Global Business Guide Indonesia

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Agriculture | An Overview of Indonesia’s Palm Oil Industry

The palm oil industry is a significant contributor to Indonesia’s economy and a vital employer in the vast rural areas of Sumatra and Kalimantan. As one of the country’s major export commodities, palm oil is also an important foreign exchange earner. Traditionally, the bulk of Indonesia’s palm oil was exported in crude form to be further processed abroad, but that is changing as the government is nurturing downstream business activity. The industry is also under pressure to react to global concerns about its environmental credentials.

An Overview of Indonesia’s Palm Oil Industry
Apart from the differentiated tax regime, the government is also promoting the development of downstream businesses in industry clusters that facilitate vertical and horizontal integration

Palm oil is popular for its frying properties and as a low-cost option in many processed foods. Outside the kitchen, it is used in body care products from shampoo to lip balm but also in detergents such as washing powder and dishwashing liquid. Finally, palm oil is a feedstock for biodiesel. Most Indonesian exports go to India, followed by the EU and China.

Accounting for roughly half of the entire global output, Indonesia is by far the largest producer of crude palm oil (CPO). In 2012, the country’s production rose by 13% to 26.5 million tons, 18.1 million tons of which was exported either in raw or refined form (Indonesian Palm Oil Association). The government hopes to raise CPO output to 40 million tons by 2020 (Ministry of Agriculture). However, the rapid increase in volumes over the past years has contributed to a global supply glut, ironically hurting Indonesia’s export revenues in 2012. Oversupply is set to keep palm oil prices subdued in the near future.

More than half of Indonesia’s CPO is produced by private companies. Major players in the sector include Singapore-listed Wilmar Group, Sinar Mas Agro Resources and Technology (SMART), Indofood Agri Resources and Malaysia’s IOI Corp Astra Agro Lestari. Smallholding farmers account for about 35% of total output, while state-owned enterprises make up the rest.

In a bid to add value to the industry, the government is pushing for more palm oil to be processed into derivatives and finished goods within the country, rather than being exported as CPO (See Opportunities in Palm Oil Derivatives). Refining capacity in the country has increased in recent years, and the Ministry of Industry has set a 2013 target of processing 65% to 70% of its crude palm oil production at home. Regardless of whether or not this goal is achieved, investors will need to go along with the political drive to prosper in Indonesia’s new palm oil industry.

The main policy tool to entice downstream investment is a differential export tax regime introduced in October 2011, which penalizes CPO shipments to the benefit of higher-value goods. The policy brought down export taxes for refined palm oil while subjecting crude exports to a progressive rate that increases with the market price up to a maximum of 22.5%.

A punitive tax on raw exports proved quite effective in the cocoa industry, and it now appears to be yielding the desired results in the palm oil sector, with increased investment going downstream. Industry representatives have pledged to spend hundreds of millions of dollars on oleo-chemical and oleo-food plants. A 2012 survey among 30 firms by news agency Reuters found that managers planned to nearly double Indonesia’s CPO refining capacity.

Apart from the differentiated tax regime, the government is also promoting the development of downstream businesses in industry clusters that facilitate vertical and horizontal integration. Palm oil clusters are to be developed in North Sumatra and Riau, and East Kalimantan as per the The Masterplan for Acceleration and Expansion of Indonesia's Economic Development (MP3EI), although private-sector interest so far has been less than impressive. The government aims to facilitate palm oil clusters through tax breaks and by providing vital infrastructure such as ports and storage tanks.

Indonesia and Malaysia together account for almost 90% of global CPO production, and fierce rivalry for export market share has complicated tax policies in both countries. The Indonesian Palm Oil Association (Gapki) lobbied for lower CPO export taxes after Malaysia slashed its CPO duty to zero at the beginning of 2013, before raising it to a still low 4.5% in March. The low rate put Indonesian growers, who were faced with higher taxes, at a disadvantage. Yet Jakarta seems adamant to stick with its tax policy of favouring domestic refining and processing.

As long as the two countries fail to use the duopoly to their mutual advantage, either government will find itself under pressure to lower palm oil export taxes to secure global market share for domestic industries. However, Indonesia’s differentiated tax policy could become self-perpetuating as the increased refining capacity threatens to stand idle unless crude exports continue to be discouraged.

Aside from increased consumption in major export markets and in Indonesia itself, potential for further growth in palm oil demand hinges particularly on its use as a renewable source of energy. EU regulations require that at least 10% of transportation fuel be biofuel by 2020, while India and China have even more ambitious targets. Capturing these markets, however, will be challenging for Indonesian CPO producers.

The EU is under pressure from its own biofuels industry and is considering imposing import duties on the grounds that Indonesia’s CPO export tax is tantamount to a subsidy for Indonesian refiners. Meanwhile, environmental and human rights NGOs are urging an end to palm oil imports from Indonesia which they say contribute to deforestation, forced evictions and unfair labour practices. The massive markets of India and China should be less sensitive to ecological and social concerns and help secure long-term demand growth for palm oil products from Indonesia.

Following temporary boycotts and demonstrations, producers and processors of Indonesian CPO are aware of the need to maintain a positive image in terms of sustainability and corporate social responsibility (CSR). Rather than a simple PR exercise, this will increasingly put companies, both local and international ones, under pressure to obtain certificates to demonstrate that their produce meets certain standards. The most prominent body issuing certificates is the Roundtable on Sustainable Palm Oil (RSPO), which brings together plantation firms and environmental NGOs.

While criticism has been lodged at the RSPO, it is still the principal organization setting the minimum ecological standards for the global palm oil industry. The Indonesian government has come up with a competing scheme, the Indonesian Sustainable Palm Oil (ISPO), which some argue is easier to comply with but global companies should be advised to aim for the more widely recognized RSPO certification.

CSR can help palm oil firms improve their image in their plantation area and one way to do this is by supporting local palm oil farmers. Since smallholders are vulnerable to global downswings in palm oil prices they have a business interest in cooperating with corporations that can provide them with more stable pricing. Yet, smallholder integration is often found wanting as many plantations prefer to employ the locals and use their land rather than enter into harder-to-govern business relationships with them.

The extension of a moratorium on forest clearance in May 2013 poses challenges for the further expansion of the country’s palm oil sector. The presidential decree means the government will issue no new permits for the use of primary forests and peat lands until 2015; though loopholes blunt its effectiveness. Also in May 2013, the Constitutional Court decided that so-called customary forests are no longer state forests. The ruling effectively gives communities with traditional land claims ownership rights rather than use rights to the lands they inhabit or cultivate. While the specific consequences of the ruling remain unclear pending implementing regulations, they are likely to complicate land use by palm oil corporations.

Despite obstacles to acreage expansion, growth potential is said to be substantial. For a start, the government is keen to develop plantations on millions of hectares of so-called degraded land rather than by converting natural forest. More importantly, productivity gains can be unlocked in existing cultivation areas. Per-hectare yields in Indonesia are considerably lower than in Malaysia, highlighting room for improvement through more advanced technology, knowhow, and better seeds. The government has expressed hope to more than double productivity from 3.57 tons per hectare in 2012 by 2025 (Ministry of Agriculture). Substantial gains can be made with fairly little effort on smallholder lands. Closer cooperation with smallholders, including by providing financing, could help corporations and investors tap into this growth potential.

Should plantations adhere to good governance and environmental standards and explore new ways of engaging with smallholders, ample growth potential exists in Indonesia’s upstream palm oil sector. Indonesia is not only the largest and a very cost effective CPO producer; but it is also a major consumer and strategically located close to growing export markets. Rising labour costs over the coming years should be offset to some extent by lower logistics costs on the back of improving infrastructure. The downstream sector offers bright investment prospects, though the risk of overcapacities in the region must be taken into consideration. Foreign investors can therefore capitalise on opportunities in CPO refining and processing in joint ventures with local companies.

Global Business Guide Indonesia - 2013

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Indonesia Agriculture Snapshot

Contribution to GDP: 13.70% (2016 including Fisheries & Livestock)
Number Employed in the Sector: 46 million (2016)
Main Products: Palm Oil, Palm Kernel, Rubber, Cocoa, Coffee, Tea, Tobacco, Rice, Sugarcane, Maize, Cassava, Tropical Fruits, Spices, Poultry, Fisheries.
Main Export Markets: China, USA, Japan, India, Singapore, Malaysia, Pakistan, South Korea, Italy, Netherlands, Bangladesh, Egypt.
Relevant Law: Presidential Regulation No. 39 of 2014 on the Negative Investment List imposes varying degrees of foreign ownership limitations in plantations depending on the crop type, and Government Regulation No. 98 of 2013 limits private plantations to 100,000 hectares.