PLANT RESEARCH INTERNATIONAL M WAG EN IN G EN

Exploringth e possibilities of carbon projectsi n thetropica l peat lands of Central Kalimantan

Gerdien Meijerink1, Mart-Jan Schelhaas2, Suwido Limin3 & Jan Verhagen4

1 LEI,Wageninge n UR

2 Alterra,Wageninge nU R

3 CIMTROP,Centr e for International Cooperation inManagemen t of Tropical Peatland University of Palangka Raya,Centra l Kalimantan,Indonesi a Kampus UNPARTunjun gNyah o PalangkaRay a KalimantanTengah ,Indonesi a 4 Plant Research International, Wageningen UR

CIMTROP mm mm

Plant Research International B.V., Wageningen January 2004 Report 73 © 2004 Wageningen, Plant Research International B.V. All rights reserved. Nopar t of this publication may be reproduced, stored ina retrieval system or transmitted, inan y form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Plant Research International B.V.

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Cover photo courtesy Henk Wösten (Alterra)

Plant Research International B.V.

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page

Executive summary 1

Glossary 3

1. Introduction 7

2. The Clean Development Mechanism 9

3. Central Kalimantan 11

3.1 Population andemploymen t 11 3.2 Current landus e andpossibl e land use options 11 3.3 Land use andcarbo n 13 3.4 Problems with cultivation of deep peatlands 15 3.5 Risks 16

4. Thefinancia l system 17

4.1 Definition of the C02 market 17

4.1.1 Demandfo r C02 reduction 17

4.1.2 Supplyo f C02 reduction 18 4.2 Examples of Emission Trading Schemes 18 4.3 Examples of project-based programs 19 4.3.1 Emission Reduction Unit Procurement Tender (ERUPT) 19 4.3.2 Prototype Carbon Fund(PCF ) 20 4.3.3 Finnish CDM/JIPilo t Programme 20 4.3.4 USInitiativ e onJoin t Implementation (USUI) 20 4.3.5 The Climate Trust (Oregon) 20 4.3.6 Activities Implemented Jointly Pilot Phase (AU) 21 4.3.7 Pilot Emissions Reduction Trading Project (PERT,Ontario ) 21 4.4 Company initiatives 21 4.4.1 BP 21 4.4.2 Shell 21 4.4.3 FACE 21 4.5 Possible future directions: financial dérivâtes and brokers 22 4.6 Relationt o International Trade Agreements 23 4.7 CDMcommunit y forestry projects 23 page

Institutional system 25

5.1 Institutional setting at national level 25 5.2 Institutional setting at project andloca l level 26 5.2.1 Maximise project success through strong local participation 26 5.2.2 Select the most suitable compensation mechanisms 27 5.2.3 Enhanceth e profitability of newlan d uses 27 5.2.4 Increase transparency ininvestor-communit y partnerships 28 5.2.5 Reduce project marketing costs andinvesto r risks 28 5.2.6 Increase scale andreduc e costs of community-based CDMproject s 29 5.3 Financial institutions 29

Discussion 31

References 33 Executive summary

Humanactivitie s have increased the concentrations of greenhouse gasses inth e atmosphere, primarily duet o the combustion of fossil fuels, but alsothroug h changes inlan d use and landcover . The resulting changes in climate andclimat e variability pose amajo r threat to the functioning of human andnatura l systems. The impacts of future changes are expected to fall disproportionately onth e developing countries (IPCCWGII ,2001) .

Asa firs t step towards reduction of greenhouse gasses emissions to the atmosphere, the Kyoto Protocol was signed in 1997. Inthi s protocol, 39 industrialised countries committed themselves to reduce their greenhouse gas emissions to at least 5%belo w 1990 levels during the period 2008 to 2012.

The Kyoto Protocol outlines three types of market-based mechanisms: emissions trading,Join t Implementation(Jl ) andth e CleanDevelopmen t Mechanism (CDM).Emission s trading allows the 39 governments committed to collective reductions under the Protocol to trade the right to pollute amongthemselves . Under this scheme, due to start in 2008, acountr y may choose to buy emission credits from another country that has managed to reduce its emissions below its Kyototargets .

The CDMha stw o main objectives: 1. To assist developing countries who host CDMproject s to achieve sustainable development. 2. To provide developed countries with flexibility for achieving their emission reduction targets by allowingthe m to take credits from emission reducing projects undertaken indevelopin g countries.

TheCD Mmechanis m provides developing countries witha nadditiona l source of income through anenvironmenta l service: carbon management. The market as it isno w emerging is still init s infancy. Asfo r any market, prices will depend largely onsuppl y anddeman d relations andth e risks involved.Th e possibility of getting paidfo r carbon management is expected to stimulate environmental protection andconservatio n andi s expected to be beneficial for social circumstances aswell . The implementation of the trade mechanisms andho wthi s will benefit the local poor will differ per region.

This study focuses onCentra l Kalimantan at the Indonesian part of the island Borneo. Large parts of this region are covered by peatlands, originally covered by peat swamp forests. In 1996 the Mega Rice Project (MRP)wa sinitiated , aimed at increasingth e self-sufficiency of Indonesia's food production.T o reachtha t goal, one million hectares of peat swampfores t was plannedt o beconverte d into rice fields. BetweenJanuar y 1996 andJul y 1997, more than 4000 km of drainage andirrigatio n channels were constructed. Asa consequence , the forests became accessible, leadingt o large-scale illegal logging activities anddeforestation . Thefastes t andeasies t way of clearingth e landi s by means of fire. In 1997 this practice, together with other factors such as the drought caused by ElNino , dried out peatlands duet o large-scale drainage, logging activities, led to large-scale forest fires. This intur n ledt o large amounts of carbon being released into the atmosphere, amountingt o 1340%o f the meanannua l global carbon emissions from fossil fuels for 1997.

The C02 market is defined by demandfo r and supply of C02 reduction possibilities. The study discusses anumbe r of different initiatives taken by public andprivat e parties.

Ingeneral ,deman dfo r C02 reduction comes from industrialised countries that under the Kyoto Protocol need to reduce their greenhouse emissions (Annex 1countries) . Besides these parties, several private corporations (mainly fossil fuel andelectricit y corporations) are initiating projects to offset their owncarbo n emissions, out of corporate

green image considerations, or expectation that inth e future C02 reductions will become more strict.

The suppliers of C02 reduction are very diverse, ranging from large multinational energy companies to small local operators,an dt ogovernment s inth eso-calle dnon-Anne x 1countries .Mos tbuyer shav esough tt o acquire reductions generated withinthei r own home country, andonl y ahandfu lo f projects located indevelopin g countries have resulted in successful emissions transactions. Projects located inthes e countries have greater perceived project risk andfe w developing countries haveestablishe d adequate institutions to review project proposals andt o grant necessary host country approvals.

Thefinancia l sector is playing anincreasingl y important role inth e carbon market. Financial dérivâtes already playa major role in emission reduction transactions, andth e role of market participants whofunctio n as brokers to match buyers and suppliers or whofunctio n as consultants is expected to increase.

The CDMca n be applied to (community) forestry projects andpotentiall y contribute to local livelihoods and ecosystem restoration as well. The costs of such aprojec t consist of the costs involved inC0 2 sequestration itself (forest management) andcost s involved inCD Mmanagemen t (also called transaction costs). For aprojec t to be successful, several criteria havet o be met concerning the national and regional institutional setting.Th e institutional requirements at national level are partially described inth e Kyoto Protocol and include the establishment ofa national CDMAuthority . Although Indonesia is a signatory to the Kyoto Protocol it has not ratified it and meaningful follow-up related to the Protocol has beendelayed .

The study also highlights several key elements of project design related to local institutional settings. Atransparen t andwell-define d project with clearly outlined compensation mechanisms and strong local participation are someo f the key elements. Attention shouldals o be given to reducing risks (e.g.fro m leakage, non-compliance) to the investor inth e project. Financial institutions can play a role in reducing risks. However, these have not developed sufficiently yett o play aconcret e role inCD Mforestr y projects. Glossary

Additionally The Kyoto Protocol established the requirement that Jlan dCD Mproject s may only count emissions reductions that are 'additionalt o what otherwise would have occurred inth e absence of the certified project activity' (environmental additionality). These reductions must be 'real' and'measurable' , andmus t bequantifie d against a project baseline. Another form of additionality (financial additionality), isth e notiontha t aprojec t is made commercially viable via its ability to generate value inth e form of CERs.Currently , there is no international agreement ona method to determine financial additionality.

Annex 1 countries These areth e 36 industrialised countries and economies intransitio n listed inAnne x 1o f the UNFCCC.Thei r responsibilities under the Convention are various, and include anon-bindin g commitment to reducingthei rGH G emissions to 1990 levels byth e year 2000.

Annex Bcountrie s These are the 39 emissions-capped industrialised countries andeconomie s intransitio n listed inAnne x Bo f the Kyoto Protocol. Legally-binding emission reduction obligations for Annex Bcountrie s range from an8 %decreas e (e.g. EC)t o a 10%increas e (Iceland) on 1990 levels by the first commitment period of the Protocol, 2008 -2012 .I n practice,Anne x 1o f the Convention andAnne x Bo f the Protocol are used almost interchangeably. Note that Belarus andTurke y are listed inAnne x 1bu t not inAnne x Ban dtha t Croatia, Liechtenstein, Monaco and Slovenia are listed inAnne x Bbu t not inAnne x 1.

Baseline CDMprojec t outcomes are measured andverifie d against abaselin e that reasonably represents the anthropogenic emissions of greenhouse gases (GHG)tha t would occur inth e absence of the CDMproject .

Carbon offsets Commonly referred to ast o indicate the output of carbon sequestration projects inth eforestr y sector or to refer to the output of anyclimat e change mitigation project more generally. Carbon credits -a sfo r carbon offsets, though with added connotations of (1)bein guse d as 'credits' in companies' or countries' emission accounts to counter 'debits' i.e. emissions, and(2 ) beingtradable , or at leastfungibl e withth e emission permit trading system.ERU s (emission reduction units)- th e technical termfo r the output of Jlproject s as defined byth e Kyoto Protocol.CER s (certified emission reductions) -th e technical term for the output of CDMprojects , as defined by the Kyoto Protocol.

Carbon sinks Astoc k that istaking-u p carbon is called a sink. Oceans, soils andforest s all offer some potential to be manageda s asink .

CER (Certified Emissions Reduction) Investors inClea nDevelopmen t Mechanism projects canear n CERcredit s for the amount of greenhouse emission reductions achieved bythei r CDMprojects . CERsar e equalt o one metric tonne of carbon dioxide equivalent (C02e).

Clean Development Mechanism (CDM) TheCD Mwa s established byArticl e 12 of the Protocol and refers to climate change mitigation projects undertaken betweenAnne x 1countrie s andnon-Anne x 1countrie s (see below). This new mechanism,whils t resembling Jl, has important points of difference. Inparticular , project investments must contribute to the sustainable development of the non-Annex 1hos t country, andmus t also be independently certified.Thi s latter requirement gives riset o the term certified emissions reductions or CERs,whic h describe the output of CDMproject s andwhic h under the terms of Article 12 can be bankedfro m the year 2000, eight years before the first commitment period (2008-2012). Emissions Trading (ET) Article 17 ofth e Protocol allowsfo r emissions-capped Annex Bcountrie s (see below)t o transfer amongthemselve s portions of their assigned amounts (AAs)o f GHGemissions . Under this mechanism, countries that emit lesstha n they are allowed under the Protocol (their AAs)ca n sell surplus allowances to those countries that have surpassed their AAs. Suchtransfer s do not necessarily havet o be directly linkedt o emission reductions from specific projects.

ERU (Emission Reduction Unit) The Kyoto Protocol specified unit of GHGemission s reduction under aJoin t Implementation (Jl) project.

Flexibility Mechanisms Refers to the three co-operative implementation mechanisms under the Kyoto Protocol (Joint Implementation, International Emissions Trading and Clean Development Mechanism).

GHG (Greenhouse Gasses) Generally defined as the six gasses regulated under the Kyoto Protocol, anddetermine d to beth e prime contributors to the Greenhouse Effect. The GHGsare :

• carbon dioxide (C02)

• methane(CH 4)

• nitrous oxide (N20) • hydrofluorocarbons (HFCs) • perfluorocarbons (PFCs)

• sulphur hexafluoride (SF6)

Joint Implementation (Jl) Setou ti nArticl e 6 ofth eProtocol ,J lrefer st o climate changemitigatio n projects implemented between two Annex 1 countries. Jlallow s for the creation, acquisition andtransfe r of emission reduction units or ERUs.Th e concept of Joint Implementation (Jl)wa s already introduced inth e UNFCCC.Dissatisfactio n of developing countries withtha tJ l model led to acompromis e inth e form of apilo t phase, duringwhic h projects were called Activities Implemented Jointly (AU). Some AUproject s may be reclassified as CDMo r Jl projects.

Kyoto Mechanisms The Kyoto Mechanisms, often referred to as Emissions Trading, allows for emissions permits to becreate d and transferred between countries withth e objective of minimisingth e cost of reducing global greenhouse emissions. The mechanisms include Joint Implementation (Article 6),th e Clean Development Mechanisms (Article 12),an d International Emissions Trading (Article 17).

Ratification defines the international act whereby a state indicates its consent to be boundt o atreat y if the parties intended to show their consent by such anact .

RMUs (removal units) The newtechnica lter m representing sink credits generated inAnne x Icountries , which can betrade d through the emissions trading andJ l mechanisms

Signatory The head of state or designated official indicates their countries agreement withth e adopted text of the convention or the protocol and its intention to become apart y bysigning .

UNFCCC United Nations Framework Convention on Climate Change Established inJun e 1992 at the Rio Earth Summit, its primary objective is 'the stabilisation of greenhouse gas concentrations inth e atmosphere at aleve ltha t would prevent dangerous anthropogenic (man-made) interference withth e climate system. Sucha level should be achieved within atime-fram e sufficient to allow ecosystems to adapt naturallyt o climate change,t o ensure that food production is notthreatened ,an dt o enableeconomi c development to proceed ina sustainable manner'. Validation The process of independent evaluation of aCD Mproject' s project design document by adesignate d Operational Entity against the requirements of the UNFCCC CDM.

Verification The periodic independent review andex-pos t verification by a Designated Operational Entity of monitored reductions in anthropogenic GHGemission s that have occurred asa resul t of a registered CDMprojec t duringth e verification period. 1. Introduction

Humanactivitie s have increasedth e concentrations of greenhouse gasses inth e atmosphere, primarily duet o the combustion offossi l fuels but also through changes inlan d use andlan d cover. The resulting changes inclimat e and climate variability pose amajo r threat to the functioning of human andnatura l systems. The impacts of future changes areexpecte d to fall disproportionately onth e developing countries (IPCCWGII ,2001) .

The logical response has beent o mitigate climate change. However, mitigation alone will not be enought o offset the climate change that has already started.Therefore , adaptation will also be necessary to cope withth e negative effects of climate change. For land use systems synergies between mitigation (carbon sequestration) and adaptation (reduced vulnerability as result of increased soil carbon content) exist. Integrating mitigation and adaptation is therefore a logical option for land use systems and needt o beexplore d inmor edetail .

The Kyoto Protocol hasopene d the wayt o seek globally the most cost effective wayt o reduce carbon emissions or enhance terrestrial carbon sinks. Industrialised countries may thus achieve part of their emission reduction target by afforestation andreforestatio nproject s inth etropic s (CleanDevelopmen t Mechanism: CDM).Th e mechanism offered byth eKyot oProtoco li suniqu ei nit sattemp tt o providegloba lenvironmenta l benefitsvi a local project implementation ina globa l carbon market.

These paid activities should stimulate environmental protection andconservation . Theimplementatio n of the trade mechanisms andho wthi s benefits the local poor willdiffe r per region. Positive effects onbiodiversity , water resources, anderosio n are anticipated, linkingthre e large international treaties: United Nations Framework Convention onClimat e Change (UNFCCC)t o the Convention onBiologica l Diversity (CBD) andUnite d Nations Convention to Combat Desertification (UNCCD).Th e Kyoto Protocol is thus atreat y with aclea r globaldimension , but alsowit h aloca l ecological and local socialdimension .

Themarke t for environmental services is still init s infancy. This study aims to explore the possibilities for Clean Development Mechanism projects inth e Indonesian peat lands (KalimantanTengah) .Give nth e resource constraint of the project wewil lfocu s oncarbon .Chapte r 2 describes the Clean Development Mechanism. The environmental system of Central Kalimantan is described inChapte r 3. Chapter 4 gives anovervie w of possible financial systems, the institutional setting is discussed inChapte r 5, followed by agenera l discussion. 2. The Clean Development Mechanism

As afirs t steptoward s reduction of greenhouse gas emissions to the atmosphere, the Kyoto Protocol was signedi n 1997. Inthi s protocol, 39 industrialised countries committed themselves to reduce their greenhouse gas emissions to at least 5%belo w 1990 levels duringth e period 2008 to 2012. These countries are knowna sth e Annex 1o r Annex Bcountries . TheNetherland s for instance, has a6 %emissio n

reduction target for greenhouse gas emissions (carbon dioxide (C02), methane (CH4),nitrou s oxide (N20) andth e fluorinated gases: HFCs,PFC san dSF6) .

Insteado freducin gemissions ,i ti sals oallowe dt oincreas ecarbo nsequestratio n interrestria l ecosystems. Measures that are eligible since 1990 under the Kyoto Protocol are ARD(Afforestation , Reforestation andDeforestation ) under article 3.3 andadditiona lactivitie si nagricultur e andforestr y underarticl e 3.4.However ,th efirs t commitment period (2008-2012) allowsfo r reforestation andafforestatio n only1, other types of land use are still under discussion.

Annex Icountrie s are not obliged to meet their targets within the country itself. Thus,th e Kyoto Protocol has opened thewa yt o seekth emos tcos teffectiv ewa ygloball yt o reduce carbonan dnon-carbo nemission s or enhanceterrestria l carbon sinks. Industrialised countries maythu s achieve part of their emission reduction target by afforestation and reforestation projects inth e tropics. The mechanisms offered byth e Kyoto Protocol are unique inthei r attempt to provide global environmental benefits via local project implementation in agloba l carbon market.

TheKyot o Protocoloutline sthre e types of market-based mechanisms: emissionstrading ,Join t Implementation(Jl ) andth eClea nDevelopmen tMechanis m(CDM) .Emission stradin gallow sth e 39 governments committed to collective reductions under the Protocol to trade the right to pollute amongthemselves . Under this scheme, duet o start in 2008, acountr y maychoos e to buy emission credits from another country that hasmanage d to reduce its emissions below its Kyototargets .

Jlan dth e CDMgran t Northern governments andcorporation s emission credits through special projects aimeda t reducinggreenhous e gas emissions inth e host country. Theseproject s can becarrie d out among industrialised countries andcorporation s (Jl)o r between one industrialised government or company andon e Southern country (CDM).

The CDMha stw o mainobjectives : 1. To assist developing countries who host CDMproject s to achieve sustainable development. 2. To provide developed countries with flexibility for achievingthei r emission reductiontarget s by allowing them to take credits from emission reducing projects undertaken indevelopin g countries.

Rulesan dguideline s are being developed asth e market further matures. Different market segments will most likely adapt different rules, e.g.th e 'voluntary' market allows buyers to establishthei r own rules, while the international market based onCertifie d Emission is stricter. Although several of the detailed procedures to beapplie dt o CDM forestry projects are stillt o be agreed upon,th e overall framework is already established for approving projects and accountingfo r the carbon credits generated (Aukland eta/., 2002; Murdiyarso, 2003): 1. Only areastha t were not forest on31s t December 1989 are likely to meet the CDMdefinition s of afforestation or reforestation. 2. Projects must result inreal , measurable and long-term emission reductions, as certified by athird-part y agency ('operational entities' inth e language of the convention). The carbon stocks generated byth e project needt o be secure over the longter m (apoin t referredt o as 'permanence'), andan yfutur e emissions that might arise from these stocks needt o be accounted for.

i Reforestationrefer st oestablishmen to ffores to n landtha tha d recenttre ecover ,wherea safforestatio n referst olan d that has been withoutfores tfo rmuc h longer.Watso nera/. ,1998 . 10

3. Emission reductions or sequestration must beadditiona l to anytha t would occur without the project. They must result ina ne t storage of carbon andtherefor e a net removal of carbon dioxide from the atmosphere. This is called 'additionality' andi s assessed by comparing the carbon stocks andflow s of the project activities withthos etha twoul dhav eoccurre dwithou tth eprojec t (its 'baseline'). This ist o avoid giving credits to projects that would have happened anyway. 4. Projects must be inlin ewit h sustainable development objectives, as defined byth e government that is hosting them. 5. Projects must contribute to biodiversity conservation and sustainable use of natural resources. 6. Only projects starting from the year 2000 onwards will be eligible. 7. Two percent of the carbon credits awarded to aCD Mprojec t will be allocated to afun dt o help cover the costs of adaptation in countries severely affected by climate change (the 'adaptation levy').Thi s adaptationfun dma y provide support for land use activities that are not presently eligible under the CDM,fo r example conservation of existing forest resources. 8. Some of the proceeds from carbon credit sales from all CDMproject s will be used to cover administrative expenses of the CDM( a proportion still to bedecided) . 9. Projects needt o select acreditin g period for activities, either amaximu m of sevenyear s that can be renewed at most two times, or amaximu m of ten years with no renewaloption . 10. Thefundin gfo r CDMproject s must not come from adiversio n of official development assistance (ODA)funds . 11. EachCD Mproject' s management plan must address andaccoun t for potential leakage. Leakage isth e

unplanned, indirect emission of C02, resulting from the project activities. For example, if the project involves the establishment of plantations onagricultura l land,the n leakage could occur if people who were farmingo n this land migrate to clear forest elsewhere.

12. The emission reduction shouldals o account for non-C02 Green House Gases (GHGs such asN 20,CH 4).

Thefirs t commitment period or window (2008 -2012 ) allows for reforestation andafforestatio n only, other types of land use are still under discussion2.

TheCD Mmechanis m provides developing countries with anadditiona l source of income through anenvironmenta l service: carbon management. The market as it is now emerging is still in its infancy. Asfo r any market, prices will depend largely on supply anddeman d relations andth e risks involved.Th e possibility of getting paidfo r carbon management is expected to stimulate environmental protection andconservation , andi s expected to be beneficial for social circumstances aswell . The implementation of the trade mechanisms andho wthi s will benefit the local poor will differ per region.

Details onth e project cycle are not discussed inthi s document, for information onth e project cycle look at www.unfccc.int 11

3. Central Kalimantan

Inthi s study, wefocu s onCentra l Kalimantan atth e Indonesian part of the island Borneo. Large parts of this region are covered by peatlands, originally covered by peat swamp forests. It usedt o bea ver y sparsely populated area, where the humanimpac t onth e environment was negligible. In 1996 the Mega Rice Project (MRP)wa sinitiated , aimed at increasingth e self-sufficiency of Indonesia's food production. To reachtha t goal, one million hectares of peat swamp forest was plannedt o beconverte d into rice fields. BetweenJanuar y 1996 andJul y 1997, more than 4000 km of drainage and irrigation channels were constructed.A sa consequence , the forests became accessible, leading to large-scale illegal logging activities anddeforestation . Thefastes t and easiest way of clearing the landi s by means of fire.A tth e beginning of the dry season in 1997, many fires were ignited.Th eE lNin o Southern Oscillation (ENSO)even t of that year extended the dry season, so that large areas were burned.Du et o thene w drainage system the upper peat layers dried out and also caught fire. Fires spread outfro m the logged areas into the primary forest. Thepea t layers represent anenormou s stock of carbon.A s aresul t of the large fires, itwa s estimated that between 0.81 and2.5 7 Gt of C02 were released to the atmosphere, which is more thanth e annual emission of the total European Union(Pag e etal., 2002). The cleared peatlands are not suitable for the cultivation of rice. Avas t area is left behind,mostl y deprived from its original vegetation and not very suitable to grow foodfo r the localpopulation .Du et oth edrainage ,th epea ti sslowl ydecomposing ,releasin gth estore dcarbo nt oth eatmosphere . There is stillth e risk of new massive fires, againleadin g to the release of large amounts of carbon.

3.1 Population and employment

The Central Kalimantan province holdsfiv e regencies andon e municipality, 85 districts, 1,328 villages including transmigration places settlements andindigenou s natives civilisation settlements.

In200 0th etota lpopulatio no fCentra lKalimanta nwa s 1,823,715, ofwhic h49 %femal ean d51 % male.Th epopulatio n density is approximately 12 persons per square kilometre. In200 0 2641 households (10551 persons) consisted of incoming migrants through thetransmigratio n programme. Theteache r student ratio in200 0 was 1:20 for the elementary levels, and 1:10 for the university level.O fth etota l population,4.5 %i s illiterate,wel l below the average (10%)fo r Indonesia. Moretha n 80%o f the work force has notfinishe d elementary school or secondary school.Th e health system is basic witha naverag e of 1docto r per 9000 persons.

The largest part of the labour force is employed inagricultur e (55%),wherea s the finance sector hasth e lowest employment. In200 0 47.5%o f the regional income was provided byth e agricultural sector, followed bytrading , restaurants andhotel s at 18%,transportatio n andcommunicatio n at 8.6%, services at 8.5%, andindustr y at 6.9%. Asresul t ofth e economic crises inIndonesi a the number of large andmediu m scale industries dropped from 100 in 1997t o 80 in 1999, resulting in a substantial loss ofjobs .

Productivity of food crops, notably wetland anddrylan d paddy, has increasedfro m 2.2 ton per ha in 1996 to 2.4 ton per hai n 2000. Thedecreasin g forest area also means adecreasin g timber production.Anima l husbandry (pig, poultry, sheep) andfisher y (mainly sea-fish) provide avaluabl e source of protein. Statistical data of this sectionwa s takenfro m Kalimantan Tengahdala mangk a (2000).

3.2 Current land usean d possible landus eoption s

Noare a datawer e foundfo r the current land use situation.I n 1997, before the start of the Mega Rice Project, the land cover situation ina stud y area of about 5 Mha is shown inTabl e 1,a swel l asth e changes inth e period 1991-1997. These figures were obtained via remote sensing. 12

Table 1. Landuse (1997) and land use change (1991-1997) asassessed by remote sensing for astudy area inCentral Kalimantan (Boehm &Siegert, 2000).

Vegetationtyp e Land cover Landcove r Land cover change in 1997 in 1997 1991-1997 (ha) (%) (% relative to 1991)

Closed forest 2,231,239 43.0 -8.3 Openfores t 365,132 7.0 -1.6 Fragmented forest 494,471 9.5 -0.4 Forest plantation 29,244 0.6 0 Forest regrowth 60,146 1.2 -0.3 Mosaics 477,875 9.2 -1.9 Grasslands, woods & shrubs, nonfores t regrowth 354,900 6.8 -0.5 Agriculture 408,606 7.9 1.1 Unvegetated 245,529 4.7 4.4 Not visible 441,829 8.5 7.4 No data 76,690 1.5 0

Roughly, current land cover can be classified asfollows : Forest, including undisturbed forest, logged over forest and spontaneous regrowth Forest plantations Grasslands,woods , shrubs Agriculture Unvegetated

Forest Peat swamp forests encompass a sequence of forest types running from the perimeter to the centre of each swamp. Sixfores t communities that have adistinc t structure, physiognomy, andflor a are discernible(Anderson , 1983; Whitmore, 1984). Ramin(Gonystylu s bancanus Kurtz) and Meranti (Shorea albida) are the most valuable timber tree species inthes e forest types. Illegal logging has increased considerably after the construction of the drainage canals,throug h animprove d accessibility. Also legal loggingtake s place,wit h apropose d cutting cycle of 35 years. Thegrowt h rate of the trees is lower than incomparabl e forest types onminera l soil.

Forestplantations Forest plantations form only aver y small part of the land cover. Some local people have started to grow arang e of peat swamptre e species, including ramin,i n small plantations. Inrecen t years,th e cultivation of estate crops, particularly coconut andoi l palm, has rapidly expanded onto the lowland peats of Indonesia, especially inRia uan d West Kalimantan,utilisin g deep peats.Th e establishment of plantations faces many specific problems related to the substrate.

Grasslands Part of the peatlands are invaded byth e aggressive grass species Imperata cylindrica, locally known asalang-alang . This species is prone to fire andi s notver y suitable for cattle grazing.Du et o its high competitiveness it is not easy to convert these grasslands into other landuses .

Agriculture Originally, agriculture was only practised atth e shallow peats alongth e rivers,wher e crops such as rice could be grown. Also pineapple, banana andcassava ,vegetable s andvariou s types of beans are cultivated here.Th edee p peats that became available after clearingth e forest are not suitable for rice.A variet y of other species are attempted, withvaryin g success (Table 2).Farmers ' experience andvariou s studies carried out so far strongly 13 indicate that horticultural crops are the most suitable commodities onth e peat soils, irrespective of peat thickness. Oneo f the problems of agriculture on peat soils isth e lowfertilit y of the substrate.

Table 2. Suitabilityof various crops onpeat soilsbased on peat thickness (Boehm &Siegert,2000).

Thickness of peat 0-100 100-200 >200

Wetland rice Moderate Low - Uplandfoo d crops: rice, soybean, corn, peanut, etc. High Moderate Low Horticulture: Chinese cabbage, papaya,pineapple , High High High cucumber, kankung, etc. Estate crops: coconut, oil palm,rubber , cacao, High Moderate Moderate coffee, etc. Industrial crops: rami, medicinal,etc . High Moderate Moderate

Unvegetated Part of the area is unvegetated for various reasons. Some parts are recently burned andhav e not yet revegetated and other parts have been seriously degraded making growth virtually impossible.

3.3 Landus ean dcarbo n

Whenth e peat is still accumulating, undisturbed peat swampfores t is probably asmal l net sink of carbon,an d otherwise it will be more or less inbalance . Draining and conversion of this forest will inevitably leadt o loss of carbon, bothfro m biomass andsoil . Not many studies of biomass andcarbo n sequestration inundisturbe d peat swampforest s have beenconducted . However, we can get aroug h idea if we compare with lowland dipterocarp forests which are muchriche r inbiomass .Yamakur a etal. (1986) found anabovegroun d biomass of 5091dr y matter per hectare ona 1hectar e sample plot. If weassum e acarbo n content of 50%,w e get anestimat e of around 2501carbo n per hectare inabovegroun d biomass.Thi s agrees quite wellwit h Kuusipalo etal. (1996) who give avalu e of slightly less than 2401carbo n per hectare;thes e authors estimate the carbon stock inth e root system to beabou t 951pe r hectare.

Forestplantations Ofth e other land uses,th e carbon balance of tree plantations probably comes closest to the one of the original swamp forest. Iftre e species are usedtha t are adapted to high groundwater levels, peat decomposition canb e slowed down by maintaining ahig h groundwater table. The stems of the trees will sequester carbon, but it depends onth e management regime how large its contribution to the total carbon balance will be.W emad e some preliminary calculations for Acacia andoi l palm plantations.

Acaciamangium plantation Acaciamangium Willd\s one of the species that can be usedfo r plantations inIndonesia .Accordin g to Kuusipalo etal. (1996) it can beuse dt o outcompete Imperata ongrasslands . Duet o the lowfertilit y of the*peat, it will probably grow slower thanth e growth rates of upt o 60 m3ha 1 yr1o nminera l soils that are mentioned inth e literature. For this casew eassume d anaverag e growth rate of 25 m3ha' yr'. Wederive d relative proportions of biomass instem , leaves andbranche s at different ages from the sample trees and biomass equations from the project 'Carbon sequestration of man-madefores t inth e tropics' (Http://www.f.waseda.jp/yasu/database.html). Fromth e average growth rate wederive d biomass in stems at different ages,fro m whichw e estimated biomass in leaves and branches. Forturnove r of foliage we assumed 1an dfo r turnover of branches we assumed 0.2. Roots have not been included since nodat a are available.W eassume d arotatio n of 10 years.Afte r 10years , atota l aboveground carbon stock of about 601pe r hectare willb e reached.Thi s ismuc hles stha nth e 1201 reported by 14

Kuusipalo étal. (1996) The difference is probably caused byth e lower growth ratew e assumed, and may also be influenced by differences in branch andlea f biomass. See Figure 1.

60

•stem s - - •foliag e branches

Time

Figure1. Carbon stock developmentin aboveground biomass of Acaci a mangiumplantation in a 10-year rotation,average increment25 m3ha 1 yr'.

Oilpalm Oilpal m is regarded as apossibl e crop onpeatlands . Based onbiomas s data from Cannell (1982), we madea n estimate of aboveground biomass development ina noi l palm plantation.Wit ha nassume d rotation of 15 years,a maximum carbon stock of about 601pe r ha is reached after 15years . However, the sample data were from mineral soils. Duet o the low fertility of the peat, carbon stocks will probably be lower onpeatlands . See Figure 2.

50

m 40

I 30 — stems u - • leaves w 20 — fruits c o S3 n O 10

Time

Figure 2. Carbon stock developmentin aboveground biomass of an oil palm plantation, basedon data from Malaysia. 15

Grasslands Imperata grasslands onminera l soils have anabovegroun d stock of 5-15to n Cpe r ha,an dth e belowground stock inroot s andrhizome s isabou t half of that (Kuusipalo etai, 1996). The figures for Imperata onpea t will probably not be very different from those on mineral soils.

Agriculture The carbon stock inbiomas s onagricultura l sites isver y small since it is harvested every year. This meanstha t there is no net effect of biomass growth oncarbo n sequestration. Duet o the drainage,th e peatwil l continuously decompose, turning agriculture into ane t source of carbon.Additionally , often ash is applied from burned vegetation from elsewhere. Sobeside s the impact onth e site itself, agriculture is likely to change the carbon balance of other areas aswell .

There may be other uses of peatland areastha n those already mentioned. Oneo f the possibilities isth e use of peat for energy production. Outo f 8.8 Mhao f deep peat intota l Indonesia, 4.46 Mha is estimatedt o bepotentiall y extractablefo r energy productionan dothe r non-renewable uses. This amounts to 3 billionton s of peat. However, peat extraction could leadt o serious degradation of the area andi s not asustainabl e andrenewabl e source of energy.

Ingeneral ,w e seetha t all drainage andconversio n of forest leads to carbon loss. Ofth e substituting land uses,tre e plantations will probably haveth e least negative effects onth e carbon balance since they will form some biomass that remains onth e sitefo r alonge r period. Imperata grassland, agriculture andunvegetate d sites will have aver y low carbon stock (Table3) .

Table 3. Carbon stock inliving biomass in variousland use types.

Aboveground Belowground

Fallow small small Imperata 10 5 Agriculture small small Oilpal m <30 ? Acacia 30 ? Natural forest <240 <95

3.4 Problemswit hcultivatio n of deep peatlands

Several problems arise during crop cultivation ondee p peat. Most peats are poor innutrient s andar e very acidic (pHusuall y < 4). Fertilisation is often done by applying ash of burnedvegetatio n onth e soil. However, large quantities of ashar e neededt o sustain production. Manure is another possible source of nutrients.

Managing peatlands is managing water. After draining andclearing ,th e peat will relatively quickly,subside duet o drying anddecomposition .Afte r awhile ,thi s will slow downt o 2-5 centimetres per year. Subsidence speed mayb e controlled to acertai n extent by controlling drainage. Duet o the subsidence andth e loose nature of the peat, the anchorage of trees will be problematic. Ifth e peat is compacted before establishment of the tree crop, subsidence will be limited and root anchorage will be less problematic. Another problem related to the loose structure of the peat is its low carrying capacity, whichcause s problems inmechanica l farming.Als o many undecomposedan d partly decomposed logs inth e soil hamper mechanisation. 16

Generally, ground level differences inth e peatlands are very small. Duet o the subsidence of the peat,th e topography may change, causing problems such as flooding andwaterloggin g after heavy rainfall. Inorde r to cultivate deep peat, agoo d water management system is required to regulate the groundwater level.

3.5 Risks

The existence of risks is animportan t factor inCD Mprojects . Risks pertain to the (unintentional) loss of carbon from the forest project duet o various factors. Some are related to forest (or carbon) management, others are related to the procedures linkedt o the CDM(e.g .financia l aspects, payments etc). The risks should be clear to those parties buying carbon emission reductions. Whentrading , it is inth e interest of both parties that the risk of failure is low; eliminating risk is not possible but reducing it to anacceptabl e level should be possible.

InKalimantan ,fores t fires constitute amajo r risk of loss of sequestered carbon. Fire is part of the peatland forest system andcontrolle d fire is usedt o clear landfo r agriculture. Uncontrolled fires, e.g. as result of poorly managed controlled fires, can leadt o large-scale destruction of peatland andvegetation . Tropical peatlands are,durin g the dry season, highly susceptible to fire. In 1997-'98, fires devastated 5.2 +-0. 3 million hectares inEas t Kalimantan (Siegert et ai, 2001). Table 4 showsth e damaged area for different landcovers .

Table 4. Damagedarea for differentland covers in East Kalimantan.

Land cover Area(ha ) Burned(ha ) Burned(% )

Grassland (mainly Imperata cylindrical, lowbushe s 368,900 292,600 79.3 Lowland dipterocarp forest 5,379,600 2,177,900 40.5 Mangrove forest 1,042,100 91,700 8.8 Peat swamp forest 426,100 311,100 73.0 Secondary forest, plantation, farmland 2,283,400 1,723,400 75.5 Wetlands 358,700 290,400 81.0 Landcove r not mapped by ERS(mainl y highland dipterocarp forest) 3,882,600 330,800 8.5

Total 13,741,400 5,217,900 -

Source:Siegert et ai, 2001.

Page etal. (2002) estimated that in 1997 between 0.81 and2.5 7 Gt of carbonwa s released into the atmosphere as aresul t of burning of peat andvegetatio n in Indonesia.Thi s amount is equivalent to 1340% of the meanannua l global carbon emissions from fossilfuels .

The damage byfir e was greater (49.5%) in recently logged forest areas (between 1966-1998) than inearlie r logged forests (26.3%) or pristine forests (17.3%). This means that the risk from damage byfir e decreases as the forest matures. However, it also meanstha t (illegal) logging will increase the risk. If risks from forest damage aret o be lowered,the n land-use policies should be inplac e to control logging, or to introduce reduced impact logging techniques. Otherwise, recurrent fires will leadt o acomplet e loss of lowlandfores t (Siegert etai, 2001).

Besides the risks relatedt o forest or carbon management, areliabl e legal andinstitutiona l infrastructure needs to be inplac et ob eabl et o start payments for environmental services. Asth e rulesfo r the CDMar e still not clear, capacity islackin gt o implementan dmonito r carbonprojects . Especially inKalimanta nth enecessar y institutional infrastructure is not yet in place (see Chapter 5). 17

4. The financial system

4.1 Definition ofth e C02 market

Wewil linvestigat eth eC0 2marke t bytakin ga close r looka tth edeman dan dsuppl ysid eo fC0 2 reduction.Th e market is still init s infancy, but it is growing andwit h several important initiatives underway. The market is,fo r instance, expectedt o increase byth edecisio ntake nb yth eE U Commission inDecembe r 2002 that 'The EUMembe r States collectively must reduce their greenhouse gas emissions by 8%betwee n 2008 and2012 . Forth e period upt o 2008, the Parties undertake actions to make demonstrable progress inachievin gthei r commitments by no later than2005 '(EU ,2002) .Thi sway ,th eE Uwil lb y 2005 bewel lprepare dt o participate inth e emissions trading system foreseen inth e Kyoto Protocol.

4.1.1 Demandfo r C02 reduction

UNEP-FI(2002 ) identifies five categories of buyers of C02 reduction: 1. Institutional multilateral (e.g.Worl d Bank PCF,IFC ,Asia nDevelopmen t Bank) 2. Public Sector Unilateral (e.g.Dutc h ERUPTprogramme , UKClimat e Challenge Fund) 3. Private Sector Funds(e.g .Ediso n Electric Institute, Fondelec, Black Emerald) 4. Bilateral Transactions: mainly involving large industrial corporations (e.g.Shell ,TransAlta ) 5. GreenCertificat e Buyers: heterogeneous marketplace requiring heavily structured deals

Some of these will be discussed inth e section about existing mechanisms.

Thedeman dfo r C02 reduction comes from industrialised countries that under the Kyoto Protocol needt o reduce their greenhouse emissions, the Annex 1countries . The Kyoto Protocol allows these countries to achieve part of their reduction targets via projects indevelopin g countries. Clearly, countries that have little possibilities to achieve the targets withinthei r boundaries or where costs to achieve the goals are high, are potential buyers. For example, the Dutch government has agreed that a substantial part of their emission reduction should be achieved withinth e Netherlandsitsel f andth eremainin gpar t shouldb eachieve d inothe r countries throughth e three Kyoto mechanisms, includingCDM .

Besides countries, companies are becoming increasingly active onth e carbon market. This is partly related to motivations of 'greening' the corporate image or because of stewardship considerations, but atth e endo f the day it also makes economic sense:carbo n is money. Especially power producers such as electric companies andpetro ­ chemicalconcern s sucha s BPAmoc o or ShellInternationa l are active inthi s field. There are several reasons why theyvoluntaril y commit to reduction programs. Oneimportan t reason, especially for those who emit more carbon dioxide per dollar of operating revenue than others, is the perceived risk of binding limitationtha t will be imposed on GHGemission s inth efuture .The yca n hedge this risk by reducing GHGno w because it is believed that current reductions are relatively inexpensive compared to likely future prices ina regulated emissions trading system.Also , gaining experience inemissio n trading ina nearl y stage might helpthe m inth efuture , whenemissio n reduction could beobligatory . Besides this, companies have reacted to public concern over the greenhouse effect.

Estimates based onth e potential carbontrad e in NorthAmeric a and Europe indicate that it could bewort h 30 to 100 USSbillio nwhe nfull y operational (Totten, 1999) anda marke t clearing price withful l carbontradin g inth eU S could go to 3040 US$ per ton anda s high as 70-80 US$ per ton inEurop e andJapan .

Interestt o invest in(smal l scale) CDMforestr y projects in developing countries may not lie inth e possibility for cost- efficient C02 reduction alone but inth e combination of C02 reduction with improving local livelihoods of poor communities. Inthi s way, C02 reductions are coupled with sustainable development, aswa s outlined inth e Kyoto 18 protocol (article 12.2). Also, CDMforestr y conservation projects may be inlin ewit hth e Convention of Biological Diversity (CBD),whic h may add anadditiona l incentive to invest inthes e schemes.

4.1.2 Supplyo fC0 2reductio n

The suppliers of C02 reduction are very diverse, ranging from large multinational energy companies to small local operators, andt o governments inth eso-calle dnon-Anne x 1 countries. Mostbuyer s havesough t to acquire reductions generated within their own home country, andonl y a handful of projects located indevelopin g countries have resulted in successful emissions transactions. Projects located inthes e countries have greater perceived project risk andfe w developing countries have established adequate institutions to review project proposals andt o grant necessary host country approvals (Rosenzweig et al., 2002), with Costa Rica as anotabl e exception. CostaRic a became thefirs t country to turn its forests into marketable carbon sinks by issuing 'Certified Tradable Offsets' (CTOs), based ona fores t carbon sequestration program with performance guarantees, carbon reserve pools and third party certification (see also Subak, 2000).

However, tropical developing countries can offer low cost carbon offset opportunities. Based on Brown (1997) and WCFSD(1997) ,Totte n(1999 ) estimatestha t some 700 millionhectare so flan d indevelopin g countries and countries intransitio n might be economically attractive for forest carbon programs, resulting in6 0 to 87 billion tons of carbon cumulatively conserved and sequestered by 2050, equivalent to 11-15 percent of the fossil fuel emission over that period. However, if factors such as landtenure , institutional capacity, andothe r (socio-economic) constraints are taken into account, these figures may be lower.

Forthes e non-Annex 1countries , it can be attractive to host forest carbon programs, because forests can provide several other functions such aswatershe d protection andcontrollin g or maintaining biodiversity (Meijerink, 1995). For local communities there are also a number of benefits to be gained inparticipatin g in aCD Mproject , although Smith& Scherr (2002) warntha t these benefits can only begaine d if the CDM project fulfils several criteria (see 5.2). These gains can consist of livelihoods derived from forestry, but may also consist of direct or indirect paymentsfo r carbon sequestration.

Not only forest can capture carbon but other forms of land use andlan dmanagemen t provide opportunities aswell . These, however, are not eligible inth e first commitment period of the Kyoto Protocol.

4.2 Examples of Emission Trading Schemes

InDecembe r 2002, the EUreache d anagreemen t ona nE UGH Gemission s trading system (EUETS) ,whic hwil l establish absolute limits onth e emissions of C02. Bythi s agreement, the EUha sestablishe d the first trans-national emissions trading scheme inth e world. Inligh t of the upcoming EUenlargement , the scheme could cover upt o

30 countries inth e period upt o 2012. The C02 emissions expected to becovere d byth e scheme are estimated to account for about 46%o f the EU1 5 members' total C02 emissions in 2010, andabou t 4,000 to 5,000 installations across the existing EUMembe r States will be affected (GBN,2002) .

Elements agreed include: • Opt-out: Although tradingwil l start in 2005, individual installations or economic activities can be exempted from emissionstradin gi nth efina lperio di n2005-2007 . Opt-outs are,however , subjectt o approvalb yth e Commission on strict conditions. These notably include fulfilling the same emissions reduction requirements as companies andinstallation s participating inth e scheme. • Opt-in:Membe r States canunilaterall y include additional sectors andgase s from 2008 onwards, subject to approval byth eCommission . • Pooling:Th e agreement also provides for the possibility for companies to poolthei r emission allocations until 2012. 19

• Allocation of emission rights: Allocations of emission permits will befre e of charge, but Member States can auction upt o 10%o f their allowances from 2008. • Penalties: The penalty rate foreseen for the period from 2005-2007 hasbee nslightl y reduced from 50 $ to

40 $ per ton of C02 equivalent emitted inexces s of the allowance. Itwil l be 100 $ thereafter.

Several governments have initiated aGH Gemission s trading system. Rosenzweig etal. (2002) and DeConin k & Vande n Linden (2003) mention three of such schemes, inth e US,Denmar k andth e UK,whic hw ewil l discuss briefly. The EUsyste m is atrans-nationa l system,an d it is still unclear howth e systems of Denmark andth e UKwil l fit intothi s larger system.

Massachusetts wasth efirs t USstat e to impose C02 emissions limits onol dfossil-fuel-fire d power plants.Th e reduction can be metthroug h internal actions such as repowering from coalt o natural gas, but also through the purchase of offsets for compliance. Although specific rulesfo r crediting offsets are not yet inplace , emissions reduction or sequestration projects must demonstrate to the Massachusetts Dept of Environmental Protection that the reductions are real, surplus, verifiable, permanent andenforceable .

TheDanis hgovernmen t introducedth eC0 2 QuotaAc ti n 1999,whic himpose sa ca po npowe r sector C02 emissions.

For 2000, the Act specifies atota l emissions quotafo r electricity producers of 23 million metric tons of C02. By 2003 this capwil l have beentightene d to 10 million metric tons. Electricity producers cantrad e their emission allowances among eachothe r andeac hyea r until 2003. If anelectricit y producer's annual emissions exceed its holding of allowances, it is subject to apenalt y of US$ 5-6 per metric ton excess. The revenue from penalties is directed toward energy-saving projects.

In 2001, the UKgovernmen t published the finalframewor k for a national GHGtradin g program that covers most of industry, andal l GHGs.Wit hthi s program,th e UKi sth efirs t industrialised country to develop such abroad-base d GHGprogram . Although the program is voluntary, companies are inducedt o participate through ata x on industrial andcommercia l energy consumption, known asth e Climate Change Levy(CCL) .

4.3 Examples of project-based programs

Besides government systems such asth e emission trading schemes discussed above,ther e are several project- based initiatives that aretake n by individual companies to achieve voluntary reduction commitments or programs initiated by(nationa l or state) governments that allow companies to reduce their emissions voluntarily. Wewil l discuss afe w examples (information based on:Rosenzwei g etal., 2002; Face, 2003; DeConin k &Va nde r Linden, 2003).

4.3.1 Emission Reduction Unit Procurement Tender (ERUPT)

ERUPTi s aninitiativ e byth e Dutch Ministry of Economic Affairs, designed to assist the Netherlands inachievin g its national emissions limit under the Kyoto Protocol through the purchase of Emission Reduction Units (ERUs). ERUPT projects must adheret o criteria issued byth e Ministry's implementing agency SENTER. Purchases from five projects

(all inEaster n Europe) inth e first round involved atota l of 4.2 million metric tons of C02 reductions, valued at atota l of US$ 31 million.Tw oadditiona l tenders havefollowe d -a secon d round of ERUPTan da Certifie s ERUPTwhic hi s designed to purchase reductions generated from CDM-likeproject s (aiming at 3 million metric tons of C02 at US$424 5 per metric ton).

The Dutch Government has established aseparat e CDMDivisio nt o useth efund s allocated byth e Dutch government to purchase Certified Emission Reductions (CERs).I nfact , the purchase of CERscreate s anadditiona l return on project investments. Asa result , sustainable projects can be realised,whic hwoul d not have beenfeasibl e without the possibility of sellingCERs . 20

CERsar e purchased throughth efollowin g four tracks: 1. Multilateral internationalfinancia l institutions. 2. SENTER International, aDutc h agency acting onbehal f of several Dutch Ministries. 3. Privatefinancia l institutions. 4. Bilateral purchase agreements with Host Countries.

These intermediaries select sustainable projects indevelopin g countries andpurchas e the resulting CERs.Investor s from all countries may submit CDMprojec t proposals to these intermediaries who willjudg e these projects, including the compliance withth e requirements.

4.3.2 Prototype Carbon Fund(PCF )

The PCFwa s established byth e World Bank in 1999 to acquire high-quality project generated emissions reductions that could potentially be eligible for international recognition under rules governingJ lan dCDM .Privat efirm s and governments have invested atota l of US$ 180 million.Th e PCFha s purchased reductions from three projects in Latvia, Uganda andChile .

These two programs, whichhav e aportfoli o of 37 CDMan d 12 Jl projects, are fully consistent withth e Kyoto Protocol, andth e emerging framework for Jl and CDM.The y are therefore nominated for approval byth eUNFCCC . However, DeConin k &Va nde r Linden (2003) emphasise that the UNFCCCha sno tye t certified any organisation to verify and monitor JI/CDMprojects .

TheWorl d Bank recently launchedth e BioCarbon Fund.Thi s fundwhic hwil l purchase emission reductions potentially eligible for credit under the Kyoto Protocol. Besides the CDMroute , aJ lrout e is openedwhic h aims to demonstrate howcarbo nproject s canwork .Th erule sfo r theJ lar eles sstric t as it is primarily designed as alearnin g process.

4.3.3 Finnish CDIVf/JIPilo t Programme

In2000 , the Government of Finland has launched the CDM/JIPilo t Programme in preparation for the Kyoto Protocol. The aim of the programme ist o gather experience in issues specific to the CDM/JI project cycle andt o facilitate the implementation of the Kyoto Protocol inFinland .Th e invitation to propose small-scale CDMproject s closed on 31 March 2003. Intotal , 28 tenders were received,fro m SouthAmerica , Asia andAfrica . The evaluation of tenders is in progress. Projects included inth e programs pipeline will produce emission credits until 2012 at least.

4.3.4 USInitiativ e onJoin t Implementation (USUI)

Althoughth eU Sdi dno tratif y theKyot oProtocol , several different initiatives for C02 reduction are ongoing inth eUS . The USInitiativ e onJoin t Implementation (USUI)wa sth e first Jlpilo t program, initiated underth e 1993 USClimat e Change Action Plan.I twa s established to demonstrate viability of project-based emissions trading. To dateth eUSU I has approved 50 projects in 26 countries (bothdevelope d and developing).

4.3.5 The Climate Trust (Oregon)

This initiative,take n in 1997 byth e State of Oregon, obliges new power plants to offset aportio n of their projected

C02 emissions asa condition for obtaining anoperatin g permit. They may dothi s by acquiring qualifying offsets in the market or by paying US$ 0.85 per metric ton of C02 to the Climate Trust. Sofa r all have chosen the latter option andfiv e projects willfunde dfro m thefirs t million dollars inth e Climate Trust. These projects are all located in North America, except for one,whic h is inEcuador . Asecon d round of contracts (US$ 5.5 million) will be awarded comingyears . 21

4.3.6 Activities Implemented Jointly Pilot Phase(AU )

This program was initiated atth e first Conference Of Parties (COP-1)t o the UNFCCi n 1995 to gain experience with Jlan dCDM-lik eprojects . Althoughth e pilot phase was supposedt o endi n 2000, it continued after the COP-7i n Marrakech and has undertaken 155 projects in4 1 countries.

4.3.7 Pilot Emissions Reduction Trading Project (PERT,Ontario )

Thiswell-know n Canadian initiative was undertaken by industry andgovernmen t of Canada to explore and promote emissions trading byfosterin g voluntary reduction activities. To date it hasevaluate d anumbe r of projects that together have ledt o the registration of 14.6 million metric tons of C02 reduction.

4.4 Company initiatives

Severalcompanie s have set upthei r ownC0 2 reduction programs, notably the fossilfue l andelectricit y companies. Wewil l discuss afe w examples here.

4.4.1 BP

In 1998 BPcommitte d to reduce its GHGemission s 10%belo w 1990 levels by 2001. It collaborated withth eNG O Environmental Defence andlaunche d apilo t project phase in 1999 involving 12 of its business units located in different countries. In2000 , 2.7 million metric tons of C02 were traded at anaverag e price of $ 7.5 per metric ton.

4.4.2 Shell

In 1998, also Shell committed itself to reduce GHGemission s 10%belo w 1990 levels by 2002. In200 0 it instituted its ShellTradabl e Emission Permit System (STEPS) program which is modelled after CDM.Aroun d 20 of its units were required to participate inth e program (amountingfo r 30%o f corporate emissions). It has established caps for unitsi ndevelope dcountrie s(Anne xB )bu tals oallow sunit si ndevelopin g countries (non-Annex B)t o generate project- based reductions andsel lthe m into the system. However, the Shellemissio n trading scheme was not successful duet o the voluntary nature of the scheme andtherefor e ceased to exist.

4.4.3 FACE

The Dutch Electricity Board (SEP),a consortiu m of five electricity companies, created the FACEFoundatio n to promote the planting of forests to absorb anamoun t of C02 equivalent to the emissions of amedium-size d coal-fired power plant during its 40-year life span (Moura-Costa, no date). Since 2000, the Face Foundation isworkin g atth e development andreconnaissanc e of markets for the acquisition of funds inorde r to keepfulfillin g its objectives. Services related to Face's objectives concerning forestry andclimat e are: • Supplier of verified carbon credits; • Implementation of forestry projects; • Generation of carbon credits through forestry projects; • Consultancy onclimat e projects, baselines, forestry projects, certification, etc. 22

4.5 Possible future directions:financia l dérivâtesan d brokers

Rosenzweig étal. (2002) estimate that already between 25 and 50%o f the emission reduction transactions have involved anexchang e of financial dérivâtes. Onceth e carbon trading market becomes more mature, it ist o be expected that the number of transactions involving these dérivâtes will increase. Wewil l (after Rosenzweig etal., ibid.) discuss four of these: call options, put options, collars andfence s onVER s(Verifiabl e Emission Reductions), or other emissions commodities.

Call options Abuye r of acal l option,whic h is simply acontrac t specifying certain responsibilities, buysfro m a seller the right but not the obligation to purchase afixe d quantity of emissions at afixe d price (strike price) on or before afixe d date in thefutur e (expiration date).Th e buyer pays the seller of the calloptio n to accept the corresponding responsibility to sell emissions reductions according to the agreed terms. Theamoun t paidfo r the option is called thepremium . Sellers are allowed to keep the premium even if the buyer fails to useth e option. Inthi s way, call options area relatively inexpensive way to hedge risks related to future compliance costs (which may be much higher than current costs).

Put options Apu t option entitles its buyer the right to sell acommodit y (e.g.VER )a t the strike price ono r before the expiration date. The seller of the option is required to purchase the commodity atth e agreed price if the buyer uses theoption . The premium is paid byth e buyer to the seller at the time the initialtransactio n isclosed .

Collars or fences These involve two transactions inwhic h one party buys acal l and sells a put (usuallywit hdifferen t strike prices and the same expiration date), and another sells acal l and buys aput . By setting apric e floor andceiling , each position will provide protection against market movement.

Swaps These are transactions inwhic hon e type commodity is exchanged for another, rather than for cash. Swapsi n emissiontradin g can involve tax benefits whenta x authorities consider them to be non-taxable 'like-kind exchanges'.

The EU's emissions trading scheme, whichwa s agreed byth e EU's environment ministers in December 2002 andi s expectedt o beimplemente d in2005 , hasalread y ledt o the first speculative trades. InGermany ,trader s have begun brokering speculative trades of C02 certificates between companies (E5 News &Press , January 2003)

Another development that is to be expected isth e increase inmarke t participants who function as brokers to match suitable buyers and sellers.A s more initiatives will come about, their rolewil l increase. The role of other consultants whowil l assist parties in issues such as monitoring andquantificatio n of C02 sequestration, andauditor s is also likely to increase. Such consultants have already stepped into the market (anexampl e isWS PClimat e Change Services,par t ofth eWS P Group,a larg econsultanc y basedi nLondon) .Landell-Mill ss .Porra s(2002 ) observeda rapid emergence of ancillary service providers such as advisory, exchange, brokerage, investment funding, legaladvice , insurance, andcertification .Th e major share is taken up by advisory service providers, which may underline thefac t thatth emarke ti sstil la tit searl ydevelopmen t stages.However ,the yals onot etha tth emarke t isincreasingl y dominated byth e private sector indemandin g and supplying carbon offsets, anda s aprovide r of ancillary services. This is a sign of confidence that the carbon market will expand,whic h is also reflected inth e shift from aserie s ofa d hoc dealstoward sth eestablishmen t of trading systems that aim to provide abasi s for numerous transactions. 23

4.6 Relationt o International Trade Agreements

Many key aspects of the CDMwil l entail services or service-related functions. Accordingly, one of the most important WTOagreement s related to the CDMwil l beth e GeneralAgreemen t onTrad e in Services (GATS),whic h hasbee n adopted byth e World Trade Organisation (WTO).A t leastthre e basic GATS-relatedcomponent s may be identified under theCDM : • Certified Emissions Reductions (CERs) • Services employed inth e development and management of CDMproject s • Financial services related to trade inCER s

Wiser (2002) concludes that it is unlikely that the tradable allowances issued after certification of aCD M project's accrued emissions reductions could reasonably be considered products or services withinth e range of the General Agreement onTariff s andTrad e (GATT)o r GATS,bu t rather as atradabl e license or permit. This will probably imply that countries will haveth efreedo m to regulate CERsi nway s they believe are appropriate, without concern that suchtreatmen t will be subject to WTO jurisdiction.

Secondly, many of the individual services that collectively constitute CDMprojec t development are likely to fall under one or more of the categories identified inth e list of services covered byth e GATS.However , two of the most importantGAT S provisions affectingth etreatmen t ofthos eservice s are'opt-in 'commitments .Ver yfe wWT O members have made commitments for the energy or environmental services sectors, which are among the most important service sectors for CDMprojects . This meanstha t countries haveth e opportunity to taketh e initiative to ensure that the GATSenhance s rather than interferes with the CDM's sustainable development objectives.

4.7 CDMcommunit yforestr y projects

Smith &Scher r (2002), ina study drawing onexperience s with pilot carbon projects and social forestry, conclude that manytype s of CDMproject s could potentially contribute to local livelihoods andecosyste m restoration, aswel l ast ocarbo nemissio noffsets .However ,thi swil lonl yb epossibl e ifa numbe ro f criteria are met, whichar e discussed indetai l in section 5.2 oninstitutions .

Ingeneral , projects that sequester C02 will be profitable whenreturn s (i.e. price per ton Creceived ) are higher than the costs (i.e.cos t incurred per ton Csequestered) . Thecos t structure of aC0 2 sequestration project consists of the costs involved inth e C02 sequestration itself (e.g. the establishment of afores t or plantation) but also of the costs involved in management of the CDMwhic h are calledtransactio n costs. These costs are also linkedt o the guidelines establishedfo r CDMproject s (e.g.o nadditionality , leakage,permanence) .

Production costs are the costs per metric ton of carbon of establishing andmaintainin gth e new carbon-augmenting land use.Thes e include tree establishment, management, processing andth e opportunity costs of land.T o realistically reflect cost effectiveness of the project, production costs should be adjusted to take account of leakage, project duration andth e risk of project failure. These aspects are usually nottake n into account.

Transaction costs are also often forgotten whencalculatin g the costs of aprojec t (Smith &Scherr , 2002). However, these costs willpla y a role inever y carbon sequestration (CDM)programme . They usually consist of the following (Landell-Mills &Porras , 2002): • Project identification -searchin g and selecting projects thatwil l meet Kyoto aswel l as national crediting requirements • Project design and implementation • Project monitoring, enforcement andris k management • Host countries andnationa l project review — clarification andstreamlinin g national and international registration andapprova l processes • Marketing 24

Smith & Scherr (2002) have looked into the production andtransactio n costs based ona numbe r of studies on different forestry projects:

Large-scale industrial plantation: Could supply carbon protection at under $ 5 per ton C, especially whencarrie d out ondegrade d lands with low opportunity costs.However , the studies usually ignored leakage andtransactio n costs and make no adjustment for project duration.

Agro-forestry andcommunit y forest plantations: cost of production differs per type of plantation.Cost s will be higher than large-scale industrial plantations because of additional costs such as compensation payments to farmers, co-ordination andmanagemen t costs ofgroup s offarmers . Estimates in sevenstudie s (includingfores t fallow)rang e fromUS $ 8 to 70 per ton C.However , the studies usually did not include leakage, transaction costs of project duration.

Assisted natural regeneration: The production costs of these schemes tend to be lower thantre e planting andar e therefore cheaper than agro-forestry andcommunit y plantations.

Strictfores t protection:Althoug hthes eproject s cansuppl ycarbo na ta lo w price (under 5 per ton C),th e transaction costs can be substantial,a swel l as the cost of leakage.

Multiple use community forestry within protected areas: The costs of such projects will be higher than under strict forest protection because of the costs that involvement of communities incur. However, the costs of leakage will probably be lower, as well as the risk of project failure because the local communities have a stake in protecting the forest.

Poffenberger etal. (2001) note that withinth e context of carbon-credit basedfinancin g programs, transaction costs arelikel yt o behighe rtha ni nconventiona l(communit yforestry ) programs duet oth e stringent reporting requirements andth e additional costs of dealingwit h international mechanisms and markets. These transaction costs will increase asth e role of the third party 'manager' (e.g.forestr y department, NGO)increases . Givingcommunitie s greater authority andcontro l over funds for project management andoperation s would likely reduce transaction costs. However, involving communities also incurs transaction costs, especially whenth e communities are characterised by ahig h degree of conflict (DeJon g eta/., 2000). 25

5. Institutional system

Allwel lfunctionin g markets rely on astron g institutional foundation. This is especially true for markets for environmental services. Legal andfinancia l structures needt o beeffectiv e andtransparent , but also the wayi n whichth e commodity (e.g.biodiversity , carbon) is determined needs to betransparen t andverifiable . International rules andguideline s onho wt o determine andrepor t changes incarbo n are still beingdeveloped .

The institutional setting is partly prescribed byth e Kyoto Protocol.A nationa l CDMAuthorit y should be created to evaluate potential CDMproject s and seewhethe r they comply with national andinternationa l criteria (Kyoto Protocol, development plans,biodiversit y and sustainability indicators).

For Indonesia (which hasno t yet ratified the Kyoto Protocol) such anauthorit y does not yet exist. Recommendations onth enationa linstitutiona lan dlega lframewor k arealread y presentedb yth eIndonesia nStat eMinistr yfo rEnvironmen t (State Ministry for Environment, 2001).

Asuccessfu l CDMstrateg y will need active support by all regional stakeholders (local government, NGOs,privat e sector, etc.) andco-operatio n from the various sectors (agriculture, forestry, mining,etc.) .Th e integration of these players is probably notth ewa y to go; creating abod y withth e support from these players, however, could createa platform for discussion andco-operation . Linkedt o the National Authority, aRegiona l Focal Pointfo r Environmental Services could co-ordinate andfacilitat e CDMprojects . For example, sucha bod y could protect the integrity of the projects andprovid e transparency towards the buyers (e.g.n o double accounting), andi t could assist inbundlin g small scale CDMproject s andattrac t investors (this instead of having alo t of small scale initiatives that will confuse investors and leave small landowners outside the loop).

Costa Rica has,fo r instance, invested substantially init s institutional and legislative framework andnurture d capacity sotha t public, private, andcommunit y stakeholders can benefit from forest conservation measures.Thi s conservation infrastructure is crucialwhe n capitalising on andbenefitin g from opportunities in environmental services. Targeting policies, institutional frameworks andhuma n capacity is critical (GEF,2002) .

CDMforestr y projects that enhance livelihoods and result insustaine d C02 emission reductions can onlyb e successful when anumbe r of conditions are met. Becausethes e conditions are related withth e (national) institutional environment of the project aswel l asth e institutional arrangements the project needs to put inplace ,w e will describe the required institutional settings at national level,wit h special reference to Indonesia, andloca l levelo n a more generalnote .

5.1 Institutional setting at national level

The national institutional settings are important for two main reasons. First, the host country must have institutions in placet o facilitate the implementation of CDM. Secondly, the host country should create anenablin g environment that support sustainable forestry-

Thegovernmen t of Indonesia is a signatory to the UNFCCCan d ratified the convention onAugus t 1, 1994.Th e government is also asignator y to the Kyoto Protocol but is hasno t ratified it. Duet o the countryfs economic and socio-political crisis during 1997-1999, meaningfulfollow-u p related to the Protocol has been delayed.Thi s means that Indonesia has notye t established formal policies or national criteria, nor prioritised sectors with respect to CDM.

In2000 , a nationaltas k force for 'Indonesia National Strategy Study onCDM 'wa s established to advise the government on Indonesia's negotiating position onCDM ,th e benefits that could begaine dfro m hostingCD M projects, CDMpotential s andpolicie s andinstitution s required to participate effectively. The government has 26 indicated that possible CDMproject s would be mainly inenerg y sectors, followed byforestr y 'sink' projects (Soerawidjaja eta/., 2001).

In2003 , the Ministry of Environment, asfoca l point for the United Nations Framework Convention onClimat e Change (UNFCCC), has started aninitiativ e to establish the Designated National Authority (DNA)fo r host countryCD M approvalproject s inIndonesia .Thi s initiative is funded byth e German International Co-operation Agency (GTZ). The DNAi srequire db yth eMarrakec hAccord sfo r allhos t countriest o approve CDMproject s inthei r countries.I n Indonesia, the DNAwil l behoste d byth e Ministry of Environment asfoca l point of the UNFCCCan da s Chair of the National Committee onClimat e Change (NCCC).Whil e the project will be carried out in 18-24 months, it isexpecte d thata fully-functioning DNAwil ltak eplac eprio r toth eC0P 9 inMilan ,Ital y(Decembe r 2003). To empower the DNA, Indonesia has submitted ala wfo r ratification of the Kyoto Protocol.Th e draft law is currently under deliberation of parliament. TheAsia n Development Bank, after its fact-finding mission in March 2003, is likely to approvea $ 900,000 advisory technical assistance (TA)t o the Government of Indonesia onsequestratio n (forestry) CDM.Th e Ministry of Environment will assume the role asth e executing agency (Pelangi News, March 2003).

National governments also play acrucia l role increatin g the environment for (local)forestr y projects. This includes defining land (use) rights, specifying entitlements to forests andfores t products andensurin gfores t protection. Especially where poor andvulnerabl e communities are involved,thei r interests should bewel l protected. Sari eta/. (2002) argue that the underlying causes of forest destruction anddegradatio n inIndonesi a are rooted intenur e problems, conflicting andineffectiv e regulatory measures, high demandfo r forest products, and bad governance andcorruption .

Rusmantoro (2002) highlights the problems of governance andbureaucrac y inIndonesi a which will have effect on implementation of CDMi nIndonesia : 'A crucial issue is howth e international agenda andnationa l commitment can be linkedt o the commitment of local government, andho wth e bureaucracy can be reformed.Th e failure of last year's multi-sector agenda under the Interdepartmental Committee onForestr y andothe r previous international programs were duet o the absence of intensive communication to link those international commitments with national, aswel l as local,concerns . Governance andbureaucrac y problems are the most important causes of forest degradation. International initiatives cannot be more than atrigge r to further work inthi s area. Experience inth e last two years has showntha t the forest reform agendas that could becarrie d out were only those agreed through intensive communication amongth e central and local government aswel l as other stakeholders, followed by bureaucracy reform andstrengthening .An y one agenda could be better thanan y other, but it would befutil e without sufficient commitment and institutional capability.'

Therefore, Sari eta/. (2002, p. 35) conclude that 'whileth e best wayforestr y CDMca n contribute to the forestry sector is additional financial resources, the lack of which is by no means the only— eventh e most pressing — cause to forest destruction anddegradation . Forestry CDMrun s aris k of gross unfeasibility whenface d byth e complex institutional interplay inth e forestry sector inIndonesia' .

5.2 Institutional setting at project and local level

Afirs t step inestablishin g the institutional settingfo r aCD Mforestr y project is identifying the community that willb e involved inth e CDMprojec t andclarifyin g what is expected of them (interm s of C02 sequestration) andwha tthei r compensation will be ina carbo n contract. This will require well-functioning local institutions. Smith & Scherr (2002) have identified several elements for aCD Mprojec t design, based onlesson s from past forestry experiences. 27

5.2.1 Maximise project success through strong local participation

Ina CD Mproject , the local suppliers of C02 reduction (groups of individual or community landowners) andth e outside investors (or intermediary) negotiate anagreemen t oncarbo n emission reduction activities. Althoughw e have seentha t the national institutional framework is crucial,i t is equally important that the local communities are involved indecision s onprojec t design andtha t funds are usedt o finance activities that enable local people to increase their livelihoods. The definition andprioritisatio n of livelihood benefits from CDMproject s anddistributio n of carbon revenues among project partners should be negotiated directly withth e contracting local suppliers.

Poffenberger eta/. (2001) describe aCD Mcommunit y forestry project inCentra l Indiaan dho w anumbe r of institutions were involved. Some neworganisation s needed to be established to co-ordinate the program. Because the project aimedt o empower local communities asfores t managers, Forest Protection Committees andVillag e Forest Committees acted as primary implementers of the project. The support of the Forest Department to the local communities helped inestablishin g strong and successful committees andresolvin g conflicts. Research Institutions inconjunction s withth e local FPC/VFCs prepared detailed designs of carbon monitoring, verifying and reporting system, training village monitors inth e methodologies anddat a analysis procedures, andwer e responsible for verification of thefindings .

InCentra l Kalimantan, stakeholder involvement incarbo n andothe r environmental services (e.g.biodiversity ) isjus t starting. Central inthes e activities isth e Bio-Rights initiative (www.bio-rights.org)whic h aims at poverty alleviationvi a payments for environmental services.

5.2.2 Select the most suitable compensation mechanisms

Acentra lquestio ni nfunctio nendowmen t(i nthi scas eC0 2 sequestration intrees ) is how much shouldb e contributed towho man db ywhom ?An d whoshoul db ecompensate d how much,i nwha twa y andfo r howlon g(Meijerink , 1995)? According to Smith& Scherr (2002) the compensation scheme must clearly increase the well-being of local people and should be negotiated directly withthem . Four alternative compensation mechanisms for forest carbon projects can beidentified : • Pay per tree: projects directly reward individual tree growers for carbon sequestration. • Payfo r forest establishment or protection: projects compensate community organisations to protect/ regenerate forest areas or establish plantations. Thecommunit y organisation distributes benefits to members. • Facilitate profitable and sustainable land management: projects invest inextensio n services, tree nurseries, marketing infrastructure, etc. Individual producers gain by participating inne w land-use activities or sharing income from forest production. Sustainable forest management for instance, may make it eligible for forest certification andenablin g producers to sell certified timber andNTFP sfo r apremiu m or as preferred suppliers (see also Jenkins &Smith , 1999). • Pay communities with improved services: projects reward communities by improving livelihoods through providing health clinics, education, micro-finance, enhanced rights to resources etc.

Poffenberger eta/. (2001) inthei r description of the CDMcommunit y forestry project inCentra l India describea system inwhic h aforest-produce r federation was established that negotiated a50-yea r contract with aconsortiu m of outside financing agencies at afixe d rate per ton per year. Apar t of the payments was put into community run micro-credit institutions andth e rest was divided among the various support institutions (e.g.communit y group councils,join taccoun to fth eFederation ,researc hinstitution stha t provide support intraining ,monitoring , verification andreporting ,th e local Forest Divisions for operations that oversee the allocation of carbon credit resources and co-ordinate the overall technical assistance programme). 28

5.2.3 Enhance the profitability of new landuse s

Becauseth eincom efro m carbonpayment st ocommunitie swil lb esmal l inth e short term, it is important to stimulate a portfolio of diverse income streams from forest resources to raise incomes andreduc e fluctuations inincome . Examples are to increase the productivity or value of land uses,facilitatin g sustainable forest certification, useo f non-wood products, etc. Thiswil l also reduce the risks of leakage.

5.2.4 Increase transparency in investor-community partnerships

This is closely linkedt o the local institutional setting. Merely setting up institutions andorganisation s will notb e sufficient. It is also important that there is mutual confidence andtrus t between communities and external private or governmental agencies. Smith& Scherr (2002) recommend that innegotiatin g andimplementin g CDM contracts agreements andprocesse s must be understood andwidel y known.Al l stakeholders should agree onclearl y drawn maps showingth e boundaries of land-use andmanagemen t regimes. Clear criteria andtransparen t mechanisms for the distribution of costs andbenefit s among multiple stakeholders should bepu t inplace . Forest carbon contracts needt o clearly specify issues sucha s the operational plan, ownership of land, carbon sequestration rights, project termination,projec t governance,financing ,divisio no f carboncredits ,liabilitie sfo r failurest o perform, and procedures for dispute resolution.

Davis (2000) provides a blueprint for acomprehensiv e agreement with 16 articles for aCD Mprojec t whichma y readily beused .

5.2.5 Reduce project marketing costs and investor risks

Project marketing costs and investor risks are potentially high infores t carbon projects. Especially with respect to project duration,ther e are risks involved.A requiremen t mentioned inth e Kyoto protocol istha t C02 projects should result inlong-ter mcarbo n storagechange .Wha texactl y islong-ter mi sno tclear , butfo r forestry iti s clear that carbon is stored only as long asth e forest (or its harvested products) exists. Incontrast , fuel switching projects inth e energy sector reduce C02 emissions permanently. With long-term forest projects there is always the risk that land usewil l change before the projected time, especially whenther e is strong population pressures or incas e policies or market conditions change. The challenge therefore is finding aformul a that values forest-based carbon offsets appropriately when set against more secure emission reductions. Onewa y ist o discount forest-based offsets to take account of their non-permanent nature. Another option ist o devise mechanisms that provide reasonable assurance of indefinite sequestration.

Besides project duration, leakage poses another risk. 'Leakage' occurs when project activities result in anincreas e inemission s outside the project, for instance, if the project leads to increased agricultural activities infores t areas that are outside the project.

Risks associated with CDMca n decreased in several ways (Smith & Scherr, 2002; Landell-Mills &Porras , 2002): • Bundling projects within acountr y to market alarg e supply of carbon offsets. • Pooled investments in 'mutualfund ' type arrangements to lower transaction costs andth e risk of individual project failure. • Branding of socially responsible investments by site labelling or social certification to market these to utility and other companies that seek to acquire credits labelled as 'earned from livelihood-enhancing projects'. Thisma y also attract investors such as charities or development organisations. • Project insurance. Provide an insurance buffer, which has been adopted by Costa Ricafo r its CertifiedTradabl e Offsets. Essentially this meanstha t the host country supplies additional carbon sequestration as abuffe r against unexpected loss. 29

5.2.6 Increase scale and reduce costs of community-based CDM projects

The bigger the project area,th e lower the overhead costs such as project design, management andcertification . Smith &Scher r (2002) mention various institutional strategies that have been devisedt o reduce transaction costs and increase the scale of potential projects to keep costs of carbon offset competitive: • Specialised service contracts • Intermediary management organisations • Siteswit h established community organisations • Bundling environmental service payments • Bubble projects

These strategies will also reduce the risks as described earlier.

5.3 Financial institutions

The role of financial institutions inC0 2 reduction trade is animportan t one, and it is likely that this role will increase inth e future. However, UNEP-FI(2002 ) has foundtha t most mainstream financial institutions can becategorise d as being unaware of the business relevance of climate change issues, or have adopted awai t and see attitude. Onlya small handful of companies are proactive andhav e begunt o develop new products, lines of business, or new strategies and some have become sector leader interm s of product development andthinkin g onth e GHGmarkets .

There are several products financial institutions (banks and insurance companies) cantak e on:financing ,insurance , risk transfer, financial dérivâtes, carbon investment funds, corporate equity analysis, andfinancia l advisory services (e.g.tradin gemissio nreductions , portfolio advice,capita l structuring advice)(se eals oJanssen ,2000) .Ris k transfer is especially important for projects indevelopin g countries duet o perceived high political risk.

Afinancia l institution canassis t inprioritisin g the risks to betransferred , andb y definingth e potentialthir d parties best placed to absorb the risk atth e lowest cost to the project. Several risks can be envisaged inCD M projects such aseconomi c risk (revenues andcosts) , political risk (war, political violence, expropriation), regulatory risk, currency volatility risk, construction risk, operating andtechnolog y risk.

Politicalris k mayb eabsorbe db ylender s aspar to fthei rfundin gstructure s insom ecountries .However ,a combinatio n of political risk insurance anda nexistin g group of lenders may provide amor e attractive solution.Example s of other sources of political risk insurance include export credit agencies (e.g.th e Export-Import Bank of the United States (USExim )o r Japan Exim.)o r multilateral agencies (such as Japan Export andInvestmen t Insurance (EID/MITI),o r United States Overseas Private Investment Corporation (0PIQ). Traditional insurers are also now providing such insurance (C02e, 2003).

Withrespec tt otrading , producers ofemissio nreduction s maysee kt oobtai n performance guarantees,an dinsuranc e against political risks associated withth e location of the project or the regulatory implications of the Kyoto Protocol itself. For example, one issue of concern for buyers of CDMemissio n credits isth e political risk of the host government withdrawing approval of the credits at alate r date. These types of cover are not yet available but they are expected to be obtainable inth e future. Optimisingth e risk profile will enhance the value and attractiveness of emission reduction projects. 31

6. Discussion

1. Alarg e carbon offset potential exists inth e peatlands of Central Kalimantan The peatlands incentra l Kalimantan are alarg e carbon reservoir; conserving this reservoir is infac t aver y cost- effective way to preserve carbon. Reducing emissions and sequestration of carbon is clearly anoptio n inth e deforested anddegradin gareas .

CDMopportunitie s for reforestation exist onarea s near nature reserves ando nabandone d agricultural land. Large parts of the claimed land are unsuitable for agriculture (low soilfertility , regular flooding ...);thes e areas couldb e rehabilitated using localtre e species. Agricultural activities inth e peatland area inevitably leadt o loss of organic matter, depleting nutrients and inth e long runcreatin g anunsuitabl e environment for crop production.Alternativ e systems needt o bedeveloped , e.g. livestock husbandry, agro-forestry based production systems. Sofa r nj clear picture is available onth e expansion of the abandoned agricultural land andth e various strategies or alternative systems that are currently beingexplored .

2. The CDMrules ,whe n applied strictly, exclude large parts of Central Kalimantanfo r carbon offset projects Giventh e rules of the CDMonl y areastha t were deforested before 1990 are eligible for reforestation and afforestation. Most of thefores t cover inCentra l Kalimantan was removed after this date.Conservatio n of the existingcarbo n stocks is acost-effectiv e contribution to the greenhouse problem. However, activities aiming atth e prevention of deforestation andconservatio n of the peat are not eligible for crediting under theCDM .

3. Various (mostly uncoordinated) international initiatives (both public andprivate ) to facilitate carbon offset projects exist Althoughth e marketfo r carbon emission trading is still init s infancy, alarg e number of international initiatives (both public andprivate ) to facilitate carbon offset projects have been initiated inth e past decade.Althoug h severalke y players, amongst which notably the US,hav e not ratified the Kyoto Protocol;thi s has not prevented development of the market. Ingeneral , expectations are that the pressure for C02 reductions will increase inth e future. Thisha s inducedth e private sector to already invest inC0 2 reduction programmes or projects, and national governments to establish programmes for C02 reduction projects.

4. Financial Institutions are moving ino nth e carbon market; the land use sector hasonl y recently emerged inthi s market

Theexpectatio n that C02 reduction initiatives will increase andtha t the market for C02 emission tradingwil l develop has inducedfinancia l institutions to become more active inthi s area.The yar e slowly moving ino nth e carbon market.

Withinthes e developments, the land use sector has only recently emerged inth e carbon market andther e are still many uncertainties concerning the possibilities to invest inC0 2 emission reduction by changes inlan duse .

5. TheInstitutiona l setting ata nationa l andregiona l level is not clearly definedye t

Manypotentia l suppliers of C02 reductionar e not preparedt o enter the C02 market, with anotabl e exception of Costa Rica.Th e institutional arrangements that needt o be inplac e (at anationa l andregiona l level)t o effectively handle C02 reduction projects have not been clearly defined or put inplac e inIndonesia . Thiswil l hamper the establishment of CDMproject s inCentra lKalimantan . 32

6. Amajo r risk for CDMi n peatlands is uncontrolled fire: other risks may be rooted inth e institutional setting and local stakeholder involvement Severalfactor s can be identified that constitute a risk to possible CDMproject s inCentra l Kalimantan.A majo r abiotic risk for CDMproject s is the possibility of large-scale uncontrollable fires. Goodprovision s need to bemad e to prevent fires, andt o cover this risk inth e financial and crediting mechanisms. Other risks may be rooted inth e institutional setting and local stakeholder involvement. Several criteria have been identified that should be inplac e when aloca lforestr y CDMprojec t ist o be successfully implemented. Several of these criteria cannot be fulfilled (yet) inKalimantan .

7. The role of the voluntary market

There may be opportunities to interest the voluntary market to invest ina CDM-lik eC0 2 reduction project inCentra l Kalimantan.Especiall y when such aprojec t combines other objectives such as conservation of biodiversity and improving livelihoods of local communities with carbon sequestration. 33

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