Revealing Carbon Leakage: Addressing the Possibility in Indonesia’s New Carbon Trade

Indonesia stands as one of the top greenhouse gas emitters in the world. During 2022, the nation witnessed its highest coal consumption on record.

Indonesia stands as one of the top greenhouse gas emitters in the world. During 2022, the nation witnessed its highest coal consumption on record, surpassing all previous years. There was a substantial increase of 33%, rising from 559 million barrels of oil equivalent (BOE) in 2021 to a new high of 746 BOE in 2022. This has emerged amidst Indonesia’s commitment to the Paris Agreement 2015. Encapsulated in its nationally determined contribution (NDC), Indonesia strives to achieve a significant 29% reduction in greenhouse gas emissions by 2030, deviating from the business-as-usual projection. President Joko Widodo finally launched a carbon emission credit trading initiative to establish a marketplace to finance reductions in greenhouse gas emissions to show its adherence. The goal is to position the nation as a significant global carbon trade player. While this initiative can be viewed as a positive step in the fight against climate change, the potential for carbon leakage looms if the policy lacks comprehensive coverage. Hence, the success of this market relies on the adept addressing and mitigation of the risk of carbon leakage.

How Can Carbon Leakage Occur in Indonesia?

Firstly, it is mandatory to note that some literature still questions the evidence of carbon leakage. Carbon leakage supposedly occurs in regions with rigorous climate policies, a trend often observed in developed nations like the European Union (EU) or the United States. Industries may shift their production to countries lacking carbon pricing mechanisms, often referred to as the ‘developing world.’ This involves companies relocating production to developing countries and subsequently exporting goods back to EU nations, thereby sidestepping carbon taxes and mitigating increased costs. Dai et al., through their article, found empirical evidence that firms in the US outsource their production to foreign suppliers to reduce carbon emissions. Furthermore, data from the Global Climate Project shows affluent OECD countries “utilize” a considerable amount of carbon dioxide, surpassing the emissions produced within their territories, which is safe to assume production must be moved elsewhere. As a developing nation without established carbon emission reduction policies, Indonesia has been susceptible to such leakage scenarios initiated by foreign industries.

Another scenario that may give rise to leakage is when Indonesia implements its inaugural carbon trading system, signifying more stringent carbon emission policies. This could prompt similar responses as domestic companies in Europe and the US, potentially leading Indonesian companies to relocate their production to neighboring countries. Out of 11 ASEAN member states, only Singapore, Indonesia, Malaysia and Thailand have already executed a carbon trading market. This opens up opportunities for Indonesian companies to offshore their production to nearby Southeast Asian countries, like Vietnam, which has been a significant partner of the EU. As of August 2022, 25 of the 27 European Union member states have invested in Vietnam, contributing to 2,384 projects with a registered capital of 27.6 billion USD. This constitutes 6.42% of the country’s overall registered capital, which is still primarily dependent on high-carbon sectors and fossil fuel-based power. In addition, Vietnam and other countries in the ASEAN region that have yet to implement carbon trading markets and emission reduction regulations offer a more appealing prospect for companies seeking to avoid the extra expenses associated with stringent climate policies.

Carbon Leakage Scenario: Learning from the EU

Carbon trading is a cap-and-trade market scheme that allows entities to offset their high-intensity emissions by purchasing credits from other endeavors that generate carbon stocks. In Indonesia’s case, tradable items include carbon quotas from the compliant sector (referred to as Penetapan Batas Atas Emisi bagi Pelaku Usaha or  PTBAE-PU) and carbon credits (SPE-GRK). PTBAE-PU is exclusively available for purchase and sale by the mandatory sector, which operates under a maximum cap for emissions. In contrast, carbon credits can originate from various projects such as peat restoration and renewable energy, allowing all participants to procure credits as a means of emission avoidance.

Moreover, to engage in the carbon exchange, entities must acquire a permit from the National Standard Registry (SRN), a platform overseen by the Ministry of Environment and Forestry, regardless of their emissions status. Many are questioning Indonesia’s ability to manage such a policy, considering the absence of a comprehensive market ecosystem. Learning from the European Union Emissions Trading Scheme (EU ETS) experience, sustaining equilibrium between supply and demand in the market is crucial to upholding market enthusiasm and facilitating seamless transactions. In 2007, the cost of a permit to release one tonne of carbon dioxide plummeted by 40% to €2.81, significantly lower than its previous peak of €32, but later rebounded to surpass €4. The Emissions Trading System (ETS), designed to curtail emissions across Europe’s energy and industrial domains, has grappled with excess permits, partly stemming from initially generous allocations prompted by industry lobbying. Indonesia’s carbon trading is potentially faced with the same scenario.

The maturity of the carbon trading market in Indonesia may impact the awareness and participation of industries. A less mature market is more likely to face challenges in balancing supply and demand, which adds to the diverse economic landscape with various industries. Different sectors may exhibit varying levels of commitment to carbon reduction and demand for carbon quotas, leading to disparities in the availability of credits. Furthermore, the forthcoming inclusion of international companies in Indonesia’s carbon market raises the prospect of carbon leakage. This risk arises if the pricing structure lacks competitiveness and domestic enterprises fail to reap the incentives offered by the carbon market. Beck et al. state when a country’s emissions policy increases local costs, another country with a more lenient policy may gain a trading advantage. If the demand for these goods remains constant, production may shift to the more affordable country with lower standards, thwarting efforts to reduce global emissions. Domestic companies may be motivated to relocate to nearby countries with no carbon trading policy whatsoever.

A Substantial Challenge for the Economy

With the world moving towards an environmentally friendly framework, carbon leakage could raise a substantial challenge for progress in Indonesia. First and foremost, it undermines the effectiveness of emissions reduction efforts. The phenomenon contributes to a rise in global emissions rather than a decline, thereby aggravating the challenges presented by climate change. Given the interconnected nature of the Earth’s climate, emissions released in one region impact the entire planet. Not only does carbon leakage negate green efforts, but it also harms economies. Countries or industries adhering to stringent carbon regulations face a competitive disadvantage compared to areas with weaker or no carbon constraints.

The competitive disadvantage stems from industries in areas with lax carbon regulations incurring lower environmental compliance costs, enabling them to produce goods and services more cost-effectively. In essence, while environmentally conscious policies benefit the planet, they present economic challenges for regions or industries committed to sustainability. This disparity may prompt a shift in economic activities as industries seek locations with less demanding environmental regulations, potentially impacting Indonesia’s economic vitality and job market adhering to strict carbon constraints. Furthermore, the condition may also trigger economic inefficiencies, as companies perpetuate a reliance on high-emission production methods.

Driven by a cost-saving mindset, they prioritize short-term over long-term sustainability, leading to inefficiencies in the production process. Industries might not be utilizing the most advanced or environmentally friendly technologies available. Moreover, domestic market competition would fail to prioritize products with lower climate impact, resulting in a departure from minimizing the cost of product supply. On the demand side, the distortion arises from the domestic price, which does not accurately reflect the genuine social cost of the product, leading to consumption discrepancies. For example, if carbon pricing is overestimated, the product appears excessively expensive compared to its actual social cost, discouraging consumer purchases. 

Preventing the Leak: Comprehensive Policy and Regional Cooperation

How can Indonesia combat a potential carbon leakage? Considering the market’s immaturity, the country must learn from the existing policies, especially the EU’s CBAM or Carbon Border Adjustment Mechanism framework. CBAM aims to establish a fair carbon price emitted during the production of carbon-intensive goods at risk for carbon leakage entering Europe. Indonesia could consider a parallel mechanism, where imports from countries with less stringent carbon emissions standards would be subject to additional tariffs or carbon pricing. This would discourage domestic industries from relocating to these countries and importing back into Indonesia, as the financial advantage would be neutralized.

From an economic standpoint, it is crucial for the government to establish a solid and accurate domestic carbon pricing system that aligns with the actual societal costs associated with carbon emissions. To achieve this, the government must set a carbon price that is neither too high nor too low, effectively encouraging emission reductions while avoiding practices that heavily rely on carbon. Incorrect pricing could disrupt the market balance for these products. It’s also important to consider such policies’ potential initial financial burdens, underscoring the need to incentivize businesses that implement eco-friendly technologies and practices. These incentives include tax deductions, subsidies for adopting green technologies, or improved access to financing for environmentally friendly initiatives.

Finally, working closely with ASEAN neighbors to align carbon pricing strategies is critical for both domestic and international policy effectiveness. Such collaboration can deter businesses from relocating to countries with less stringent environmental regulations. Establishing regional agreements can aid in exchanging best practices and advanced technologies for reducing carbon emissions. Additionally, governments need to develop frameworks that support these future policies, particularly in aspects of monitoring and evaluation, to guarantee that carbon trading is making a tangible impact on reducing emissions.

Gracia Ayni Warella
Gracia Ayni Warella
A highly motivated and critical third-year undergraduate International Relations student from Universitas Gadjah Mada, Indonesia. As an IR student, her interest is in transnational crimes, green economy, humanitarian law, and research. She is currently serving as the Manager of Research and Development at the Foreign Policy Community of Indonesia (FPCI) Chapter UGM and was a Dissemination Intern at the Institute of International Studies (IISM) Universitas Gadjah Mada.