordinating Ministry of Economic Affairs can be illustrated by reference to
Regulation No. PER- 3/M. EKON/07/2007 of the Coordinating Ministry of Economic Affairs. Under
article 2 of this regulation, the ministry is responsible for assisting the President to coordinate the
planning and development of some policies, and synchronizing the implementation of those
policies across the economy.
Line ministries
In effect, the majority of the relevant policy settings on climate change continue to be determined
by various line ministries and agencies, including the Ministries of Forestry, Agriculture,
Environment, Energy and Mineral Resources, Trade, Industry, Transportation, and Public Works.
The potential for overlap exists, not only between the line ministries themselves, but also between
the line ministries and the various coordinating ministries and agencies. There is considerable
anecdotal – and some direct – evidence to suggest that overlapping and inconsistent formulation
and implementation of policies have hampered efforts to achieve a uniform approach to climate
change.
Ministry of Finance
Of special interest in this report is the Ministry of Finance – what it can do to help formulate
national economic policy on climate change, and its responsibilities.
In December 2007, Indonesia hosted the High Level Event on Climate Change in conjunction with
COP13 in Bali, the first dedicated international meeting of finance ministers on climate change. In
April 2008, the Minister of Finance, through the ministry’s Fiscal Policy Office, established a
working group to study methods and strategic options to optimize fiscal policies for mitigation and
adaptation to climate change in Indonesia. During 2009, the Ministry of Finance has become
increasingly engaged with the international dimensions of climate change and climate finance, in
particular through its role in the G20. This Green Paper is a step toward creating an
implementable strategy for economic and fiscal policies on climate change.
Looking ahead, the Ministry of Finance will likely play an increasingly strong role in the
development of climate policy, especially in the areas of fiscal policy reform and economic input
into government-wide climate change policy formulation and implementation. This has been the
experience of overseas countries where climate change preparations have progressed further,
and is consistent with developments in Indonesia to date. The Ministry of Finance therefore needs
to prepare now for its strengthened role in the future.
The role of the Ministry of Finance in conducting climate change activities is governed by various
laws and regulations. For instance, under article 2 of Ministry of Finance Regulation No.
100/2008, the Ministry of Finance has the task of assisting the President in carrying out
government affairs in the field of finance and state assets. A review of this regulation found that

the Fiscal Policy Office within the Ministry of Finance was best suited to exercise this
responsibility with respect to climate change.
For the Fiscal Policy Office to be most effective in supporting the ministry in the climate change
area, two strategies may be helpful:
1. formation of a unit specializing in climate change matters; and
2. capacity building of that unit to ensure Indonesia adopts world best practice in fiscal and
budgetary practice on climate change.
More broadly, the Ministry of Finance needs to participate proactively in climate change policy
development across government to ensure that policies are economically sound. The line
ministries, for their part, need to seek the views of the Ministry of Finance at the earliest possible
stage in policy formulation. Looking to the immediate future, it will be critical to ensure that the
Ministry of Finance provides economic input into the development of climate change policies,
such as those outlined in Indonesia’s 100-day, one-year and five-year plans.
The Ministry of Finance will also have a key role in the allocation of funding for climate change
through the budget. As such, it will need to ensure that climate measures are economically
sensible and cost effective. A useful metric in climate change mitigation is the cost per tonne of
emissions reductions. Furthermore, the Ministry of Finance can assist in assuring consistency in
budget allocations over time, in both medium- and long-term expenditure plans.
Institutional strategy
An appropriate strategy for the Ministry of Finance to meet the institutional challenges discussed
in this chapter would be to:
1. Establish a climate policy unit within the Ministry of Finance.
This would strengthen its capacity to evaluate and contribute to the formulation of climate
change policy. It would also include efforts to ensure consistency and effectiveness of
budget allocations for climate measures. A high-powered climate policy unit as part of its
formal structure is best suited for the task. It could consist of selected officers, drawing in
experts from across the ministry, and possibly externally.
2. Establish a working group on climate policy across the Ministry of Finance, Bappenas, and
the Coordinating Ministry of Economic Affairs.
The working group would ensure that economic considerations related to climate change
policy formulation and implementation are coordinated across government. A coordinated
approach would help to establish mainstream economic principles in climate policy across
government, and to ensure that Indonesia’s climate policy portfolio achieves the desired
outcomes at least cost and with maximum economic benefit.
3. Encourage an interministerial review of existing legal, regulatory, and institutional structures
currently affecting climate change policy formulation and implementation.
A thorough review of the impact of government rules, regulations, and institutions on climate
change policy implementation is warranted, through a time-bound interministerial review.
This could include recommendations to fix the issues that are identified. This is essential if a
national climate change vision is to be achieved and successfully implemented.
4. Encourage the commissioning of an integrated review of climate policy.
Good policy in a new field like climate change requires systematic analysis to explore
options, scrutinize proposals, and make the latest thinking accessible to all stakeholders and
the broader community. Such a review could be modelled on Australia’s Garnaut Climate
Change Review. It could build on the various studies and strategies prepared by government
agencies, and critically assess policy options and emerging policy directions from a whole-
of-society perspective.
NOTES
1 The Coordinating Ministry for Social Affairs also has a coordination role in dealing with central
government and regional relations, as does the Ministry for Home Affairs.

APPENDIX 1 GEOTHERMAL ELECTRICITY
BACKGROUND
Geothermal electricity generation is a form of energy supply that exploits the natural heat within the Earth’s
crust. The amount of energy stored in the Earth’s interior is immense, and this energy flows naturally and
constantly from the interior of the Earth to its surface at a rate of 44,000,000 MW (Gupta and Roy 2006: 20).
The natural flow of geothermal heat energy is around 20 times the current global electricity consumption.
The source of the heat within the Earth is heat left over from the original formation of the planet billions of
years ago, as well as heat generated by the ongoing natural decay of radioactive elements deep within the
planet. As the Earth cools and energy is released by the decay of elements, this energy flows outward and
escapes through the planet’s surface.
Geothermal energy is considered to be renewable, because although the reservoir of heat and decaying
elements is finite, it will take billions of years to exhaust. In practice it can be considered a constant and
inexhaustible source of energy.
Geothermal technology involves capturing some of this heat flow and converting the heat energy into
electrical energy. Despite the vast amount of geothermal heat energy that is constantly flowing from the
Earth’s interior, the surface of the Earth is also large and in most places the intensity of the flow is much too
low for economic extraction of this heat resource to be possible. However, the availability of geothermal
energy is not distributed evenly across the Earth’s surface and there are areas where much higher extraction
rates are possible. In such locations, extraction of electrical energy from geothermal heat is viable. In this
sense one may talk of geothermal resources and their geographic distribution.
Indonesia is blessed with a very high proportion of the global geothermal resources – around 40% of the
world’s geothermal resources are located within the Indonesian archipelago (JICA 2008). The estimated
potential for geothermal electricity generation in Indonesia is 27,000 MW. This is comparable in magnitude to
the entire currently installed power capacity of Indonesia (29,400 MW in 2007 according to IEA 2008).
Most of Indonesia’s geothermal resources can be considered to be “steam” resources. Rainwater naturally
seeps underground until it meets high-temperature rocks, where it is heated to temperatures well above the
normal boiling point of water. Geothermal power plants work by drilling deep wells – up to several kilometers
deep – to tap into these reservoirs of hot water. The water then rises to the surface where its heat is
extracted by steam turbines.
Indonesia already has operating geothermal power plants, amounting to an installed capacity of around 1200
MW. This is only 4% of the potential capacity. Most of this capacity was installed in the 1990s prior to the
Asian financial crisis. Development of the geothermal energy sector in Indonesia has stalled since then.
Indonesia’s geothermal resources are of a high quality, meaning that it has a natural comparative advantage
in this field relative to other countries.
Geothermal power offers attractive benefits for Indonesia, and there is interest within the Indonesian
government to kick-start its development.
Geothermal heat energy flows at a constant rate. This means that geothermal electricity can provide
baseload power, available around the clock with high reliability. This is very different to many other sources
of renewable energy such as wind, solar or wave power, each of which is dependent on the vicissitudes of
the weather. Solar power is even more variable since it is completely unavailable during the night.
The baseload capacity is a large and important part of Indonesia’s installed power generation system.
Electricity demand is growing quickly and it will be difficult to expand the supply of baseload power quickly
enough to meet this growing demand. Already there are problems in Indonesia with insufficient supply, and
power shortages are common (IEA 2008a: 179).
The technologies that are best suited to providing baseload capacity are those that can generate power with
low operating costs. The conventional technologies that are used worldwide for baseload power generation
are coal, hydro, and nuclear, each of which is characterized by higher up-front capital costs followed by
lower ongoing (per kWh) generating costs. Geothermal technology fits neatly into this category, since the
main cost of geothermal electricity is in the initial exploration, drilling, and construction of the power plant.
Once a productive steam well has been established and the power plant to extract its energy installed, the
ongoing cost of operation is a minor part of the overall project cost.
Appendix 1 Page 131

Currently, most of Indonesia’s baseload power capacity is supplied by coal. Geothermal energy offers an
opportunity to diversify the installed baseload capacity, with important implications for energy supply security
and risk mitigation. Geothermal energy also has the important advantage of producing very low greenhouse
gas emissions. Coal generation, on the other hand, is one of the dirtiest technologies.
The current situation with geothermal energy in Indonesia
Geothermal energy is expected to help Indonesia meet its rising demand for energy in the future. The current
installed capacity of 1200 MW was mainly installed in the 1990s. Since then further development has stalled.
The Ministry of Energy and Mineral Resources has produced a Geothermal Development Road Map to
develop the capacity to 9500 MW by 2025. The Japan International Cooperation Agency (JICA) has
produced a geothermal Master Plan Study that evaluates the potential of 50 geothermal fields on the basis of
existing survey information (mainly surface surveys) (JICA 2008). It concludes that a potential capacity of
around 9000 MW is obtainable from those fields. There are other potential geothermal fields in Indonesia
that were not included in the JICA study, including extremely large prospective engineered geothermal
capacity.
Promising and significant geothermal fields are present in Java–Bali, in Sulawesi and Eastern Indonesia, and
in Sumatra (Table A1.1).
Table A1.1 Location and capacity of Indonesia’s geothermal fields (MW)
Location Estimated capacity
Sumatra 14071
Java–Bali 9329
Sulawesi 1233
Nusa Tenggara 1932
Maluku/Irian 584
Kalimantan 50
Total 27189
The main buyer and supplier of electricity in Indonesia is PT PLN, the national electricity company. PLN
operates its own power stations as well as buying electricity from independent power producers (IPPs). It is
obliged to sell electricity to consumers at heavily subsidized prices. This means that it cannot cover its costs,
and the Indonesian government must make up the budget shortfall. The cost of the electricity subsidies is
very high and is also very dependent on fuel costs – in 2008 the budgetary provisions for the electricity
subsidy were raised from Rp 29.8 trillion to Rp 60.3 trillion in response to increasing oil prices.
Consequently, PLN is not able to cover its own costs or make the necessary investments in Indonesia’s
future energy system, and is only able to purchase energy at prices below its own “cost” of generation. Since
its cost structures are heavily distorted, it is difficult for developers of geothermal power to sell their energy at
a price that justifies geothermal development.
Methodology for assessing geothermal policy
Indonesia’s geothermal resource can be understood as a potential economic resource that should be
exploited for the benefit of the people, as expressed in Article 33 of the Indonesian Constitution:
The land, the waters and the natural resources within shall be under the
powers of the State and shall be used to the greatest benefit of the people.
The value of a geothermal resource can be understood as the value of the services that can be extracted
from that resource, minus the cost of extraction. This resource value belongs to the people of Indonesia, and
the Indonesian government should institute policies to ensure that they benefit from this value. The net

benefit that can be obtained from exploiting a natural resource is often referred to as the “rent” obtainable
from that resource.
One use of geothermal resources is to generate electricity. In this case, the value of the electrical energy can
be gauged using the true cost of energy calculation from this Green Paper. On top of this, there are
additional benefits to the Indonesian people of using geothermal power to partially displace other forms of
baseload electricity generation. These benefits are discussed below, and should be included when
calculating the value of the services obtainable from Indonesia’s geothermal endowment.
On the cost side, there are intrinsic “technical” costs of exploiting geothermal resources for electricity
generation. These costs depend on the quality of the geothermal resources and on the technology used. The
regulatory environment may impose significant additional costs. As will be seen below, there are currently
significant barriers to the successful development of Indonesia’s geothermal resources. These barriers
increase the cost of extraction. This means that the true value of Indonesia’s geothermal resources is not
made available to her people.
In practice, exploiting geothermal resources requires substantial capital investment and technical know-how.
It is therefore likely that the organizations best placed to develop and operate geothermal installations will be
the IPPs. This is consistent with the indication in the government’s second “crash program” launched in
December 2008 that over 70% of the companies exploiting geothermal fields should be from the private
sector.
A large part of the cost of extracting geothermal energy is the cost of capital invested in the project and also
the “cost of risk” that the project carries. Investors will need to recoup this cost as part of their operations.
The cost of capital can be understood as the “normal” return on investment that any investor expects to
receive as a reward for dedicating their wealth to a particular project. The “cost of risk” can be understood as
an additional premium that the risk-bearer can reasonably demand as a reward for uncertain future returns.
The policies of the Indonesian government should provide incentives for IPPs to invest in the geothermal
sector in Indonesia. The policies should allow IPPs to receive reasonable rewards for their efforts, including
components for the cost of capital and the cost of risk. Net benefits obtained from the geothermal
endowment beyond these costs belong to the people of Indonesia, and policy should, as far as possible,
reap those benefits on their behalf.
There are distortions present in the Indonesian economy that put geothermal energy at a disadvantage
compared with competing energy technologies. For example, there are direct and indirect subsidies available
for competing technologies that are not available for geothermal power production. As discussed in the
Green Paper, these distortions in the economy mean that Indonesia pays more than necessary for its
energy.
In the longer term, the goal of government energy policy should be to remove such distortions. In the shorter
term, while such distortions are still in place, it may be appropriate for the government to offer additional
assistance to the geothermal sector to counteract the effect of the original distortions. It is important, though,
that any such “counteracting” assistance to geothermal generation be retired over time as longer-term
reforms are put in place across the energy sector. In practice, this means that the size of such subsidies
should be tied to the size of the distortions that they are counteracting.
Geothermal policy can thus be evaluated on several criteria.
Geothermal policy evaluation criteria

 Policy should encourage the exploitation of all geothermal resources that are economically desirable
within Indonesia. This requires setting the geothermal tariff at a level consistent with the technologies
that are being displaced by geothermal – the true cost of electricity to the government of Indonesia,
 The net benefits obtained from the geothermal endowment Indonesia is blessed with belong to the
people of Indonesia, and policy should be designed to reap those benefits on their behalf. Profit-sharing
arrangements such as those implemented in the Indonesian oil and gas sectors are best suited to
achieve this.
 The least costly techniques of extraction should be encouraged. The main tool for assuring this is to
encourage competitive bidding for extraction by IPPs.
 The policy should be designed to minimize the “cost of risk” component of the overall cost of extraction.
Below, examples are given of policies that make the “cost of risk” higher than necessary, and policy
alternatives that can reduce the cost of risk.
Appendix 1 Page 133

Benefits of geothermal power generation
Geothermal electricity generation has the potential to partially displace other competing generation
technologies. Its use can reduce the dependence on coal generation and also on much more expensive
generating technologies such as diesel generation.
Where geothermal displaces coal generation, the cost of the displaced energy is roughly 13 cents per kWh.
The breakdown of this is shown in Table A1.2. More detail on the true cost of electricity is provided in
Chapter 4.
The fuel price risk cost, the carbon cost, and the air pollution/carbon price risk cost are “off-book”
components of the true price of carbon, and merit some discussion.
Table A1.2 Components of the true cost of coal energy (cents per kWh)
Cost component Levelized cost
Capital cost 5.4

Operating cost 0.7
Fuel cost 2.9
Fuel price risk cost 1
Carbon cost 2
Air pollution cost, carbon price risk and 1
other externalities and co-benefits
Total cost 13
Source: McLennan Magasanik Associatesmodelling for the Green Paper.

Fossil fuel prices are subject to considerable volatility. This translates into a risk of rising generation costs. In
Indonesia’s case, price pass-through provisions mean that the cost of this risk is borne by the Indonesian
government and hence by the people.
The fact that Indonesia produces coal domestically and is a net coal exporter does not mean that there is no
“cost” associated with international price rises. Indeed, coal consumed locally in coal power plants is not
available for export, so the cost of rising coal prices is the value of the lost export opportunity.
Recent years have shown that international coal prices can fluctuate widely. Since the fuel cost of coal
generation amounts to around half of the total costs at current fuel prices, changes in fuel cost have a big
impact on overall costs. Expert analysis by McLennan Magasanik Associates suggests that an appropriate
fuel price risk premium for coal generation is 1 cent per kWh.
Carbon cost
The Clean Development Mechanism (CDM) already provides a price for avoided carbon emissions, and
similar mechanisms are very likely to emerge from international climate change negotiations. At a price of
US$20 per tonne, this translates to 2 cents per kWh.
Air pollution cost, carbon price risk cost, and other externalities and co-benefits
Coal combustion produces local air pollution that is injurious to the health of local inhabitants. World Bank
studies for China, adapted to the Indonesian case, suggest a cost of between 0.5 and 1 cent per kWh for air
pollution cost.
The strength and resolve of the international response to climate change is uncertain, and the costs
associated with a future need to account and be liable for carbon emissions are therefore also uncertain. If
the government of Indonesia required investors to face this carbon price risk themselves, say through
contractual arrangements that explicitly passed the cost of any domestic carbon price on to installations,
investors would build a (higher) carbon price risk premium into their investment decisions. However, as
matters stand, the Indonesian government is carrying some of this risk premium itself, essentially providing a
free (partial) carbon price hedge.
Coal power requires transport infrastructure (ports, roads, railways, and so on) to move coal from mine
mouth to power station. In many cases, public infrastructure is used. This amounts to an implicit subsidy for
coal generation.

In reality, the current generation capacity is inadequate and it will be very difficult for coal generation to
expand quickly enough to achieve the Indonesian government’s electrification targets (93% by 2020; see IEA
2008: 179). In the absence of geothermal, it is likely that much more expensive generation technologies such
as diesel will be used to try to fill the gap between supply and demand. In these situations, geothermal
generation has the potential to displace much more expensive technologies, and at least in the short term, a
substantial margin can be added to the cost of energy in such situations.
Also, in isolated regions where demand is low and connection to a main grid is not feasible, coal power is not
likely to be viable and geothermal power would be displacing a more expensive technology such as oil or
other renewables.
The costs associated with these externalities are difficult to quantify and further study would be required to
obtain a precise estimate. For the purposes of this paper, a combined cost of 1 cent per kWh is taken to
represent the aggregate impact of all of these effects.
There are also societal benefits from the use of geothermal energy that do not appear in the simple
calculation of the true cost of electricity presented above. These include supply diversification benefits,
enhanced reliability and availability of supply, employment benefits, and the potential for co-generation.
These are briefly discussed in the following subsections.
Supply diversification
Fossil fuel generation is dependent on the use of fossil fuels, which are internationally traded commodities
and therefore subject to price and supply volatility. The true cost of electricity calculation includes a premium
that compensates for this risk (1 cent per kWh), but this is the premium that a single IPP operator would
require to insure a single plant against the risk of adverse price or supply movements. It does not take into
account the possibility of correlated adverse cost movements across a large slice of the power sector.
Insurance against the possibility of correlated cost movements across the sector requires larger societal risk
premiums, particularly in the Indonesian case where generators are shielded from coal price volatility by
price pass-through, so that in practice the Indonesian government bears the entire aggregated and
correlated risk.
A recent example of this phenomenon occurred in 2008, when the rising price of oil resulted in dramatic
increases in the cost of the electricity subsidy provided by the Indonesian government, because of the heavy
reliance on oil and diesel in power generation. Between 2005 and 2008 the subsidy grew from Rp 5 trillion
per year to Rp 60 trillion per year.
A very good way to reduce the cost of this risk is to diversify the supply of power into technologies with
uncorrelated risks. Geothermal power is an excellent tool here, since its risks are relatively independent of
the risks in coal markets, and once a geothermal plant is established and operating, the risks associated with
its operation are very small and uncorrelated with coal or other fossil fuel markets.
These considerations mean that an additional premium may be added to the true cost of electricity when it is
supplied from a diversified source, with risks uncorrelated to the main risks borne by the coal-fired subsector.
Reliability and availability of supply

Different power generation technologies exhibit different “capacity factors” – that is, the average fraction of
the rated capacity of the plant delivered over a year of operation. Downtime for maintenance and repairs
mean that the capacity factor will always be somewhat less than 1.
Geothermal power plants have a capacity factor of around 86–95%, compared with around 71% for coal-
fired plants (Kagel 2006: 6). Also, individual geothermal plants tend to be a lot smaller than coal-fired plants.
This means that less excess capacity is required in the system to cope with outages from a single plant.
Excess capacity is particularly undesirable in the baseload subsector, since high capital costs mean that is it
very expensive to allow baseload power stations to stand idle. The alternative, in which excess demand
created by the temporary outage of a baseload station is met by non-baseload plants, is also expensive.
Therefore, even when a geothermal plant is considered to displace a coal-fired plant, the higher capacity
factor and the smaller per-plant size of geothermal installations means that, in actual operations, geothermal
power will sometimes either displace more expensive non-baseload power, or displace a power shortage
(which is even more expensive for the end users).
This gives rise to another additional premium that should be added to the true cost of electricity where
geothermal displaces coal generation.
Appendix 1 Page 135

Regional benefits – employment
The costs of geothermal development are mainly in the up-front site preparation, drilling, and plant
construction. These are labor-intensive operations that will require substantial involvement from the regional
labor force. Building and operating a coal-fired plant requires relatively less regional labor and depends more
heavily on imported equipment. Consequently, geothermal development produces a greater regional and
domestic economic “ripple effect.”
JICA has used modeling to quantify and compare the magnitudes of the economic ripple effect for
geothermal and coal construction. The study concludes that the construction of a geothermal power plant
has a much larger positive impact on domestic employment and consumption than the construction of a coal-
fired power plant of equivalent capacity.
This means that more of the flow-on benefits associated with the “costs” of geothermal power remain in
Indonesia than is the case with coal power. The flow-on benefits largely accrue in the region where the
geothermal plant is constructed, stimulating the local economy.
Local benefits - possibility of co-generation

Beyond extracting heat to convert to electricity, it is possible that additional value can be extracted from
geothermal resources, for instance by employing the rejected heat from steam power plants to assist with
the drying of agricultural crops. This technique is referred to as co-generation. It would confer benefits to the
local community around the geothermal field that are not included in the “full cost of energy” calculation.
True value of geothermal energy

The discussion above, and the fact that geothermal also displaces other technologies at the margin,
suggests that the Indonesian government should consider the “true value of geothermal energy” to be
somewhat higher than the generic “true cost of electricity” of 13 cents per kWh used in the present study.
The premium for geothermal energy that the Indonesian government perceives would depend on budgetary
considerations as well as its evaluation of the issues discussed above.
Current barriers to the development of Indonesia’s geothermal resources
Why has so little of Indonesia’s geothermal potential been tapped so far? There are several contributing
causes. The main problem relates to the nature of geothermal development, and the tendering process for
eliciting bids from developers.
The problems with the existing system can be summarized as follows.
 The state-owned company PLN is the sole buyer of electricity from the IPPs. PLN produces a
“benchmark price,” set at 80–85% of PLN’s local cost of generation, to guide the purchase price of
geothermal electricity it is willing to consider and possibly act as a maximum price it will accept. The
benchmark price that PLN issues does not reflect the full cost of electricity generation, nor does it
capture the additional benefits of geothermal electricity over conventional technologies. Consequently
the price offered by PLN may be significantly lower than the true economic price that should be paid for
geothermal electricity.
 The calculation of the benchmark price is not transparent and will vary from year to year. This lack of
transparency and clarity makes forward planning by IPPs unnecessarily difficult.
 The current tender process adds unnecessary commercial risk to geothermal development projects. The
lack of adequate data on geothermal fields and the lack of a power purchase agreement before
investment mean that there is substantial uncertainty about the viability of the field and the ability of the
IPP to sell the generated energy. IPPs must deal with this by adding a risk premium to their sale price.
This additional risk premium can be significant and can render otherwise viable projects uneconomic.
Even when projects remain viable, the additional cost of risk amounts to lost rent that is not gathered on
behalf of the Indonesian people.
Geothermal resources are very variable in character. The capacity and cost of development of a particular
geothermal resource cannot be foreseen until after a certain amount of exploration and even production
experience with the field.
The geothermal development process

The process of developing a geothermal resource to produce electricity involves the following phases.
 Identification: The identification of potential geothermal resources.

 Exploration: Study of the site using geophysics techniques.
 Confirmation: Preliminary drilling to confirm the existence of the geothermal resource and to assess its
capacity and characteristics.
 Drilling: – Production and injection wells that will be used to obtain geothermal power and dispose of the
extracted fluids.
 Construction: Building the steam power plant.
 Commissioning: Production of power, incurring ongoing operational and maintenance costs.
The costs of exploration and initial confirmation drilling are a relatively small fraction of the overall project
cost. An indication of the development process and of the accumulation of project costs is shown in Figure
A1.2. It can be seen that the bulk of the project costs are expended before production drilling is finished, and
that substantial costs are incurred even before the resource is confirmed and its capacity assessed.
Geothermal resources are extremely variable in their characteristics, and the costs involved in drilling cannot
be predicted with much certainty without prior experience of the site. Many factors influence the costs of
drilling and exploiting the steam resource, such as the depth of the geothermal resource, the type of
geological structures that overlay the resource, the geological characteristics of the resource itself, and the
chemical constitution of the geothermal fluid. Also, the existence and capacity of the geothermal resource
cannot be known with certainty until after the exploration phase at least, and potentially into the
development/production drilling phase.
This combination of high upfront costs and variable geothermal characteristics means that there is a certain
amount of technical risk involved in a geothermal project. The exact costs of exploitation of the resource
cannot be predicted with much certainty until the project is under way, and there is the possibility that the
geothermal resource will substantially underperform or not exist at all.
On the other hand, once a geothermal field has been developed and the steam plant commissioned,
geothermal energy supply is usually very reliable, constant, and available with very little downtime for
maintenance.
Figure A1.1 Geothermal project development, activities, and costs (cost on a logarithmic scale)
Source: SKM (2006).
This means that most of the commercial and technical risks for a geothermal development project are
concentrated in the development phase. This contrasts with coal generation, in which there is little technical
or commercial risk associated with development, and most of the risk relates to the risk of fuel price
fluctuations during the operation phase.
Appendix 1 Page 137

The technical risks of geothermal development can be expressed by looking at the probabilities of a
geothermal project proving viable after each stage in the development process. Since projects that prove
unviable at each stage will be abandoned, the probability of eventual success rises as the project progresses
through each stage. According to a report commissioned by the US Department of Energy in 2008 (Deloitte
2008), the probabilities of eventual success after each development stage are as follows (Table A1.3).
Table A1.3 Probability of commercial success after various development stages
Development stage Probability of eventual success (%)
Reconnaissance 10
Geophysics 20
Exploration drilling 40
Delineation drilling, feasibility study 80
Initial production drilling 95
Source: Deloitte (2008).
Developers manage risks by adding a risk premium to the returns required by the project before they accept
it as a viable investment. The size of the risk premium demanded by developers will depend on how averse
they are to a worse than expected outcome. A large company that executes many small projects may expect
that, across its entire portfolio of projects, the outcomes of risky investments average out to yield “expected”
returns. At the other extreme, a small company undertaking a large project will be very wary of the possibility
of a worse than expected outcome, since a loss from a large project may be enough to bankrupt the
company. Generally speaking, the larger the project is, the higher the proportional “risk premium” that will be
demanded by developers.
The current tender process involves putting Geothermal Working Areas out for bid. Developers bid on the
basis of the sale price of electricity from the Working Area. The winning bidder must develop the Working
Area within four years (with a possibility of a one-year extension). The big problem is that the developer has
to base its bid on the information and geological data made available by the Centre for Geological
Resources within the Directorate-General of Geology and Mineral Resources. However, this data includes
only surface survey data and does not include either magnetotelluric survey results or exploration well data.
Consequently the developer has very little information on which to base its bid, and will be forced to add a
significant risk premium to the entire project.
Costs of geothermal energy, and the offered purchase price

While the actual costs of geothermal energy will vary from site to site and must be considered on a case-by-
case basis, it is possible to get an impression of the situation and of the artificial barriers to investment that
exist today in Indonesia by looking at some indicative calculations.
Estimates by JICA (2008: 6–15) indicate that a typical geothermal plant in Indonesia can produce electricity
at a cost of 11.9 cents per KWh and that the price currently paid for geothermal electricity in Indonesia
and the Philippines is closer to 6 cents per KWh. In any case, the cost is lower than the 13 cents per kWh
figure for the true cost of electricity calculated in the Green Paper, even before the various additional benefits
that accrue to geothermal energy are taken into consideration. In contrast, the benchmark prices offered
by PLN may be preventing many economically worthwhile fields from being exploited. For instance, in the
Java–Madura–Bali system the benchmark price offered by PLN is around 6 cents per kWh (JICA 2008:
Tables 3.5-2).
Many of the benefits that make up the true cost of electricity are not received by PLN, so it is not surprising
that it is not able to pay the full economic value of geothermal electricity. In fact, since PLN cannot sell
electricity at a price that covers its own operations and is dependent on the Indonesian government to make
up the shortfall in its operating budget, it is not even exposed directly to the components of the “full cost of
energy” that could accrue to PLN, such as the benefits of system stability and diversification.
Because the only buyer of electricity, PLN, does not receive the full value of the electricity that it purchases,
and the economic costs of lost opportunity that arise from this are borne by the Indonesian government and
the people of Indonesia, it is sensible for the government to intervene with appropriate fiscal, financial, and
regulatory measures. These will be discussed in the sections below.

Geothermal policy options and comparison
In the long term, the ideal solution for the geothermal industry would be for the government to reform
Indonesian energy markets so that the price of electricity reflected its true cost, including externalities. In the
shorter term, to level the playing field an appropriate transition measure is for the Indonesian government to
underwrite an increased tariff for geothermal electricity.
Optimally, the geothermal tariff should be set at the true cost of electricity as supplied by competing
technologies in the region – that is, the full cost (including externalities) that PLN and the government is
currently paying for electricity. This is optimal because any geothermal project that can supply electricity
profitably at this price is economically worthwhile – that is, would produce a net economic benefit.
This, then, gives us a baseline approach for pricing geothermal electricity and so determining which
geothermal developments should go ahead. Since Indonesia has the world’s richest endowment of
geothermal resources, such development will release substantial benefits. It is likely that in many locations
the true cost of electricity as defined above will exceed the geothermal generation cost. Measures need to be
in place to ensure that excess profits from geothermal projects accrue to the Indonesian people rather than
to the IPPs.
Investment in geothermal electricity generation is technically risky, because the characteristics of a
geothermal field vary widely and cannot be predicted with certainty before development is under way. This
technical uncertainty translates into great uncertainty about the economic costs of development, which
investors will then factor into their valuations of projects as a risk margin at the point of bidding in a tender
process. From an economic point of view, the technical uncertainty ultimately translates into a higher price
for geothermal energy and hence a reduced value for Indonesia’s natural geothermal resources. This issue
of risk can be mitigated by improving the quality and depth of the geothermal exploration information that is
available to developers before the tender process. The following strategy is therefore being put in place.
Geothermal policy strategy

 Implement a two-phase approach to geothermal development, separating the field survey, exploration,
and confirmation drilling phase from the commercial development phase.
 Enhance Badan Geologi’s role and capacity to coordinate tenders for field exploration and initial
confirmation, and to manage the publication of exploration results.
 Institute a power purchase agreement, backed by the Indonesian government, providing a tariff for
geothermal energy that reflects the true cost of electricity. This will serve to counteract the economic
distortions that arise from existing direct and indirect subsidies for other power generation technologies.
 Design a tender structure and profit-sharing regime to obtain the best outcome for the Indonesian
people.
The tender for the development of each geothermal field should be structured as follows:
 Provide high-quality scientific data prior to the tender for the exploitation of geothermal working areas.
To this end, the quality of surface survey and other geophysical data should be enhanced and a
separate tender should be undertaken for confirmation drilling.
 The data package (including the results of confirmation drilling) and the pre-determined geothermal tariff
should be published as part of the tender documentation. A power purchase agreement that reflects the
geothermal tariff should be made available to IPPs through PLN. PLN should be funded to reflect the
geothermal tariff it is expected to underwrite (noting that the true-cost-of-electricity elements of the tariff
quantified in this study accrue to the government of Indonesia more broadly, not to PLN).
 Bids for development rights to a field should be invited from the public. Bids would be made for an up-
front, fixed license fee to be paid by the successful bidder. The bidder making the highest bid would be
selected.
 Profits after cost recovery from the geothermal project would be shared with the government using a
profit-sharing arrangement, in analogy with the existing production-sharing arrangements used for oil.
Production sharing allows a fair share of the benefits of geothermal electricity to be captured by the
government of Indonesia.
Appendix 1 Page 139

Comparison with other structures
Other policy combinations could be proposed to encourage geothermal development. It is worth comparing
the features of different combinations to see their relative merits.
For the sake of comparison, the following combinations are considered:
 Green Paper model (GP model). As described above, this involves a fixed geothermal tariff set on the
basis of the true cost of electricity; bidding through an up-front license fee; and a higher rate of taxation
(production sharing). High-quality field data from publicly funded exploration is provided at the time of
tender.
 Bid FIT. In this model, developers bid on the basis of the FIT and the bidder with the lowest FIT bid is
awarded the license. Field survey data is made available at the time of tender but no additional public
exploration is done.
 Fixed FIT + tax concessions. In this model, an FIT is offered based on the current price PLN pays for
coal-fired electricity, plus some additional margin to help bridge the gap between that low price and the
cost of geothermal energy. Additionally, tax concessions are provided to make geothermal development
relatively more attractive. Field survey data is made available at the time of tender but no additional
public exploration is done. This is essentially the scheme recommended in the JICA (2008) study.
In addition to these models, many other models to incentivize geothermal development exist. One worth
mentioning here, even if it is not part of the comparisons below, is the internal rate of return (IRR) guarantee.
In this model, the government pays developers an FIT or supplemental subsidy to ensure that a specific IRR
(say 16% or 17%) is achieved for the project. This is essentially a cost-plus model. Some have suggested
that an IRR guarantee model can be combined with a bid FIT, but any initially agreed FIT is rendered
meaningless by the IRR guarantee since this guarantee ensures a specific IRR on the basis of cost,
regardless of the FIT. (In the case where the FIT is adjusted to ensure the guaranteed IRR, this is obvious.
In the case where other forms of payment are used it is less obvious, but still in practice equivalent to
adjusting the FIT post hoc.) A key problem with cost-plus models generally, including the IRR guarantee
model, is that there is no incentive for firms to operate efficiently. The only advantage of the IRR guarantee is
that it removes project risk for the project proponent, but this comes at enormous cost. The government of
Indonesia shoulders that same risk instead; that is, it is no longer on the project proponents’ books but is still
being paid for as a liability of the government of Indonesia. What is worse is that the IRR guarantee also
shields project proponents from the consequences of their own decisions, introducing additional costs and
removing incentives for firms to operate efficiently.
Geothermal development stages

The stages in geothermal development and the relationship with the Indonesian government and the IPPs
are illustrated in Table A1.4.
Table A1.4 Stages in geothermal development
Fixed FIT + tax

Surface surveys Government of Government of Government of

Indonesia Indonesia Indonesia
Exploration drilling Government of IPP IPP
Indonesia
Resource assessment & feasibility IPP IPP IPP
study
Development & production drilling IPP IPP IPP
Production IPP IPP IPP
The question of who should conduct each stage of the geothermal development requires discussion. At one
extreme, the government of Indonesia could conduct the entire project itself, from initial survey to production.
However, it is difficult for state-run businesses to operate efficiently, and the government may not have
access to suitable capital for the development. Therefore, there is a preference to persuade the private
sector to conduct as much of the development as possible. On the other hand, there are substantial
problems with getting IPPs to take over all stages of development. The main problem is that, at the

beginning, the value of the geothermal resource is unknown, so it is difficult for the government and IPPs to
negotiate a reasonable licensing arrangement.
The GP Preferred policy involves publicly funded exploration drilling in addition to the surface surveys
(geological, geochemical, and geophysical surveys). Estimating the properties of a geothermal resource, and
hence its economic potential, involves understanding and modeling a number of physical characteristics of
the field. The accuracy of the model depends on the amount and quality of the physical data gathered, and
will improve over time, even during the operation of a production geothermal plant. However, a substantial
amount of important information is obtained at the first successful confirmation well (the first well that
produces commercial-grade steam). Having this data available at the time of the bid will substantially
improve the accuracy of the bidders’ reservoir models and hence will substantially reduce the risk premium
that bidders need to apply to their economic models.
Tariff and tax structures

A comparison of the features of the model tariff and structures is described in Table A1.5.
Fiscal impacts
The cost of preliminary exploration, borne by the government of Indonesia, is estimated at approximately
US$2.8–3 million per field. Since some fields may not become viable, the cost per successful field is likely to
be around US$4–5 million. This is a small fraction (less than 1%) of overall project costs, which for a
200 MW development would be around US$600 million.
These costs should be funded initially by budget measures. There is scope to attract international financing
to assist in the development of geothermal resources. The funds obtained through the license fees for
tendered fields can then create a revolving fund for future exploration.
The fiscal cost of an FIT for the Ministry of Finance is offset by several factors:
 Up-front fees from successful bidders: These provide a positive cash flow.
 Reduced coal price risk and supply diversification: The Ministry of Finance has reduced exposure to fuel
(coal and oil) price fluctuations through the price pass-through mechanism.
 Reduced infrastructure requirements for coal: Insofar as the infrastructure is built using public money,
the avoided costs accrue to the line ministries and hence to the Ministry of Finance.
 Reduced costs due to airborne pollution: This translates to lower healthcare costs, which are partly
publicly funded and hence reduce budgetary pressure for public health.
 Improved reliability and availability of supply: By operating a more efficient system, PLN’s costs are
reduced, hence reducing its dependence on the subsidy from the Ministry of Finance.
 Regional benefits from construction: Improving the local economy increases incomes and reduces
pressure on the Ministry of Finance to continue to provide subsidies for low-income earners. This
impacts the subsidy on electricity or other fuels as well as other subsidies for low-income earners.
Appendix 1 Page 141

Table A1.5 Tariff and tax structures of the three schemes
GP model Bid FIT Fixed FIT + tax concessions
Form of electricity Fixed, based on the true Based on cost to PLN of

sale price cost of electricity. Set through bidding. coal plus a margin.
Competitive up-front fee

captures the ex-ante Managed through the bid
expected profits. Production level of the FIT. No
sharing of profits after costs mechanism apart from Not managed. Tax
reduces supernormal profits normal income tax to concessions mean
in case the field turns out to accommodate supernormal supernormal profits are
Management of be more productive than profits in case of higher than potentially taxed even less
excess profits anticipated. expected productivity. than for other industries.
Large. The FIT is fixed and

Minimal. Fields with Managed through the bid not able to reflect local cost
expected positive returns FIT. However, due to structures. Fields with costs
given the true cost of significant uncertainty at this above the fixed FIT remain
Distortions on electricity and profit-sharing stage, risk premiums may unexploited even if they are
investment before arrangements should attract be very high, implying below the true cost of
tender bids, allowing development. unacceptably high FIT bids. electricity.
Minimal. As field Large. Activities only

characteristics are proceed where the cost is Large. As with the Bid FIT
discovered, the full less than the FIT set at scheme, activities do not
economic price of tender. This may result in proceed where the cost
conventional generation is underinvestment by the exceeds the FIT. Setting the
available, with taxation developer. Field is never FIT uniformly across
Distortions on applied only to profits after exploited to full economic regions or plants will
activities after tender costs. potential. exaggerate this effect.
Higher. Technical risk not

mitigated. If managed
through post-tender
negotiations, asymmetric
information becomes an
Lower. Technical risk issue. Also, provides Lower. Higher technical risk
mitigated by pre-tender incentives for firms to bid a is counterbalanced,
exploration and low FIT and then because excess profits are
Risk for investors confirmation drilling. renegotiate. retained by the IPPs.

APPENDIX 2 REMARKS BY PROFESSOR ROSS GARNAUT
Ross Garnaut’s speech at lunch meeting with Minister Sri Mulyani, 16 July 2009
Ross Garnaut is Professor and Vice Chancellor’s Fellow, University of Melbourne, and
Distinguished Professor, The Australian National University. He conducted the Garnaut
Climate Change Review, an independent policy review commissioned by Australia’s
Prime Minister and delivered to Australian governments in 2008. Professor Garnaut is
chairman and board member of several international organizations and multinational
companies, is a former ambassador to China, and was economics advisor to Prime
Minister Hawke. He has a longstanding association with Indonesia.
INDONESIA’S ROLE IN GLOBAL CLIMATE POLICY
Climate change is a difficult policy issue. It is complicated and has many aspects.
One reason why it is difficult from a policy perspective is that we need to take action now, when the benefit
from action comes much later. We are not used to accepting costs now for benefits a long time in the future.
Hopefully we can learn. In other areas where we should have taken early action and did not, we have ended
with a mess. That’s why we have the global financial crisis now. A proposal was put to Bill Clinton in 1997 for
controlling derivatives. It was argued that these financial instruments were growing very rapidly so that if
controls were not applied, there would be large risks in the financial system. Others including the Treasury
Secretary and Chairman of the US Federal Reserve advocated that it was better not to impose regulation but
leave it to the markets to resolve any difficulties. They argued that regulation would disturb Wall Street and
other key players in the financial system.
We now know that not doing anything created a major disturbance. Climate change is like that; and even
worse because the consequences of not doing anything are much bigger than the impact of the global
financial crisis.
Climate change mitigation is an even harder issue because all the significant countries in the world, at least
all of the G20, must play a part in an effective policy response. From a narrow national point of view, each
country has an interest in letting others do more and in doing less itself. In such a situation we can expect an
outcome that everyone thinks is bad.
While we’re dealing with a hard issue, the good thing is that we are making progress. Indonesia’s leadership
in Bali, where the President’s role and senior GOI Ministers’ roles were recognized and appreciated in the
world, gave us a base from which there is a chance of success at Copenhagen. Indonesia showed it was
thinking through concrete ways in which it can put in place policies that will prepare Indonesia for playing a
part in the international system.
We need to think about two dimensions of Indonesian action on climate change mitigation. One is the part
Indonesia will play in shaping the global system. The second is what Indonesia will do at home as its
commitment to play a part in the global mitigation effort.
INDONESIA’S ROLE IN THE GLOBAL SYSTEM
On the first dimension, I have just completed a book called The Great Crash of 2008. One of the conclusions
I reached is that the financial crisis will slow down growth in a number of big developed countries for quite a
long time: the United States, Britain and some countries in Continental Europe. But it’s not slowing down in
the same way in developing countries; especially the big developing countries, China and Indonesia and
India. We are going to get a shift in economic weight, between the old developed and the big developing
countries. We were getting the shift anyway, but the global financial crisis accelerated that shift.
The future international system after years of this change is going to be one in which nothing works without
the cooperation of the big developing countries, so China, India and Indonesia will play a major part in
Appendix 2 Page 143

shaping the system and providing leadership in its outcome. After the Great Crash, we are moving more
quickly into that world. It’s going to be a big challenge for the international system to adjust to this world.
President Obama has come to office with a strong commitment to addressing climate change. He is a
wonderful leader. He grew up in Indonesia, which was a big benefit to him in his international leadership role.
Despite his commitment and despite his quality as an international leader, America is going to have to share
the leadership with others. We need the big developing countries to be active in shaping the climate change
regime.
The outcomes in Rio de Janeiro and Kyoto were mainly influenced by developed countries, especially by
Europe. That is partly because the rest of the world wasn’t paying much attention. We need now to have
deep involvement by a wide range of countries so it works for everyone.
And that’s going to be important on several levels.
We need to agree on global objectives for mitigation. I think that should be relatively easy.
I recommended to the Australian government in my Climate Change Review that it’s in Australia’s national
interest for the world to aim at 450 thousand parts per million of carbon dioxide equivalent or less.
Europe for a long time has had that sort of objective and now Obama is headed in that direction. Australia is
trying to secure a strong outcome from the global discussions, and after one or two false starts is
establishing a strong commitment to a strong outcome. I think that when Indonesia has a detailed look at the
cost of mitigation, it will also move in the same direction. All of this will help to get a global understanding on
the objective of mitigation.
Then, once we have agreed on the objective, we face a very big issue: there’s only a certain amount of
emissions that the people of the world can put up in the air from now on if we are to meet our climate change
mitigation objective. We need some principles for allocating that limited amount of emissions entitlement
across countries. This is a really important issue in which we all have to be involved. The issue has big
distributional implications. I suggested in my review that the central principle for allocating entitlements for
emissions should be convergence toward equal per capita entitlement in 2050. This principle would involve a
big adjustment for the high-emissions developed countries – Canada, Australia and United States – but I
cannot see any other principle that could work.
The implication is that Australia would have to reduce its total emissions by 25% from the 2000 level by
2020, and by 90% by 2050 That’s a big adjustment. My recommendations led the Australian discussion into
areas in which it had never been before … it was quite a big surprise, a shock to begin with, but gradually
people are getting used to the discussion.
There is a real question about what is a reasonable time/period for achieving equal entitlement per capita.
Different countries have different interests, and people in different countries have different views. If you make
the period too short, then the adjustment on the developed countries would just be unmanageable. If you
make it too long, it’s not fair for developing countries.
There is also a real issue related to historical legacy. Developed countries put the emissions up in previous
decades and gave us the problems that we are facing now. I have discussed this matter of historical legacy
and responsibility with policy analysts in India, China and here, and it is widely accepted that this matter is
best handled by agreements outside the allocation of emissions entitlements. It is best handled by other
agreements, for example related to technology development and transfer, and support for adaptation to the
inevitable climate change that is going to happen whatever we do.
So the developing countries need to be involved in a practical, concrete discussion of the detail of global
climate change mitigation policy. The world would benefit from Indonesia’s participation in developing a
global agreement that everyone thinks is fair, and with commitments by the developed countries on
technology transfer and adaptation assistance. We will have to see it all as a package. I would hope that in
the end we could come up with a package that all the substantial countries think is reasonable. There’s no
doubt that we all have a very strong interest in a right outcome and that we all be damaged greatly if we
don’t come together. We have to be clever in designing a package that is seen by a wide range of countries
as being fair.
Let’s not work on this design in Brussels, Washington and Beijing alone. We need a wider base of
involvement in the discussion. In the international regime, I don’t think we have quite enough time by
Copenhagen to come up with a comprehensive agreement with all the details. So maybe what we will end up
having is agreement on principles out of Copenhagen, with more work to be done by officials later.
Whatever the regime is going to be, if it’s going to work there is responsibility over time on all countries,
developing and developed, to reduce their emissions to well below what they would otherwise be as a

contribution to climate change mitigation. The awful arithmetic is that even if all developed countries reduce
their emission to zero, and there is no change in business as usual in the developing countries, we still have
a terrible climate change problem.
To get the shift from business as usual, we all understand that commitments of developing countries need to
be fair and practical but they also need to be very clear commitments, which when added to the developed
countries’ commitments, add up to a solution to the climate change problem.
We may not end up there in the series of meeting follow up from Copenhagen. We may end up with a
transitional regime after Copenhagen with a view to having a more comprehensive arrangement not too far
in the future. But if high risks of dangerous climate change are to be avoided, sooner or later we are all going
to be working with carbon entitlements, and entitlements which a wide range of developing countries
consider to be fair.
ACTION NEEDED AT HOME, AND OPPORTUNITIES FOR INDONESIA
If that’s the world we are going to head towards, we really need to be preparing the structure of our
economies now. If we head off in another direction now it will be tremendously and needlessly costly to turn
around, with a need to radically change the structure of the economy later on. So, it is important that we are
putting in place now the policy framework that starts to turn the ship around towards a low carbon emission
economy.
Catching up with the discussion here today, I am very pleased to see the focus on a range of critical issues;
Indonesian land-use and forestry related activity is very important, and getting the policy regime right from
now is very important. How incentives will apply to demonstrate large reduction in emissions is a key issue
nationally and internationally; today, partial incentives for certain emissions-reducing activities but not others.
But Indonesia won’t be able to take advantage of international incentive arrangements unless you establish a
mechanism for transferring benefits internationally to the domestic contributors to reduced emissions from
different patterns of land use. They are the people that are most affected by mitigation; they need incentives
to manage the land in a different way.
We don’t have any mechanism ready on the shelves. We have to think through how the systems should
work, and if Indonesia can get that right, it’s going to be a running model for the world to notice and learn
from. The world is looking for a model, so it will be great if Indonesia can contribute a working model, and
others in the international community interested in funding improvements can connect to and lock into this
system.
Other big emission sectors other than land use and forestry are energy and transport sectors. In Australia we
developed our energy system on the basis of whatever happened to the cheapest at the time without taking
into account the carbon externalities. We’ve got the most emissions intensive energy sector of all countries
because coal is cheap. And the cheapest coal is near the city of Melbourne in Victoria. Right near the
surface you get very cheap coal – very cheap but actually quite expensive if you count the cost to the
environment.
And we are not going to get on top of the problem in Australia until we price the carbon externality. Australia
is going to put a price on carbon through the emissions trading scheme. And no other country will get on top
of the issue without pricing this externality. This trading scheme is complex and has quite high transaction
cost; but on balance it was the best way to go.
Regarding a carbon tax, I can see how it would be easier and much better in the Indonesian environment.
The most important characteristic of either the emissions trading scheme or carbon taxing is its application
comprehensively and consistently to similar activities. If you don’t do that, you’ll end up with a dreadful
political economy situation. I’m afraid Australia has got itself into that situation.
The recovery from the recession following the global financial crisis is a good time for supporting innovation
with new technology. Geothermal power is well established in the Philippines, New Zealand, the United
States and Papua New Guinea. It is not yet as well advanced in Indonesia. Some research development and
commercialization of new technology generates knowledge that the people or company who made the
investment can’t fully capture and own. If the knowledge become available to others who wants to go to the
same business, and then it create a justification for public support for innovation in low emission technology.
There is such a case for initial public support for the introduction of geo-thermal power technologies into
Indonesia.
One source of the funding for that can be the revenue from carbon tax or the emission trading scheme. In
that way, the support from the technology need not become a burden on the budget.
Appendix 2 Page 145

To summarize: The world has a tremendous challenge in addressing climate change. The financial crisis
reminds us that delaying action that we know needs to be done can have terrible later economic
consequences. And there is an important role to be played by Indonesia on the global stage. At the same
time, policy changes are needed domestically to swing Indonesia’s economy towards a low-carbon future,
and many economic opportunities lie that way.

APPENDIX 3 ROSS GARNAUT: CLIMATE CHANGE AND INDONESIA
Address given at the national seminar, “Financial crisis,

green growth and climate change,” Jakarta, 16 July 2009
Professor Ross Garnaut

Professor and Vice Chancellor’s Fellow, University of Melbourne; and
Distinguished Professor, The Australian National University
My presentation this morning is about climate change and Indonesia.* But we cannot sensibly talk about
climate change only in one country. The impacts of climate change know no boundaries. Neither do
contributions to the mitigation of climate change. The only solutions are global, with participation from all
substantial economies. Failure to find and to apply effective global solutions will hurt some countries earlier
and more than others, but in the end it will hurt all countries. It happens that Australia and Indonesia will be
hurt more and earlier than most countries.
While there are large uncertainties about the detail, the overwhelming weight of relevant global scientific
opinion says that human-induced climate change is happening, and will intensify for as long as the
concentrations of greenhouse gases in the atmosphere continue to grow. The effects are not linear: the first
doubling of concentrations will have a larger proportionate effect than the second, but this does not save us
from immense incremental damage from a second doubling. There are lags in the effects of changes in
concentrations of greenhouse gases on climate, so that the full effects of the acceleration of the increase in
emissions in the early twenty-first century will not have its main effects for two or three decades. By the end
of this time, the mainstream science expects that, in the absence of effective global mitigation, global
temperatures will have moved above the range that has been present through the emergence of human
modern civilization over the last 10,000 years or so (Garnaut 2008: Chs 2 and 4).
Human-induced climate change is caused by rapid growth in the concentrations of carbon dioxide and other
greenhouse gases in the atmosphere, principally from the combustion of fossil fuels. There are also large
contributions from changes in patterns of land use, especially deforestation.
The concentrations have been growing particularly rapidly in the early twenty-first century because the
beneficent processes of modern economic growth have moved powerfully into the world’s most populous
countries – China, India, Indonesia – and other developing countries. Without strong measures to reduce
global emissions, the costs of climate change will continue to increase through the twenty first century and
beyond, with potentially catastrophic economic as well as environmental effects.
Modern economic growth is a wonderful phenomenon, and all of the people of the world want and are
entitled to enjoy its full benefits. Unfortunately, in the form it has taken until now, it has some unfortunate
environmental side effects. One of these, human-induced climate change, has the potential to change the
world so much that the living standards now enjoyed by the world’s high-income countries would not be part
of the lives of people in any country. It would be undesirable and impractical to expect people in the
developing countries to truncate their hopes for rising living standards. The mitigation task is to end the
connection between economic growth and greenhouse gas emissions.
The 2008 global financial crisis is a timely reminder of how closely we are joined across the world today, as
societies and economies. The problems of some of us quickly become the problems of all of us. The crisis is
also a reminder that short-term policy issues can deflect attention from long-term structural issues. And the
crisis is a reminder that money politics can distort policy towards private interests and away from the public
interest even in the most sophisticated economy in the world, in ways that cause immense damage to people
everywhere.
That is the way it could be with climate change policy. If climate change is managed as badly as financial
regulation, our generations will have left greatly diminished possibilities for life to our children and their
children. While our own parents and grandparents left us much more than they had had, we will have let
down those who come after us. Our generations will have broken the thread that has joined the generations
of humanity in the building of the wonderful structures and potential of civilization.
I describe climate change as a diabolical policy problem, because of its complexity; because of the mismatch
of time frames between the costs of mitigation (which come early) and the benefits (which come much later);
and because of the prisoner’s dilemma that inhibits international cooperation on mitigation (with each country
Appendix 3 Page 147

having an incentive to do as little as possible if it thinks its own actions will not affect the policy decisions of
others).
While an effective response to climate change must be global, it must be built from the national contributions
of sovereign countries, acting alone or together with others. We will not get a good outcome unless all
substantial countries make large contributions.
My country, Australia, has big responsibilities, as the developed country with the largest per capita
emissions, as the world’s largest exporter of the world’s most emissions-intensive major form of energy
(coal), and as a country with immense human and natural potential for the development of low-emissions
energy and for development and application of sequestration technologies.
Indonesia also has large responsibilities. Its total emissions are actually very large, because of land-use
change and forestry, and also because its emissions from fossil fuel and especially coal combustion are
growing rapidly. Indonesia is a leader of the developing world, and many other countries, in Southeast Asia
and far beyond, look to it for directions. President Yudhoyono’s hosting of the Bali conference of the United
Nations in December 2007 is widely recognized as having been critical to a successful outcome, and this
gives Indonesia continuing respect and influence.
In addition, the Great Crash of 2008 and its recessionary consequences have accelerated changes in the
global centre of gravity of economic activity and strategic weight in ways that enhance the global leadership
opportunities and responsibilities of Indonesia and the other large developing countries. The Great Crash
has left an awful legacy of debt and weakened financial institutions in much of the developed world, which
will slow their growth for a long time to come. But it has had much less effect on the growth and growth
prospects of the large developing countries, first of all China, India and Indonesia. The Great Crash has
accelerated movement towards a world in which no major international cooperation efforts can work without
the major developing countries helping to shape them and playing major roles in their implementation. This
carries responsibilities as well as power and opportunity, not least in relation to global climate change policy.
VULNERABILITY TO CLIMATE CHANGE
Indonesia shares vulnerability to climate change with all countries on earth. It is highly vulnerable because
the science indicates that the tropical regions will suffer greater negative impacts on agriculture than all but a
few developed countries. Reefs and fisheries will experience severe effects. People already living in tropical
regions, near the upper limits of the range of temperatures in which humans make their lives, will find it
harder to adapt to even higher temperatures. In addition, the rise in sea levels, which is a signature impact of
climate change, will have especially damaging effects on low-lying cities, including the great cities of Jakarta
and Surabaya. It is likely to displace large numbers of people from coastal and riverine rural communities all
over the archipelago, including from the vast lowlands of Papua.
Among the largest points of vulnerability to unmitigated climate change for Australia and Indonesia is one
they share with each other. Australia and Indonesia share the Asian and western Pacific regions with other
vulnerable countries. Some of our neighbours in this region are populous countries with vast communities
inhabiting river deltas that would be damaged disproportionately by rising sea levels. On the mainland of
Asia, many of our populous neighbours depend in important ways on the steady flows in the great rivers that
have their origins in the Himalayas and the Tibetan Plateau – the Yangtse, Yellow, Mekong, Ganges,
Brahmaputra and Indus rivers and others. This steady river flow has nurtured human civilization since the
cradle. It is threatened by climate change.
Developing countries will find adaptation to climate change especially difficult. With unmitigated climate
change, we in Australia and Indonesia will have great problems of our own. In addition, the problems of other
developing countries in our region will become our problems.
I should mention one other way in which Australia and Indonesia share exceptional vulnerability. Both of us,
but especially Australia, have export structures that cause slower growth in the global economy to damage
our terms of trade. In this, we are unlike nearly all developed and many high-income developing countries.
Unmitigated climate change would cause slower growth in economic activity through the second half of the
twenty-first century, the more so with each passing decade. Both of us would be hurt more than the average
country by deterioration of our terms of trade resulting from the growth effects of climate change.
INDONESIA AND THE GLOBAL MITIGATION EFFORT
The first requirement of effective global mitigation is an international agreement on the concentration of
greenhouse gases in the atmosphere that represents the right balance between the costs of mitigation and

the risks of dangerous climate change. Discussion of the right level of global mitigation ambition has so far
taken place mainly in the developed countries, although on average developing countries have an even
greater interest in how this matter is resolved. The G8 meeting of heads of government in Japan in July 2008
agreed that global emissions should be reduced by 50% by 2050. This was not unequivocally supported by
the developing countries which participated in the larger meeting alongside the G8 meeting in Rome last
week. There was, however, widespread support for the ambitious objective to contain the change in global
temperature to a two-degree-Celsius increase from pre-industrial levels. This would require the holding of
concentrations in the atmosphere to about 450 ppm of carbon dioxide equivalent, and it is hard to see how
this would occur if global emissions were not reduced by half from 1990 levels by the middle of the century.
Since it is universally acknowledged that developed countries will have to accept much larger proportionate
reductions in emissions than developing countries, the achievement of the “two degrees” objective would
require reductions by developed countries to much less than half of existing levels. The Rome meeting
spoke of a reduction of 80 percent in the developed countries. That may not be enough.
It is widely accepted that most developing countries will need to be allowed to increase emissions in absolute
terms for some time. To avoid high risks of dangerous climate change, it will nevertheless be essential for
them to reduce the growth of their emissions to below business-as-usual levels from an early date.
The objectives of holding the temperature increase to two degrees, or the greenhouse gas concentrations to
450 ppm, or lower, or of reducing emissions by half or more by 2050, make excellent sense from the
viewpoints of Australia, Indonesia, our neighbours in the western Pacific and the international community.
When careful economic analysis has been undertaken of the costs of achieving ambitious mitigation
objectives, it generally shows that these are small alongside the increases in living standards over the next
several decades and next century that would occur within a framework of effective global mitigation. The
costs, if the mitigation is pursued through economically sound policies, are substantial but manageable for
each of us.
There are several reasons why costs can be expected to be generally lower for developing than for most
developed countries. It is less costly to transform emerging than established economic structures. Many
developing countries, including Indonesia, have exceptional opportunities for low-cost biosequestration,
including through a diminished rate of destruction of established forests.
Once there is broad agreement on the desirable objectives of mitigation policy, the really hard task is to
agree on the distribution of the emission reduction burden across countries. At some time, it will be
necessary to allocate emissions entitlements to each country that add up to totals consistent with the agreed
environmental objective. This requires the articulation of principles for allocation that are widely seen as
being fair and practical.
Entitlements are not the same thing as emissions. In a good global system, there would be trade in
entitlements. Countries which have the capacity to reduce their emissions at low cost can sell the
entitlements that exceed their allocation to those who are unable or unwilling to keep emissions within their
entitlements.
I cannot see any alternative to allocation eventually on the basis that entitlements across countries will be
equal per capita. This was the approach taken by the Garnaut Review last year, and it has been reinforced
by much discussion since then. Most recently, a paper by staff members of China’s National Development
and Reform Commission, the agency with responsibility for climate change policy, made exactly this point at
a conference in Canberra earlier this week.
There will remain a question about when the equal per capita entitlements should take effect. It would be
difficult for high-emissions countries to go immediately to equal per capita entitlements, and they will argue
the case for an adjustment period. The Garnaut Review suggested convergence to equal per capita
entitlements by 2050. Many developing country analysts argue for immediate and early convergence on
equal per capita entitlements. This is a crucial issue that we have to talk through earlier rather than later.
Playing its full proportionate part in a global effort to stabilize greenhouse gas concentrations at or below 450
ppm, within a framework of convergence towards equal per capita entitlements in 2050, would require
Australia to reduce emissions from 2000 levels by 25% by 2020, and by 90% by 2050. Convergence towards
equal per capita entitlements before that date would require larger Australian reductions, and would make
correspondingly smaller demands on low-income developing countries. The timing of convergence towards
equal per capita entitlements is an important matter for international discussion and agreement.
The Garnaut Review’s work on “business-as-usual” emissions (Ch. 3) notes that past analysis of the
prospects for global warming, in the Intergovernmental Panel on Climate Change (IPCC) review and the
Stern review of the economics of climate change (IPCC 2001a, 2001b, 2007a, 2007b; Stern 2007), greatly
underestimates the future growth of emissions from Asian developing countries. This is because it
Appendix 3 Page 149

underestimates the likely rates of economic growth of China, India, Indonesia and other developing
countries, the energy intensity of that growth, and the emissions intensity of energy use. It therefore misses
the urgency of including China and other developing countries in a regime designed to constrain the growth
of global emissions below “business-as-usual” levels.
An immense effort in international cooperation is required over the months ahead, leading up to the United
Nations conference scheduled for Copenhagen in December 2009, to bridge the gulf between general
objectives and national commitments. In this context it is crucial that national commitments are backed
realistically by policies to implement them that add up to achievement of desired global objectives. One big
gap between reality and the current official international discussion arises from the premise that developing
countries will not accept binding constraints on emissions for the foreseeable future. Unfortunately, the
arithmetic of global mitigation does not add up without substantial reductions in developing country
emissions below business-as-usual levels.
There are advantages in shifting the emphasis from whether it is fair for developing countries to have fixed
entitlement obligations, to what would constitute a fair allocation of entitlements that was consistent with
satisfactory increases in living standards in developing countries. Unfortunately, these discussions are not
well enough advanced for us to be able to expect a conclusion in Copenhagen. There is probably a need for
meetings beyond Copenhagen to settle details. And it is probably necessary for Copenhagen to settle on
transitional post-2012 arrangements, towards comprehensive global commitments that add up to an effective
global effort five or seven years after that.
The Garnaut Review devoted considerable effort to the development of proposals that have a chance of
being acceptable to developing countries within a global agreement. The proposals cover not only the
allocation among countries of entitlements to emit greenhouse gases but also cooperation on the
development of public investment in new low-emissions technologies and on adaptation to climate change.
On research, development and commercialization of new technologies and on adaptation, high-income
countries, with per capita incomes exceeding $11,000 per annum, would take on special global
responsibilities. Developing countries that participate in and accept mitigation responsibilities under a global
agreement would be beneficiaries of transfers under the international technology and adaptation
commitments.
A fair allocation of entitlements across countries, that allowed many developing countries to generate export
revenue from the sale of surplus permits, together with technology and adaptation commitments that would
only be available to developing countries that participated in the global mitigation effort, would provide
incentives for developing countries voluntarily to constrain emissions below the defined trajectories. The
incentive for poorer developing countries to be part of a global mitigation effort would be increased by high-
income countries providing assistance for adaptation to climate change to low-income developing countries.
SCOPE FOR INDONESIA TO CONTRIBUTE TO MITIGATION
While there is uncertainty about the precise levels of emissions from land-use change and forestry, the best
estimates suggest that these are large on a global scale, and that as a result Indonesia may be the world’s
third-highest emitter of greenhouse gases in absolute terms, or at least may have been at the end of the
1990s. Indonesia has taken important initiatives to measure and to monitor emissions as a first step towards
constraining net emissions from forestry. There are opportunities for large reductions in emissions from land-
use change and forestry at relatively low cost. The global community and Indonesia both have strong
interests in introducing incentives for greenhouse gas abatement to take place at low cost in Indonesia rather
than at higher cost elsewhere. The opportunities for low-cost abatement cover afforestation and re-
afforestation as well as avoided deforestation. The United Nations’ acceptance of credits for forest
conservation provides opportunities for Indonesia and other developing countries, along the path to
comprehensive inclusion of land-use change and forestry in a global mitigation regime. Leading the design
for these new arrangements could be a special Indonesian contribution to the global mitigation effort.
At the same time, Indonesia has rich opportunities for generating low-emissions power at relatively low cost.
It has considerable unutilized capacity for hydroelectric and conventional geothermal power generation. The
development of appropriate incentive structures for making good use of this capacity, assisted by gains from
the international sale of carbon credits, would be highly beneficial for Indonesian development, and helpful to
the emergence of an effective global emissions regime covering developing as well as developed countries.
As in all countries in which the cost of energy has been relatively low (including Australia), there are large
opportunities for reducing emissions in Indonesia from improvements in energy efficiency. There are no good
reasons for keeping energy prices below international prices through the use of subsidies for petroleum
products and electricity. Subsidies slow economic growth and the rise in living standards of Indonesians as

well as artificially increase energy use and greenhouse gas emissions. Their removal would be a first step in
improving energy efficiency in Indonesia. In addition, the provision of information to businesses and
households on how they can reduce the use of energy could often enhance the living standards of people
making the changes, in addition to contributing to environmental objectives.
Both Australia and Indonesia have large, cooperative and productive relations with developing countries in
the western Pacific region. This gives both of us special capacities in the development of mechanisms for
encouraging developing country participation in an effective global mitigation effort, and also in the shaping
of mechanisms for assisting developing countries with adaptation to climate change.
WHAT DIFFERENCE DOES THE GLOBAL FINANCIAL CRISIS MAKE?
What difference is made by the unprecedented financial crisis that began in 2007 and plumbed new depths
from September 2008? Does it make mitigation genuinely less urgent, by slowing global growth in economic
activity and therefore energy use and emissions? Will it reduce commitment or capacity to sustain economic
costs to reduce emissions? In particular, will it reduce the chances of strong mitigation in major emitting
countries – in particular, the United States?
A decision to reduce emissions in the interests of limiting the risks of dangerous climate change is not a
decision to favour the environment over the economy. Unmitigated climate change is likely to have large
environmental costs, but it would also have large economic costs. The policy challenges of mitigation derive
partly from the reality that the costs of mitigation come early and the gains from reduced costs of climate
change come later. So the economic policy choice is not between economic costs and environmental
benefits. It is between short-term economic costs and long-term economic benefits, the latter potentially of
much larger dimension. In this context it is worth keeping in mind that the financial crisis itself can be
understood as a consequence of favouring the short term over the long term in private and public decisions
affecting the economy.
The acceleration of economic growth in China, India, Indonesia and other major developing countries that
has made early and strong mitigation more urgent has deep foundations. It has not been permanently
knocked off course by the crisis. The “business-as-usual” trajectory of emissions growth beyond 2008 and
2009 in the large developing countries is likely to be much the same as is anticipated in the Garnaut Review.
For the world as a whole, the effect of the crisis may be a pause for two or three years in rapid emissions
growth as a result of widespread recession in developed countries. This gives us no more than a little
breathing space – which may turn out to have been necessary for the attainment of anything like announced
mitigation objectives, given the points from which we are starting in mid-2009.
The biggest effect of the crisis may be on the acceleration of the shift in economic and geostrategic weight
from the developed to the large developing countries. This reduces the former’s capacity and increases the
latter’s responsibilities for global leadership on climate change as on other important issues requiring
international cooperation.
Fortunately, the change of government in the United States in January this year has made that country a
leader rather than a drag on global climate change policy. This is the result of political forces separate from
the Great Crash and its recessionary effects, and offsets what may have been negative effects on the United
States’ global role on climate change policy.
Financial crises, however severe, are short-term phenomena. The current signs of a shift from recession to
prospects for tepid growth in the developed countries, and of a reasonably robust outlook in the large
developing countries, are helpful to the preparations for Copenhagen. The crisis will have left a legacy of
reduced wealth, incomes and in some countries of growth prospects, the extent of which will depend on the
effectiveness of policy decisions that are still under consideration at the time of writing. But the financial crisis
itself will be passing into history.
By contrast, climate change is a long-term structural issue. It is bad policy to allow the approach to important
long-term structural issues to be determined by short-term cyclical considerations. Moreover, the period of
accelerated growth out of recession is a favourable time to implement policies involving major investment in
new technologies and considerable structural change. So the financial crisis does not materially reduce the
magnitude or urgency of the mitigation task. Nor does it create a sound reason for delaying mitigation.
In short, climate change mitigation may be more difficult politically in the immediate aftermath of the financial
crisis, but it will be neither less important nor less urgent. Without effective global mitigation, climate change
will still be here tomorrow. The possibility of effective action to remove great risks to economic as well as
environmental values may not.
Appendix 3 Page 151

CONCLUDING REMARKS ON INDONESIAN POLICY
Effective global mitigation is unlikely to be achieved unless Indonesia plays a leading role in its contributions
to building an international policy framework, and in its domestic mitigation efforts. Indonesia has already
played a large and constructive role in international climate change policy, and has started the task of
adjustment of domestic policy to allow it to play a positive role in a large global mitigation effort.
Indonesia’s international role will be more important than ever in the period ahead. It will need to play a role
in shaping arrangements that have a chance of being seen as fair by enough countries to make a global
effort work. It has a particular opportunity in relation to the shaping of the role of land-use change and
forestry in an effective international regime.
And what Indonesia does at home will be of crucial importance. The world needs to move quickly towards a
global regime that systematically rewards reductions in and sequestrations of emissions. If that is the
direction in which the world is heading, there will be large economic benefits in Indonesia shaping all new
investment consistently with those longer-term directions. Otherwise there are potentially large costs in
carrying or scrapping investments that have been made redundant by the emerging greenhouse gas
regimes.
A good domestic policy framework will need to put a price on carbon dioxide and other emissions that is
similar to the emerging and rising global emissions price – in addition to removing current subsidies which
from time to time reduce fossil fuel prices below world prices. It will need to systematically reward the
sequestration of greenhouse gases in plants or in the ground, at that same price. It will also need to
systematically provide for public support for research, development and commercialization, and especially
for their first application in a new environment in Indonesia, in recognition that the pioneers carry risks and
costs from which the whole community receives benefits. The large revenues form putting a price on
emissions, in Indonesia probably most efficiently through an emissions tax, would provide the means for
supporting the new technologies as well as assisting low-income households to adjust to higher energy
prices.
It is important that Indonesia’s efforts are deeply integrated into mainstream economic policies, as both
climate change and its mitigation have economic consequences of national significance.
The whole world is fortunate that Indonesia, with its newly elected and experienced government, and with
robust economic growth continuing through the deepest global recession since the 1930s, is well placed to
manage the large challenges that lie ahead on climate change and its mitigation.
NOTE
* This presentation draws on The Garnaut Climate Change Review (Cambridge University Press, 2008
and www.garnautreview.org.au) and my Panglaykim Memorial Lecture in Jakarta last October, published
in the Indonesian Quarterly 36 (3–4), December 2008, and the Bulletin of Indonesian Economic Studies
45(1): 107–16 April 2009.

APPENDIX 4 ARMIDA ALISJAHBANA: GREEN ECONOMY
Presentation by Professor Armida S. Alisjahbana, ISEI and Universitas Padjadjaran

at the national seminar, “Financial crisis, green growth and climate change,”
Jakarta, 16 July 2009
Green Economy Framework (UNEP, 2009)
Ecosystems &
Biodiversity
• Green Economy:
I. Focus on sectors with the largest CO2 Emission
II. Encouraging green investments
III. Policy implications
Appendix 4 Page 153

I. Focus on sectors with the largest CO2 Emissions:
Results of study by CEDS Universitas Padjadjaran,
Strategic Asia, and Ministry of Environment (June,
2009)
Analytical method: 30 Simulations using Model
INDONESIA‐E3
Analytical Framework

policy‐sequences alternatives
6
 
FUEL SWITCH: Coal 50% Gas 

Electricity Industry
7
Appendix 4 Page 155

FUEL SWITCH + ENERGY EFFICIENCY
Fuel Switch

Electricity Industry
8
Carbon Tax

10
Policy Alternative/Sequence 25%EE
CO2 emission reduction, Million tCO2
GDP gain as clue for upper‐bound cost (Trillion Rupiahs)
29.43 9.56 5.18 27.74 5.25 7.03 5.90 1.78 0.50
Potential CDM financing with $20/tC (TrillionRupiahs)
1.31 0.82 0.74 0.73 0.52 0.28 0.50 0.08 0.04 11
Appendix 4 Page 157

Focus: Energy‐intensive manufacturing
(20% output of manufacturing Sectors)
12
Focus: 25% Richest Urban Households
• Only 11% of total
households in Indonesia
• ¼ emissions reduction
compared to total
households
• Low investment cost:
energy efficiency, not
on new technology
investments
13

Focus: Land Transportations
14
Large Emissions Reduction
from Fuel Switching
15
Appendix 4 Page 159

Carbon Tax
16
Opportunity Cost of Reducing Deforestration (by 10%, in Rp.
Trilion GDP)
Note: Non‐
Market Forest
Benefitis Rp 40
Trilion/yr
17

II. Encouraging Green Investments
Investing in Green Sectors (UNEP, 2009)
• Renewable energy
• Industry: material & energy efficiency
• Low carbon cities
• Green buildings
• Transport
• Agriculture
• Waste management
• Forests
• Water
18
III. Policy Implications
• The role of fiscal instruments:
– Subsidy
– Taxation including tax incentives
– Green stimulus packages
– etc
19
Appendix 4 Page 161

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Ministry of Finance Green Paper

Economic and fiscal policy

Ministry of Finance, Republic of Indonesia

Page ii Ministry of Finance Indonesia Green Paper on Climate Change

Dr Sri Mulyani Indrawati

Ministry of Finance Indonesia Green Paper on Climate Change Page iii

Page iv Ministry of Finance Indonesia Green Paper on Climate Change

Ministry of Finance Indonesia Green Paper on Climate Change Page v

Foreword by the Minister of Finance iii

Foreword by the Head of the Fiscal Policy Office iv

List of tables ix

1 Introduction: effective and efficient carbon policies for Indonesia 17

2 Carbon emissions pricing 23

3 International carbon finance 43

4 Policy options in the energy sector 69

Ministry of Finance Indonesia Green Paper on Climate Change Page vii

6 Institutions for carbon policy 125

Appendix 1; Geothermal electricity 131

Appendix 2; Remarks by Professor Ross Garnaut 143

Appendix 3; Ross Garnaut: Climate change and Indonesia 147

Appendix 4; Armida Alisjahbana: Green economy 153

Page viii Ministry of Finance Indonesia Green Paper on Climate Change

Table 1 Average price impact of Rp 80.000 carbon price 8

Ministry of Finance Indonesia Green Paper on Climate Change Page ix

Figure 1 A business-as-usual scenario for Indonesia’s greenhouse gas emissions 3

Figure A1.1 Geothermal project development, activities, and costs 137

Page x Ministry of Finance Indonesia Green Paper on Climate Change

INDONESIA’S ROLE IN GLOBAL CLIMATE CHANGE MITIGATION

Executive summary Page 1

THE STRATEGIES IN BRIEF

EMISSIONS AND REDUCTION GOALS

Page 2 Ministry of Finance Indonesia Green Paper on Climate Change

Data sources and notes: see Figure 1.2 in Chapter 1.

Box 1 The importance of business-as-usual scenarios

Executive summary Page 3

Figure 2 Carbon finance needs in developing countries, financing

Page 4 Ministry of Finance Indonesia Green Paper on Climate Change

The cornerstones of an international carbon finance strategy, based on the

ENERGY AND CARBON PRICING

Executive summary Page 5

Box 3 Emissions pricing versus other policy options

Page 6 Ministry of Finance Indonesia Green Paper on Climate Change

Executive summary Page 7

Price increase Tax/levy revenue Possible use of revenues

Electricity Rp 60 per kWh Revenue would rise Government free to

Economic modeling indicates that a relatively low carbon tax/levy, implemented

Page 8 Ministry of Finance Indonesia Green Paper on Climate Change

Figure 4 Breakdown of the true cost of coal-fired electricity

Fuel price risk cost

Source: McLennan Magasanik Associates modeling for the Green Paper

Executive summary Page 9

A vibrant geothermal program in Indonesia could result in healthy receipts from

Page 10 Ministry of Finance Indonesia Green Paper on Climate Change

REGIONAL ACTION ON LAND-USE CHANGE, FORESTRY AND

Sources and notes: see Figure 5.1 in Chapter 5.

Executive summary Page 11

Figure 6 Payment transmission under a Regional Incentive Mechanism

International carbon finance, public and private market sources

National regulatory policies for land-use and forestry

Central govt budget

Page 12 Ministry of Finance Indonesia Green Paper on Climate Change

Box 5 Regional climate change incentives beyond REDD

Support for climate change mitigation measures through intergovernmental fiscal

Executive summary Page 13