AVOIDING DEFORESTATION:

The case for allocating Oil Palm to degraded lands under REDD

By Emil A. Antlov

This Dissertation is submitted for the degree of

MASTER OF PHILOSOPHY

ST. EDMUND’S COLLEGE, CAMBRIDGE

July 2010

ii

I hereby declare that my dissertation entitled:

AVOIDING DEFORSTATION: The case for reallocating Oil Palm plantations to degraded lands under REDD

is:

the result of my own work and includes nothing which is the outcome of work done in collaboration except where specifically indicated in the text

not substantially the same as any that I have submitted or will be submitting for a degree or diploma or other qualification at any other University

within the word limit

that I agree to my project being run though plagiarism detection software, should the need arise and that I have read the University’s guidance on the matter.

Signed:…………………………………………… Date: 26.07.2010

iii

Acknowledgements

I would like to express my most sincere thank you to my supervisor Danilo Igliori for his invaluable

guidance and enthusiasm throughout this project. I also owe great debts to Beth Gingold and Moray

McLeish at the World Research Institute for providing the data that ultimately made this project

possible. Finally I offer my deepest gratitude to Melissa Kowara for her endless support and patience,

and for whom I dedicate this to.

iv

Abstract

Mechanisms that reward developing countries for Reducing Emissions from Deforestation and

Degradation (REDD) have been gaining momentum as a means to combat global warming and

preserve biodiversity. A widespread assumption within REDD discourse however has been that forest

conservation means completely forgoing agricultural production. Such an approach will reduce

commodity supply which in turn affects both viability and effectives of REDD. In this paper it is

proposed that deforestation can be reduced and demand met by instead relocating planting

concessions from forested to degraded land. Incentives for converting such land can be created if

compensation from avoided emissions from deforestation is rewarded. It is argued that such an

approach will allow for a more efficient and effective means to reduce deforestation. This framework

is grounded in the case of Oil palm in Indonesia and tested empirically. By modelling the economic

viability of oil palm conversion versus forest conservation under both the current REDD approach and

our proposed REDD framework, it is found that reallocating concession to degraded lands is more

cost-effective and allow for a greater scope of activities which threaten forest to be made viable for

conservation under REDD. Whilst a number of studies have argued that the inclusion of REDD into a

Post-Kyoto compliance regime will be necessary to prevent deforestation from the threat of oil palm,

it is found that even if carbon credits are priced in voluntary carbon markets, forest can still be

safeguarded against such threats under the alternative approach. The economic limitation comes

predominantly from the type of degraded land converted.

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Contents

I. Introduction 1

II. Theoretical Framework 4

III. Case Study: Indonesia and Oil Palm 11

IV. Methodology 15

V. Data Description 21

VI. Results 25

VII. Discussion and Policy Implications 31

VIII. Conclusion 33

IX. References 35

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Tables

Table 3.1 Statistical Snapshot: Indonesia, CIA World Factbook; Mangobay.org (2008)

Table 6.1 NPV (US$ ha-1) of Oil Palm Conversion on various soil type

Table 6.2 NPV (US$ ha-1) of REDD scenarios

Table 6.3 Minimum carbon price (US$/tCO2) required to sway forest conversion

Figures

Figure 2.1 Incentive framework for land-uses options considered (indicative)

Figure 2.2 Marginal cost curves of REDD mitigation under PES and Permit-Swaps demonstrating efficiency

Figure 2.3 Marginal cost curves of REDD activities under PES and Permit-Swaps demonstrating effectiveness

Figure 2.4 Market phenomenon causing leakage, adapted from Murray (2008)

Figure 3.2 Area Growth of Oil Palm in Indonesia according to sector (1986-2004) from Casson et al (2007)

Figure 5.1 FFB Yield Curve according to soil type

Figure 6.1 Sensitivity Analysis

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8

9

12

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Abbreviations

CPO Crude Palm Oil

EPO Emission Reduction Option

GHG Global Greenhouse Gases

KE Palm Kernel

NPV Net Present Value

REDD Reduced Emission from Deforestation and Degradation

REDD+ Reduced Emission from Deforestation and Degradation Plus

WB World Bank

1

I. Introduction

Deforestation and degradation account for nearly 20% of global carbon emissions. A natural sink of

carbon has become a major source of greenhouse gases (GHG) as a consequence of anthropogenic

land-use change. This is not only threatening our global climate system, but is also becoming a

leading cause of biodiversity loss. Domestic policies to reduce deforestation in the developing world

have been unsuccessful due to lack of incentives and capacities (Peterson et al. 2007). In recognition

of the vital services forests provide, the international community is now stepping in with the proposed

Payments for Reduced Emission from Deforestation and Degradation (REDD). By rewarding

individuals, communities and states for reducing emission from deforestation and degradation, REDD

has the potential to create significant incentives where other policies failed.

Many uncertainties still remain however. Its credibility has been weekend in the past by technical

limitations to ensure that any emissions reductions would not have occurred in a business-as-usual

scenario (additionality), that such reductions are permanent (permanence) and that forest

conservation in one area does not simply shift deforestation to another (leakage). For these reasons,

avoided deforestation was not included in the Kyoto Protocol’s Clean Development Mechanism when

the Marrakesh Accord was signed in 2001. Negotiations have since progressed with the latest

proposal, REDD+, further encompassing reward for forest stewardship, sustainable forest

management and enhancement of land-based carbon in addition to reduced deforestation and

degradation. With the recent fifteenth Conference of Parties failing to set up an international

framework, it still remains unclear whether future incentives will come from a market-based approach

where emitters buy credits to offset their own emissions, or simply voluntary contributions from

international community, or a combination of both. Whichever mechanism will drive the agenda,

compensation for reduced emissions from deforestation is fundamental. The success of REDD is thus

tied to its economic viability and ability to create effective incentives.

Understanding land-use motivation is imperative for effective incentives. For the environmental

service provider, this means that any compensation must at least meet, and ideally exceed, the

economic benefits conversion brings (Murray et al. 2009; Martin 2009). What becomes evident in

literature, however, is a paradigm based on the assumption that forest conservation means completely

stopping and forgoing the economic productivity such conversion would have brought. Papers such

the Stern Review (2007), Nepsted et al. (2007) and Olsen and Bishop (2009) quantity the cost of

reducing deforestation by predicting how much deforestation would occur under a Business-As-Usual

(BAU) scenario and the net return such conversion would bring. They in turn assume that this is

equivalent to lost productivity under a forest conservation scenario, thus the minimum compensation

(or cost) that must be paid to prevent deforestation. What they do not consider is that governments

2

participating in REDD will likely increase commodity production in ways that do not lead to further

deforestation. If this is the case then actual amount of forgone productivity will be less than estimated.

This paradigm has important implications on not only viability and cost of REDD, but also

effectiveness of any emissions reduction. Any policies which promote large-scale forest conservation

will likely have implications on global and domestic markets (Persson 2009). If demand does not

change, forgoing large amounts of potential economic activity for conservation means prices will rise

as supply is reduced. This will not only create incentives for illegal logging, but also makes forest

conservation less viable as agricultural prices rise and potential returns from conversion increase

(Persson 2009). The need to reduce demand for those products which cause deforestation must

become key if REDD is to be successful (Angelsen 2008; Martin 2009; Murray et al. 2009, Spingate-

Baginski and Wollenberg 2010). If demand cannot be reduced, then the need to meet demand without

further deforestation must become a priority.

In this paper we propose an alternative approach - that deforestation can be reduced and demand still

met by incorporating degraded lands into an overall REDD strategy. If reallocating planting

concessions from forested to degraded lands leads to reduced deforestation, incentives for converting

such land can be created if agents are awarded a compensation based on avoided emissions from

deforestation. We argue in this paper that reallocating concession to degraded lands allows for a more

efficient and effective means to reduce deforestation in comparison to current REDD approach.

Likewise, allowing economic development to be brought back to otherwise ‘wasteland’ has the

potential for a ‘win-win’ scenario.

This framework is grounded within the case of Oil Palm in Indonesia. Indonesia presents a particular

relevant case as it is has seen extensive deforestation in the past two decades and is now emerging as a

key proponent of REDD. Central to deforestation has been the growth of Oil Palm, not least by

demand for a cheap food and cosmetics supplement, but also climate policy leading to increasing

demand for biofuels in which crude Oil Palm is a key feedstock. As the highest yielding oil crop in

the world it is, however, problematic under the current REDD paradigm. Recent studies find REDD

cannot compete against the economic benefits forest conversion for oil palm brings as long as REDD

funding is based on carbon prices in the voluntary carbon market (the only market place currently

available for REDD-based credits). Given its significance as a deforestation driver there is likelihood

that oil palm will undermine any REDD activities in the region (Butler and Koh 2008; Persson et al.

2009). Relocating Oil Palm concessions to degraded lands may prove an alternative policy approach

in light of this.

In this study we examine both the theoretical motivation for integrating degraded into REDD and

empirically assess the economic viability of such an approach with case of Oil Palm in Indonesia. Our

3

discussion contributes to current discourse in a number of ways. Foremost, the paper presents the first

known discussion that integrates the economic potential of degraded land with the emerging REDD

agenda1. Although the underlying idea of converting degraded lands as a means to reduce

deforestation is not a new one (see Reinhardt et al. 2007; Koh and Wilcome 2008; Gallagher 2008),

literature that explore this concept within REDD discourse and carbon funding is almost non-existent;

Venter et al. (2009) mentions briefly the idea in his concluding remarks, but does not consider it in

any depth. Atmadja and Wollenberg (2010) discusses domestic REDD strategies in which degraded

lands are proposed, though no discussion of wider economic implications are mentioned. By

grounding the discussion with the case of oil palm in Indonesia, we seek to examine the economic

motivation for a particularly problematic deforestation driver and the potential an alternative policy

approach to REDD may have in this.

The dissertation is structured as following: the following chapter examines the theoretical motivation

for integrating degraded lands and the economic rational as they relate to efficiency and effectiveness

of REDD. Chapter 3 presents the case of Indonesia and oil palm, and potential for utilising degraded

land in the region. Chapters 4 and 5 detail the methodology, models and data used for the analysis

with Chapters 6 and 7 discussing the results and wider policy implications. Chapter 8 concludes.

1Degraded land in this study specifically refers to anthropogenic savannah-like landscapes as opposed to degraded forest, which is already part of the REDD agenda.

4

II. Theoretical Framework

The Economic Perspective

In the broadest sense, REDD is a mechanism which confronts the problem of excess deforestation and

degradation by allocating value on carbon stock. Deforestation is an inevitable consequence in the

development-conservation trade-off. To completely stop deforestation would result in a loss to society

greater than the gain from deforestation (Barbier 1997). Optimal allocation of land between forest and

an alternative land-use is achieved when marginal benefits of forested land are equivalent to marginal

benefits of an alternative land use (Hartwick 1992). In allocating land use it is vital then that all

benefits and costs are accounted for as failure to do so will result in a less than optimal allocation of

land.

The difficulty arises in the nature of benefits forest provides. This encompasses its direct value as an

input or consumption good, its indirect value through sustaining economic activity and its non-use

value to people who derive satisfaction from the mere existence of a resource (Bishop 1998; Barbier

1997). At a global level, forests serve to preserve biodiversity and to regulate the global climate

through carbon sequestration. Given the non-excludable, but rival nature of timber, the problem of

open-access arises and competition for remaining resources accelerates the depletion of natural

resources (Hardin 1968). The pure public goods nature of ecosystem services (non-rival and non-

excludable) means no scarcity arises and the price mechanism fails. With unaccounted costs,

externalities arise and markets fail to allocate resources efficiently.

The emergence of degraded land is a particular type of market failure. In its most simple form, land

degradation is the “long-term loss of ecosystem functions and services caused by disturbances from

which the system cannot recover unaided” with the primarily effect in lower agricultural outputs

(UNEP 2007). Degradation itself is a process that refers to both the gradual loss of forest cover and

soil quality, eventually resulting in the anthropogenic savannah-like degraded lands that have become

widespread around the globe. Such land emerges when either timber is harvested at an unsustainable

rate (above socially optimal levels) or severe degradation of soil leads to abandonment of land.

Barbier (1997) specifically attributes soil degradation in developing countries to the failure of rural

households and firms to invest in long-term land improvement on existing agricultural land. Given the

significant amounts of degraded land available, it becomes equally evident that the private incentives

to convert such land do not exist, despite evidence suggesting that it can in fact be highly profitable

under optimised management (Fairhust 2009; Goh et al. 2000). Yet if converting degraded land can

reduce deforestation then socially it must carry some benefits. Degraded land is thus not allocated

optimally.

5

Below we discuss the motivations of the various land-uses options considered in the paper. Figure 1

illustrates the incentive framework for pursuing these land-use options by focusing on net internal

benefits (profitability), opportunity cost and global externalities (climate regulation and biodiversity).

For a land-use option to be feasible in economic terms it must be profitable financially from a private

perspective and socially from a public perspective (Tomich et al. 1997). If a given activity is

financially profitable, but not socially then government intervention is justified. The case of forest

conversion in Figure 1 shows how a profit-seeking agent will fail to consider the value of forest and

consider only the benefits that can be incurred from conversion and timber. As long as this yields

positive net benefits then it will be more profitable than a standing forest and conversion is justified.

In the absence of policy intervention, conversion results in the global cost of carbon emission and

biodiversity loss. Although this is inevitable in economic development, without accounting for these

costs internally, forests become underpriced and overexploitation occurs.

Conversion of forest

REDD: Permit-Swap model

REDD: PES-like model

Conversion of degraded land

Benefits Carbon Credits (c)

Biodiversity Conservation

Alternative Land-use (d)

Loss of biodiversity (b)

carbon emission (c)

Alternative Land-use (a)

Surplus

Opportunity cost

Internal

External

Opportunity Cost (a)

Carbon Credits (c)

Biodiversity Conservation

Opportunity Cost (a)

Figure 2.1 Incentive framework for land-uses options considered (indicative)

Alternative Land-use (d)

Climate Regulation

Biodiversity Conservation

Opportunity Cost (a)

Costs

6

If an activity is socially profitable, but not financially, then private incentives are insufficient to

induce investment (Tomich et al. 1997). The case of converting degraded lands in the absence of

policy intervention shows how even if net benefits are positive, if these are less than benefits from

converting forest, then the profit seeking agent will choose the latter given the choice. Under this

rationale, degraded lands are underutilised not because of perceived unprofitability, but because of the

opportunity cost (of not converting forested land) which arise by easy access to forest frontiers. From

a social perspective, the global public goods characteristic of biodiversity conversion and climate

regulation which converting degraded land allows means that direct benefits to landowner are near

zero, thus private incentives are inadequate.

REDD intervention allocates property rights on the carbon stored in forests biomass and internalises

emissions from deforestation. What we see is a mechanism which builds on the concepts developed

under Payments for Environmental Services (PES); forests are able to provide important ecosystem

services and in order to maintain the provision of these benefits, the beneficiary must purchase the

services from the providers (Peterson 2008). REDD is in essence a global PES scheme where

International Beneficiaries purchases the regulatory service forests provide (Olsen 2008). Coase

(1960) argued in his famous theorem that any externality can be internalised regardless of who

initially gains the property right and still achieve the same socially efficiency. In the case of

developing countries, the ‘polluter-pays’ principle fails because of the global dimension of

externalities, sovereign rights and poverty of polluters, thus the ‘beneficiary-pays’ principle is pursued

(Murray et al 2009).

Under the current REDD paradigm, herein referred to as the PES-like approach (see Figure 1), an

agent is compensated for completely stopping land conversion. This compensation must meet the

forgone productivity (or opportunity cost) to sway land-conversion. Under REDD, the amount of

carbon benefits (or compensation) that can be generated in turn depends on the value of carbon stock

within a given piece of standing forest, a function of biomass (equivalent to avoided emissions) and

market price of carbon. As long as this exceeds the opportunity cost of conservation for a given piece

of land, deforestation can be avoided. Whether landowners on the ground will receive the full carbon

benefits or only an amount equivalent to opportunity cost (or even none) will however depend on the

exact benefits arrangement with the government2. Nevertheless, with costs more accurately reflecting

the true value of forest under REDD, land uses will be allocate more efficiently.

Under the alternative framework, which we call Permit-Swaps, the assumption is taken that

deforestation can be reduced by increasing supply through non-deforestation means. Specifically, an 2 This could be the case under for-profit initiatives where investors will seek to minimise cost of reducing deforestation in order to maximise surplus from carbon benefits that are generated at the end of an commitment period from international sources (Peterson 2007)

7

agent is compensated for reallocating concession from forested to degraded land as opposed to

completely stopping conversion. Given that converting degraded lands is able to produce some

benefits and carbon benefits from avoided deforestation are incurred, then profitability to pursue a

permit-swap will likely exceed that of PES-like conservation (see Figure 1). Even if we assume that

landowners only incurs a compensation equivalent to opportunity cost, then this will be lower than

required under a PES-like approach as benefits from converting degraded land will offset much of the

forgone productivity. Under this approach, both excess deforestation and underutilised degraded land

will be allocated more optimally. We examine the rational for Permit-Swap as it relates to efficiency

and effectiveness of REDD below.

REDD Efficiency

A key motivation behind the Permit-Swap model is our argument that deforestation can be reduced

more efficiently. Efficiency under REDD means reducing emissions at the lowest cost possible

(Angelsen 2008). If we assume that under the PES-like approach minimum compensation required to

avoid deforestation is equivalent to forgone agricultural activity, Ba, then under the Permit-Swap

approach, minimum compensation is Ba less the profit degraded land can brings, Bd. This means that

as long as net benefits from converting degraded land (Bd) are positive, Permit-Swaps will be more

cost-effective than PES-like conservation. Figure 2 illustrates how the Permit-Swap model impacts

marginal cost curve of REDD mitigation under the assumption that degraded lands yields positive

returns;

Mitigation Quantity (CO2)

$/tCO2

P1

P0

MC1 MC0

Figure 2.2 Marginal cost curves of REDD mitigation under PES and Permit-Swaps demonstrating efficiency

Q

8

The marginal cost curve shows how successively higher levels of mitigation become more costly,

starting with cheapest reductions first (those with lower opportunity costs, such as low hanging fruit)

to more expensive reductions (those with higher opportunity costs, e.g., intensive agriculture). If MCO

is marginal cost function under PES-like conservation, a reduction in the compensation required to

avoided deforestation will move the cost curve downwards to MC1. To achieve an amount Q in

mitigation quantity, it is then sufficient for the price of carbon to be priced at only P1 rather than P0.

Thus, a given amount of emission reduction from deforestation can be achieved at a lower cost under

the Permit-Swap approach (assuming compensation is equivalent to opportunity cost). Alternatively,

if compensation is based on full carbon benefits an agent will generate a greater surplus compared to a

PES-like approach.

REDD Effectiveness

Pursuing the Permit-Swap model also has important implications on the effectiveness and ability of

REDD to achieve emission reductions. If the price per ton of CO2 required to avoid deforestation

under the Permit-Swap model is reduced, then the ability of REDD to cover the minimum opportunity

cost to sway land conversion will increase, allowing a greater scope of activities to be viable for

conservation than otherwise. Figure 3 illustrates this; if the price of carbon is fixed at price P0, then

Q0 of avoided emissions can be achieved under the PES-like approach. Under Permit-Swaps, the

lower compensation required means Q1 of avoided emission can now be achieved as marginal cost

function shifts from MC0 to MC1.

$/tCO2 MC1 MC0

Figure 2.3 Marginal cost curves of REDD activities under PES and Permit-Swaps demonstrating effectiveness

Mitigation quantity

P0

Q1 Q0

9

Additionally, if conversion of degraded land also leads to a net increase in carbon stock, then carbon

sequestration will occur in addition to avoided emission from deforestation. Aforestation and

reforestation initiatives under the CDM mechanism currently generate carbon credits based on carbon

sequestration. If carbon sequestration is accounted for then Q1 would shift even further to the right as

MC1 moves down and greater emissions are able to be reduced at the same carbon price.

Furthermore, relocating plantations to degraded land, as opposed to stopping conversion, also has the

potential to reduce leakage. Leakage is the phenomena by which emission reductions are simply

shifted to another location or sector due to complex market interaction that arise from mitigation

efforts (Murray 2008). Although leakage at the national level is relatively easily accounted for by

using a national monitoring system which measures local displacement, the international level

presents a more contentious case as deforestation can easily be shifted to less regulated countries.

Murray et al. (2004) and Gan & McCarl (2007) find evidence that suggest as much as 48%-76% of

emissions reductions leak into other countries in absence of adequate policies.

Figure 2.4 Market phenomenon causing leakage, adapted from Murray (2008)

COUNTRY A

Reduce deforestation and commodity supply

GLOBAL MARKET

Net effect of country A and B responses

P1 P0

Quantity

$

Quantity

$

Quantity

$

QW1 QW

0 QB1 QB

0 QA0 QA

1

SW0 SW

1 SB

SA1 SA

0

COUNTRY B

Increase deforestation and commodity supply

10

The PES-like approach to REDD is particularly susceptible as forgoing large-amounts of potential

agricultural commodity will likely have some impact on markets (Persson 2009). Figure 4 illustrates

how leakage may occur under this approach; if we assume that Country A is participating in REDD,

then avoided deforestation in Country A causes commodity supply to reduce and shift inwards. Given

that global demand is D, this reduction induces the price to rise from P0 to P1. With an increase in

price, the supply in Country B will increase from q0 to q1. The corresponding GHG emissions that

come with this increase make up the leakage. With permit-swaps reallocating conversion instead of

stopping it, leakage will be reduced vis-à-vis the PES-like model as long as conversion of degraded

land is able to produce some output which enters the global supply curve. Although leakage is more

complex than this, reducing forgone productivity does tackle a key driver.

It becomes clear that the Permit-Swap model, by theory, carries a number of advantages to the current

approach. Whether this holds true on the ground needs to be tested however. The following section

presents the case of Oil Palm in Indonesia which is adopted for our empirical examination.

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III. Case Study: Indonesia and Oil Palm

Overview

The Indonesian archipelago spans more than

17,000 islands across a diverse landscape from the

island of New Guinea in the East to the Aceh in the

West. It is the third largest carrier of tropical forest

and hosts some of the riches ecosystems globally.

With 230 million people (see Table 3.1) it is also

the fourth most populated country and makes up

the largest economy in Southeast Asia. Economic

growth has seen a large rise in the past decade,

relying heavily on extractive industries such as oil,

natural gas, mining and forestry products (Wardojo

and Masripatin 2002). Per Capita GDP (US$2,329

in 2008) and education remains low nevertheless,

especially outside urban centres where the majority

of population live and rely on agricultural income (45% of total labour force). It is estimated that 15%

of population live on less than US$1.25 per day.

Not surprisingly, economic development have also been correlated with increasing deforestation rates

from 1.61% between 1990-2000 to 1.91% between 2000-2005, while annual loss of primary forest

increased by 25% over the same period (Olsen and Bishop 2009). Since 1990, 30 million ha of

tropical forest has been lost and at the current rate another 14 million ha is expected be lost by 2030

(Atmadja and Wollenberg 2010). A combination of deforestation, degradation and forest fires

(making up 85% of national emissions) have made Indonesia the third largest emitter of GHGs

globally (Olsen and Bishop 2009).

Indonesian forest policy can be characterised by the decentralisation of land-use regulation following

Reformasi after the fall of 30-year dictatorial New Order regime under President Suharto in 1998

(Wardojo and Masripatin 2002). Motivated by greater autonomy, many district governments have

been keen to develop land as they rely on such income to support local development and

infrastructure. The conversion of forest into large-scale industrial plantations (oil palm, timber for

pulp and paper), small-scale commodity-based agriculture (rubber, cacao, coffee and rice), and

mining are key activities promoting deforestation (Wardojo and Masripatin 2002; Atmadja and

Wollenberg 2010; Olsen and Bishop 2009). This is further exacerbated by a combination of weak

Statistical Snapshot: Indonesia 2008

Land Area Population GDP per capita GDP growth rate GDP composition Forest Cover 1990 Forest Cover 2000 Forest Cover 2008 Primary forest Imperata Grassland

181,157,000 ha 229,965,000

US$2,329 5.3%

Agriculture 34.1%, Industry 44.5%, Services

21.4% 116,568,000 ha 97,852,000 ha 88, 495,000 ha

48, 702,000 ha (55.03%) 8,7000,000 ha (9.8%)

Table 3.1 Statistical Snapshot: Indonesia 2008 Sources: CIA World Factbook; Mongabay.com

12

governance, corruption and ill-defined property rights which contribute to land-use conflict and illegal

deforestation (Atmadja and Wollenberg 2010). It is estimated that up to 70% of timber supply in 2000

was illegally logged (IFCA 2008).

The growth of Oil Palm (Elaeis Guinneensis) has been central in this. In 2007 Indonesia became the

world’s largest producer of oil palm, surpassing Malaysia. The tropical climate of Indonesia coupled

with an abundance of suitable soils and low labour costs makes oil palm production particularly viable

for the region (BAPPENAS 2009). It is a sector dominated by large-scale industrial estates,

employing around 7 million nationally and an increasingly important source of income in the rural

side. Between 1986 and 2005, private oil palm estates increased 38 fold from just 144,000 ha to 5.5

million ha while smallholder plantations increased 11 fold from 129,000 to 1.1 million ha and

government estates increased only 2 fold from 332,000 ha to 677,000 ha (Casson et al. 2007)

Figure 3.2 Area Growth of Oil Palm in Indonesia according to sector (1986-2004).

Source: Casson et al. 2007

Increased global demand, rising prices and policy distortions are underlying causes for this growth.

Emerging economies, particularly China and India, are increasingly relying on oil palm as a cheap

supplement in the food and cosmetics industry. This is further fuelled by climate policy increasing

demand for biofuels, of which oil palm is a key feedstock; Stromberg et al. (2010) investigates EU

biofuel directives and find a significant correlation between the strengthening of biofuel policy in the

EU and deforestation in Indonesia. At a domestic level, a mandate issuing an 8% mix of biofuel in all

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000

Tota

l Are

a (h

ecta

res)

Private Estate Governement Estate Smallholders

13

petrol is adding further demand, whilst a number of government subsidies also encourage investment

in the oil palm sector.

As of 2008, oil palm plantations covered seven million hectares of land in Indonesia, with over half

allocated on previously forested land (Casson 2007). Kalimantan, Sumatra and New Guinea – the

main oil palm producing regions in Indonesia - have seen the most severe environmental damage. An

estimated 65% of tropical forest was lost in Sumatra between 1981 and 2003, whilst simultaneously

oil palm production increased fortyfold (WWF 2007). Fitzherbert et al. (2008) notes how oil palm

expansion may contribute to deforestation either directly through conversion of intact forests or

indirectly, by generating improved road access to previously inaccessible forest or displacing other

crops into forests. Much of this deforestation has occurred on peatland forest which releases large

amounts of carbon into the atmosphere when converted. Gibbs et al (2006) estimates that peatland

conversion takes up to 900 years to repay its carbon debt, in comparison to mineral soil forest

conversion which carry a carbon debt of 30-120 years. Although peatland only makes up 12% of

forest area, it accounts for more than half of national emissions. Furthermore, Soyka et al. (2007)

finds a significant correlation between the expansion of oil palm in Indonesia and global food

shortage. Indeed, over two million hectares of agricultural crops were converted into oil palm in

Indonesia between 2000 and 2007, which has been a key source for inducing conflict in the rural side

(Oxfam 2008).

REDD & Permit-Swaps

With the forestry sector having undoubtedly played a key role in the reduction of poverty and

economic development seen over the past 30 years in Indonesia, the dilemma facing the government

has been the classic conservation-development trade-off. With the emergence of REDD and

significant funding available, however, Indonesia passed legislation in 2009, becoming the first

country to officially adopt a national framework3. This framework sees a ‘nested’ approach under

which both public and private carbon forest initiatives can be undertaken as part of an overarching

national REDD strategy and accounting system. The Australian-Indonesian partnership was

announced in 2009 to provide funding for readiness activities including capacity building and pilot

projects. In May 2010, Norway pledged another US$3 billion to be rewarded as performance based

credits, paid ex-post to any commitments period on emission reductions from an agreed baseline.

Despite significant institutional barriers, REDD is gaining grounds with over 20 pilot schemes

currently in various stages around Indonesia as of 2009 (Mann and Surya 2009).

3 See http://redd.pbwiki.com/ for a summary of polices and regulation related to REDD in Indonesia

14

Permit-swaps can play an important role in an Indonesian REDD strategy. Garrity et al. (1997)

estimates that 8.5 million hectares of savannah-like degraded land, in the form of imperata grassland,

exist in Indonesian, although it is likely that the actual amount is significant higher following

aggressive development polices in the last decade (Fairhurst 2009). Imperata cylindria is in essence a

resilient weed which develops after destructive logging or continuous periods of slash and burn

agriculture leading to degradation. Although imperata is generally regarded a ‘problem’ for

agriculture conversion, recent studies have shown that optimised land management, as opposed to soil

type, is a far more important determinant of output when converting such land (Fairhust 2009; Casson

2007; BAPPENAS 2009). Thus even highly degraded soils in which imperata may exhibit can be can

be made profitable using the correct measures.

Pursuing Permit-Swaps can be particularly important for oil palm. Given its high yield, forest

conservation under the PES-like approach is currently not a viable option as long as credits are priced

in voluntary carbon markets. Butler and Koh (2008) and Venter et al. (2009) investigate this and find

that conservation of mineral soil forest against the threat of oil palm will only be viable if carbon

credits are priced in a Kyoto-based Compliance Market. Peatland forest, with its significantly higher

carbon content, is the only forest type currently viable for conservation. Given that forgone

productivity, thus minimum compensation required to avoid deforestation, is reduced under Permit-

Swaps, the potential to safeguard forest is increased. With an estimated 8 million ha of additional oil

palm plantations needed to meet Indonesian 2020 oil palm target, the amount of degraded land is

potentially sufficient (Casson et al. 2007)

15

IV. Methodology

Analytical Framework

Proponents of REDD need to prove that intervention is able to improve on the baseline of forest-based

emissions and provide better outcome than other strategies. Viability is central to this in regards to

both its ability to reduce deforestation (competing against the economic benefits of forest conversion),

as well as its ability to mitigate CO2 emissions at a lower cost than other Emissions Reduction

Options (EROs), such as solar and wind power. Measuring viability does not replace policy

evaluation, but does provide a measure of cost effectiveness and indicates whether REDD is able to

create effective incentives. The difficulty analysts have in reaching consensus over this goes to the

heart of deforestation - “drivers are diverse, layered and synergistically linked” (Murray et al. 2009

p.11). With key determinants, such as agricultural returns and carbon stock varying greatly over

space, forest conservation as a competitive ERO will vary equally. The following section outlines the

framework for empirically assessing the incentive framework of Permit-Swaps proposed in Chapter

II.

Literature reveals two district approaches for determining viability; global top-down models and

regional bottom-up assessments. Top-down approaches use aggregated global data to model land-use

change. General and partial equilibrium models which integrate deforestation with the rest of the

economy (thus capturing market feedbacks) have been particularly popular among top-down

assessments (see Satataye et al. 2005; Kindermann et al. 2006; Hertel et al. 2007). Bottom-up models,

on the other hand, tend to be built ad hoc to local conditions with a focus on specific activities in a

given region. Butler and Koh (2008) and Venter et al. (2009) for examining the viability of REDD

against oil palm adopt this approach using an NPV framework and empirical data from local sources.

The strength of this approach is capturing local variations and ground realities which global models

fail to consider. Inputs are, however, assumed fully exogenous thus bottom-up approaches often fail to

account for market feedbacks that may arise (Nepsted 2007).

In this analysis a bottom-up approach is adopted. REDD activities will ultimately be carried out at the

local level, thus assessing viability against local conditions will be more representative. We focus on a

single sector in a given region which allows us to examine in depth various possible scenarios that

reflect local conditions and variability. To assess viability, a hypothetical agricultural/agroforestry

concession on a piece of forested land and the profit-seeking agent is considered. This agent is faced

with the decision to either a) convert the piece of forested land into agriculture/agroforestry b)

conserve forest under the PES-like approach or c) reallocate concession to degraded land under a

Permit-Swap. If an economic agent is profit maximising, then s/he will pursue the land-use option

16

which maximises private benefits given available skills, finance, technology and policies (Tomich

1997). Under this assumption, a land-use option will be preferred to another if its net discounted

benefits exceeds that of the alternative (Barbier 1997). In other words option a will be preferred to

option b if;

Ba –Bb > 0 (1)

If land-use is considered an investment, then net discounted benefits of a multi-year investment can be

determined by adopting the Net Present Value (NPV), defined as;

T

tttt

dCBNPV

1 )1()(

(2)

where Bt are benefits of project in year t, C is its cost at year t, r is the discount rate, and T is the

duration of the project in years and t is time (denoted in years). An investment is profitable if NPV >

0. If NPV < 0, then there is no financial incentive to make the investment and an agent is better off

pursuing an alternative option, or indeed do nothing. Viability under this approach is determined by

comparing financial profitability of land-use options considered. Deforestation will be avoided if any

of the two REDD approaches is able to produce a higher NPV than agricultural conversion. Permit-

Swaps is in turn more viable than PES-like conservation if it is able to produce a higher NPV and vice

versa.

Models

Several land-use scenarios need to be considered. In the case of land-conversion, conversion of

forested and degrade land into agricultural use is considered. Conversion of forest is particularly

important as it represents the forgone productivity, thus opportunity cost that arises in a conservation

scenario. Under a PES-like approach, compensation under REDD will require at least this amount for

a landowner to be willing to stop land conversion The net benefit that can be generated from

converting degraded lands represents the amount by which this compensation is reduced under the

Permit-Swap approach.

To determine our profit function for converting land into agriculture, we start with the basic NPV

equation; profit is a function of total discounted revenue from agricultural income and total

discounted cost in investment period T, where i is either conversion of forested (a) or degraded land

(d);

P

tt

tiT

tt

tii d

Cd

BNPV

1

,

1

,

)1()1( (3)

17

The revenue that can be generated is in turn dependent on annual yield, q, at price, p. Costs can be

separated into fixed costs, f, and variable cost, v. Fixed costs relate to initial investment from, inter

alia, clearing, rehabilitation and set-up, which is spread over time P. Variable cost denotes the annual

operational cost, which is dependent on yield and incurred throughout investment period T.

NPVi qi,t .( pt v i,t )

(1 d)tt1

T

f i,t

(1 d) tt1

P

(4)

Any revenue generated will, however, be subjected to tax by amount τ, thus,

NPVi qi,t .(pt v i,t ).(1 )

(1 d) tt1

T

f i,t

(1 d) tt1

P

(5)

This is the most basic model of land conversion which we adopt for conversion of degraded land. In

the case of forest conversion, logging income (L) will also incur in the initial clearing phase over

period L,

P

tt

taT

tt

tattaa d

fd

vpqNPV

1

,

1

,,

)1()1()1).(.(

+ L (6)

NPVa qa,t .(pt va,t ).(1 )

(1 d) tt1

T

fa,t

(1 d) tt1

P

qa ,t

L .ptL .(1 )

(1 d) tt1

L

(7)

where qL is annual timber logged over clearing phase L at price pL and taxed at τ . We assume that a

standing forest or degraded land carry no value to the landowner in absence of policy intervention.

Any land conversion will thus generate a positive NPV as long as Bi,t > Ci,t. Furthermore, as long as

NPVa – NPVd > 0, utilising degraded land is less desirable than forested land, even if converting

degraded lands yields a positive NPV.

Under the alternative scenario – REDD conservation - policy intervention internalises carbon

emissions and a price is allocated on CO2 (per ton). The profit function can be determined as

following;

T

tt

Ct

T

tt

CtiC

i dC

dB

NPV11

,

)1()1( (8)

where Bc is benefits that can be incurred from carbon storage for a given piece of land and Cc is the

related project cost of pursuing REDD, i is either PES-like (PES) conservation or Permit-Swaps (PS) .

The value of standing forest, Bc, is in turn a function of annual income of carbon benefits. If we

assume these are spread evenly throughout the investment period (reflecting an equal allocation

18

model4) then annual income is function of annual avoided emission, qc, valued at price, pc per ton of

CO2. Although many of the costs associated with REDD will be funded through readiness grants (as

opposed to performance based compensation payments), project specific cost arises from set-up and

operational costs. We account for these as CtC, where t=1 is set-up costs and t=2...T is annual

operation cost. Thus we have,

T

tt

Ct

T

tt

Ct

CtC

i dC

dpq

NPV11 )1()1(

. (9)

In the case of Indonesia, credits generated from private initiatives will be taxed in the same way any

other land-use would (Atmadja and Wollenberg 2010). If we assume that profit is taxed then,

T

tt

Ct

T

tt

Ct

CtC

PES dC

dpqNPV

11 )1()1.(

)1()1.(.

(10)

where τ is tax rate. Public initiatives, however, will not be taxed, thus we adopt both use both a

‘taxed’ and ‘non-taxed’ scenario. These models represent the profitability of the PES-like approach.

Conservation under the

Permit-Swap differs to the PES-like approach as two lands are considered simultaneously. We are

interested in both the net benefits that avoided deforestation brings, NPVac, and benefits of converting

degraded land, NPVd. The Permit-Swap proposal, NPVp, can be model by combining equations (7)

and (12);

dC

aC

PS NPVNPVNPV (11)

Some transaction cost Ct, is however likely to arise in revising land permits. Thus;

dC

aC

PS NPVNPVNPV – Ct (12)

This is the most basic version of our proposed model. If carbon sequestration, NPVs, from converting

degraded land into agriculture is considered then;

dC

aC

PS NPVNPVNPV – Ct + NPVs (13)

The inclusion of carbon sequestration is considered under a ‘High C’ and a ‘Low C’ scenario, the

former accounting for additional sequestration. Under the Permit-Swap model, avoided deforestation

will be viable if CPSNPV > NPVa. As long as NPVd > 0 and transaction cost, Ct is not greater than

4 Explain equal allocation model (compensation paid throughout investment period in equal amounts as incentive to retain forest as opposed to lump sum at start of project)

19

either CPESNPV or NPVs, the Permit-Swap model will generate a positive net present value, C

PESNPV >

0.

These models allow us to determine NPV of the various scenarios considered. The majority of

viability studies, however, give their estimates in opportunity cost per ton of carbon which allows for

comparison of cost-effectiveness between ERO’s across sectors. Under REDD, this is the minimum

price of carbon required to sway forest conversion which can be determined by rearranging the NPV

framework (Venter et al. 2009). Under a PES-like approach, this means,

C

PESNPV = NPVa (14)

If this is expanded, rearranged and simplified then minimum price of carbon is given by,

T

tCt

Ct

T

tt

Ct

aCt q

C

dqNPVp

1

1 )1()1.(

(15)

For the Permit-Swap model (without tax and carbon sequestration), minimum carbon price is

determine by,

C

PESNPV + NPVd = NPVa (16)

Likewise, if this is expanded and rearranged then,

T

tCt

Ct

T

tt

Ct

daCt q

C

dq

NPVNPVp1

1 )1()1.(

(17)

Viability under this approach is determined by comparing minimum carbon price to current carbon

prices. If the required carbon price calculated is less than actual carbon prices in the market than

REDD will fail to conserve forest and vice versa. In this study, both NPV and minimum carbon price

are calculated to allow for comparability with other studies.

20

Assumption and other caveats

Several important assumptions are made. Foremost, farmers are profit-seeking with no other

objectives or preferences such as establishing land tenure or a benevolent desire to conserve forests.

Decisions made about land-use are based only on internal factors and any external factors are not

considered. Under a conversion scenario, the complete removal of forest vegetation to provide for

agricultural purposes is assumed. In the case of conservation, we exclude any returns a standing forest

may generate, such as sustainable logging of timber or ecotourism. Likewise, degraded land is

assumed to carry no financial value on its own5, thus no opportunity cost arises when converting such

land.

Compensation is based only on avoided emissions and no other ecosystem service. To calculate

avoided emissions, we adopt the methodology developed by Venter et al. (2008) where the following

sources are considered; 1) decomposition of forest timber products (Ctimber), 2) burning of above

ground vegetation (CburnAGV), 3) decomposition of unburned above and below ground vegetation

(CdecompABGV), and 4) peat oxidation and increase probability of peat burning (Cpeat). To calculate avoid

emissions, the following formulas are used;

Ctimber = [Cforest * (1 – a) – d] * [b] * [1 – c]

CburnAGV = [[Cforest * (1 – a) – d] * [(1 – b) + (b * c)] * (1 – f)] * e

CdecompABGV = [Cforest * (1 – a) – d] – [Ctimber + CburnAGV ] + [Cforest * a]

Cpeat = [g + h]

where a is below ground carbon, b is forest harvest, c is harvest discard, d is oil palm above and

below ground carbon, e is fire burning efficiency, f is charcoal and Cforest is above and below living

vegetation carbon. For peatland we include peat oxidation (g) and emission from increased incidence

of peat burning (h). The variables Ctimber, CburnAGV, CdecompABGV , and Cpeat are derived in a per hectare

basis. To determine annual avoided emissions, qc (as per our the models above) total area needs to be

accounted for. Any credits generated are also assumed to paid in equal amounts through the 25-year

commitment period, reflecting an equal-allocation model (Butler and Koh 2008). Finally, we assume

full additionality and no leakage, meaning reductions are real and not shifted elsewhere. Although

reduced leakage is a key motivation for permit-swaps, given its uncertainty and difficulty to measure,

it is not accounted for in this analysis.

5 Fieldwork has shown that in may in fact carry a number of uses to local people (Tomich 1997). Given the uncertainties associated with assessing such value they are left out of the analysis.

21

V. Data Description

The models developed in the previous chapter are adopted for the case of Indonesia and the large-

scale oil palm producer6. The analysis relies primarily on empirical data collected from peer-review

journals, gray literature and personal correspondence. In the case of oil palm, data is limited

specifically to cases within Indonesia to reflect local conditions. REDD costs are more problematic as

pilot projects are likely not representative of actual costs (Olsen and Bishop 2009). World Bank

estimates for best-practice scenario are adopted instead.

To account for economies of scale, it is assumed that the forested and degraded considered in our

hypothetical scenario (see analytical framework) covers an area of 10,000 ha each. As a rule of

thumb, a 10,000 ha plantation is the minimum required for a processing plant to operate profitably

(Tambunan 2006). A 25-year investment period is adopted reflecting both the productive lifecycle of

an oil palm tree and the maximum time span allowed for an REDD initiative under Indonesian

legislation before being reconsidered (Casson et al. 2007; Atmadja and Wollenberg 2010).

To account for intra-regional variability, the analysis is separated into four soil types; Mineral soil

rainforest and Peatland rainforest are considered for forested land, and for degraded land, imperata

grasslands on Ultisols and Entisols soils are considered. The Indonesian rainforest is split between

88% Mineral soil forest and 12% peatland and represent the main threats by oil palm conversion.

Imperata grassland is found in a variety of soils of which Utisol and Entisol are most abundant, thus

represent the greatest opportunities for permit-swaps. Given the difference in returns and costs

associated with these soil types, individual cashflows are modelled for each using MS Excel 2007 (the

examiner is encouraged to read the analysis together with models). To allow for comparability, the

analysis is carried out in 2008 US dollars with inputs adjusted accordingly and results denoted in per

hectare units. For a summary of inputs and relevant sources see Appendix A.

Oil Palm Conversion

For the conversion of land (degraded and forested) into oil palm, a conversion rate of 1250 ha per year

is assumed, also leaving an 8 year productivity gap between first and last generations planted. In the

case of forested land, a timber income of $1,099 per ha is used (Tomich et al. 2002; Grieg-Gran

2008). Primary yield from oil palm comes from Fresh fruit Branches (FFB) harvested. To determine

output, empirical data on average lifetime FFB output (per year) in large-scale estates in Indonesia is

used; 21.97 tFFB/ha/yr for mineral soil; 27.46 tFFB /ha/yr for peatland; 21.87 tFFB /ha/yr for Utisol;

6 Large-scale estates represent the greatest threat to forest as smallholder farmers tend to convert existing agricultural land (Casson et al. 2007)

22

16.12 tFFB /ha/yr for Entisol (Persson 2009; BAPPENAS 2009; Fairhurst 2009). These are then

applied to a standardize yield curve over a 25-year cycle to derived the per-year output (see Figure

5.1). Productivity gap between degraded land and mineral soil forest is minimal after rehabilitation,

whilst peatland is generally able to achieve higher productivity per hectare as trees can be planted at

up to 30% greater density (Casson et al. 2007; BAPPENAS 2009).

Figure 5.1 FFB Yield Curve according to soil type

From respective FFB yield curves, per-year production of Crude Palm Oil (CPO) and Palm Kernel

(PK) is obtained using the 20.65% and 5.1% extraction ratio with the assumption that these

extraction-ratios stay constant across the differing soil types (Mahlia 2001; Persson 2009). Prices are

based on the latest projections by the World Bank (2008) which includes estimates up to the year

2020. These see the price of CPO rise to $643 in 2015 and decreased to $510 by 2020 (World Bank

2008). The price of PK is assumed to be 60% of CPO prices aligned with industry estimates (Butler

and Koh 2008). Note that our calculated total annual production takes accounts the phased expansion

and yield differentials between plant generations

For costs we consider inputs up to the processing of CPO and KE after which we assume it is sold off

to a secondary supplier. In the case of forest conversion, set-up costs (clearing, rehabilitating and

planting) range from $3,441 ha-1for mineral soil to $4,190 ha-1 for peatland per whilst annual

operational expenses (cultivation upkeep, farm overhead, harvest and transport, factory processing,

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

40.00

3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

Yie

ld (t

ons

per h

a)

Year

MINERAL PEATLAND

UTISOL ENTISOL

23

and admin) range between $253 (mineral soil) to $308 (peatland) per hectare (Rotheli 2007). For

degraded lands, we use empirical estimates by Fairhurst (2009) where set-up costs range from $3,847

per ha of Utisol to $4,799 per ha on Entisol with annual operating cost ranging between $851 per ha

for Utisol to $1,258 per ha or Entisol. Entisol have particularly high costs as its hard pan surface

needs to broken up with higher drainage and fertiliser requirements (Fairhurst 2009). Given that

companies often do not pay rental for land allocated by government (as they incur income from taxed

production), land price is not included as an input (Casson et al. 2007). Under the profit function, a

30% tax rate is used aligned current tax rate in Indonesia and deducted from the operating profit

(excluding any initial investments). Finally, a discount rate of 10% is applied, reflecting rates used in

similar studies (see Butler and Koh 2008). Note that first year is discounted with the assumption that

that income is incurred at end of the year.

REDD Conservation

Under a conservation scenario, avoided emission from deforestation is determined by the

methodology described in section 3.3. Under a ‘High C’ scenario, carbon sequestration from

conversion of imperata grassland to oil palm is accounted for; imperata grassland contains 39 Mg/C

per ha, oil palm contains 91 Mg/C per ha allowing for net sequestration of 52 Mg/C per ha (Casson et

al. 2007). Any values estimated in Carbon are converted into Carbon Dioxide by applying a

conversion rate of 3.67 (Butler and Koh 2008). Whether payments will come though a fund or market

based system, we assume they will reflect current carbon prices. Given the variability of prices in the

different carbon markets, three pricing scenarios are adopted; the CCX for voluntary market, and the

CER and EUA for the compliance market;

The Chicago Climate Exchange (CCX) is currently the only platform where credits from

avoided deforestation can be traded. With the economic downturn in 2009 the value of CCX

credits have declined sharply to only $0.01 per tonne of CO2 (June 2010). Given that this is an

exceptional circumstance and likely not permanent, values from 2008 are used where CO2

was traded at $4.40 per tonne. An annual appreciation of 5% is applied aligned with

assumption by Butler and Koh (2008).

Certified Emissions Reductions (CER) are credits generated by initiatives under the Clean

Development Mechanism of the Kyoto Protocol. As REDD will not be part of any

compliance market until at least the post-Kyoto regime in 2012, we use the market price for

2012 CER future contract of $37.56 per to CO2 as basis for forecast.

EUA represents the compliance market for EU countries where carbon credits are traded for

international obligations and targets, primarily based on the Kyoto Protocol. For the same

24

reason as above, market price for 2012, 2013 and 2014 CER future contracts ($46.89, $50.29,

$52.44 per ton of CO2 respectively) is used. From 2015 to 2025, the 2014 carbon price is

adopted.

Our cost estimates for REDD are based on the World Bank’s Forest Carbon Partnership Facility

(FCPF; carbonfinance.org) best-practice standards which suggest £25 per ha set-up cost (assumed to

incur in the first year) and $10 per ha for annual operating expenses. Set-up cost accounts for cost of

project design, governance and planning, enforcement, land tenure and acquisition, monitoring and

measurements, surveying and other costs (Eggleston et al. 2006; Thoumi 2009). Operational costs

include, inter alia, governance and planning, enforcement, infrastructure maintenance, information

and education, monitoring, marketing, finance and administration (Eggleston et al. 2006; Thoumi

2009). As there is no clear estimate for transaction cost associated with relocating concessions in

permit-swap, we assume these incur as part of the REDD project cost given that they account for

similar factors. Finally, a 30%, tax rate is used for our ‘Taxed’ scenario which reflecting the rate that

will be used for private REDD initiatives in Indonesia (Atmadja and Wollenberg 2010). The ‘No Tax’

scenario reflects government based initiatives where no tax is incurred . Finally, a discount rate of

10% is applied, aligned with rates used in similar studies (see Butler and Koh 2008; Venter et al.

2009). Again the first year is discounted as we assume that income is incurred at the end of the year.

25

VI. Results

Table 6.1 NPV (US$ ha-1) of Oil Palm Conversion on various soil types

Soil Type NPV (US$/ha)

Mineral (forested) $4,531

Peatland (forested) $4,282

Utisol (degraded) $4,172

Entisol (degraded) -$895

Table 6.2 NPVs (US$ ha-1) of REDD scenarios

Soil Type Tax No Tax CCX CER EUA CCX CER EUA

PES-Like Model Mineral 569 3,054 4,212 813 4,362 6,017

Peat 3,751 18,538 25,431 5,358 26,482 36,330

Permit-Swaps Model Mineral to Utisol High C 5,052 8,736 10,453 5,428 10692 13,145

Low C 4,741 7,226 8,384 4,985 8535 10,189

Mineral to Entisol High C -16 3,669 5,386 361 5,624 8,078

Low C -326 2,159 3,317 -82 3,467 5,122

Peat to Utisol High C 82,34 24,220 31,672 9,974 32,812 43,458

Low C 79,23 22,710 29,603 9,531 30,655 40,502

Peat to Entisol High C 3,166 19,153 26,605 4,907 27,744 38,391

Low C 2,856 17,643 24,536 4,463 25,587 35,435

26

Table 6.3 Minimum Carbon Price (US$/tCO2) required to sway forest conversion

Soil Type Tax No Tax PES- Like Model

Mineral 50.46 35.57 Peat 8.02 5.66

Permit-Swaps Model Mineral to Utisol High C 3.19 2.40

Low C 4.73 3.56

Mineral to Entisol High C 40.65 28.62

Low C 60.27 42.43

Peat to Utisol High C 0.31 0.26

Low C 0.34 0.28

Peat to Entisol High C 8.94 6.30

Low C 9.67 6.81

Our analysis reveals that forest conversion for oil palm will generate an NPV between $4,531 and

$4,282 per hectare (see table 6.1) over a 25-year period for mineral and peatland respectively,

suggesting that despite higher yields achieved from peatland, their higher costs also offset these gains.

Nevertheless, any conservation scenario under REDD must generate an NPV which exceed these

values in order to prevent deforestation in the respective forest types. The PES-like approach ,

however, will only generate an NPV of $569 (Taxed) and $813 (Non-taxed) for conservation of

mineral soil forest when carbon credits are traded in a voluntary market (see Table 6.2) – far below

what is needed to prevent conversion. Given the significantly higher carbon content of peatland, on

the other hand, NPVs range between $3,751 (Taxed) and $5,358 (No tax) in a voluntary market. This

suggests that as long as credits are not taxed, peatland can be conserved even under voluntary market

prices for carbon. In terms of minimum carbon prices, these range from $5.66 per ton CO2 (peatland,

not taxed) to $50.46 (mineral soil, taxed).

27

These estimates reinforce the findings of Butler and Koh (2008) and Venter et al. (2009), suggesting

that as long as REDD credits are only tradable in voluntary markets, oil palm conversion will almost

always be the more profitable option (under the PES-like approach). If credits are priced in a

compliance market, on the other hand, significantly higher NPVs are achieved, ranging between

$3,054 for mineral soil forest (Taxed, CER) to $36,330 for peatlad forest (No tax, EUA). Given that

this market is not yet accessible for REDD-based credits, however, it should not be relied upon as a

solution.

In the case of degraded land, we see from Table 6.1 that converting imperata grassland on Utisol soil

for oil palm is itself able to generate an NPV of $4,172 - just below that of peat soil ($4,282) and

mineral ($4,531), confirming the notion that degraded lands are less profitable, although only

marginally. While rehabilitation is costly, significant saving appear to be made in land clearance with

productive yield almost identical to that obtained on mineral soil forest after rehabilitation.

Relocation concession from either mineral soil forest or peatland to Utisol under Permit-Swaps, will

generate an NPV between $4,741to $7,923 per ha respectively in a voluntary market (Taxed),

suggesting that even if carbon is priced in non-compliance market and credits are taxed (as per a

private initiative), pursuing the Permit-Swap approach is a highly viable option. If in addition carbon

sequestration from reforestation is included (as under our ‘High C’ scenario), the NPVs will increase

further to $5,052 per ha when taxed and $5,428 per ha if not taxed for mineral soil, or for peatland

between $8,234 (Taxed) to $9,974 (non-taxed). In terms of carbon prices (see Table 6.3), these range

from $4.73/tCO2 for mineral soil forest or $0.34/ tCO2 for Peatland forest under a conservative

scenario (Low C, Taxed). Alternatively, from an optimised approach (High C, No tax), carbon prices

range from or $2.4/ tCO2 (mineral forest) to $0.26/ tCO2 (peatland forest) – significantly lower than

under the PES-like approach and well within the reach of carbon prices in the voluntary market.

Imperata grassland on Entisol soil, however, appears more problematic. Conversion for oil palm on

such land produces an NVP of -$895 per ha, indicating that is not a profitable investment on its own.

Compared to Utisol, set-up and operating costs associated with Entisol is significantly higher whilst

simultaneously lower yield even after rehabilitation. Under Permit-Swaps, relocating oil palm

concession from mineral under voluntary carbon markets still produces negative NPVs from -$326

per ha (Taxed) to -$82 (Non-taxed). Permit-swap for Entisol are only able to generate a positive

returns when concession are reallocated from peatland allowing for NPVs between $2,856 (Taxed,

Low C) to $4,907 (No Tax, High C) when carbon is priced in voluntary markets. Under this scenario,

however, NPV are lower than under a PES-like approach, thus a profit seeking agent will not opt for

permit-swaps. Even if carbon sequestration from oil palm trees is accounted for, the PES-like model

still produces the higher NPVs.

28

Sensitivity Analysis

Predicting viability of multi-year investment involves considerable uncertainties. To assess the

robustness of our findings against variability, a sensitivity analysis is carried out. We focus on 7 key

variables which are tested individually ceteris paribus; a) FFB Yield, b) FFB price c) Oil palm costs

on forested land (set-up and operation cost together), d) Oil palm costs on degraded land (set-up and

operational cost together), e) Avoided emissions, e) REDD costs (set-up and operational together), f)

Discount rate. A -20/+20% variability is tested against the minimum price of carbon needed to avoid

land conversion, except for Discount Rate in which we use a 0-20% nominal variability. Minimum

carbon price is adopted as dependent variable rather than NPV as it does not limit the scenarios to any

specific carbon market. Given the numerous scenarios examined in our original analysis, the

sensitivity analysis is limited to scenarios within the Permit-Swap model, specifically for;

Mineral to Utisol (taxed)

Mineral to Utisol (not taxed)

Mineral to Entisl (taxed)

Mineral to Entisol (not taxed)

We exclude relocation of permits from peatland, as the cashflow analysis confirms that PES-like

conservation of such land is already viable when credits are priced in a voluntary market. We also

exclude carbon sequestration from converting degraded lands (our ‘High C’ scenario) to allow for

more conservative estimates. Figures 6.1 illustrates the results of the analysis with vertical axis

indicating the minimum price of carbon as dependent variable and horizontal-axis the -20/+20%

variability. Each graph includes the price of carbon at the voluntary CCV exchange (the horizontal

line at $4.40/tCO2) as an indicator of viability. If values are above this threshold, then the price of

carbon required to avoid deforestation is above voluntary market prices, thus not viable if traded in

the CCX. Values below this threshold, on the other hand, indicate that voluntary carbon prices are

sufficient for preventing deforestation.

29

Figure 6.1 Sensitivity Analysis

-20

0

20

40

60

80

-20% -10% 0 +10% +20%

US$

/ton

CO

2

% of FFB Yield

0.00

20.00

40.00

60.00

80.00

-20% -10% 0 +10% +20%

US$

/ton

CO

2

% of CPO Price

-20

0

20

40

60

80

100

-0.20 -0.10 0.00 +10% +20%

US$

/ton

CO

2

% of Oil Palm Cost (Forested)

-20

0

20

40

60

80

100

-0.20 -0.10 0.00 +10% +20%

US$

/tons

CO

2

% of Oil Palm Cost (Degraded)

-10

10

30

50

70

90

-0.20 -0.10 0.00 +10% +20%

US$

/ton

CO

2

% Avoided Emissions

-10

10

30

50

70

-0.20 -0.10 0.00 +10% +20%

US$

/ton

CO

2

% REDD Costs

-20

0

20

40

60

80

0.00 0.05 0.10 0.15 0.20

US$

/ton

CO

2

Discount rate

1. Mineral to Utisol, tax, low C

2. Mineral to Utisol, no tax, low C

3. Mineral to Entisol, tax, low C

4. Mineral to Entisol, no tax, low C

CCX

30

Two key observations emerge from the sensitivity analysis; relocating permits to Entisol remains

unviable against carbon prices in the voluntary market even in the presence of variability. In all

instances, the minimum price of carbon required to avoid deforestation remains significantly higher

than the $4.40/tCO2 in the voluntary CCX market. Secondly, the viability of relocating permits to

Utisol soil is highly susceptible to variability, with small percentage changes in key variables

significantly affecting the ability to sway-land use conversion under voluntary carbon prices. This is

particularly the case for costs related to oil plam conversion on forested and degraded land. A 3%

increase in set-up and operating costs of degraded land or a 3% decrease in the same costs for oil palm

on forested land results in the Permit-Swap approach being unviable to prevent deforestation if credits

are traded in voluntary markets.

Likewise, a small decrease in FFB yield (for both conversion of forest to determine opportunity cost,

and that of degraded land conversion), leads to minimum carbon prices above voluntary market

prices. On the other hand, a small increase in FFB yield significantly increases viability of the Permit-

Swaps, thus it works both ways. Negative carbon prices is achieved after a 10% increase, which

suggests that planting on degraded lands is more profitable than conversion of forest without credits

from avoided deforestation. This reflects the notion of several other studies – that converting degraded

land is in fact more profitable than conversion of forested land due to significantly lower clearing

costs (see Fairhust 2009; Goh et al. 2000; BAPPENAS 2009). The problem is in the business model

of many oil palm companies which value total revenue more (BAPPENAS 2009)

CPO prices and REDD costs appear least susceptible to variability, with relatively horizontal lines.

This can be explained form the fact that an increase in CPO price increase profitability of both

conversion of forested land and degraded land. REDD costs are also relatively small compared to

other inputs considered. Further, changes to Avoided Emissions yield relatively horizontal curves for

the Utisol scenarios, whilst a significant gradient is observed for Entisol scenarios, suggesting that

REDD compensation have a relativity larger impact on viability for the latter. Not surprisingly,

increasing discount rate also reduces viability of permit-swaps as value of income over time is

reduced. An increase of 1-3% makes Permit-Swap unviable for voluntary carbon markets, suggesting

that discount rate affects carbon benefits and conversion of degraded land more than conversion of

forested land (opportunity cost). That the gradient for Utisol is steeper than for Entisol can be

explained by the lower initial investment and greater revenue Utisol produce, thus proportionally

greater loss to higher discount rates.

31

VII. Discussion and Policy Implications

When these results are reviewed in context of the wider incentive framework, as discussed in

Chapters I and II, several implications become clear. First, reallocating concessions to degraded lands

largely allows deforestation to be avoided at a lower cost than under the current PES-like approach.

This confirms our hypothesis that Permit-Swaps make for a more efficient approach for reducing

deforestation. Carbon under the PES-like model needs to be priced at $35.57/tCO2 to sway land

conversion of mineral soil forest for oil palm, compared to permit-swaps where carbon only needs to

be priced at $4.73/tCO2 under a conservative scenario (Mineral to Utisol, Low C, Taxed). Secondly,

this reduction in cost is sufficient enough to allow land-use activities with otherwise high

opportunities costs to become competitive for forest conservation, confirming our hypothesis for

effectiveness. Whilst a number of studies have argued that the inclusion of REDD into a Post-Kyoto

compliance regime will be necessary to prevent deforestation from the threat of oil palm, we

demonstrate that even if carbon is priced in voluntary markets, rainforest with ‘lower’ biomass can

still be conserved against such threats if concessions are directed to degraded lands.

If these results are weighted against other abatement options within the climate change agenda, further

implications emerge. McKinsey & Company (2009) finds that popular mitigation options such as

solar and wind energy are able to reduce emission at a cost of $25/tC02 and $31/tCO2 respectively7.

This is more cost-effective than our estimates for PES-like conservation of mineral soil forest of

$35.57/tCO2 (also consistent with their estimates for high intensive agriculture at US$33/tCO2),

suggesting that PES-like conservation for high intensive agriculture is currently not a competitive

mitigation option. Under Permit-swaps, however, prices range between $2.40/tCO2 and $4.73/tCO2

(Mineral to Utisol), making such an option significantly more competitive than both wind and solar

energy, on par with geothermal solutions (6.25/tCO2) and grassland management (4.15/tCO2). This

cost-effectiveness against other EPOs increases potential to attract investors seeking to maximise

carbon offsets or reduced emissions.

This opens up significant opportunities from a policy perspective. The consensus in REDD discourse

so far has been that land-uses with lower opportunity costs are prioritised for REDD conservation

(Angelsen 2009, Olsen and Bishop 2009, Murray et al. 2009). This is problematic as such activities

may not necessarily be significant determinants of deforestation. With Permit-Swaps allowing a

greater scope of land-use activities to be made viable for conservation, prioritising Permit-Swaps for

7Estimates by McKinsey & Co. (2009) are denoted in 2008 EUR. A 2008 exchange rate of US$1 = 1.25EUR is used for conversion.

32

high yielding agricultural activities can ensure that maximum deforestation is reduced at the lowest

cost. In the case of oil plam, this means that permit-swaps which target concession on threatened

mineral soil rainforest (as opposed to peatland which is already viable under PES-like conservation),

will allow for more efficient reductions.

The economic restriction to Permit-Swaps lies predominantly in the type of degraded land converted.

The case of imperata grassland on Utisol and Entisol soil reveals that the former is significantly more

profitable to convert than the latter even after extensive rehabilitation. When conversion of degraded

land yields negative returns, Permit-Swaps are less profitable than PES-like conservation (as per our

theoretical framework). It is vital then that the suitable degraded land is targeted under such a policy.

In the case of Indonesia, permit-swaps should prioritise concession to imperata grassland on Utisol

soil. This, however, is purely from a financial perspective, and if factors such a leakage is accounted

for (which was assumed to be zero in the analysis) pursuing such land may still be profitable socially.

There are, nevertheless, limitations to this approach. Whilst the paper provides an incentive

framework for incorporating degraded lands into REDD, it is important to recognise that land-use

decisions are not solely economic, but the result of a complex set of factors not captured in this study.

Our sole focus on the financial and economic aspect of permits-swap should also not deceive one of

the challenge implementing permit-swaps would present. Political and institutional barriers lower the

realistic scale that emissions from deforestation can be reduced. Issues of property rights, equity, and

technical capacity are just a few of the challenges that need to be addressed if Permit-Swaps are to

work on the ground. It is also important to recognise that even if Permit-Swaps can be implemented

perfectly, incentivising degraded lands as mean to reduce deforestation is limited by default. Such

supply-side policies, as argued by Tisedl and Natha (2008), do little to tackle the underlying causes of

deforestation. If demand is not met, then any incentives to utilise degraded lands may reduce as

commodity prices rise. Indeed, the sensitivity analysis demonstrated that relatively small changes in

commodity price will affect viability of permit-swaps. If demand is not reduced, then degraded lands

will only provide a temporary solution given its limited nature. Nevertheless, the economic potential

of Permit-Swaps that has been demonstrated is an important first step towards considering such a

policy approach.

33

VIII. Conclusion

This study parts from dominant paradigm within REDD discourse. By proposing a new framework

that integrates degraded land into the emerging REDD agenda and assessing it empirically, important

insights have been made about the ability of REDD to create effective incentives under both the

current approach and our proposed model. It becomes evident, that simply stopping conversion will

not suffice to reduce deforestation given the exclusion of REDD from a Kyoto-based compliance

regime and emergence of highly efficient agricultural and agroforestry systems. Likewise, its

susceptibility to leakage remains a key concern in negotiations.

The case of Indonesia and oil palm demonstrated that reallocating concessions to degraded lands

allow such high-yielding deforestation drivers to become viable for conservation and prevent

deforestation where it otherwise would have occurred. Greater emission is avoided at a lower cost.

Beyond emissions, this has potential to safeguard important biodiversity which face the threat of high

intensive agriculture as well as reduce global food shortage as degraded land does not compete with

agricultural commodities. The provision of similar co-benefits has been a key factor for REDD

negotiations gaining ground at the international level for which Permit-Swaps can contribute further

(Petkova and Verchot 2009).

It is important that Permit-Swaps is not seen as a replacement nor a sole policy approach, however,

but an option that is part of a wider basket of REDD activities. Reducing emissions from deforestation

will require a combination of policies and measures at the domestic level to tackle the various facets

such a challenge pose. Permit-Swaps on its own will be highly limited unless measures are taken to

reduce the demand that leads to deforestation. The onus will rest with the government to get the

incentives through to the local level and overcome powerful institutional barriers and underlying

incentives for forest conversion.

While this study lays the foundation for a new framework, there are limitations to our findings.

Firstly, the bottom-up approach adopted fails to capture market feedbacks. This means our motivation

for reduced leakage under Permit-Swaps has not been captured in the analysis. Given the

susceptibility of PES-like conservation to leakage, this may well improve the viability of Permit-

Swaps further. Secondly, the sole focus on a single sector for a specific region makes extrapolating

our findings to a wider context difficult. Returns across sectors and regions will vary and may not all

be suitable for Permits-Swaps. Likewise, our focus on large-scale estates will not be applicable to

smallholders where output is significantly lower (Casson et al. 2007).

Further research should address these issues. Adopting a top-down approach will allow market

interactions and leakage to be simulated, though care must be taken with the highly aggregated data as

34

they may distort local applicability. At the regional level, expanding the empirical examination to

other activities and landscapes for both smallholder and industrial estates will allow for a more

comprehensive view of viability to identify where Permit-Swaps should be priorities. Modelling

viability will also benefit from greater stakeholder participation. An evaluation of qualitative benefits

gained from permit-swaps should be made a priority. Research in governance challenges and wider

equity concerns of permit-swaps would also provide valuable perspective. Improvements in these

areas will make for a comprehensive case of degraded land to be built for consideration by policy

makers.

35

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39

APPENDIX A – MODEL INPUTS

VARIABLE UNIT SOIL TYPE VALUE SOURCE

OIL PALM CONVERSION Productive Lifetime Average ton/ha/yr Mineral 21.97 Persson 2009; Casson 2007

ton/ha/yr Peatland 27.46 BAPPENAS 2009

ton/ha/yr Utisol 21.85 Fairhurst 2009 ton/ha/yr Entisol 16.12 Fairhurst 2009

Crude Palm Oil Price US$/ton all vary World Bank Commodity Price Data 2008 (Palm Kernal/Crude Palm Oil) Price % all 58.5 Butler and Koh 2008

Extraction Ratio (Crude Palm Oil) % all 20.6 FAO 2007 Extraction Ratio (Kernal palm) % all 5.1 FAO 2007

Standardised Yield Curve all vary Butler and Koh 2008 Logging Revenue US$/ha all 1099 Tomich et al 2002; Grieg-Gran 2008

Plantation Set Up Costs US$/ha Mineral 3,816 Rotheli 2007 US$/ha Peatland 4,579 BAPPENAS 2009

US$/ha Utisol 3,847 Fairhurst & McLaughlin 2009 US$/ha Entisol 4,799 Fairhurst & McLaughlin 2009

Annual Maintenance Costs

total US$/ton Mineral 381 Rotheli 2007 total US$/ton Peatland 457 BAPPENAS 2009

operating costs US$/ha Utisol 851 Fairhurst 2009 operating costs US$/ha Entisol 1258 Fairhurst 2009

FFB harvest and transport costs US$/FFB

ton all 8 Fairhurst 2009

CPO processing costs US$/POE

ton all 11 Fairhurst 2009

Tax Rate % all 30 Casson 2007

REDD CONSERVATION

Below Ground Carbon (a) % all 24.1 Mokany et al 2006 Forest Harvest (b) % all 53 Swallow et al 2007

Harvest Discard (c ) % all 40 IPCC 2003 Palm Oil Above and Below Ground

Carbon (d) Mg C / ha all 37.3 Henson 2003; Swallow et al 2007 Fire Burning Efficiency (e) % all 40 IPCC 2003

Charcoal (f) % all 3.3 IPCC 2003; Eggleston et al 2006 Peat Oxidation Carbon Emissions

(g) Mg C /ha/yr Peatland 15 IPCC 2003; Melling et al 2005

Emissions from increased incidence of peat burning (h)

Mg C /ha/yr Peatland 8.7 Venter et al 2009

Above and Below Ground Living Vegetation Carbon (C(forest)) Mg C /ha all 145 Ruesch & Gibbs 2008

REDD Development Costs US$/ha all 25 FCPF; carbonfinance.org; Eggleston et al 2006

REDD Maintenance Costs US$/ha all 10 FCPF; carbonfinance.org; Eggleston et al 2006

Coversion of C to CO2 - all 3.66667 Butler and Koh 2008 Imperata Grassland Carbon Content Mg C /ha all 39 Casson et al 2007

all 39 Casson et al 2007 Palm Oil Carbon Content Mg C / ha all 91 Casson et al 2007

Tax Rate % all 30 Atmadja and Wollenberg 2010

Carbon Price US$/ton

CO2 all vary Chicagoclimateex.com; ecx.eu

40