Case study: peatland protection and restoration in Kalimantan, .

Box 1 Profile and Key Conclusions

● This case study is based on an existing $42 million USD investment managed by a local project developer in Indonesia. The project seeks to protect and restore peatland ecosystems that are under threat from conversion to agriculture through partnership with local communities. The project has been accredited under the Verified Carbon Standard (VCS) and is able to sell Verified Carbon Units (VCUs) in the voluntary carbon market.

● The project area leases a government concession of an area of 306,000 hectares, of which 150,000 hectares are peatland, which store extensive volumes of CO2. The climate change mitigation impact of the project is 230 million tonnes of avoided CO2 emissions up until 2050 in the SS. Additional environmental benefits include protection of biodiversity benefits from conservation of forests are on the peatland (biodiversity benefits are not quantified in this case study).

● The case study has been considered under a range of future conditions and is modelled in two specific scenarios using the Model of Agricultural Production and its Impact on the Environment (MAgPIE): (1) Business as Usual (“BAU”), with an average carbon price in the voluntary market of $5 USD/tonne of CO2 for the 2020-2050 period; and (2) the Sustainability Scenario (“SS”), where significant global action to meet Net Zero goals is implemented and carbon prices rise meaningfully to an average of $40 USD/tonne of CO2 in the same period.

● The business case is compelling and robust across scenarios: for BAU, the investment is estimated to deliver a 16% unlevered real return to 2050, while in SS unlevered real returns approach 21%.

● Peatland degradations currently contributes about 10% of global greenhouse gas emission from the land use sector. Hence, the protection and restoration of peatlands are associated with significant carbon revenues. An economic modelling exercise identifies an investible universe of $120 billion USD with a similar profile in and Pacific, illustrating the potential scope for projects of this nature.

● Challenges to overcome include: policy uncertainty, as the business model is based on the concession awarded by the government; cash flow duration because the project takes 10+ years to be set up and verified; uncertainty around the carbon price; and an increase in demand for oil palm and biofuels that will intensify land competition.

1. Investment Thesis

Investment overview

This archetype investment is inspired on the Katingan Mentaya project1 in . This is a comprehensive peatland forest protection and restoration project spanning climate change, biodiversity and community goals. The project area licensed under the ecosystem restoration concession encompasses 149,800 ha of land.

Figure 1 Location of Katingan project

Source: Katingan VCS project document

Peatlands in Indonesia are being drained and burned to create nutritious soil for agriculture. This issue is especially prominent in Kalimantan, where unsustainable palm oil and acacia plantations are lucrative and expand significantly. It is important to highlight that there are sustainable palm oil and acacia plantations (e.g. FSC certified) in the region which are not contributing to the depletion of peatland.

The project reverses this trend by undertaking the following activities and getting issuing Verified Carbon Units for sale to the voluntary carbon market:

1 https://katinganproject.com

● Avoid peatland degradation: avoid the deforestation, degradation and drainage of by getting legal licence to protect the project area.

● Rewet the drained peatland in areas where drainage canals already exist while the conservation of undrained and partially drained peatlands in the rest of the project area.

● Agroforestry, fire break plantation and intensive reforestation.

The involvement of communities is key for the success of the project. This project requires participatory planning and the deployment of micro-finance schemes, sustainable energy development and enhancement of public services (health, sanitation and education). Additionally, the project will restore degraded habitats and therefore needs to manage species and their interaction with communities.

This case study focuses on the protection aspect of the project (as opposed to restoration and agroforestry)—leading to avoided CO2 emissions compared to a business-as-usual scenario—because most of the cost and revenues are associated with these types of activities. Additionally, carbon revenues associated with peatland restoration often materialize on a timescale beyond the scope of this analysis.

Carbon Pricing Scenario Descriptions

The Government of Indonesia and the international community recognise that the high level of emissions associated with forest and land conversion in the region is a critical environmental issue, both from climate change and biodiversity perspectives. Public actors are putting in place a number of initiatives that aim at facilitating the development of carbon markets:

● The Environmental Fund Management Agency (Badan Pengelolaan Dana Lingkungan Hidup— BPDLH). Announced by the Government of Indonesia in 2019. The BPDLH will streamline flows of national and international finance into sustainable land use projects through the voluntary market.

● The jurisdictional Reduced Emissions from Deforestation and Degradation (REDD+) programme developed in the region and supported by the World Bank’s Forest Carbon Partnership Facility.

● The Government of Indonesia is considering putting together a nationwide Emissions Trading Scheme that is expected to cover the land use sector.

The future investment opportunity in peatland restoration via REDD+ projects is modelled using two scenarios: Business as usual (BAU) and Sustainable Scenario (SS). The main assumptions behind each scenario are described in Table 2. The future costs and revenues of the project are then estimated using an economic model that optimises land use at the global and regional scales (see technical annex for detailed information).

Table 1 Scenario description

Scenario Mitigation Carbon Annual Productivity Area Ruminant Policy price Bioenergy increase by protection meat Demand 2050 relative fadeout to 2020

Business as Currently Gradual 20 EJ by 37% 352 Mha No usual (BAU) implemented increase 2050 (IUCN fadeout policies only. from $2 Category Consistent with USD in I,II) a 3-4C global 2020 to $5 temperature USD from increase. 2025 onwards Sustainable Consistent with Gradual 60 EJ by 108% 352 Mha 25% scenario a below 2C increase 2050 (IUCN fadeout (SS) global from $2 Category by 2050 temperature USD in I,II increase. 2020 to 110 USD in 2050

Source: Vivid Economics

Under BAU, the project is expected to sell its VCUs in the voluntary market with relatively low prices (like it has been doing since 2017). On the other hand, under the SS, compliance markets will develop in Indonesia and/or international trading will be supported by Article 6 of the Paris Agreement or other international mechanism, and the project will be able to sell its credits at a significantly higher price than in BAU.

Land Use Dynamics

The future land use dynamics in the area will determine the future of the Katingan project and other peatland protection projects. The difference in land use dynamics between the two scenarios are driven by two main factors:

1. A carbon price increase from $2 USD in 2020 to $110 USD in 2050 in the SS. This fiftyfold increase generates incentives to use more land as a carbon sink rather than agriculture.

2. An increase in agricultural productivity of 108% from 2020-2050 in the SS, meaning that less land is required to fulfil food demand.

Figure 2 Peatland distribution in Kalimantan- comparison of Current, BAU and SS

3,5

3,0

2,5

2,0

(Mha) 1,5

1,0

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Distribution of Peatland in Kalimantan 0,0 Agriculture on Peatland Peat Swamp Forest Other peatland

Current BAU SS

Note: Current data refers to circa 2018. Source: Vivid Economics using MAgPIE results and Miettinen et al, 2016 for baseline data.

Figure 2 illustrates the land use dynamics that result in both BAU and SS scenarios, and compares them to current (c.2018) values. The results focus on peatland in Kalimantan.

● Current values: Kalimantan has a total area of 54 Mha, 5.7 Mha of which are categorised as peatland. Out of the total peatland area, 1.5 Mha are being used for agricultural plantations, both industrial and small scale, 2.4 Mha are still covered by peat swamp forest (although more than 80% presents some degree of degradation), and 1.8 Mha are open undeveloped areas that present some sort of secondary regrowth 2.

● BAU: Despite the Indonesian peatland moratorium of 2012 that forbids the issuance of new agricultural concessions on peatland, the increasing demand for bioenergy and palm oil has led to a widespread expansion of plantations onto peatland3. Drained peatland provides a suitable soil for oil palm, acacia and other commercial land uses that have high market values. Experts in the field of peatland protection4 predict that this phenomenon will continue to happen indefinitely unless stricter environmental regulation comes into play. Therefore, the economic model predicts a further increase in agricultural production on peat swamp forests of 320,000 ha by 2050. The increase is moderate, especially because a large extent of the peat swamp forest in Kalimantan is protected5, either by the moratorium, by being natural parks or by the large-scale REDD+ activities in the region6.

● SS: the SS is expected to generate commercial incentives for more land to be used as a carbon sink. These incentives in the SS are large enough to shift the balance in favour of carbon revenue generating activities over agricultural land, hence stopping agricultural expansion onto peatland, and increasing restoration activities. The economic model indicates that the introduction of the carbon price in SS will stabilise peat swamp forests at current levels, while further 350,000 ha would be lost to agriculture under BAU. Furthermore, the model predicts

2 https://www.sciencedirect.com/science/article/pii/S2351989415300470 3 https://www.cifor.org/publications/pdf_files/infobrief/6449-infobrief.pdf 4 https://iopscience.iop.org/article/10.1088/1748-9326/abae2a 5 https://www.protectedplanet.net/country/IDN 6 Katingan, Mawas, Rimba Raya and Rimbak Pakai Pengidup, which combined add up to 315,000 ha of protected peatland.

that 1,3 Mha of agricultural land will be converted into restored peatland. This is shown by the significant drop in “Agriculture on Peatland” from the Current to SS scenarios in Figure 2 above.

The resulting land use dynamics under BAU show that the Katingan project is not likely to expand onto other areas, mainly because agriculture will still be more profitable than protection and restoration activities. On the other hand, under SS, the project is likely to expand its peatland rewetting/ecosystem restoration activities to areas where agriculture will stop being the most profitable land use. This shift in land use demonstrates the powerful impact of carbon pricing in this landscape.

The resulting land use dynamics under BAU show that the Katingan project is not likely to expand onto other areas, mainly because agriculture will still be more profitable than protection and restoration activities. On the other hand, under SS, the project is likely to expand its peatland rewetting/ecosystem restoration activities to areas where agriculture will stop being the most profitable land use. This shift in land use demonstrates the powerful impact of carbon pricing in this landscape.

Carbon Sequestration and Other Environmental Benefits

While peatlands only cover ca. 3% of global land surface, they store more carbon than all other vegetation combined7. Peatlands build up over hundreds or thousands of years and can be several meters deep, keeping carbon in an anaerobic environment where CO2 cannot form. However, once peatlands are drained, they start leaking this carbon out in the atmosphere, currently contributing about 10% of global greenhouse gas emission from the land use sector. Hence, the protection and restoration of peatlands are associated with significant carbon revenues.

Additionally, peatland degradation causes negative impacts on biodiversity, generates soil erosion, instability, and severe fire hazard. All these negative consequences are avoided through protection and restoration activities.

The Verra project protocol for this avoided peatland conversion project assigns approximately 50 verified carbon units (VCUs) per hectare per year to the Katingan project, corresponding to 50 tonnes of CO2 equivalent sequestered. This number is considerably higher than an average tropical avoided deforestation project of 3-15 VCU/ha/year8.

Main challenges

The project is considerably de-risked because it has been verified and has a long track record of selling carbon credits in the voluntary market. However, developing country risks still apply as well as policy risk around the future of REDD+ projects in the area. It is still unclear how national and jurisdictional REDD+ programmes will nest exiting projects like Katingan. It is possible that performance-based credits will only be valid is the jurisdiction as a whole performs better than BAU, creating material risk for the project’s future cash flows.

Additionally, cash flow duration could be a challenge for certain types of investors because the project takes 10+ years to be set up and verified. Finally, an increase in demand for oil palm and

7 https://www.iucn.org/resources/issues-briefs/peatlands-and-climate-change 8 Benchmark taken from a large scale avoided deforestation project: Mataven project

biofuels that will intensify land competition, which could probably affect the price and availability of concessions.

2. Investment Results and Future Outcomes9

Profitability

An average carbon price between 2020-2050 of $40 USD per ton of CO2 emissions in the SS compared to $5 USD in the BAU scenario drives the Net Present Value (NPV) upwards in SS to $886 million USD in 2050 (see Table 2). This increase in NPV reflects higher revenues due to a higher carbon price and an expansion of the project into neighbouring areas. In the SS scenario, the internal rate of return (IRR) is 21% until 2050. This is higher than the 16% in the BAU.

Table 2 Net Present Value (NPV) calculations (million 2019 USD)

Year BAU SS 2030 121 174 2040 200 525 2050 225 886

Note: 12% discount rate. Source: Vivid Economics Modelling based on GGGI (2015), Costs and Benefits of Investing in Ecosystem Restoration and Conservation: Green Growth Opportunities in Katingan Peatlands; VCS (2016) Project Description Document (PDD); internal Vivid Economics database on REDD+ project costs.

The increase in VCUs generated by the project accompanied by the sharp increase in carbon price leads to a substantial surge in annual revenue from VCU sales, amounting to over $9 billion USD cumulative revenue by 2050. The project is expected to break even in the 2020-2030 decade.

9 Cost and Revenue numbers are indicative because they have been estimated using averages from similar projects and have not been signed off by Katingan’s project developers.

Figure 3 Discounted Profits in SS - Katingan project

Discounted profits discount rate = 10% 60M Discounting outweighs the 1.300M 40M slowing growth in carbon price and annual profits 800M 20M start to decrease. 300M M 2008 2012 2016 2020 2024 2028 2032 2036 2040 2044 2048 -20M -200M

Annual Annual profits (2019 USD) -40M -700M Date (Year) Cumulative profits (2019 USD)

Annual discounted profits Cumulative discounted profits

Notes: Discount rate = 12% Source: Vivid Economics

CAPEX consists of fencing and set-up activities, together with some certification expenses. Hence, because the expansion of protected peatland area is minimal, CAPEX is heavily front-loaded. On the other hand, OPEX consists almost entirely of capacity building10 and community involvement. Therefore, it is roughly constant in time. Some argue that OPEX can even be decreasing due to conservation activities becoming the habit within the community. Overall, protection activities have low maintenance costs and are associated with moderate upfront investment.

Large plantations and restoration projects operate under a concession model, where the Government owns the land and leases it to the project developer. The mechanism to determine lease prices is not transparent and has not followed market dynamics in the past. It is also important to highlight that lease prices have traditionally been substantially below the market’s willingness to pay for them. This phenomenon likely responds outdated cadastre values, strong lobby power of the palm oil sector (one of the main users of land), among others. Lease prices are therefore not modelled. It is expected that lease prices will increase significantly more in the SS scenario because there will be more interest in conservation projects with a higher carbon price.

The compensation of communities is something that varies from project to project. Many of the avoided peatland projects have been developed by not-for-profit entities, leaving all profits to the communities. In the case of the Katingan project, 11.500 households live around the project area. REDD+ guidelines and standards are increasingly requiring project developers to share benefits with the communities involved.

Net-profits increase throughout the period, being driven by the rising carbon price. However, from around 2040 the discounting outweighs the slowing growth in carbon price and so annual profits start to decrease in net present value terms.

10 That is a wide variety of activities aimed at convincing and enabling local communities to protect and improve peatland.

Climate Impact

Assuming that the Verra protocol for the Katingan REDD+ project is a good measure of carbon storage and sequestration, the cumulative climate impact in the SS scenario is 233 million tonnes of CO2 emissions avoided between 2020 and 2050. This is equivalent to 1.7 million typical passenger cars taken off the road for the same period.11 Since this particular project is also viable in BAU, it would avoid 231 million tonnes of CO2 under this scenario. The difference would be attributed to the predicted project expansion in SS.

3. The Investible Universe and Opportunity to Scale

In this section, the economic model is used to measure the size of the opportunity to invest in protection project like Katingan in the East Pacific Asia region.

Opportunities for peatland protection

The increase in carbon price is expected to increase avoided peatland drainage project sizes 38 fold compared to the BAU of a flat price. This constitutes an opportunity in the order of 120 billion USD. Error! Reference source not found. and Figure 5 show that cropland and pasture lands will expand between 2020 and 2050 in BAU. This is what endangers peatlands and what is avoided via the carbon price and new policies in SS.

Figure 4 Regional land dynamics: cropland

Source: Vivid Economics – MAgPIE

11 https://www.epa.gov/greenvehicles/greenhouse-gas-emissions-typical-passenger-vehicle

Figure 5 Regional land dynamics: pasture land

Source: Vivid Economics - MAgPIE