Kurnya Roesad, Anna van Paddenburg, Yong Sung Kim1

1 Global Green Growth Institute (GGGI)

Special Economic Zones and Green Growth in Indonesia

Working Paper and Chapter for Wahyuni, Sari (ed.) (forthcoming, May 2015). Panduan Praktis Pengembangan Strategi Kawasan Ekonomi Khusus (Practical

Guide For The Development of Special Economic Zones). University of Indonesia, Faculty of Economics/Department of Management and National Board for Special

Economic Zones (Dewan Nasional Kawasan Ekonomi Khusus), Coordinating Ministry of Economic Affairs.

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Contents 1 Introduction .......................................................................................................................................... 3

2 SEZs and the environment .................................................................................................................... 4

2.1. The role of SEZs in economic development ....................................................................................... 4

2.2. SEZs and the environment: The rationale for cost internalization .................................................... 5

3 A Green Growth Framework for SEZs ................................................................................................... 8

3.1. The five desired outcomes of green growth ...................................................................................... 8

3.2. SEZs and green growth....................................................................................................................... 9

3.3. SEZs and green growth investment opportunities in Indonesia ...................................................... 10

3.4. Creating synergies between SEZ planning and green growth policies ............................................ 14

4. Financing Green SEZs .............................................................................................................................. 17

4.1. Linking green SEZ development to innovative financing mechanisms ............................................ 17

4.2. Public Private Partnerships (PPPs) ................................................................................................... 19

4.3. Green capital market instruments ................................................................................................... 20

5 Conclusion ................................................................................................................................................ 22

References .............................................................................................................................................. 23

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1 Introduction

As mentioned in Chapter 1, prosperity is the ultimate goal of many nations. ‘Green Growth’ can be a means to that end, whereby policies, innovation, and investments drive good quality growth which leads to the prosperity of a nation. A good quality of growth includes for example new jobs, cleaner air and waterways resulting in better health and more energy security. Environmental stewardship and reducing the risks to climate change is no impediment to economic growth and is possible by implementing systematic reforms to speed up structural and technological changes for greater economic efficiency.

The key question this chapter seeks to address is: How can SEZs drive green growth? This chapter provides an analytical framework to conceptualize the links between green growth and SEZ policies, thus complementing the cluster development strategy employed in this book. It explains the concept of green growth, and presents five desired outcomes of such kind of growth. It highlights how natural capital plays an important role in driving growth. Moreover, it describes how a SEZ-specific green growth policy and incentive framework can help policymakers to think about and identify policy synergies to encourage an investment climate conducive to trigger green business, technology and innovation.

The first part looks at how environmental issues have become an important factor for the development of SEZs, elaborates on the rationale for sustainability, and highlights cost internalization as a crucial determinant of competitiveness. The second part presents a green growth framework which can be applied to design or re-design SEZs as well as identify and quantify green investment opportunities, as illustrated by two case studies from Indonesian economic zones that used extended cost benefit analysis (eCBAs). It also outlines the potential of SEZs as innovation zones for applying green growth policies. The last part discusses the main policy implications in terms of creating innovative financing mechanisms to support the planning and development of SEZs in Indonesia.

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2 SEZs and the environment

2.1. The role of SEZs in economic development In many countries, the development of Special Economic Zones (SEZs) is an important strategy to enhance the competitiveness of an economy and increase economic growth. Establishing SEZs can achieve this objective in four ways. First, SEZs can serve as tools to enhance industry competitiveness and attract foreign direct investment (FDI). Second, SEZs can support large-scale job creation, thus alleviating poverty and reducing unemployment rates. Third, SEZs can support broader economic reform policies, for instance by promoting the diversification of a country’s export base while preserving national protective barriers. Fourth, SEZs can provide room for experimenting with new policy approaches and regulations in areas like customs, labour, legal and public-private partnership initiatives (FIAS/World Bank 2008). The global record of SEZs in achieving these objectives is mixed, but they have played an important role in contributing to high economic growth in Asia, notably in the East Asian ‘Tiger economies’ and later in China. 2 What is clear is that the development of SEZs remains a popular policy instrument for many countries, as the number of SEZs has grown significantly since the mid-1980s. Globally, SEZs accounted for US$ 200 billion in global exports, employing 40 million workers in 2008 in 130 countries (Farole and Akinci 2011, FIAS/World Bank 2008). However, rapid economic globalization has also changed the nature and objectives of SEZs. The old SEZ model has focused on export processing activities by way of attracting multinational assembly activities within global production networks (Farole and Akinci 2011). In recent years, however, newly established SEZs are based on more sophisticated strategies to attract Multinational Corporations (MNCs). These strategies tend to center around the following features: shifting away from fiscal incentives to value added services; focus on improving the investment climate within the zones to allow for differentiation; developing strategic, physical and financial links between zones and local economies; establishing highly specialized SEZs focusing on high-end industries like IT and biotechnology; and the emergence of privately owned, managed or operated zones (Farole and Akinci 2011: 7). Most importantly, the development of SEZs has to accommodate a shift of global consumer preferences toward more sustainable production patterns. Rising concerns about global climate change accompanied by insecure energy supplies have increased the demand for environmentally sustainable goods and services. Global firms are now concerned about the sustainability of their supply chains. They increasingly focus on the need to impose higher production standards in order to ensure resource efficiency, lower GHG emissions, lower local pollution and waste minimization and recycling (World Bank 2014: 5). Thus, sustainability and the capability for cost internalization have become economic factors that increasingly determine the competitiveness of SEZs in developing countries.

2 For a detailed overview of the performance of SEZs, see Farole and Akinci (2011).

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2.2. SEZs and the environment: The rationale for cost internalization Indonesia experienced high economic growth in the past 30 years except for the period of the Asian Financial Crisis in 1997-1998 and the recovery period afterwards. The size of the economy has grown more than 10 times from 85.3 billion US$ in 1983 to 868.3 US$ (in current GDP terms). That growth has brought along enormous social progress, with the poverty headcount ratio falling from 23.4 percent in 1999 to 11.4 percent in 2013. 3 Rapid economic growth, however, has also brought social and environmental costs. In Indonesia deforestation has averaged 0.6 percent per year since 1990; mineral stocks are depleting at around US $ 10 billion per year; and reserve/production ratios have fallen to 14 for coal and 11 for oil. In addition, carbon emissions are also rising on a per capita basis. Social inequality is also a rising concern to policymakers, as income distribution has worsened, as seen in an increase of the GNI Gini coefficient since the 1990s ( GGGI 2015c, forthcoming).

Figure 1: Forest and mineral depletion rates 1990-2010

Figure 2: Carbon emissions per capita 1990-2010

Source: World Bank database at data.worldbank.org Source: World Bank database at

data.worldbank.org

Mainstream economic policies have largely not addressed these environmental and social risks, as these costs are often not properly accounted for in official statistics. As such they are seen as external costs, which do not constitute part of cost-benefit analyses that form the basis of many investment decisions. Externalities occur when an economic activity or a product affects people in a way that are not reflected in the market price (New Climate Economy 2014: 12). Thus, they can be seen as the failure of the market to address global externalities such as climate change or national and local externalities such as air or water pollution.

3 Word Bank Database at http://data.worldbank.org/indicator/SI.POV.NAHC/countries/ID?display=graph

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From a government perspective, addressing externalities clearly provides a rationale for public policy intervention. In many cases, external costs have not been accounted for by firms during the production process, but show up later as clean-up costs accrued to society. If these costs are known and quantifiable, then governments have an evidence-based platform on which to design policies and regulations to impose costs on polluters. In other words, these hidden costs need to be internalized, that is identified and monetized. From a private sector perspective, applying policies for cost internalization should be seen as an opportunity for the Indonesian economy to increase its competitiveness. There are various reasons for the increasing importance of environmental policies and management strategies as competitiveness factors. First, there is little evidence to suggest that stronger environmental regulations have an adverse effect on a country’s competitiveness (Dechezleprete and Sato 2014). Factors such as market conditions or the quality of the local labour force are more significant in influencing trade and investment patterns compared to environmental regulations. Furthermore, the benefits of strong environmental regulations frequently outweigh their costs, especially when taking account of hidden health benefits. Moreover, there is a lot of evidence that suggests that environmental regulations do foster innovation in clean technologies (Dechezleprete and Sato 2014). Second, negative environmental and social externalities are becoming real costs to corporations and thus pose barriers to investors. The effects of negative externalities such as pollution, carbon emissions and ecosystem damage are becoming significant public health and security concerns. An increasing number of studies show that the private sector accounts for a significant share of environmental and social externalities. For example, a report by KPMG in 2012 found that the cost of environmental damage caused by 11 key industry sectors in 2010 was equivalent to 41 percent of their pre-tax profits (KPMG 2014). With increasing population, wealth and consumption growth, natural resources and ecosystem services are becoming scarce. With scarcity, prices of natural resource inputs will increase in the long-term and thus affect profitability levels of firms. Third, internalizing corporate externalities can be profitable business, contribute to social value and create new markets. There is increased evidence that by adopting practices that increase positive externalities and decrease negative ones, corporations can increase revenues, cut costs and reduce risk. For example, energy efficient retrofits of commercial and public buildings are estimated to create a market worth 127.5 billion USD by 2023 (Navigant Research 2014). Smart regulatory environments are needed that can offer financial incentives for companies to create positive externalities or impose direct costs on them for their negative externalities (KPMG 2014). Fourth, addressing environmental concerns is an important risk mitigation measure as part of corporate social responsibility (CSR). Increased public awareness on externalities caused by corporations is growing, as more information becomes available due to increased global digital connectivity. Some SEZs have a record of increased environmental pollution and community health issues as result of not taking account of sustainability issues. This has contributed to social conflicts, created operational problems for businesses, and would ultimately provide significant disincentives and policy barriers to attract investors (DFID and PWC 2009).

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Policies in support of cost internalization are therefore at the core of efforts to address sustainability and green growth issues. These policies aim to reward companies for their efforts to create societal values and/or make them fully account/pay for costs imposed on society as a result of their operations. Policies are mainly shaped in the form of regulations but they are inter - connected with stakeholder action and market dynamics (KCMG 2014: 7). However, the rationale for cost internalization – as a core strategy to address sustainability issues - adds another public policy dimension to government action. Policies to support cost internalization can be seen as part of the government’s function to protect public goods and maximize social returns on public investment. In this sense, governments need to provide the best policy environment in SEZs that enables private sector stakeholders to implement management strategies which take account of social returns in order to mitigate risks, increase efficiency and drive innovation (DFID and PWC 2009). There is a growing global consensus that efforts to mitigate global, national and local externalities can result in win-win solutions in terms of gaining development benefits while reducing climate risks (New Climate Economy 2014). For instance, benefits can be realized by combining policies to reduce local air pollution with climate mitigation policies to reduce the use of fossil fuels. In 2010, health damages caused by air pollution were estimated to be an average of 4 percent of GDP in the 15 largest CO2 emitting countries alone. Reducing them in conjunction with GHG mitigating measures would result in health benefits of US$ 73/tonne of CO2 abated (New Climate Economy 2014:1). However, when adopting reforms, decision-makers need to be aware of potential transition costs and trade-offs across sectors and time. Moreover, in an economy characterized by multiple imperfections attempts to address one imperfection could have differential and possibly adverse impacts on social welfare (New Climate Economy 2014: 13). For example, employment and productivity effects of greener policies do have short-term transition costs especially in pollution-intensive sectors, as the economy moves towards cleaner production processes (Dechezleprete and Sato 2014). Therefore, the challenge for policy makers is to create institutional and regulatory mechanisms that allow for innovative policy solutions and early adoption of new technologies. This would help to anticipate and minimize the transition costs. In thinking about the development of SEZs to attract foreign direct investment, policymakers have to face three critical challenges. First, they have to devise policies that make SEZs attractive for firms in creating jobs, which is in line with the objectives of the old SEZ model. Second, they have to ensure that the SEZs are economically sustainable and deliver positive externalities to the local and national economy. This could include the upgrading of infrastructure or triggering wider structural transformation and economic reforms. Third, policymakers have to ensure the social and environmental sustainability of SEZs by minimizing externalities but also to deliver non-economic benefits to the society (Farole and Akinci 2011: 7). The next section explains how these multiple challenges and objectives can be examined by clearly identifying and understanding desired outcomes of a SEZ in Indonesia. The green growth framework can be taken as a starting point to give context to answer questions related to improving policy and investment decision making.

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3 A Green Growth Framework for SEZs

3.1. The five desired outcomes of green growth Currently, the Government of Indonesia (GoI)-Global Green Growth Institute (GGGI) Green Growth Program for Indonesia aims to promote green growth in Indonesia that recognizes the value of natural capital, improves resilience, builds local economies and is inclusive and equitable (GGGI 2012). Based on consultations with stakeholders, GGGI with GoI are developing a framework and suite of tools that can be used by GoI to help mainstream green growth more systematically into existing planning and investment appraisal instruments. Green growth is an evolving paradigm in which green policies, innovation, and investments drive sustainable economic development. More broadly, green growth is an approach for achieving a number of simultaneous objectives bringing Indonesia closer to achieving true sustainable development: through avoiding and curbing greenhouse gas emissions, building resilience to climate extremes and longer term change, using resources more efficiently, providing sustainable and equitably-distributed increases in GDP and standards of living, and valuing the often economically invisible natural assets that have underpinned economic success over the centuries (GGGI 2015c). The essence of the framework is to make green growth measurable along the five desired outcomes outlined in Figure 3 below. These desired outcomes are interrelated and a positive contribution to one can often simultaneously provide benefits to others. Only by making progress along all of these outcomes can Indonesia plan for inclusive and equitable growth that is sustainable over the course of generations. The concept of green growth in Indonesia has been informed by the views of leading international organizations involved in green growth planning and development (GGGI 2015c). Figure 3: The 5 Desired Outcomes of Green Growth developed with key stakeholders in Indonesia

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3.2. SEZs and green growth How could the development of SEZs contribute to these desired outcomes? The main argument here is that SEZs can be seen as potential innovation zones, where government, business and stakeholders can experiment to discover the optimal combination of policy instruments and regulatory mechanisms that maximize the economic benefit from cost internalization and sustainable use of natural capital and ecosystem services. The development of “Green SEZs” or “Low-Carbon SEZs” can therefore be seen as an opportunity to create innovative mechanisms on a smaller scale, which can then trigger wider green growth – oriented reforms in the whole economy (see Box 1).

Box 1: Three main policies to design green SEZs Policies to establish green SEZs can contribute to economy-wide green growth outcomes in three major ways. Incentivize green products to enter SEZ: This would help regulate and incentivize good

practices outside of the zone, including imported and exported manufacturing products. Specifically, SEZs would only accept products for further processing and downstream production when they can prove independent certification for minimal environmental contamination or have followed all environmental regulations in the processing.

Design green growth policies for the entire SEZ in the earliest planning stage: Another set

of policies aim to plan and build SEZs to improve overall environmental performance of the entire zone by ensuring all investment have to consider the 5 desired outcomes of green growth. These would include land-use planning, protection and promotion of green spaces, eco-friendly transportation, electricity demand management, use of renewable energy to operate and electrify all industries in the SEZ and imposing high standards and regulations on firms’ solid waste and water treatment processes.

Provide incentives and regulate economic activities to attract green technologies and

innovation within the SEZ. This objective would result in SEZ policies that aim to de-risk green investment by reducing operating costs for the investor. SEZ – specific incentives such as tax deductions, capital subsidies or waivers aim to attract investors into the SEZ, as these incentives would not be available in other locations in the country. Incentive policies are especially useful in promoting green innovation and attract new technologies. Examples include technologies for energy efficient building or recycling technologies. An example for the latter would be recycling technologies that convert waste in one industry to an input in another industry, like in the case of fly ash/slag in the cement industry (GGGI 2014, p.32). Investment into production practices that increase added value generation would also contribute to green growth outcomes such as turning fish waste into fish oil (see Box 2 below).

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The extent to which these policies and policy objectives are applied, depends on the nature of the SEZs. Following Yeo and Akinci (2008) it is useful to conceptualize low carbon or green SEZs in three stages of development. Early forms of green SEZs are seen as Environmental Compliance or Pollution Control Zones, focusing on the adoption and enforcement of environmental management standards. In this stage of development, policymakers want to ensure that basic national environmental regulations are complied with and voluntary but internationally accepted standards are adopted by firms operating in the SEZ (Yeo and Akinci: 285). An example for the former would be AMDAL, the Indonesian mandatory Environmental Impact Assessment (AMDAL), whereas the ISO 14001 certificate would be an example for the latter. More advanced Eco-Industrial Zones go one step further by reducing the negative impact of pollution and develop an integrated process of efficient management (reuse and recycling) within the whole local production system (World Bank 2014). This requires a higher degree of coordination and collaboration of firms operating in the SEZs to implement networks to establish a system of integrated use and re-use of material inputs. One example is the Ulsan Eco-Industrial Park in Korea, which hosts 897 companies across a variety of industrial sectors such as petrochemicals, automobiles and heavy industry (World Bank 2014). The Ulsan SEZ applied industrial symbiosis techniques in order to optimize the resource use or waste / recycling management processes between firms such as the exchange of steam between two firms. In 2013 22 industrial symbiosis projects were registered and have attracted R&D support in the order of 2.5 million USD. An estimated 331 Mt of annual Co2 emissions have been abated by the Ulsan SEZ (World Bank 2014: 12). Low carbon or green SEZs constitute the most advanced and comprehensive concept in terms of environmental sustainability, as they are conceptualized, managed and operated to reduce carbon footprint from the outset and effectively address climate change mitigation in the process of their economic and social activities (Yeo and Akinci 2008). A green/low carbon SEZ framework would include among others the following policies: GHG emissions target; sustainable infrastructure (e.g. energy-efficient buildings); comprehensive investment strategy to attract green investment; low-carbon policy incentives and regulations; and carbon finance. Several SEZs with specific GHG emissions targets do already exist. The Incheon Free Trade Zone in South Korea was given the target to reduce GHG emissions by 30 percent relative to the BAU scenario for 2020. The Jilin SEZ in China has a target of 37 percent reduction compared to the 2030 BAU. The SEZ in Falta, India, has target to cut emissions intensity by 20 percent by 2020 from levels in 2005 (World Bank 2014: 55).

3.3. SEZs and green growth investment opportunities in Indonesia Currently operating and planned SEZs in Indonesia are far from being conceived of as green SEZs. They are mainly seen as conventional economic zones without coherent environmental management frameworks in place. Therefore, the short-term challenge for policymakers in Indonesia is to identify the potential for and demonstrate the viability of green growth policy interventions in existing SEZs. In the medium and long-run, policy makers would ideally opt to plan and build comprehensive green and low-carbon economic zones from the beginning.

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The challenge for policymakers is to find ways of making it economically attractive for consumers and producers alike to minimize the depletion of resource commodities and to maximize the value of ecosystem services. As many of these resource commodities and ecosystem services are not valued in financial and economic terms, economic activities and projects have many hidden social costs. Thus, a first step to identify green investment opportunities in SEZs is to provide a comprehensive assessment of monetary costs and benefits associated with environmental impacts of projects. The Green Growth Assessment Framework (GGAP) was developed by GOI and GGGI to create

indicators specific to projects, sectors, districts, provinces and Indonesia as a nation, in order to use

tools to prioritize and assess projects or policies for green growth in a consistent manner, similarly to

a Multicriteria Analysis (MCA). This framework allows for a systematic step-by-step screening process

to identify, quantify and prioritize policy interventions to improve green growth performances of

projects. Notably, extended Cost Benefit Analysis (eCBAs) can be used to develop financially modelled

business cases and formulate policy enabling conditions to develop green projects (see Figure 4). 4

Figure 4: Green Growth Assessment Process (GGAP)

Two examples illustrate the potential of benefits from green growth interventions in SEZs in Indonesia (Box 2). Extended Cost Benefit Analysis (eCBA) was applied to identify the monetary values of public goods, environmental externalities and social returns associated with many projects in the economic zones of Maloy, East Kalimantan and Mamminasata, South Sulawesi. Expected net benefits associated with can be significant in the order of between 355 million and 3.8 billion USD in net present value terms (GGGI 2015a and 2015 b). In this sense, results of an eCBA can be used as a base of evidence to determine the size of public and private investment flows needed to maximize these values over time.

4 A comprehensive description of the GGAP can be read in a forthcoming document by GOI and GGGI, namely (GGGI 2015c, forthcoming), “Delivering Green Growth: A Roadmap for Policymakers.

GGF

Roadmap

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Targets inform and test the vision

Feasibility assessment

GG potential assessment

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Sector plans

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Connectivity

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Inclusive and

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Sustainedeconomic

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It should be noted that these examples illustrate the benefits of re-designing already existing projects within the economic zones and the identified policy interventions would make them ‘greener’ when compared to the BAU scenario. Most recommended interventions require a mix of incentive policies and adoption of certain standards and certification in order to attract green technologies into the SEZs. As such they represent only individual and project-oriented policy measures and not integrated solutions to reduce the carbon footprint of the whole SEZ. Ideally, the use of eCBAs to quantify their impact should be applied and identified green growth interventions should be in place before the SEZ is designed in order to attract green investors.

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Source: GGGI (2015a, 2015b)

Box 2: Applying extended Cost Benefit Analysis to identify green growth policy interventions in

the Special Economic Zone of Maloy and the Strategic National Zone Mamminasata

Conducting an eCBA is a process that relies on the support and expertise of local and national

stakeholders. The consultation process involved the following activities:

Identifying the project baseline with the help of project representatives and stakeholders in East Kalimantan and South Sulawesi

Identifying options to improve Green Growth performance with the help of local stakeholders and Green Growth experts

Mapping out impact pathways, linking changes in investment to monetizable impacts on stakeholders

Identify the monetary values of public goods, environmental externalities and social returns associated with projects

Validating the data, assumptions and results with local stakeholders

KSN Mamminasata is located in the province of South Sulawesi and covers four areas, including the city of Makassar, and the Gowa, Takalar, and Maros Districts. Activities in the zone include infrastructure development (road, rail, water supply), solid and liquid waste management, reforestation, new settlement construction, industrial and maritime zones. Proposed green growth policy interventions include:

Construct Municipal Solid Waste (MSW) to Energy through methane gas capture from municipal waste landfill

Generating higher value-add fish products (fishmeal, fish oil) through better utilization of fish processing waste

Reforestation of Jeneberang watershed Recommended policy instruments include:

Guaranteed feed in tariff

Tax relief for investment into waste to energy equipment

Financial support for local fish meal industry

KIPI Maloy is located in the district of East Kutai, East Kalimantan, and aims to build up a competitive industry cluster generating increased value-added economic activities from natural resource-based industries. In particular, palm oil and coal-based activities (oleochemicals, biodiesel, export processing) will account for most of the zone’s output. Proposed green growth policy interventions include:

Substitution of coal for biomass in power generation

Implementation of Best Management Practices (BMP) in palm oil operations

Promote local processing of coal into fertilizer and natural gas

Re-routing of planned railway for coal transport along existing road and re-design to accommodate CPO freight

Recommended policy instruments include:

Feed-in tariffs for biomass power

Capital subsidies and financial guarantees

Payment of ecosystem services

Total potential net societal benefit of policy interventions across the 5 outcomes of green growth: $3.8bn in Net Present Value terms (10% discount rate) equivalent to 10% of East Kalimantan ‘s GDP in 2012

Total potential net societal benefit of policy interventions across the 5 outcomes of green growth: $355m in Net Present Value terms (10% discount rate) equivalent to 6% of South Sulawesi’s GRDP in 2012

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3.4. Creating synergies between SEZ planning and green growth policies In designing ‘green’ SEZs, the primary aim is to ensure that sustainability concerns are built into the policy process. However, policymakers would have to be aware that they face a multitude of drivers and issues of sustainability (see Figure 5). Thus, policy makers need to take account of policy trade-offs, at least in the short –term. While many green policy interventions will result in longer term benefits for society, some companies and other stakeholders face immediate costs as part of a transition towards a green economy. The complexity of drivers and factors make participatory policy processes imperative. This would necessitate a process of stakeholder engagement and consensus-building which go beyond the traditional dialogue between government and business and include the expertise of various actors. Moreover, regulations and policy incentives for cost internalization do impact firm at various levels in the value chain: upstream at the supply chain; at the operational level within the manufacturing process; and when the firm’s products are used and disposed of (DFID and PwC 2009). Figure 5: Drivers and Issues of Sustainability in SEZs

Source: DFID and PWC (2009:2)

Given the complexity of sustainability factors and drivers, policy synergies need to be identified to enable policymakers to craft innovative regulatory incentive instruments to maximize green growth benefits. In this regard, SEZs offer an ideal environment for green growth public policy experimentation, because they form relatively ‘isolated’ enclaves and they have built-in compliance mechanisms that do not typically exist outside the zones. Examples include issuing of licenses, the ability to monitor firms in a short time frame, and ultimately the ability to revoke a license, terminate a lease, or impound goods (DFID and PwC 2009).

Policy synergies frequently require policymakers to find the ideal mix of free market-oriented policy prescriptions that usually govern SEZ regimes and public/fiscal policy interventions to enable green

Government and

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growth policy solutions. Many of the policy recommendations under a green growth scenario are actually in tune with traditional SEZ policies in the sense that they build on fiscal and regulatory incentives to reduce the cost burden for enterprises to adopt new technologies. As described in the 2 Indonesian case studies, tax exemptions and capital subsidies could be used to accelerate renewable energy deployment in SEZs. Subsidies for pollution reduction provide incentives to private sector players. Clearer regulations governing sectors such as waste management or palm oil could reduce business costs (GGGI 2015 a, 2015b). In order to identify these complex policy synergies and develop innovative interventions, it is useful to build on the cluster analysis framework of policy recommendations developed by Wahyuni (2013: 33), which frames the main policy recommendations to develop SEZs in Indonesia in three stages (Figure 6). In stage 1, the economy is in a situation where policies are mainly aimed to maximize returns on given factor endowments of a country or region. In the second stage, policymakers are able to implement efficiency enhancing policies to increase the quality of products manufactured in SEZs. In the third and final stage, governments are capable to provide a policy environment in which companies can develop and apply innovative and sophisticated production processes, which result in highly competitive products. Conceptually, it could be argued that these policies depend to some extent on a country’s income level. The higher one country moves up the income ladder the more likely it can fiscally afford policies that aim to lure higher value-added and innovation-driven investment flows. It is fair to say that the current Indonesian investment policy conditions do reflect very much the features in the first stage when compared to other countries in the region (Wahyuni 2013). Specifically, policies focus too much on natural resource extraction but neglect the necessity to climb up the production and value chain ladder. Consequently, seen from a green growth perspective most investment opportunities and interventions in Indonesian SEZs are mostly about developing weak green growth scenarios which emphasize the adoption of basic cost internalization strategies. This corresponds broadly to policies under Environmental Compliance or Pollution Control Zones. The challenge for policymakers is now to assess whether it is possible to leapfrog to stronger policy interventions associated with moderate and strong green growth scenarios to develop integrated eco-industrial and green SEZs. In fact, SEZs as ‘isolated’ economic enclaves could provide the ideal ground to experiment with innovative green growth investment regimes and thus provide the opportunity to ‘leapfrog’ national policies. However, a more ambitious SEZ regime with a ‘strong green growth’ policy design requires sophisticated regulatory and management structures, which is often lacking in many Indonesian provinces. Nevertheless, the use of the green growth and eCBA framework can help policymakers to identify realistic green growth policy options and synergies in SEZ planning. The problem is whether these SEZ-specific remedies can be exempted from wider distortions in the economy and whether the fiscal and human resource capacity of local governments is sufficient to provide the enabling conditions to leapfrog to more value-added and green SEZs. All this point to the crucial role of international finance mechanisms in reducing risks for the private sector in undertaking green investment in SEZs and to increase the fiscal capacity of the government .

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Figure 6: An integrated SEZ and Green Growth Framework

Factor – driven

Good macro economy

Strong and clean government

Good corporate governance

Infrastructure

Education

Health

Efficiency Enhancers

Excellent cluster strategy

Labor efficiency

Growth of financial market

Readiness of technology

Size of the market

Innovation-driven

Innovation and creativity

Partnership and coordination among institutions

Education, vocational training

Transfer of knowledge

Developing traditional SEZs

Developing green or low-carbon SEZs

Weak green growth Environmental Compliance / Pollution Control SEZ Identify policy barriers and adopt basic cost internalization measures Examples:

ISPO certification required for palm oil operations in SEZs

Local pollution charges in SEZs

Moderate green growth Eco-Industrial SEZ Strengthen policy enabling environment Examples:

Reform of energy subsidy system

Well-designed feed in tariff system

Subsidized finance, capital subsidies targeted at green integrated industries in SEZs

Strong green growth Green / Low-Carbon SEZ Proactive government policies to stimulate green growth interventions Examples:

Carbon tax for whole economy aligned with SEZ-specific incentives

SEZs designed as green growth economic clusters from the planning stage

Green growth analysis: GGAP and eCBAs

Cluster analysis

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4. Financing Green SEZs

4.1. Linking green SEZ development to innovative financing mechanisms What are the main policy implications for the planning and development of green or low-emissions special economic zones in Indonesia? First, monetary benefits associated with green growth interventions in SEZs are potentially significant, as the two examples in section 3.3. have shown. Second, many of these identified benefits are cases for public policy intervention, if they are to be materialized as public and private investment flows. Therefore stakeholders need to make a case for public policy intervention to monetize benefits of investing in low-emission projects in SEZs and find ways to fund these investments. SEZ planning, policies, project development and available financial mechanisms need to align in a strategic way to provide an enabling environment for investors. In the following we present some thoughts on how to conceptualize this alignment process and several challenges along the way, especially from the perspective of sub-national governments interested in green SEZ development (Figure 7 below). In many ways, SEZ planners face the same obstacles to attracting green finance and investment flows as in the case of attracting funds to large infrastructure projects. Many low-emission or green infrastructure projects do not have financially attractive risk-return profiles not only due to the presence of high capital costs and price distortions, but also due to externalities. Even in cases where the returns are potentially favourable, a higher risk premium has to be added because of information gaps in the capital markets about the nature of many green projects (World Bank 2012). A key first step towards attracting financial flows to green SEZs is to identify the monetary benefits of low-emission projects and assess the viability gap to fund those projects. In assessing this viability gap, planners must look beyond the financial costs of a project and make an economic case for a green project that takes account of the expected monetary benefits of green growth interventions. As shown in the previous section, these monetary benefits can be significant, providing some justification for the use of green growth assessment tools like eCBAs in the planning of SEZs in Indonesia. These expected benefits from project interventions range across a variety of infrastructure sectors, but can be grouped broadly into four broad sectors: conventional and renewable energy, land-use and forestry, transport, and other physical infrastructure. These benefits could potentially be even larger, given that true costs of ecosystem services are very likely under-estimated due to scarcity of primary data. Moreover, it is also important to decide whether to conceptualize SEZs as green, low carbon SEZs from the beginning or to adopt green growth interventions for particular projects within existing or already planned SEZs. In the Indonesian case, to date no green SEZ is currently in place. The eCBAs for the economic zones of Maloy and Mamminasata were conducted relatively late in the project implementation and planning cycle. An early adoption of the eCBAs in the pre- or at the feasibility study level would enable policymakers to identify larger avoided costs and longer-term benefits associated with ecosystem services and efficient use of natural capital (GGGI 2015a,2015b). Furthermore, in identifying green projects eligible for financial support, planners need to differentiate between capital-intensive and less capital intensive projects. The former are typically to be found in

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infrastructure development such as renewable power generation projects. The latter are characterized by adopting efficiency-enhancing production measures, typically as a response to regulations mandating energy efficiency programs or certification standards. This distinction is crucial in attracting financial support: capital-intensive projects usually require the design of complex project finance vehicles, while money flows to less capital-intensive green projects can be channeled through existing balance sheets of participating stakeholders (World Bank 2012). Once stakeholders have agreed on specific green growth interventions for the SEZ, effective public sector leadership is needed to attract financing and investment. As there is only a limited global pool of climate funding available, policymakers need to find creative ways to combine multiple public and private instruments in an integrated manner in order to optimally leverage the use of these limited domestic and international funding resources. Multilateral international funding mechanisms for green investment are the primary source for governments to access climate financing in the form of lending instruments such as concessional financing and direct grants. The Climate Fund – consisting of the Clean Technology Fund and the Strategic Climate Fund – provide financial resources 6.4 billion US$ (as of 2012) to help developing countries in piloting low-emission projects in core infrastructure and land-use/forestry sectors (World Bank 2012). Other international vehicles include the Global Environmental Facility (GEF), the Global Energy Efficiency and Renewable Energy Fund (GEEREF) and the CDM mechanism. The latter, however, faces uncertainty about its future in the post-Kyoto environment (World Bank 2012). Green finance can be used to support a mix of domestic policy instruments and close the viability gap in two ways. Firstly, it can help rebalancing policy distortions that make some low-emission investments not viable and secondly, by monetizing benefits accrued from mitigating externalities. An example for the former would be to provide budget support for governments to subsidize special feed in tariffs to promote uptake of renewable energy. This is especially necessary in countries such as Indonesia where governments find it politically difficult to reduce fuel and electricity subsidies which not only drain public resources, but also distort energy prices. Leveraged international funds could also be used to fund the payment of projects that abate GHG emissions and address negative externalities like local air or water pollution. Domestic fiscal incentives include tax deductions, subsidized credits for installing or importing environmentally friendly technologies such as waste water treatment equipment. All these instruments aim to de-risk green projects and create a level-playing field between low and high-emission projects (World Bank 2012). The application of these policies depends very much on the fiscal capacity of and relations between national and sub-national government entities. A report by Ministry of Finance Indonesia and CPI (2014) finds that there are barriers to the quick flow of domestic climate finance to local governments. Central budget money allocated to climate mitigation (678 million USD in 2011), including international money, were disbursed mainly to central government (97%), with little flows going to local governments (Ministry of Finance Indonesia and CPI 2014). Moreover, climate – related investment flows going from central government through equity participation and specialized revolving funds – seen as potentially effective instruments to leverage international funding – were also disbursed slowly. The gap between investment flows and realized disbursement points to fiscal capacity problems, hindering the implementation of direct project activities. Figure 7 illustrates potential financial flows from international funding mechanisms to national and sub-national levels, indicating

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that current flows mostly go through government –owned SOEs and the private sector (Ministry of Indonesia and CPI 2014: 15).

4.2. Public Private Partnerships (PPPs) Given that there are currently no viable markets for green projects in Indonesia, the government can use Private-Public-Partnerships (PPPs) to attract private sector investment. The GoI has implemented a PPP framework as part of accelerating projects under the Masterplan. PPPs are broadly defined as long-term contractual agreements between a private company and a public entity, under which a service is provided (Merk et al: 29). There is a wide range of contractual agreements, as they will differ in terms of different risk-sharing and management schemes. A crucial distinction is between PPPs operated as concessions, where the operating company depends on user fees as the main source of revenues, or as private finance initiatives, where the payment to the private operator depends on delivery of the infrastructure. This distinction has important implication for the allocation of risks, with concession-type PPPs shouldering much of the demand risk burden to the private operator (Merk et al, 2012). From a green growth perspective, several critical challenges need to be addressed if PPP financing vehicles can be successfully used to support green infrastructure projects. The first issue is that the current PPP framework itself does not contain rigorous formal procedures to ensure that projects are designed in a ‘green’ way. Clear environmental objectives need to be integrated in the awarding process and they must be regarded as critical evaluation criteria that drive effective green PPPs (Merk et al, 2012: 35). Government agencies interested in developing green infrastructure projects should require project developers to rigorously assess incoming projects, potentially using the Green Growth Assessment Process (GGAP) and eCBAs as part of the mandated pre-feasibility and feasibility studies, especially when accessing the Viablity Gap Fund (VGF) under the MoF (see Figure 6). 5 A second important issue is that PPPs cannot be isolated entities but need to be embedded in a fiscal support and risk guarantee package in order to make them work. One example is Korea, which has implemented comprehensive fiscal policy packages to de-risk green urban infrastructure PPPs. These include instruments such as construction subsidies; compensation mechanisms to reduce investment risk of private operators; infrastructure credit guarantee fund; and tax incentives (Merk et al, 2012: 33). The current Indonesian PPP framework envisions that any government contracting agency interested in developing a project can apply for tax incentives to the Ministry of Finance. In addition, risk guarantees and low-cost debt financing facilities can be provided by the Indonesian Infrastructure Guarantee Fund (IIGF) and PT SMII and PT IIF (Bappenas 2013).6 However, the number of realized projects on the ground has been very limited and the long completion time of the only documented successful PPP project is far from international best practice (Strategic Asia 2012: 36). Barriers to the effective implementation of PPP vehicles are the lack of capacity of public sector actors as the PPP mechanism is poorly understood; lack of coordination between central and local governments; overlapping regulations and problems associated with the implementation of the new land acquisition Law (Strategic Asia 2012).

5 Set up under Ministerial Regulation PMK No 223/PMK.011/2012. 6 Bappenas, 2013, Public-Private Partnerships Infrastructure Project Plans in Indonesia

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From a sub-national government perspective, capacity building to build effective partnership with and ensure credible commitment by national government and private sector partners are of special importance. The government needs to have sufficient capacity and expertise to evaluate projects. This is specifically important in the negotiation phase with bidders from the private sector in order to generate sufficient competition to ensure best possible project selection. Moreover, effective partnership is an important element for successful implementation of PPP – based projects. As green PPP projects are long-term ventures, potentially lasting at least 15 years, credible commitment and cooperation needs to be institutionalized (Merk et al 2012).

4.3. Green capital market instruments In recent years green capital market mechanisms have emerged as innovative sources of funding, as they have the potential to keep down the cost of infrastructure. Infrastructure bonds enable institutional investors (e.g. pension funds) can directly invest in long-term and low-risk investment. YieldCos are equity vehicles which bundle equity and debt in one package and thus can avoid the project finance premiums associated with single projects. Municipal bonds can also bring down the financing costs of projects by having municipal government take on the role of investor itself and shoulder the equity risk (New Climate Economy2014). The most promising capital market instruments are green bonds. They are a variation of infrastructure bonds, but are bonds or a portfolio of bonds which are rated as environmental or ’green’ projects (HSBC 2013). They are targeted to investors with preferences to invest in environmentally safe projects. In fact, these bonds are creating a whole new green financial market, which might be able to bring down financing costs in green infrastructure projects in the long-run through competitive forces. In 2013 green bonds worth US$ 11 billion were issued, which is still a small portion of the global bonds market but one that is growing (New Climate Economy 2014: 11; HSBC 2013). Within the Indonesian context, SOEs and municipal governments would be the most obvious entities to issue green bonds, but the market for these green financial products is still in its infancy. The establishment of a green investment bank, following the example such as the German KfW, the China Development bank or the recently established New Development Bank (formerly known as BRICS Development Bank), could help trigger investor demand for low-carbon assets in the domestic market, especially if the focus would be on investing in regional green infrastructure projects (New Climate Economy 2014). However, like in advanced economies, investors in the Indonesian financial market are still oriented toward short-term growth and are more inclined to look for liquid assets. Moreover, the existing rules framing the finance industry – accounting rules and investment regulations - might also discourage institutional investors (such as pension funds) from long-term and illiquid assets such as green infrastructure bonds (New Climate Economy 2014: 12). Of particular relevance for the Indonesian context are regulations that mandate stricter capital adequacy rules intended to reduce exposure of banks to long-term debts. While meeting the demand for a more prudent financial environment, as a legacy from previous financial crises in 1998 and 2008, it also limits the willingness and capacity of domestic banks in taking up green investments, including green bonds (New Climate Economy 2014).

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International Community International Financial Market Rating Agencies

Main Stakeholders: Sub-national / Local government Private Sector , CSOs,

Main Stakeholders: Sub-national government, private sector, CSOs, research/academic institutions, donor agencies

Main Stakeholders: National Government / Sub-National government agencies

Note: Red arrows denote potential financial flows, blue arrows are policy and planning links

Green SEZ Policy, Planning and Project Development Development

Identifying Green Growth Interventions Design of Policy Instruments

GoI

State Budget

SOEs

Revolving Funds

PPP

Private Sector

Combining Financial Instruments Financial Sources and

Mechanisms

Green Growth Interventions

Feed in tariffsCapital subsidies

Tax exemptions

Subsidized credits

Monetizing Benefits

Growth

Equity

Resilience

Reducing GHG

Healthy Ecosystems

eCBAs and GGAP

ExternalitiesPolicy

distortions

Development of Bankable Green Project and Securing Project Financing

Forestry and Land Use

Transport

Energy Other

Infrastructure

Project selection:

Capital intensity

Individual green project

Green SEZ

Assessing Financial and Economic Viability Gap

International

Climate Funds

Capital Markets

Infrastruture bonds

Green bonds

Municipal bonds

YiedCos

Fund Project Development

Figure 7: SEZ Planning and Financing Links

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5 Conclusion

This chapter makes the case for integrating green growth objectives into the planning and development of special economic zones. The first part looked at how environmental issues have become an important factor for the development of SEZs and highlighted the rationale for sustainability and cost internalization to be included as important factors in determining competitiveness. The second part provided an analytical framework on how to analyze green growth in terms of striving for 5 desired outcomes of such growth: through avoiding and curbing greenhouse gas emissions, building resilience to climate extremes and longer term change, using resources more efficiently, providing sustainable and equitably-distributed increases in GDP and standards of living, and valuing the often economically invisible natural assets that underpin much of economic growth. We outlined the potential of SEZs as innovation zones for applying green growth policies. Three main policy interventions to design green SEZs were identified. These include, firstly, the provision of incentives to ensure that green products enter a SEZ; secondly, implement green growth policies for the entire SEZ in the earliest planning stage and thus ensure the best environmental performance for the entire economic zone ; and thirdly, allow for incentives and regulation of economic activities to attract green technologies and innovation within the SEZ. This green growth framework can be applied to design or re-design SEZs as well as identify and quantify green investment opportunities by using extended cost benefit analysis (eCBAs). Expected monetary benefits associated with green growth policy interventions are potentially large, as shown in 2 cases of economic zones in Indonesia. However, making green projects investable requires public policy interventions in order to increase project rewards and/or reduce project risk. The third and last part made the case for identifying innovative financing mechanisms to support the planning and development of green SEZs in Indonesia. Stakeholders need to make a case for public policy intervention to monetize benefits of investing in low-emission projects in SEZs and find ways to fund these investments. SEZ planning, policies, project development and available financial mechanisms need to align in a strategic way to provide an enabling environment for investors. From the perspective of national and sub-national governments, public private partnerships (PPPs) and new instruments such as green bonds are promising financial sources for green infrastructure projects, but there are still significant institutional and policy barriers to be overcome before they can be used as effective instruments in the Indonesian financial market. If these green growth – oriented interventions and policies to enable them lead to the development of green SEZs, better management of natural capital would be ensured and the prospects for welfare-enhancing benefits for the economy and society as a whole would be vastly improved.

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