Scholarly article on topic 'The complexity of the institution of payment for environmental services: A case study of two Indonesian PES schemes'

The complexity of the institution of payment for environmental services: A case study of two Indonesian PES schemes Academic research paper on "Law"

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Ecosystem Services
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{"Payment for environmental services" / "Institutional attributes" / "Fiscal mechanism" / "Transaction costs" / "Property rights"}

Abstract of research paper on Law, author of scientific article — Akhmad Fauzi, Zuzy Anna

Abstract Payments for Environmental Services (PES) have been widely adopted worldwide as a new market-based initiative for conservation and environmental management. In Indonesia several PES initiatives exist ranging from watershed and terrestrial to marine ecosystem. Nevertheless, developing and managing PES programs in Indonesia are exacerbated by the complexity of institutional arrangements. Fiscal constraints are still the main obstacle of sustainable financing of PES mechanism. Rules and regulations with regard to PES fiscal mechanism are rather lacking, making it difficult for effective management of PES programs. As a consequence, efficient mechanism between users (firms) and environmental services is rather weak. This paper explores such a problem based on case studies of two existing PES programs in Indonesia. The paper analyzes the complexity of fiscal mechanism as a derivative of regulations and discusses challenges to overcome the constraints.

Academic research paper on topic "The complexity of the institution of payment for environmental services: A case study of two Indonesian PES schemes"

Ecosystem Services I (I

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The complexity of the institution of payment for environmental services: A case study of two Indonesian PES schemes $

Akhmad Fauzia,n, Zuzy Anna b

a Department of Resource and Environmental Economics, Bogor Agricultural University, Jl. Kamper Wing 10 Level 4, Kampus IPB Darmaga, Bogor 16680, Indonesia

b Padjadjaran University, Jl. Raya Bandung Sumedang KM 21, Jatinangor 40600, Bandung, Indonesia


Payments for Environmental Services (PES) have been widely adopted worldwide as a new market-based initiative for conservation and environmental management. In Indonesia several PES initiatives exist ranging from watershed and terrestrial to marine ecosystem. Nevertheless, developing and managing PES programs in Indonesia are exacerbated by the complexity of institutional arrangements. Fiscal constraints are still the main obstacle of sustainable financing of PES mechanism. Rules and regulations with regard to PES fiscal mechanism are rather lacking, making it difficult for effective management of PES programs. As a consequence, efficient mechanism between users (firms) and environmental services is rather weak. This paper explores such a problem based on case studies of two existing PES programs in Indonesia. The paper analyzes the complexity of fiscal mechanism as a derivative of regulations and discusses challenges to overcome the constraints.

© 2013 The Authors. Published by Elsevier B.V. All rights reserved.

Article history: Received 18 May 2012 Received in revised form 30 April 2013 Accepted 8 July 2013


Payment for environmental services Institutional attributes Fiscal mechanism Transaction costs Property rights

1. Introduction

During the last three decades, Indonesia's economic development under President Suharto's administration has relied heavily on the extraction of natural resources, including oil, gas, and forests. Although the Indonesian economy has grown 6.11% per year during the last 10 years (Indonesian Central Statistics Agency, 2012), this growth has affected Indonesia's environment. A study conducted by the World Bank (Leitmann et al., 2009) shows that the cost of environmental degradation and climate change was over 5% of the GDP per year and will likely increase. In the forestry sector, Indonesia is well known in the international arena as the country with the third largest area of forest degradation. For example, Leitmann et al. (2009) indicate that, between 1990 and 2000, some 21 million hectares of forest cover were lost due to unsustainable forestry practices.

In response to the cost of environmental degradation, climate change, and Indonesia's unsustainable forestry practices, significant changes have occurred in terms of pursuing Indonesian

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economic development since the end of Suharto's regime in 1998. These changes include the management of natural resources. One of the significant changes regarding natural resource and environmental management is the decentralization of natural resource management and recognizing the environment as one of the key pillars of economic development. Previously, Indonesia's development was based on three pillars: (1) pro-growth, (2) pro-employment, and (3) pro-poor. Acknowledging the importance of the environment, however, has led to the inclusion of a fourth pillar into economic development: pro-environment. This pillar has been formalized in the Indonesian Medium-Term of the National Development Plan of 2010-2014 as stated in Presidential Regulation No. 5/2010, in which one of the eight development missions is to achieve a "green and everlasting Indonesia."

Various strategies have been developed to overcome environmental problems in the country. In addition to the conventional command and control mechanisms (e.g. standards, bans, permits, and quotas), market-based instruments (e.g. fees) and payment for environmental services (PES) schemes are now gaining popularity as vehicles for the protection of the environment. The PES scheme or mechanism, in particular, is gaining more support from local government and communities because of its attractiveness as an incentive mechanism and as a poverty reduction program (Antle and Stoorvogel, 2009; Lipper et al., 2009; Pagiola et al., 2004). For at least two reasons, it is also in the interest of local governments and communities to adopt the PES instrument as they learn from the past failures in managing the environment using command

2212-0416/$-see front matter © 2013 The Authors. Published by Elsevier B.V. All rights reserved.

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and control mechanisms. The first reason is that, since the establishment of Law 32/2004 on decentralization, the management of natural resources and environment has been transferred to the local government. That is, the local government has full authority to manage their natural resources for the benefit of their own welfare. Therefore, PES schemes could be considered a promising alternative method to managing natural resources. Second, at the local level, adopting the PES mechanism is relatively more acceptable for the community since it involves local people instead of a top-down approach by means of command and control, which is more or less similar to the centralistic management approach under Suharto's regime.

Payment for Environmental Services schemes has been widely adopted in Indonesia. They range from pilot programs to more established schemes. The PES concept was initially introduced in 2002 through collaboration between the Institute of Research, Information, and Education of Social and Economic Affairs (LP3ES) and the International Institute for Environment and Development (IIED) (Budhi et al., 2008). The collaboration between these two institutions led to the establishment of some PES pilot projects in Cidanau (Banten Province), Brantas (East Java), and West Lombok Regency (West Nusa Tenggara). Following these three pilot projects, other PES-like schemes were established in Sumber Jaya, Lampung; in Sungai Wain, East Kalimantan; in Cirebon-Kuningan, West Java; and in other locations. Most PES schemes in Indonesia are established in the areas of forest and watershed managements. These two areas are the most complex management areas because of their multifaceted interactions among components and institutions such as inter-provincial arrangements and inter-sectoral mechanisms.

Although various institutions (such as communities, private institutions, and the local government) have chosen PES schemes as one of the market-based mechanisms for environmental management and ecosystem conservation, they were only formally recognized when the Indonesian Law on Environmental Protection and Management was established in 2009. This law, Law No. 32/ 2009, recognizes two different categories of environmental management schemes: (1) payment for environmental services (PES) and (2) compensation for environmental services (CES). Both terms refer to the same schemes (i.e. using market-based mechanisms for managing the environment, especially in the area of conservation), but the law distinctively separates CES and PES with regard to the identity of the institutions involved. The term "CES" indicates a scheme established between the governments (e.g. between two provinces or between a province and the central government). In contrast, the term "PES" indicates a scheme established by a private institution (e.g. a scheme between a drinking water company and a community).

A conceptual and operational definition of Indonesian PES schemes is currently being drafted under the government regulation on economic instrument for environmental management. However, as of February 2013, the draft is still awaiting endorsement. Nonetheless, most PES schemes in the country have been adopting the commonly used PES definition used by scholars such as Wunder (2005, 2008) and Greiber (2009). This definition specifies that a PES is a voluntary transaction where a well-defined environmental service (ES) is being 'bought' by a minimum of one buyer from a minimum of one ES provider, if (and only if) the ES provider secures the ES provision conditionally (Wunder, 2005). This general definition emphasizes four aspects of a PES scheme: (1) the voluntary transaction, (2) well-defined environmental services, (3) the buyer and seller, and (4) the conditionality of the transaction. Some of these components, such as voluntary transaction and conditionality, might not be compatible in the Indonesian case, and will be discussed further in this paper.

This paper investigates how Indonesia PES programs function when a number of institutional aspects are involved. In particular, the paper attempts to address the complexity of institutional arrangements as well as institutional governance, including fiscal matters concerned with PES scheme implementation. It focuses on two PES schemes in Lampung and West Nusa Tenggara. These two PES schemes have different institutional arrangements, different issues with regard to property rights, and different schemes of buyers and sellers. The other reasons to choose these two schemes are that both schemes have unique "success" and "failures" stories viewed from different perspectives. They are also interesting for institutional analysis due to the complexity of the institutional arrangements in these two schemes. The paper begins with an overview of the two different PES programs in Indonesia followed by a discussion of their institutional aspects. It then concludes with some implications, lessons learned, and challenges that need to be addressed for future PES development.

2. Payment for environmental services and institutional aspects: general overview

Institutions play a significant role in a PES scheme since a PES scheme cannot work in a vacuum. Institutions are written and unwritten rules, norms, and constraints that humans devise to reduce uncertainty and control their environment (Menard and Shirley, 2005). Institutions also regulate what to do and not to do (Corbera et al., 2009). In the context of PES schemes, institutions also regulate human interaction with natural resources and they affect the resilience and services of the environment (Dietz et al., 2003).

In order to implement effective and efficient PES schemes, an institutional framework is required. Law and policy on the PES mechanism, for example, are the basic ingredients for the establishment of a PES institution (Greiber, 2009; Ruhweza and Masiga, 2007). They determine the key actors in a PES scheme, set the rules for the establishment and operation of a PES scheme, and provide general administrative guidelines (Greiber, 2009). Similarly, Vatn (2010) also emphasizes the importance of institutions in PES implementation. Most PES schemes depend strongly on the community and state involvement. Therefore, they are not purely voluntary market transactions, and rules and other institutional arrangements are required to make them work. The presence of state intervention, for example, is necessary to provide a legal framework since a PES scheme involves a contract, land ownership rights, and transaction costs.

In the context of PES schemes, Corbera et al. (2009) show that an institutional analysis could shed light at least on three important issues. First, an institutional analysis could help to identify the potential tension between PES design rules and PES players as well as potential controversies over who owns the services and who benefits from them. Second, an institutional analysis could be used to measure the positive and negative impacts of the schemes and the distributional aspects of the scheme (i.e. who should be included in the program and who should be excluded). Third, an institutional analysis could identify how a PES scheme could influence the local ecosystem management practices and cultural values, and factors that could strengthen the beneficiaries' interest in conserving the ecosystem. Corbera et al. (2009) further emphasize that an institutional framework analysis could contribute to improving the PES scheme design and overcome potential negative outcomes that might arise from their implementation.

Various institutional approaches can be used to analyze the effectiveness and the performance of PES schemes. Kaplowitz et al. (2008), for example, use a situation, structure, and performance (SSP) framework to analyze a PES scheme in Eastern Costa Rica.

A. Fauzi, Z. Anna / Ecosystem Services I (IIII) III-III e3

They focus on analyzing the impact of the PES scheme (i.e. who is impacted and how they are impacted), and they suggest an alternative institutional arrangement that might control the relationship between the environmental services and actors. Corbera et al. (2009), Greiber (2009), the Institute for Global Environmental Strategies (IGES) (2011), and Lipper et al. (2009) use different frameworks when analyzing the institutional dimensions of PES schemes. Corbera et al. (2009), for example, use the institutional framework of design, interplay, and performance to analyze a PES scheme in Mexico. A similar approach was followed by Khatri (2009) to analyze a PES scheme in Nepal. Vatn (2009), on the other hand, argues that using institutional settings that favor social rationality and communicative action are the most consistent approach for the analysis of PES schemes. In contrast, Farley and Constanza (2010) argue that the physical and economic characteristics of ecosystem services will determine what institutional setting is suitable for a PES scheme. This line of argument implicitly assumes that one has to understand the nature of the physical and economic settings of a PES to understand the institutional aspect of the PES mechanism.

Perhaps the simplest way to analyze PES effectiveness by means of institutional framework is by using institutional attributes and their interaction with the physical attributes of environmental services. Institutional attributes such as legal framework, property rights, and transaction costs are important components of PES schemes and these attributes are linked to the physical characteristics of PES schemes. For example, a PES program for carbon sequestration may need a different institutional set-up than a PES program for a watershed due to different physical characteristics. Alston et al. (2013) use such an approach to assess the effectiveness of various schemes. An almost similar approach can be found in Klein (2000) who categorizes institutional attributes into two general categories: (1) institutional environment and (2) institutional arrangement. Institutional environment refers to the background constraints or rules of the game that guide the behavior of individuals (e.g. law and property rights), while institutional arrangement refers to a governance structure designed to involve partners in mediating economic relationships. The attributes of this institutional arrangement include contracts and transaction costs (Klein, 2000). This paper will follow both the approaches of Klein (2000) and Alston et al. (2013) by exploring the institutional attributes of Indonesian PES schemes with respect to legal aspects, fiscal arrangement, property rights, and transaction costs. These attributes are dominant attributes and mostly concern institutional aspects that currently hinder the implementation of PES schemes in Indonesia. Legal, fiscal, and property rights, for example, have been identified as a main stumbling block in Indonesian PES schemes (Budhi et al., 2008), while transaction costs constitute a significant portion of the PES establishment in Indonesia (Arifin, 2005).

3. Brief overview of the payment for environmental services schemes under discussion

Most PES schemes in Indonesia are located in forested regions because the Indonesian forest sector has suffered massive degradation due to deforestation and illegal logging activities. Although Indonesia's forests account for about 10% of the world's remaining forests and are important for Indonesia's economy, biodiversity, and freshwater supply, the forest cover has declined over the last two decades. Data from various sources indicate that Indonesia's forest degradation occurred at a rate of 1.8-3.6 million hectares per year during the 1990s until 2000, and at an average rate of 728 thousand hectares per year from 2001 to 2006 (Yeager, 2008). Developing PES schemes in forested regions not only makes sense

with respect to conservation efforts but also is important in maintaining environmental services in these regions using market-based mechanisms.

Payment for environmental services schemes in Indonesia is driven by various initiatives within communities, private institutions (e.g. electricity companies, steel industries, and drinking water companies), national and international nongovernmental organizations (NGOs), and the local government. They are established for different purposes and schemes. For example, a national steel industry located in Banten Province, Java, initiated PES schemes within local communities in the upstream area to protect the water supply for this industry. Similarly, a state hydropower company used its own corporate social responsibility fund (CSR) to establish a PES scheme in the forested area of Lampung. Regardless of the purposes of these industries and the processes of development, PES schemes play an important role in replacing the failed command and control system that was used in Indonesia throughout the last three decades. This system failed due to weak enforcement and corruption (International Crisis Group, 2001). A comprehensive overview of PES schemes in Indonesia can be found in Suyanto et al. (2005) and an additional review can be found in Arifin (2005).

This paper will focus on two PES schemes: (1) one developed to counter a water crisis and watershed protection in the upstream forest area in Lombok, West Nusa Tenggara Province, and (2) one developed to counter forest degradation and sedimentation in Sumber Jaya, Lampung Province. The data and information were gathered from a series of focus group discussions (FGDs) conducted with key stakeholders (i.e. farmer groups (sellers), buyers (water users), facilitators (mediators), related agencies, and local village informal leaders). The FDGs were held from February 2011 to May 2011 in Sumber Jaya, and during April 2012 in Lombok.

3.1. The payment for environmental services scheme in Lombok, West Nusa Tenggara

The PES scheme in Lombok, West Nusa Tenggara Province, was initiated by various NGOs such as LP3ES. It is continued by the World Wide Fund (WWF) Lombok chapter and KONSEPSI (a local NGO), and is located in the West Lombok Regency in the village of Sedau where "the heart of the water sources" of Lombok is found. The upstream area is part of Rinjani Mountain, one of the volcanic mountains in West Nusa Tengara Province. Forest degradation, illegal logging, unsustainable farming, and shifting cultivation practices in this area have led to severe environmental problems resulting in decreased water quantity and quality (Prasetyo et al., 2009). The decrease in water quantity and quality was exacerbated further by a growth in the tourism industry, such as hotel and other tourism infrastructure development, which drew more water from the springs. Prasetyo et al. (2009) state that, by 2003, 40% of the 85 springs had disappeared due to the aforementioned destructive practices. Both water quality and quantity are vital for those living in Mataram City, the capital of the province.

Recognizing these critical issues related to forested regions and water problems, the PES scheme was set up after a series of processes were completed including a study of the economic valuation of Mount Rinjani's ecosystem, a survey of the Mataram City residents' willingness to pay (WTP) for environmental services, and stakeholder dialogs. The study of the residents' WTP was conducted in 2004 by KONSEPSI using questionnaires completed by respondents from household registered tap water users. They found that the WTP was between Rupiah (Rp) 500 ($0.05 U.S.) and Rp 5000 ($0.50 U.S.) per month. Following the survey of the residents' WTP, a series of dialogs with local government agencies, village leaders, and farmers in the upstream areas were held

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during the period of 2004-2006. The results of the WTP survey and dialog yielded useful inputs in setting up the initial design of the PES scheme and building trust among the stakeholders involved in the program.

The first trial of payment from the tap water users of the East Mataram precinct was held in February 2006, and, in 2007, the local bylaw on payment for environmental services was endorsed by the West Lombok parliament. The PES scheme is relatively simple. Farmers in the upstream area are compensated for planting trees and preserving water resources. The source of funding derives from the downstream users of the water resources. In this case, the funding source comes from households in the city of Mataram who use tap water from the regional drinking water company known as Perusahaan Daerah Air Minum (PDAM) or Regional Company of Drinking Water. The water users (i.e. the registered tap water households) pay a flat rate of Rp 1000 per month (approximately $0.10 U.S.). Even though the initial proposal of PES scheme also included having hotels and restaurants pay the same charge, this has not been implemented due to legal reasons.

The payment is embedded in the residents' monthly water bill and is designated specifically as the "Pembayaran Jasa Lingkungan" or PES. It is enforced by local regulation (bylaw). In this sense, the payment is "mandatory" (Pirard, 2012) rather than voluntary, which differentiates this scheme from a typical PES scheme. The money collected from the water users is then managed by a multi-stakeholder institution or Institusi Multi Pihak (IMP) consisting of local government agencies (led by the forestry agency), NGOs, the drinking water company (PDAM), and representatives of the upstream communities. The IMP is recognized in the Mataram City Bylaw and, therefore, is the official agency that manages the PES scheme in the watershed areas of Lombok. The revenue is collected from PDAM by Dinas Pendapatan Daerah (DISPENDA) or the Local Revenue Office and is deposited in the Local Revenue Office under the Dinas Kehutanan or the Local Forestry Office's account. The Local Revenue Office then distributes the funding to the IMP, which then allocates the money throughout the forested community based on proposal programs submitted to the IMP. After a proposal is approved and funding is received, the forest restoration program is then carried out by the community. Since the disbursement of the first funding in 2009, more than Rp 445 million ($44,500 U.S.) has been distributed to four farmer groups in different villages. The payment system for the PES scheme in Lombok is illustrated in Fig. 1.

Although the PES scheme has been running for 4 years, it is difficult to judge its success and effectiveness. However, results from the FGDs conducted with groups of PES-member farmers in the upstream regions suggest that there has been an improvement in the upstream regions. More trees are being planted, and there is an economic impact for the farmers as a result of the program. The leader of one of the farmer's groups, for example, claims that his income from the coffee business has increased due to funding from the PES scheme. According to him, this increase in income is attributed to an increase in the frequency of grinding coffee beans from once a week before the PES scheme to three times a week after the PES scheme. He stated that the increase in the frequency of grinding the beans increases his revenues from selling the coffee to the markets.

3.2. The payment for environmental services scheme in Sumber Jaya, Lampung

The second PES scheme operates in the forest village of Sumber Jaya, Lampung Province. The name of the village itself literally means "source of glory," which is a non-native name of Lampung. It was established in 1952 as a designated area of transmigration for migrants from the West Java Province, and, therefore, is mostly

populated with migrants from West Java. The population is approximately 80,000 people. Forty percent of the Sumber Jaya region consists of protected forests while 10% of the area is a national park. This designation was established in 1990 under Suharto's regime (Arifin, 2005). Nevertheless, only approximately 10% of the protected forests and the national park are forested. The rest has been deforested for a quite some time (Pender et al., 2008).

Not far from Sumber Jaya's protected forested area, a hydropower company in Way Besai has installed more than a 100 MW generation capacity to provide electricity to Lampung and the surrounding areas. The hydropower dam has been experiencing water deficit and sedimentation due to logging and deforestation activities in the upstream area. The forested area and its watershed in Sumber Jaya, therefore, play a pivotal role in ensuring the functionality of the hydropower dam. In addition, it also plays a crucial role in maintaining the livelihood of upstream communities since the forested area and its watershed contain fertile soil that supports coffee and rice cultivations, which are commodities the community relies upon.

The hydropower company known as Pembangkit Listrik Tenaga Air (PLTA) Way Besai used its Corporate Social Responsibility (CSR) funding to provide incentives to the farmers in the upstream area communities to conserve the forest. The PES scheme was then established with help from the World AgroForestry Centre (ICRAF) under its Rewarding Upland Poor for Environmental Services (RUPES) program in 2004. The ICRAF also facilitates contract mechanisms and provides monitoring programs for the PES scheme. The objective of the PES scheme is twofold: (1) to reduce sedimentation, which ensures water flow to the dam, and (2) to rehabilitate the deforested area while simultaneously ensuring a sustainable livelihood for the upstream communities. The payment system for the PES scheme is based on evaluation criteria on the reduction in water turbidity resulting from the conservation program. If farmer groups are able to reduce water turbidity by 30% (e.g. from 100 g soil/l to 70 g soil/l), the groups will be awarded an electric turbine for micro hydropower worth Rp 20 million (approximately $2000 U.S.). If the turbidity reduction is less than 30%, the compensation will be awarded in cash based on the range of turbidity level:

• If the turbidity reduction is less than 10%, the compensation will be Rp 2.5 million ($250 U.S.).

• If the turbidity reduction is between 10% and 20%, the compensation is Rp 5 million ($500 U.S.).

• If the turbidity reduction is between 21% and 29%, the compensation is Rp 7.5 million ($750 U.S.).

In addition, the payment scheme is not only in the form of a cash transfer but also in other forms such as a revolving fund for goat farming, the development of micro hydropower installations, and tree seeds.

The PES system in Sumber Jaya's forested area is in two different formats. The first is a typical PES scheme between the private sector and the community. Farmers form a farmer's organization or group, which then receives a small amount of funds from PLTA in exchange for planting trees, which they can also benefit from by harvesting the trees. Coffee agroforestry was chosen as an appropriate PES product given its economic value to the community. The farmer's group is also provided with a small amount of funds to purchase goats for an animal husbandry program. It is expected that the goats will induce tree or grass planting because goats need to be grass-fed. These grasses would then retain water and reduce soil erosion, thus reducing sedimentation in the dam area. The second format involves local government agencies. In this case, the forestry agency gives incentives

A. Fauzi, Z. Anna / Ecosystem Services I (I

Fiscal/revenue affair

Fig. 1. PES mechanism in West Lombok.

Budget allocation

not in the form of cash money (indirect payment) but in the form of rights to use the land for economic and conservation purposes. Land rights are expected to provide incentives for farmers to engage in protecting forests and the environment. Secure land tenure is critical in this case. Uncertainty in land tenure during Suharto's era has led to a series of conflicts between migrant farmers, which have led to a series of evictions (Wendland et al., 2010). In response to these conflicts and evictions, farmers illegally cultivate the land and deforest areas.

The flow between environmental services and payments from buyer to provider in the Sumber Jaya case is different from that of the Lombok case. Because the contract is between the hydropower company and farmers, there is no need to have a local law (bylaw) in place as in Lombok. Additionally, multi-stakeholder institutions are not required in the Lampung case. The payments can be made directly to the farmer's group as long as they submit the proposal. River Care Community, an organization formed by local NGOs, provides guidelines for writing the proposal and selects the best programs to be funded under the PES scheme. Here, the role of the local government in managing PES fiscal matters and funding management is minimal compared to the role of the local government in the Lombok case. Nonetheless, the role of the government agency (i.e. the Forestry Agency) is critical in providing secure land rights for the PES scheme this area. Without this governmental involvement, the PES program cannot be executed because of land conflicts and uncertainty in property rights. Fig. 2 provides a graphical description of the PES system in Sumber Jaya, Lampung.

A simple comparison between the PES schemes in Lombok and Lampung in terms of problems they addressed (seller and buyer types as well as programs and payment schemes) can be seen in Table 1. The "Inclusion" column indicates the degree of intervention and stakeholder involvement in the PES program.

4. Institutional analysis

4.1. Institutional environment: legal and fiscal arrangement

The institutional environment forms the framework in which human action takes place (Klein, 2000). Two attributes of the institutional environment are laws (the legal component or regulations) and property rights. Other attributes include norms and social conventions. In the PES context, regulations not only serve to harmonize the roles and responsibilities of individual

partners (Greiber, 2009), but they also serve to reduce the uncertainties of managing PES programs. This paper will discuss the laws or the legal component and the property rights. Discussion on the norms and social conventions of PES schemes can be found in Arifin (2005).

Theoretically, the PES mechanism draws on Coasian principles (Coase, 1960) with well-defined property rights and low transaction costs. Yet, empirically, it is in these legal components, property rights, and transaction costs aspects that PES schemes in Indonesia face challenges. The paper will also pay more attention to the role of fiscal matters in a PES scheme. The fiscal component is essential to make sure that the PES system will not run into fiscal hurdles (Mayrand and Paquin, 2004). This is because every PES scheme requires a specific payment structure. Therefore, a different fiscal arrangement might be needed. Fiscal reform might be necessary to allow room for a PES scheme to work such as in the case of fiscal reform in the Costa Rican Forest Law (Mayrand and Paquin, 2004). The fiscal arrangement for the PES scheme in Indonesia is rather complicated due to overlapping regulations as shown in the following section.

Most PES programs in Indonesia, as described above, are located in the forested areas. Yet, the forest areas in Indonesia are subject to several regulations and are managed under different authorities. The list below contains many of the laws and government regulations related both directly and indirectly to forest management, environmental services, funding mechanisms, and fiscal arrangements:

Law No. 5/1960 on Basic Regulation on Agrarian Principles. Law No. 41/1999 on Forestry. Law No. 26/2007 on Spatial Planning. Law No. 32/2009 on Environmental Protection and Management. Law No. 7/2004 on Water Resources. Law No. 32/2004 on Regional Autonomy. Law No. 4/2009 on Coal and Mining. Law No. 17/2003 on State Finance Management. Law No. 28/2009 on Regional Taxation. Law No. 20/1997 on Non-taxation Revenues. Law No. 33/2004 on Fiscal Balancing between Central Government and Regions.

Law No. 9/1985 on Conservation of Natural Resources and the Ecosystem.

Government Regulation No. 34/2002 on Forest Planning and Utilization of Forest Areas.

Government Regulation No. 3/2008 on Forestry Governance.

e6 A. Fauzi, Z. Anna | Ecosystem Services l (I

Fig. 2. PES mechanism in Sumber Jaya Lampung.

Table l

The characteristics of PES schemes in Lampung and Lombok.

Location PES case

Seller type Buyer type


Payment scheme Inclusion

Lombok Water crisis and watershed protection in upstream forest area

Lampung Forest degradation, sedimentation

Community Local government tap Tree planting, water/drinking company tree seed program

Community State-owned Coffee

hydropower agroforestry,


Water charge/bill (flat rate)

First municipal PES program, government intervention: moderate (through IMP)

CSR funding through Private operation. Government program proposal intervention through granting land rights

• Government Regulation No. 2/2008 on Revenue from Forest Use.

• Government Regulation No. 10/2010 on Land Use Change in Forest Areas.

• Government Regulation No. 42/2009 on Forest Financing.

• Government Regulation No. 22/1997 on Non-taxation Revenues.

Concerning the PES scheme, some of the aforementioned laws and regulations are not compatible. One such incompatibility involves the issue of fiscal matters. For private PES schemes with no government intervention, the transfer of payment can be made directly between buyers and sellers without any legal implications. However, in the semi-public PES scheme, such as the one in Lombok, this fiscal issue can be complicated. Law Nos. 28/2009, 17/ 2003, and 20/1997 do not recognize revenue from environmental services. Therefore, there is no room for earmarking such revenue. In the Lombok case, for example, revenue from the PES scheme should be treated as "other revenues" and fees collected from the PES scheme should be deposited in the Local Revenue Office under the Dinas Kehutanan's (Local Forestry Office) account. Thus, in principle, this revenue could be used for other purposes than environmental services.

The complexity of the fiscal arrangement caused the PES payment scheme in Lombok to be suspended. Individuals involved in the collection of payment were questioned and accused of wrongdoing by the local police and the district attorney for collecting money from tap water users, which is not recognized under the taxation law. The earmarking problem perhaps is not unique to Indonesia. May et al. (2004), for example, show that although ecological value-added taxation has been practiced in Brazil and has been shown to have a significant impact on the PES

scheme, the fiscal problem in terms of earmarking revenue remains an obstacle.

Conflicting regulations on the fiscal aspect of the PES scheme also exist related to the water charge. Law No. 28/2009 on regional taxation allows the regional authority to impose a charge on surface water and deep water, yet Government Regulation No. 34/2002 states that water utilization is one of the utilization forms of environmental services. Thus, a water charge on the forested area is part of forestry revenue known as the provision of forest resources. These two regulations might not be compatible with Law No. 7/2004 on water resources whereby water used for basic needs and agriculture inputs is free of charge. These three conflicting regulations make it difficult to define water payment clearly, even using the PES scheme. In an ex-ante situation, payment for water services face fiscal hurdles to which laws should be used as the legal basis. In an ex-post situation, the earmarking of revenue from environmental services has no legal basis. Fig. 3 illustrates the complexity of the fiscal mechanisms of collecting and distributing the PES payment in the watershed area in Indonesia.

Fig. 3 also describes the complexity of overlapping authorities on the management of forested areas. In the upstream area (forested area), at least seven regulations overlap with respect to the same area: Laws Nos. 5/1960, 41/1999, 26/2007, 32/2009, 4/2009, 7/2004, and 9/1985. For example, Law No. 5/1960 recognizes right to land into three categories: (1) state land, (2) community land, and (3) private land. Implicitly, the law recognizes land property under community (known as ulayat in Indonesia). Law No. 41/1999, on the other hand, does not recognize hutan adat (customary forest) owned by the community. Similarly, Law No. 41/1999 often overlaps with Law No. 4/2009 with regard to exploitation in protected forests. Law No. 41/1999 strictly prohibits

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Fig. 3. Overlapping laws and regulations related to PES schemes.

the exploitation of mineral resources in protected forests, while such a prohibition is not recognized in Law No. 4/2009 and mining permits are often issued in the protected forest based on the availability of mineral resources. In the downstream area, when dealing with the payment for the PES scheme, several laws and regulations overlap with respect to how to collect the payment and who should collect it. These include Laws Nos. 17/2003, 28/ 2009, 20/1997, and 33/2004. In addition, the watershed is bordered by many municipalities wherein Law No. 32/2004, concerning regional autonomy, states that bordering municipalities have the autonomous right to manage watersheds in areas under their jurisdiction. This undoubtedly complicates the overall PES process once the government is involved.

4.2. Property rights

The second aspect of institutional environment is property rights. Property rights play a crucial role in a PES scheme. Clear property rights entitle sellers to utilize their choice fully regarding the assets. As Demsetz (1967) states, property rights should not be interpreted narrowly to the legal notion of "right" but should be interpreted as the ability to make all manner of choices. Demsetz (1967) also note that different patterns of property rights could lead to different patterns of behavior. This notion carries significant implications for PES schemes because this issue underlies the problem of PES mechanism. In the PES mechanism, property rights should help to define clearly who holds the respective right over ecosystem services. However, most ecosystem services in Indonesia's PES schemes are derived from forested areas in which property rights are problematic. According to the national law, forested areas are under state ownership except when traditional

communities hold the title of ownership per customary law. The watershed systems in which most PES schemes are practiced are also frequently tied to the land use system. Here, the National Land Agency or Badan Pertanahan Nasional (BPN) is the only authorized agency that can issue certificates of entitlement for land. Complexities of the land management system and land ownership raise the awareness of uncertainties in many PES schemes in Indonesia.

Recognizing such complexity in the property rights system, some PES schemes, such as those in Lampung, seek a way to resolve the problem. In the forested areas, another low-level regulation can be used to bridge the gap: the Forestry Ministerial Decree No. 31/2001. This decree recognizes that Hutan Kemasyar-akatan (HKm) or community-based forest management grants a 5-year tenure of land as long as the community forms a farmer's group. Using this mechanism, the PES scheme in Lampung is able to provide secure temporary property rights to groups of farmers under the PES scheme for at least 5 years. The tenure can be extended up to 25 years to utilize state-owned forest land. Such "hitchhiking" on low-level regulations to address property rights issues might reinforce public policy toward forestry management in general (Pirard, 2012) so that the PES scheme and Hutan Kemasyakatan could serve as a good example of how a PES scheme works in the absence of property rights. Nevertheless, given that the initial allocation of tenure in Lampung was based on a "first come first served" basis, conflict over access to and use of state-owned land still occurs due to the heterogeneity of the community. Most of the people living in this area are migrant workers from Java, and they face continuing encroachment from other migrant people from Java. The conflict over access to and use of state-owned land might hinder the success of PES schemes in the future if no proper solution is found.

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4.3. Institutional arrangements: transaction costs

The third aspect of the institutional analysis of PES schemes is institutional arrangements. This is similar to what Williamson (1996) refers as "institutions of governance." Here, the role of contract, organization, and transaction costs associated with property rights plays a greater role in determining the success of the PES scheme. In the PES mechanism, institution governance includes buyers and sellers as well as the management of PES organization. Since the notion of PES governance has been implicitly discussed in Section 3, only the notion of transaction costs in PES schemes will be discussed in this section.

Transaction costs are ubiquitous. Transaction costs also have important implications for environmental governance since with positive transaction costs, environmental governance cannot be designed (Paavola and Adger, 2006). In the PES scheme, transaction costs could occur from the designing stage (ex-ante) to the monitoring and evaluation stages (ex-post), and might be quite costly. Jindal and Kerr (2007) note that transaction costs are a significant component of most PES schemes. For example, they found that transaction costs in a carbon sequestration PES scheme could range from 6% to 45% of the total PES cost. In a Mexican study, one community spent more than $1.3 million U.S. (33% of the budget) on transaction costs (Jindal and Kerr, 2007). Alpizar and Madrigal (2008) found that the transaction costs of a PES scheme in Copan, Honduras, were estimated around $4000 U.S. per year. In the PES schemes being studied, no data were available on the amount of transaction costs spent in the Lombok case. However, a rough figure of the transaction costs was obtained in the Lampung case. A study by Arifin (2005) shows that the transaction costs in the form of establishing property rights (the HKm permit) over forest land in Sumber Jaya, Lampung, are around $55.00 U.S. per household. This amount is more than half of the annual income of these farm households and does not include the opportunity costs that farmers have to incur due to the slow and lengthy processes of obtaining the permit.

There are many different definitions for the term "transaction costs." In this paper, we adopt Allen's definition of transaction costs (Allen, 1991) as the costs of establishing and protecting property rights. In the world of perfect economies, zero transaction costs would be associated with the optimal allocation of goods and services. However, there is no such thing as a perfect economy, and, therefore, transaction costs are ubiquitous. High transaction costs would undoubtedly disrupt efficient allocation. Therefore, any mechanism to minimize transaction costs is sought. Farmers and companies, for example, have incentives to adopt contracts to minimize the dissipation of benefits from transaction costs (Leffler and Rucker, 1991). According to Leffler and Rucker (1991), minimizing transaction costs could be accomplished through payment options. In the forestry sector, for example, a lump sum payment or payment for a unit of service could be used to minimize transaction costs. However, for the PES scheme in Lombok, this is not the case. The PES scheme payment does not determine any transaction costs because the determination of the payment is carried out simply by people's willingness to pay (derived from a survey) and is not based on the costs of maintaining rights within the PES scheme. In the PES scheme, especially in developing countries such as Indonesia, attributes of environmental services are very complex and difficult to measure. It might lead to commodity fetishism (Kosoy and Corbera, 2010), the term coined by Karl Marx in nineteenth century, which refers to the situation that a commodity is perceived to have some magical power. Kosoy and Corbera (2010) extend this notion into the PES context in which commodity fetishism in a PES scheme might arise due to the complexity of ecosystem. In this case, the PES system has ignored the complexity of the ecosystem so that

Benefits and Costs of ownership

Benefit of full property rights

Second best valu

Reduction of PES's benefits due to insufficient contract -''Benefit due to incomplete property rights

■Transaction cost (TC)

TC due to incomplete Property right

First best value Of asset

Fig. 4. Transaction cost, property right and contract.

the services can be transacted using monetary value. Therefore, the system ignores the value of the ecosystem in a broader sense (Kosoy and Corbera, 2010). This incomplete specification and the measurement of attributes alter transaction costs, which, in turn, lower the value of the environmental services. Fig. 4 illustrates changes in transaction costs as a function of PES scheme values.

Fig. 4 is adopted from Allen (2002). The diagram was originally drawn by Umbeck (1977), and is modified and used for the context of the PES scheme. The first best value of asset is on the horizontal axis (e.g. water sources in the forest area) whereby its value is determined by the trading mechanism in the PES contract. On the vertical axis are the benefits and costs associated with the ownership of the asset obtained (e.g. through contract). If the ownership is complete (i.e. ownership is perfectly defined), the benefits are shown by the 45° line. That is, the benefits from forming property rights are equal to the value of assets when they are used in their best use. The cost function in Fig. 4 represents the cost of establishing and maintaining rights (i.e. the transaction cost function that includes the cost of enforcing, moral hazards, etc.) (Allen, 2002). It intersects at point C since, even though the asset has no value, there would be positive costs due to activities such as getting people together to negotiate a contract (Umbeck, 1977). The vertical distance between the 45° line and the transaction cost line represents the second best value of the asset. At V0, the second best value of the asset is positive. Therefore, it is economical to form property right through a contract. The first best value at Vc represents the critical point regarding whether a contract would exist. In the area to the left of Vc, the transaction cost is higher than the benefit of a contract. Therefore, it is not economical to form property right through a contract. In the PES case, there is no point in establishing a PES scheme in this area because the asset has no value, and no contract would be established between buyers and sellers. This is a case where the area designated for PES schemes is in the public domain, and establishing a contract would be expensive.

When ownership is incomplete, such as in Indonesia's PES schemes, the benefits line falls as indicated by the dashed line (pivoting clockwise). This could be due to an insufficient or incomplete contract, which is often experienced in a PES scheme because of its complex environmental attributes. When property rights are incomplete (e.g. farmers only acquire 60% of ownership), the cost of enforcement is also lower (the cost of enforcing a 60% property right is lower than the cost of enforcing a full property right), as indicated by the new transaction cost dashed line. Consequently, the second best value would also be lower, leading to fewer incentives for farmers to conserve the environment or to engage in a PES program.

As can be seen from Fig. 4, the second best value increases as the value of the asset increases, and the vertical distance would be greater the lower the transaction cost. The transaction cost analysis enables us to understand why the PES scheme needs more innovative breakthroughs in terms of contract, design, and

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property rights given the complexity of environmental services and institutional arrangement within PES schemes.

5. Concluding remarks

During the new order regime, Indonesia's dependency on natural resources, especially on its forests, has resulted in unpleasant environmental consequences. In particular, these consequences are deforestation and environmental degradation in the forestry sector. The command and control approach practiced by the new order regime has proved to be ineffective in controlling encroachment, illegal logging, and other unsustainable forestry practices, and in solving environmental problems. The PES system is now recognized as one of some new market-based mechanisms that are considered both attractive and acceptable at local levels. This instrument is also gaining strong support since its recognition in Law No. 32/2009 on Environmental Protection and Management. The legal aspects of the PES scheme, however, raise two critical issues.

First, the recognition of PES schemes in the laws, both nationally and regionally, will eventually make the PES scheme a mandatory mechanism rather than a voluntary mechanism as described under the ideal PES scheme. Nonetheless, such a unique arrangement could perhaps be used as a leverage to mainstream the market-based environmental management, especially to prevent further forest degradation in Indonesia. In Indonesian society, voluntary initiatives for conserving forests are rather weak due to poverty and other socio-economic constraints. Thus, the presence of the legal aspect of the PES scheme would encourage local governments to initiate more PES-like initiatives to address the on-going environmental problems in Indonesia. In addition, it is recognized that the government still plays a crucial role in making PES programs work in Indonesia. However, the presence of legal aspects of the PES scheme further complicates the management of existing PES schemes as well as developing new schemes. The complexity in laws and regulations as well as the problems of establishing property rights over land use and land ownership has hindered the effectiveness of various PES schemes in the country.

A second issue that needs more serious attention in PES management, especially in the forest and its related watershed areas, is fiscal arrangement. The results from the analysis of the two PES programs in Lombok and Lampung show that, even though there is some promising progress in solving watershed and forestry problems in the upstream areas, the programs face many challenges in terms of fiscal arrangement and higher transaction costs. The evaluation of the current fiscal system to accommodate revenues from environmental services is sorely needed. In the absence of fiscal policy regarding the PES financial mechanism, some innovative breakthroughs are needed. Local governments, especially at provincial levels, could use other means such as government regulation on regional cooperation (Government Regulation No. 50/2007) and government regulation on regional incentives (Government Regulation No. 69/2010) to remove fiscal constraints. In addition, other regulations regarding regional autonomy and the decentralization of natural resource management need to be streamlined so that they will not become a bottleneck for PES implementation. Current drafts of governmental regulation on economic instruments for environmental management, in which PES is one component that will be regulated in more detail, need to be sped up for presidential approval because it is from this regulation that other PES bylaws will follow at regional levels. Although the proposed government regulation on economic instruments for environmental management will not serve as a silver bullet for entangling the complexity of the PES scheme in Indonesia, it is expected to reduce uncertainty with respect to PES

implementation, and to provide a more comprehensive understanding of the PES mechanism.

From the two case studies, it seems that PES scheme arrangement involving the private sector (i.e. the PES scheme in Lampung) is less complicated and has a better chance to work than a public funding mechanism (i.e. the PES scheme in Lombok). This is shown also in other PES schemes involving the private sector such as in Cidanau in Banten Province, Java, as studied in Budhi et al. (2008). The private sector (in this case, the Krakatau Steel Industry) provides cash payment to upstream farmers for a PES program in upstream area. This scheme is less complicated in that it works better than other PES schemes. This is because ex-ante transaction costs are lower in the case of the private sector. There is no need to conduct a survey of the willingness of residents to pay to determine the payment. Other transaction costs associated with public funding accountability and monitoring and evaluation are in the hand of the private sector, and do not involve many other institutions. Nevertheless, a PES scheme involving the private sector also needs clear property rights as well as legal back up from the local government in order to function.

In conclusion, although the PES scheme is gaining popularity, and is proposed to be widely adopted in Indonesia as a market-based mechanism for environmental conservation, it cannot be separated from its institutional facet. The market-based mechanism alone will not solve the complex problems related to natural resource management and environmental conservation. However, the market-based mechanism could be used as a catalyst to reinforce the benefit of adopting PES schemes along with poverty alleviation in a rural-based economy. The role of government and other institutional arrangements still play a pivotal role in PES implementation in developing countries such as Indonesia, yet institutional complexity should be addressed before a PES scheme is adopted.


The authors wish to acknowledge the Ministry of Environment of the Republic of Indonesia, the WWF Lombok Chapter, and the West Lombok Environment Agency for their support during field visits.


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