Assessing the Potential of Indonesia’s Islamic Carbon Market

Indonesia’s Islamic Carbon Market

By Bazari Azhar Azizi

Although Indonesia ratified the Kyoto Protocol in 1998, a carbon trading market has been established recently in the country. Bazari Azhar Azizi describes how such a system could operate in conformance with Islamic doctrine.

The capital city of Indonesia, Jakarta, has experienced worsening air quality over the last few months. This issue contradicts the fact that Indonesia is one of the lungs of the Earth and has tremendous potential to contribute towards sustainable development goals, including emission reduction. Indonesia has set a target of reducing emissions by 43.2 per cent in 2030 and ratified the Kyoto Protocol in 1998.

However, only a few significant measures have been taken into action in Indonesia among the three mechanisms of the Kyoto Protocol over the last two decades, including International Emission Trading (IET). This trading is also known as carbon trading, where the market trades emissions under cap-and-trade schemes or with credits to offset greenhouse gas (GHG) reductions. Meanwhile, no carbon market has been established until recently launched in 26 September 2023 in Jakarta.

Carbon trading, in its essence, is supposed to be adhering to Islamic principles, since it aims at reducing excessive greenhouse gas emissions.

Hence, the government and regulator issued laws and regulations to set up a carbon market in Indonesia, starting from the Development and Strengthening of the Financial Sector Law in January 2023, followed by the Financial Services Authority Regulation regarding Carbon Trading through Carbon Exchange and Regulation of the Minister of Environment and Forestry regarding Procedure of Carbon Trading in Forestry Sector, in August 2023 and June 2023 respectively. The issuance of these regulations ignite the inception of the first carbon market and trading in Indonesia.

Carbon trading, in its essence, is supposed to be adhering to Islamic principles, since it aims at reducing excessive greenhouse gas emissions.Besides, the Islamic financial system, including Islamic banks, has to uphold ethical and moral codes in its operation and follow sharia rules and guidelines, including preserving the environment.

A recent study from Silefanee et al. (2022) found that Islamic financial development reduces the positive impact of energy consumption on greenhouse gas emissions through escalating energy efficiency. Their study also discovered that advancing the Islamic financial market may result in a better environment in a country. Therefore, there are viable opportunities for Islamic banks and financial players to contribute to the carbon allowances market and help the nation’s development beyond financial contribution per se.

Indonesia, home to the largest Muslim population in the world, should consider developing a sharia-compliance carbon market. Furthermore, Indonesia has to look at the opportunities of initiating such a market as one of the top global Islamic finance players.

IndonesiaFirst, according to the Environment and Forestry Ministry, the country’s economic potential for carbon trading stands at about Rp350 trillion (US$25 billion) between 2022 and 2026. Concurrently, the carbon dioxide emission per capita in Indonesia in 2020 reached 2.1 metric tonnes and fell below the world’s average, which is put at 4.3 metric tonnes. However, if Indonesia further delayed the emission initiatives, the number could exceed the current world average.

Secondly, Indonesia led the issuance of sovereign green sukuk and retail green sukuk globally, following Saudi Arabia in the first place. The total outstanding of ESG sukuk of Indonesia in 2021 accounted for US$4.207 million. This number portrayed the considerable amount of potential investors that put their interests in green instruments, and hence the carbon market. Research conducted by Nazir (2013) explained that if carbon trading was considered and included in the Islamic financial system, the growth rate of Islamic banking and sukuk would be increased from 15 per cent and 25 per cent to 18 per cent and 28 per cent respectively. Then, the growth of Islamic finance in Indonesia could be enhanced further through the carbon market.

Cleanliness is a substantial part of Islamic tenets and in accordance with maqashid (the aims) shariah.

Third, there has been a growth of Islamic institutional investors in Indonesia over the last few years. These investors range from the Hajj Financial Management Body (BPKH), Islamic pension funds, Islamic asset management, and Islamic insurance. The total investment potential from those institutions reached Rp259.8 trillion (US$16.9 billion). These investors need various investment avenues, and the sharia-compliance carbon credits should be considered there.

In addition, the Middle East is among the fastest-growing in global hydrocarbon consumption. The top carbon-producing countries per capita in the region are Qatar, Kuwait, the UAE, and Bahrain. These countries also ratified the Kyoto Protocol and must reduce their emissions, and this can be done through cap-and-trade carbon emission trading. Also, Islamic Funds Assets in these countries reached US$56 billion in 2021. Through the inception of domestic Islamic carbon, these funds could be invested in Indonesia in green and sustainable projects to offset the emissions produced in their region.

Co2Despite these opportunities, several challenges need to be addressed to incite the Indonesian Islamic carbon market. First, which market should become a benchmark for Indonesia? Currently, only Bursa Carbon Exchange (BCX) has been developed in Malaysia, describing itself as the sharia-compliant voluntary carbon market. The Bursa Malaysia Berhad announced the inauguration of this exchange earlier this year. Meanwhile, the other carbon markets are deemed to be non-sharia-compliant. Therefore, only a limited benchmark is available for the Islamic carbon market mechanism.

Second, the specified regulation for the Islamic carbon market is imperative to begin the initiative. Notwithstanding the aforementioned regulations from the government and regulators that may set a foundation for a conventional carbon trading market, neither specified articles nor paragraphs mentioned Islamic carbon trading licence or permit.

Lastly, there is a need for fatwa issuance related to the domestic carbon market as a sharia-compliant basis for market operation. The previous fatwa on the carbon market announced by the International Islamic Trade Finance Corporation (ITFC) during the COP27 event in Egypt could become a reference for the fatwa settling body in Indonesia. The fatwa will play a pivotal role in maintaining the adherence to sharia principles for Islamic carbon market players, due to the use of derivatives or complex financial instruments commonly used by the other market.

In conclusion, cleanliness is a substantial part of Islamic tenets and in accordance with maqashid (the aims) shariah. Therefore, the efforts towards clean air should be paid attention to, including establishing the Islamic carbon market. By looking at the opportunities, the enactment of such a market in Indonesia is possible by swiftly tackling the immediate challenges.

This article was originally published on 17 October 2023.

About the Author

Bazari Azhar Azizi-Bazari Azhar Azizi is currently working as a Senior Resident Researcher at BSI Institute, Bank Syariah Indonesia. He obtained his Master’s degree in Islamic Finance from the University of Durham, UK, and his Bachelor’s degree in Islamic Economics at Tazkia Institute, Indonesia. He can be contacted at bazari.azizi@bankbsi.co.id or bazari91@gmail.com.

References

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The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.