How carbon markets can help Malaysia achieve its climate targets

Leaders around the world have set ambitious targets to curtail emissions. As of June 2022, countries with announced net-zero targets cover more than 80 percent of global emissions and account for more than 90 percent of the world’s GDP (by purchasing-power parity) and 80 percent of the world’s population. The challenge is to develop plans that can mobilize a broad set of stakeholders to achieve progress at a scale required to meet these targets. Countries are applying a variety of market and nonmarket mechanisms to accelerate progress toward their goals.

Malaysia has committed to achieving climate neutrality¹Twelfth Malaysia plan, 2021-2025, Economic Planning Unit, Prime Minister’s Department, Malaysia, 2021. and to cut greenhouse-gas (GHG) intensity against GDP by 45 percent by 2030 compared with 2005 levels. According to Malaysia’s Third biennial update report to the UNFCCC,²Malaysia: Third biennial update report to the UNFCCC, Ministry of Environment and Water, Malaysia, December 2020. the country’s annual emissions in 2020 amounted to 334 metric megatons of CO₂ equivalent (MtCO2e). Malaysia’s forests play a significant role in mitigating climate impact, sequestering an estimated 259 MtCO₂e a year through measures such as legally designating reserved forests and protected areas including national parks and wildlife sanctuaries. Given the importance of forest-based sequestration in Malaysia, the country would need to maximize efforts to avoid deforestation and sustainably manage land use to meet its climate goals.

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The potential of carbon markets

Malaysia could expand carbon sequestration in forests and the natural environment beyond current levels through an array of measures. These include restoring degraded forests, mangroves, and peatlands and increasing the amount of carbon sequestered per hectare of land through better land management practices.

Nature-based solutions (NBS)—projects that aim to increase carbon sequestration in the natural environment—could be a key element of this effort. Projects receive carbon credits commensurate to the amount of emissions either removed from the environment or prevented from being emitted into the environment when executed in line with methodologies prescribed by carbon standards.³A carbon credit (often called a carbon offset) is a certificate with a unique serial number on a carbon registry, representing one metric ton of carbon dioxide equivalent that is either prevented from being emitted (emissions avoidance or reduction) or removed from the atmosphere by carbon-reduction projects through activities that are “additional.” A carbon credit is considered additional if the prevention or removal of one ton of CO₂e would not have been achieved without the carbon project, and the carbon project itself would not have happened without the proceeds from the sale of carbon credits. The impact of a carbon credit can only be claimed once the credit has been retired (canceled in a registry), after which it can no longer be sold onward.

Malaysia has more than 18 million hectares of forest cover, which could be managed to ensure permanent carbon sequestration. According to McKinsey Nature Analytics,⁴Our analysis covers eight different natural-climate and NBS activities: reforestation, avoided deforestation, coastal restoration, avoided coastal degradation, peatland restoration, avoided peatland degradation, trees in cropland, and cover crops. It combines geospatial data on ecosystems and their degradation status with carbon sequestration potential per ecosystem type. The total sequestration potential is then compared with the agricultural rent of the different ecosystems and the cost of typical carbon project activities (for example, project development and carbon credit monetization costs). Agricultural rent is the economic return that may be generated from alternative land use, such as agriculture. The agricultural rent is estimated using granular crop yields for more than 40 different crops and for eight different livestock categories, and the prices for these commodities. the country has a carbon crediting potential of up to 40 million tons of CO2 annually through NBS projects—equivalent to 3 percent of the world’s NBS potential (Exhibit 1). Forest-based sequestration could account for up to three-quarters of the country’s crediting potential, while the remaining potential could be unlocked by peatland-based sequestration (Exhibit 2).

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Carbon markets, in which carbon credits are traded, can provide powerful incentives for nature-based conservation efforts and could be instrumental in supporting Malaysia’s efforts to become carbon-neutral. In a voluntary market, companies can purchase carbon credits to fulfill part of their emission-reduction targets or create carbon-neutral products for their customers. In some compliance carbon-pricing systems, such as emission-trading systems or carbon tax regimes, companies are allowed to use limited quantities of carbon credits to achieve their compliance commitments. Carbon markets thus enable companies that are looking to compensate for their emissions to finance carbon mitigation projects, either directly or indirectly. This provides incentives to protect and restore natural environments by making the conservation and restoration of forest lands competitive relative to other economic uses.

A robust carbon market—including demand for carbon credits, a strong ecosystem to supply carbon credits, and a rules-based marketplace for trading—could be a key enabler of Malaysia’s climate ambitions. However, not all of these elements are currently in place.

Foundational elements of a high-functioning carbon market

Malaysia could focus on three key elements to translate potential carbon credits into a thriving carbon market.

Demand for carbon credits

Globally, we see encouraging signs of growing demand for carbon credits from companies that have committed to mitigation and net-zero targets. Recent studies forecast a 15-fold increase in demand by 2030, to 1.5–2.0 metric gigatons of CO₂ equivalent (GtCO₂e) a year.⁵State and trends of carbon pricing 2022, World Bank, 2022; Putting carbon markets to work on the path to net zero, McKinsey, October 28, 2021. Although demand is currently low in Malaysia, our analysis reveals that up to one-third of the country’s top 80 companies have voluntarily adopted emission-reduction targets, and many of these may require carbon credits to meet their targets. Our analysis indicates that a majority of Malaysia’s emissions come from the energy and heavy-industrial sectors. Along with airlines and maritime, these sectors may have residual emissions that could be compensated for by carbon offsets, despite in-sector abatement. Demand for carbon credits will begin to accelerate as requirements for climate-related disclosures and sustainability reporting increase. However, for this demand to materialize, companies may need support in assessing the role carbon offsets could play in their decarbonization journey.

A robust ecosystem to supply carbon credits

Malaysia could rapidly mobilize the development of its carbon project ecosystem by addressing several gaps.

The country currently lacks a sufficient number of nature-based projects. According to McKinsey’s project database, Malaysia has just two active projects. Over the past five years, Indonesia, Cambodia, and Thailand have issued carbon credits of approximately 87 MtCO₂e, 43 MtCO₂e, and 17 MtCO₂e, respectively, compared with less than one MtCO₂e from Malaysia (Exhibit 3).

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Malaysia has very few carbon project developers today. While some Malaysian firms might be able to draw on past project experience under the Clean Development Mechanism (CDM),⁶The Clean Development Mechanism, which was defined in the Kyoto Protocol, allows a country with an emission-reduction commitment to implement an emission-reduction project in a developing country. there is an opportunity for new entrants into the market to scale quickly. In addition, interviews with current and potential market participants indicate that the nascent market creates challenges in raising up-front financing for carbon projects.

Last, Malaysia’s constitution stipulates that land use is a state matter. This means individual states can pursue their own strategies to allocate land and resources for carbon projects. A key first step will be for state and federal governments to coordinate closely on policies to encourage and facilitate NBS projects with leading global organizations and local developers. This coordination would create clarity for market participants and facilitate the pooling of expertise and resources across states.

A rules-based voluntary and compliance carbon market

The Malaysian government has announced its intention to set up a voluntary carbon market by the end of 2022.⁷“Malaysia’s bourse to launch voluntary carbon market by year-end,” Reuters, August 14, 2022. This market will allow Malaysian companies to buy carbon credits, and it will create a reference price for carbon within the country as the government designs a compliance carbon market. A fair, orderly, rules-based market will be crucial for aggregating supply and demand and providing effective price discovery to companies and carbon project developers. Partnerships with global entities, such as established carbon standards, can ensure the design of Malaysia’s voluntary carbon market incorporates lessons learned and best practices from other carbon markets.

Compliance carbon markets that allow a limited number of carbon credits that meet specific quality criteria can also accelerate the growth of an ecosystem of service providers to support the development and scaling of emission-reduction projects and activities.

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How Malaysia can accelerate carbon projects

To support nature-based carbon projects in Malaysia, stakeholders should pursue several strategies—three in the immediate term and one with a longer time horizon.

1. Harmonize the design of voluntary and compliance carbon markets within Malaysia

Given that multiple carbon-pricing mechanisms are being considered in Malaysia, stakeholders need clarity on the links between the voluntary and compliance markets, particularly on how carbon credits may be used in carbon markets in the country and abroad. As a starting point, policy makers could clarify any restrictions or limits on use of credits in compliance markets and how these might apply in the short, medium, or long term. When the voluntary market’s carbon credits are cleared for use in compliance carbon markets, they create powerful demand signals for the carbon project ecosystem and accelerate the growth and execution of carbon projects. Market participants would also benefit from clarity about regulations on cross-border trading of carbon credits.

2. Define clear rules and guidelines for project development

Agreement on general principles to guide the development of carbon markets would be a valuable step. Subsequently, unified guidelines for project development on sectoral or geographical priorities, accepted methodologies, and requirements for accurate monitoring, reporting, and verification would provide clarity for project developers. Guidelines could be accompanied by consolidated lists of potential projects to help developers and investors identify opportunities and mobilize at pace. Such efforts have precedent in Malaysia: a similar degree of clarity was created for CDM to support green-energy projects in the previous decade.

3. Scale up carbon financing

Market participants say that the lack of financing mechanisms and expertise for carbon projects is an obstacle. Project developers should receive support to connect with a diverse array of project financing sources, from global financial institutions and investment funds to local and global grants. These sources can be bolstered by grants from government-linked institutions. Meanwhile, local financial institutions should develop the capability to finance carbon projects—for example, by collaborating with international institutions with relevant experience.

4. Establish local capabilities

Project development and validation and verification bodies (VVBs) will also need to be scaled up on the local level. Engaging local players helps accelerate the pace of project development and carbon credit issuances. Developers of carbon projects would need upskilling on recent applicable technical requirements beyond those from the CDM era. Collaborating with leading global organizations that develop and manage carbon standards is one way to help interested local project developers quickly build capabilities in the latest carbon-crediting methodologies and best practices. In addition, identifying local players that could be trained to offer VVB services and supporting them in getting accreditation from both the government and key global carbon standards will further accelerate the development of a local carbon project ecosystem.

Since carbon projects can take up to five years from initiation to the first issuance of carbon credits, rapid action is needed now to ensure carbon markets can scale in time to make meaningful contributions to Malaysia’s 2030 carbon targets. Thanks to the country’s forest endowments, Malaysia has an opportunity to not just meet its 2030 climate targets but also support the world through additional sequestration. Carbon markets could be one of the key enablers to help Malaysia do so.