Shaping a nature-positive economy

While often framed as an environmental issue, deforestation and biodiversity loss also have far-reaching strategic and security implications for Malaysia in terms of international relations, economics, trade and development:

1. Ramifications for international commitments and reputation: Malaysia has an international stature for biodiversity, placing it under much scrutiny because of widespread deforestation brought by the agri-commodity industry, especially palm oil. The country depends heavily on its forests to fulfil various international commitments, including the 50% forest and tree cover pledge made at the Rio Earth Summit in 1992, as well as climate-related commitments, such as its Nationally Determined Contribution (NDC) under the Paris Agreement and aspirations to become a net-zero nation by as early as 2050. As of 2019, Malaysia’s forest sequesters about 65% of its greenhouse gas emissions³.
2. Meeting sustainable market and trade requirements: as a small and open trading economy that is highly integrated into the global supply chain, Malaysia is subjected to various supranational trade policies, such as the European Union Deforestation Regulation (EUDR)⁴. Under the EUDR, those wanting to enter the European Union (EU) market must demonstrate that their products are legal and deforestation-free through a due diligence process that is applicable to seven commodities, including palm oil. Under the EUDR, countries will also be assigned a risk level for deforestation, which informs the scope of the subsequent due-diligence process. As Malaysia is a major palm oil exporter, the EUDR poses risks for companies in terms of delays, fines and loss of market access on top of higher compliance costs. Without jurisdictional intervention to manage deforestation risks, smallholders may lose market access to the EU supply chain. Similar regulations are expected to be developed elsewhere, beginning in advanced industrialised countries that aim to tackle deforestation in their supply chains, such as the US⁵ and UK⁶.
3. Ensuring resource security and building resilience: ecosystem services provided by our biodiversity and natural endowments are vital for building resilience against climate hazards, environmental risks, food insecurity and future zoonotic diseases. However, ongoing habitat loss and degradation are exacerbating our vulnerabilities. Official reports have confirmed that deforestation and development of monoculture plantation in hillsides and slopes have contributed to flooding and debris flow in few localities in Kedah⁷. Furthermore, the country’s key economic sectors, including agriculture, tourism and fisheries, rely heavily on the wider biodiversity ecosystem. For instance, the RM130 billion oil palm industry relies on red weevils for pollination, while durian production depends heavily on pollination by fruit bats, both of whose forest and cave habitats are under threat.

Deforestation in Malaysia is driven by a combination of economic, market and societal factors. Exacerbating this is the centralisation of government revenue which contributes to the federal-state jurisdictional dichotomy on natural resources management. Under the Federal Constitution, jurisdiction of natural resources, such as land, water and forests fall under the responsibility of state governments. While state governments are encouraged to promulgate laws and formulate policies pertaining to land and forestry matters, state governments rely heavily on narrow revenue streams from land and natural resources. This includes logging, mining and land clearance, along with income from oil palm land premiums and timber royalties.

On average, land-related revenue, including assessment tax, quit rents and forestry premiums constitutes between 50% and 90% of state government revenues. For example, forestry and land revenue constitute the majority of Pahang’s annual revenue, accounting for 70.5% in 2021 and 68.9% in 2022. The revenue gap between the federal and state governments is also enormous. In 2022, all states combined earned RM30.8 billion – amounting only to 10.5% of the federal government’s revenue of RM294.4 billion⁸.

The absence of well-aligned incentives and disincentives in the fiscal framework exacerbates environmental risks. A notable example involves the pivotal role forests play in natural flood protection. Despite the adverse consequences of deforestation-induced floods, state governments do not bear the financial repercussions. Instead, the burden falls on the federal government to fund flood-mitigation projects and disaster-relief measures.

In essence, NPE seeks to address these issues by establishing a market for conservation that creates incentives for both government and market participants to safeguard natural habitats. It achieves this by creating an enabling environment that leverages on innovative financial and market-based instruments to increase the flow of capital towards conservation projects. Besides reducing deforestation risks, increasing preservation and restoration of natural capital can continue to support the nation’s economic growth, provide essential goods and services for the wellbeing of all Malaysians, while serving as a viable habitat for Malaysia’s rich biodiversity. Furthermore, these natural assets continue to enable Malaysia to fulfil its international environmental commitments, addressing transition risks associated with the global market shifts towards sustainability, while building resilience against shocks and stresses, such as climate-related disasters. The latter will likely increase economic efficiency by reducing the nation’s expenditures on managing disaster risks, particularly expensive engineering projects, such as flood mitigation and disaster aid, especially at times when the government is under fiscal constraints.

2. Status of conservation funding and financing in Malaysia

Securing adequate funding for environmental conservation posed a persistent challenge for Malaysia. Despite the public sector being the primary source for environment-related expenses, budget allocations for conservation efforts have stayed low, below 1% of the GDP. This does not reflect the substantial contributions of biodiversity and ecosystem services to the economy and society. Though funding capacity has diversified through the establishment of various trust funds, such as the National Conservation Trust Fund for Natural Resources, the current amount is insufficient. Meanwhile, despite Malaysia previously receiving financial aid from multilateral organisations, as an upper-middle-income country, it has consciously diminished its reliance on international finance for its development. Notably, Malaysia is no longer a net recipient of official development assistance. As Malaysia transitions into a developed country, accessing multilateral and bilateral funds will become increasingly challenging. This requires innovative approaches to augment funding and financing for environment and biodiversity.

The government has prioritised the deployment of economic and financing instruments for climate and environmental policies⁹. Since the late 2000s, the country has witnessed a significant increase in the utilisation of economic tools to address environmental challenges. Malaysia is grappling with the repercussions of climate change and environment degradation, characterised by rising temperatures and more climate-related disasters. Recognising the climate imperatives to address these issues, the government has laid out various policy options in the 12th Malaysia Plan, namely the adoption of carbon-pricing instruments, carbon markets, ecological-fiscal transfer (EFT), payment for ecosystem services (PES) alongside promotion of green-financing schemes and rationalisation of fossil fuel subsidies.

The current fiscal arrangement and mechanisms are inadequate to incentivise state governments to conserve and restore their forests. The federal government has initiated EFT in 2019 with an initial amount of RM70 million and increased it to RM150 million in 2023 to channel conservation funds to state government. While this provided a good starting point, the allocation, especially after being divided among 14 states, hardly matches the revenue from forests through premium and cess from land, as well as royalties from timber and other forest-based products. As such, revenue from conservation finance mechanisms, with EFTs, must be comparable or exceed opportunity costs from extractive industries that involve forest clearance. This will make conservation a greater business case than the exploitation of forests. But the derivation of opportunity costs must go beyond strictly monetary gain and include social aspects, such as job creation and social mobility. This is pertinent as different regions and states in Malaysia have different development needs.

Among existing financial mechanisms, carbon-offset projects have arguably attracted the most interest and perceived as providing the highest potential, despite greenwashing concerns. This heightened interest could be attributed to the growing presence of private sector entities that aim to meet net-zero targets and improve ESG performance. These entities, especially those in hard-to-abate industries, are actively seeking high-quality carbon offsets, either voluntarily or as part of compliance efforts. The World Bank reports that more than 47 countries and 26 sub-national jurisdictions have carbon-pricing initiatives, boosting demand for carbon credits¹⁰. The voluntary carbon-offset market, valued at US$2 billion in 2021, is forecast to grow to US$10-US$40 billion by 2030, transacting 0.5–1.5 billion metric tonnes of carbon dioxide equivalent from the current 500 million tonnes¹¹.

Malaysia introduced its voluntary carbon market in 2022, which is also the world’s first shariah-compliant market. However, the lack of domestic carbon projects resulted in only two nature-based projects, both from Cambodia. The first is the Kuamut rainforest conservation project, a local carbon project which is expected to begin selling carbon credits in the Bursa Carbon Exchange some time in 2024¹². Notwithstanding, Malaysia currently lacks a carbon-pricing mechanism. Although the development of such a mechanism is underway, the need for a domestic emission-trading scheme is crucial to increase the demand for carbon credits. Even then, despite a modest price of US$5.80 per tonne of CO2, the investable carbon per year for natural forests in Malaysia might not be sufficient to offset the opportunity cost for all Malaysian the states¹³, not considering the development and maintenance costs of the carbon projects.

Value of natural capital extends far beyond carbon and offers the opportunities to explore other conservation-financing instruments. Besides carbon storage, preserving natural capital offers numerous other positive externalities, including water purification, pollination, biodiversity and flood protection. While it is foreseeable that nature-based carbon credits will still play a major role in conservation financing, the rationale for conserving natural capital extends well beyond carbon and overemphasising on carbon monetisation could lead to unintended incentives for nature conservation. For example, areas with low carbon sequestration rate can still potentially hold significant biodiversity, cultural and societal value. In fact, given Malaysia’s status as a mega-biodiverse country with various ecosystems, it could benefit more from nature and biodiversity credits.

It is imperative to explore other finance mechanisms that are tailored to local needs, contexts and circumstances. The Conservation Finance Alliance classifies at least 30 known conservation finance mechanisms, including grants, market-based mechanisms, return-based investments and economic instruments¹⁴. The design and implementation of these instruments is not without challenges, as they tend to be more intricate than carbon, which has a straightforward currency i.e. GHG emissions. While there have been plenty of successful cases of forest carbon projects, there are also several examples of international conversation projects that utilise other instruments (Figure 1). Ultimately, there is no one- size-fits-all model for how conservation financing works. It is highly dependent on impact, conservation outcomes, financing model, buyer willingness and local context. The major challenge in Malaysia remains on how to create an enabling environment based on national circumstances that could channel capital into conservation projects, which require the most intervention to generate local impact.

3. Challenges in transitioning towards NPE

The shifting investment landscape and rise in carbon pricing mechanisms in various countries have resulted in a spike of interest from market actors in financing conservation projects, including purchasing nature-based carbon credits in Malaysia and the Southeast Asia. To justify their investments, they seek assurances on project impacts, permanence and successful implementation. Nonetheless, there remains several interconnected challenges at the domestic level on policies, governance and market that have eroded confidence among potential investors and credit buyers in the Malaysian market.

3.1 Federal-state dynamics in environmental policies

The dynamics of current federal-state relations are impacted by issues related to jurisdiction over land and natural resources, overcentralisation of federal resources, ineffective engagements and a lack of frameworks that enable participatory policymaking. These interacting issues often result in policy conflicts and implementation challenges.

3.1.1 Trickling down federal targets, policies

The federal-state dynamic has created a disconnect between policies at the federal level and implementation at the state level. The 50% forest cover pledge and targets made under the Aichi Biodiversity Target to ensure 20% terrestrial protected areas have not been effectively translated at the state level. This includes more recent targets on climate change, such as the NDCs under the Paris Agreement. Without effective federal-state engagement and efforts to improve governance across all levels, state governments will not fully embrace their role and responsibilities delivering on the NDCs and other international environmental commitments. While state governments set their own targets and policies through structured plans and local plans, such targets are often not in sync with federal targets and commitments. An example can be seen in the Central Forest Spine Master Plan, a federal initiative launched in 2009, which aims to reconnect fragmented forest landscape in Peninsular Malaysia but has not been effectively adopted at the state level until more recently.

3.1.2 Policy conflict, incoherent

Conflicts in policies related to the environment and natural resources persist at various levels of government, with a notable instance within the spatial planning framework for the country. Specifically, the Environmental Sensitive Area (ESA) Framework, established in 2005 under the National Physical Plan under the Town and Country Planning Act 1976, often serves as a flashpoint for such conflicts. ESA employs a three-tier classification system, restricting certain designated areas, such as forest reserves and protected areas as well as habitat types like wetlands and peat swamps, from any developmental activity, permitting only minimal impact activities, such as research, recreation or at most sustainable logging for production forest reserves¹⁵.

However, not all state governments have uniformly embraced the federal ESA classifications in their structure plans. States retain the flexibility to determine classifications based on their needs and circumstances. Notably, some states like Kelantan have opted to eliminate all ESAs designation from their structure plans and district local plans¹⁶, a decision that raised concerns from the federal government and criticised by civil society organisations. Furthermore, loopholes exist in which activities such as timber-latex clone plantations, mining and quarrying within Permanent Reserved Forests are legally allowed under the state forestry enactments through the permit system. This creates a divergence between policy objectives and on-the-ground practices.

Policy conflicts also extend to the federal level, exemplified by the prime minister’s announcement permitting rare-earth mining in environmentally sensitive areas (ESA)¹⁷. This decision directly contradicts the land use policies outlined in the National Physical Plan, underscoring the existence of policy conflicts even at the highest level of government.

The multitude of issues highlighted above contributes to incoherent policies in natural resource management and forestry, posing a significant risk of eroding confidence among market players. This includes financiers, fund managers and carbon-credit buyers who actively seek assurance in the permanence and sustainability of nature-based projects. The lack of policy coherence and the existence of legal loopholes create an environment of uncertainty, undermining the reliability and credibility of such initiatives in the eyes of these key stakeholders. The resulting instability may deter investments and partnerships essential for the success of projects aimed at environmental conservation and carbon sequestration.

3.1.3 Fiscal-transfer effectiveness

A lack of effectiveness in engagements and participatory planning at the state level have also resulted in implementation challenges to EFT. While the federal government designated RM200 million annually in 2023 for distribution to all states¹⁸, a pervasive lack of clarity on the eligibility, selection criteria, disbursement procedures and intended usage of the funds persists in most states. Perak, for example, allegedly did not receive any fund at the time of writing. Conversely, Sabah reportedly found RM20 million in its coffers without prior notification, creating confusion about the purpose of these funds.

Such instances of miscommunication highlight a substantial hurdle in developing a robust and responsible carbon-trading system for the country, particularly when jurisdiction over carbon remains ambiguous. Furthermore, a level of distrust persists among states regarding the federal government’s role in managing revenue generated from carbon trading. This distrust is partly rooted in unresolved historical issues, particularly for Sabah and Sarawak, stemming from the 1963 Malaysia Agreement.

3.2 Lack of policy, regulatory framework on carbon trading and markets

Although there is an increase in regulatory focus on carbon markets globally, in Malaysia, the carbon-market landscape is currently unregulated while lacking proper oversight. To date, there is no specific carbon-trading law in place. While carbon-trading activities are mainly seen in the Bursa Carbon Exchange (BCX) that was launched in 2022, its rules offer specific instructions for carbon trading within the exchange, which solely addresses the operational side and only applies to its participants, such as operators, traders, suppliers and brokers. It does not govern the entire carbon market community in the country. There are several broader issues regarding the lack of policy and regulatory framework on carbon trading in Malaysia.

First, Malaysia is still without a carbon-pricing system, although a feasibility study by the Ministry of Finance and World Bank is on the way. Furthermore, the current globally low price of nature-based carbon credits that hovers around US$1-US$1.50 provides little incentive to engage in conservation¹⁹. As such, it creates a challenge to increase the supply and demand for domestic nature-based carbon projects. While the government has offered several financial incentives, this is insufficient to drive the uptake, with the minister of National Resources and Environment Sustainability expressing his disappointment in Malaysian corporations for their lack of engagement in carbon-credit initiatives²⁰.

Second, there is jurisdictional complexity surrounding the question of carbon sovereignty, a.k.a. if carbon falls under the purview of the federal or state government. While carbon falls under state jurisdiction, potential conflict arises with other regulations, such as the Environmental Quality Act or the upcoming climate-change bill that addresses carbon as a form of pollution. This situation also adds another dimension to the federal-state jurisdictional dichotomy, as state governments are eager to engage in carbon trading as a means of generating revenue, while the federal government prefers to keep carbon within national borders to meets its Paris Agreement targets and net zero aspirations.

Third, the absence of a formal mechanism to record carbon-trading transactions beyond the BCX, such as a national digital carbon registry, poses technical issues, such as the risk of double counting and the need for corresponding adjustments under Article 6 of the Paris Agreement. This lack of clarity extends to difficulties of tracking carbon stocks within the country, whether in national and corporate inventories or with overseas buyers. One solution could be restricting carbon trading to only domestic schemes, which could motivate the government to promote the Malaysian Forest Fund initiative that aims to incentivise carbon trading domestically. But ultimately, carbon is a state matter and it is assumed that states can participate in international markets and engage buyers willing to pay for higher prices. The absence of domestic carbon prices also hinders comparison with international prices.

Last, there are various concerns surrounding the credibility of carbon markets, in relation to permanence in verifying the environmental and social benefits in carbon-reduction projects and their lasting impact. Conflicts with indigenous and local communities arise because of differing land tenures and native customary rights, potentially leading to disputes over project implementation and benefits distribution to broader concerns about climate justice and equity. While certificates, such as Verra and Gold Standards, exist to ensure rigorous environmental and social criteria (which also face their own integrity and credibility issues²¹), adherence to these standards is not mandatory across Malaysia, relying instead on voluntary compliance and oversight outlined in the national VCM guidelines or respective state requirements. Of utmost concern, however, is the absence of a dedicated agency tasked with overseeing these matters.

The complexities and challenges surrounding carbon trading do not prevent States from moving ahead in formulating their own legal instruments to facilitate carbon trading. For instance, Sarawak has enacted the Forest (Forest Carbon Activity) Rules 2022 that provides a regulatory framework and outlines procedural steps for forest-carbon projects in the state, addressing various issues, such as real emission reductions, benefit sharing with native communities, carbon registry and corresponding adjustments²². Despite this positive step, uncertainties persist regarding how other states will develop their own carbon-related policies and align them with federal guidelines and international standards, compounded by the absence of federal-level registry and reporting mechanisms to UNFCCC.