Carbon tax: A catalyst for Malaysia's carbon market?

As Malaysia confronts the dual challenges of economic development and environmental sustainability, managing carbon emissions has become a crucial component of its strategy for long-term growth. 

In recent years, Malaysia has seen a rise in emissions due to increased industrialisation, urbanisation and population growth. However, the government has acknowledged the need to address these challenges and has committed to reducing its emissions intensity by 45% by 2030, relative to its 2005 levels, as part of its Nationally Determined Contributions (NDCs) under the Paris Agreement. 

The Voluntary Carbon Market initiative was introduced during Malaysia's 2022 Budget in response to the need for a well-designed carbon market to catalyse and encourage carbon reduction projects. The subsequent launch of the Bursa Malaysia Carbon Exchange and the nation's first carbon credit auction in March 2023 responded to a need for a transparent mechanism for pricing and trading carbon credits in Malaysia. 

In the recent Budget 2025, the government announced plans to implement a carbon tax aimed at the iron, steel and energy industry by 2026. This creates opportunities for Malaysia to put a price on carbon and incentivise carbon reductions, as the European Union (EU) prepares to commence the Carbon Border Adjustment Mechanism (CBAM) that may affect our export competitiveness. The carbon tax may be extended to other key sectors in the future, especially those already covered by EU’s CBAM (for instance, cement, aluminium, fertiliser, electricity, and hydrogen sectors) and those by other jurisdictions. 

It's worth examining the viability of these measures in the long run, in consideration of other recent proposals aimed at supporting the transition to emissions reductions such as tax exemptions for carbon capture, utilisation and storage (CCUS) activities and a RM300 million allocation for the National Energy Transition Facilitation Fund. 

Can Malaysia's carbon tax approach effectively drive and integrate the domestic carbon markets to support the country’s ambition to reduce emissions?

Malaysia, one of the world's 17 megadiverse countries, faces a critical challenge in balancing nature and biodiversity conservation with economic interests, particularly due to its significant reliance on oil palm and forestry which can be drivers for deforestation. With 55.3% of its land area covered by forests — valuable for carbon sequestration — the country has significant potential to generate carbon credits. 

Currently, there is no lack of experience among Malaysian organisations in managing projects. To successfully develop, certify and implement land-based carbon credit projects, clarity on state and federal policies on land and carbon is needed, in addition to sufficient engagement with indigenous and local communities.  

There is an opportunity to integrate Nature-based Solutions (NbS) as part of the consideration for a thriving carbon market. Bursa Malaysia’s Carbon Exchange auctioned the first NbS credits plus contracts (MNC+) in July 2024. The MNC+ contracts were cleared at RM50 per contract, and in addition to delivering on emissions reductions, they also generate tangible co-benefits for community development and biodiversity. The carbon credits were generated from the Kuamut Rainforest Conservation Project in Sabah which is certified as Gold Level for Climate status under the Climate, Community and Biodiversity (CCB) Standards. The Kuamut project is currently the only project in Malaysia certified under the CCB standards for Verra.

The success of the Kuamut project demonstrates that Malaysian forests can successfully yield high integrity or high quality carbon credits, through verified interventions that provide additional benefits than just carbon sequestration. The co-benefits are a result of interventions in relation to forest quality, biodiversity and the community. Because of these additionalities, certified NbS projects can potentially yield carbon credits with foreseeably higher quality and value. 

Comparatively, there are 14 such projects listed in Indonesia and four in the Philippines, countries that are also classified as megadiverse. Besides having the right capabilities and awareness on integrating a nature-positive approach into ESG strategy, issues on adoption of NbS opportunities in Malaysia relate primarily to land ownership and governance, often around complex jurisdictional issues, decentralised forest management and inconsistent regulations, as well as high costs of land acquisition, operation and maintenance. Despite these challenges, there can be opportunities that focus more on the added value of co-benefits such as increasing biodiversity and species conservation that can be considered from government initiatives, including state green growth plans. 

There is significant untapped potential in NbS, with the United Nations Environment Programme estimating removal potential of 10 to 12 gigatons of CO2 equivalent (CO2e) per year, or a third of global emissions, through NbS. Malaysia can leverage technology based solutions that are significantly consequential in unlocking the potential of carbon finance through generation of carbon credits. For instance, in waste management, initiatives that capture methane (e.g. landfill gas to energy), or avoid methane generation (e.g. composting) are eligible to generate credits while solving the dual purpose of mitigating emissions and waste treatment. Additionally, technological innovations in carbon capture and storage (CCS) allow for direct capture and removal of CO2 from industrial processes, providing another avenue for credit generation. Some of the other potential sectors include agriculture, transportation and distributed technologies. Malaysia thus has a high potential to generate credits and will need support from finance providers for adoption of technologies for energy transition

In some jurisdictions, regulated entities are allowed to utilise carbon credits to fulfill part of their compliance obligations. This is to enhance flexibility, reduce compliance costs, and transfer revenue from high emission sectors to carbon mitigation activities.

According to the World Bank's '2024 State and trends of carbon pricing' report, currently around 40% of existing carbon pricing mechanisms allow the use of carbon credits to offset liabilities, often with certain restrictions. For instance, nearly all jurisdictions restrict the use of carbon credits to those generated domestically. 

Carbon taxes that permit the use of domestic carbon credits for offsetting tax liabilities are found in Chile, Colombia, and South Africa. In terms of emissions trading systems (ETS), economies such as California, Mexico, and the Republic of Korea allow limited use of carbon credits from designated crediting mechanisms. 

Regionally, Vietnam, Thailand, and Singapore are increasingly aiming for synergy between their carbon pricing policies and carbon markets by incorporating carbon credit frameworks into their strategies. Indonesia’s intensity-based ETS for the power sub-sector and Korea's ETS allow the use of domestic and international carbon credits.

Integrating the approaches can create a more comprehensive policy framework, encouraging innovation across the board and aligning economic incentives with environmental goals more effectively than a credit only approach. While carbon credits can play a role in achieving emissions targets, carbon tax can ensure all sectors contribute to emissions reductions, fostering accountability and providing clear economic signals to businesses and consumers to reduce emissions through adoption of cleaner technologies. 

Setting a carbon tax at an appropriate level and ensuring well-regulated use of voluntary carbon credits is critical. An appropriately priced carbon tax provides a clear financial incentive for businesses to reduce their carbon emissions, driving innovation and investment in cleaner technologies while supporting economic growth.

If the tax is too low, it may fail to alter behavior or achieve meaningful emissions reductions. Conversely, a tax set too high can burden industries and consumers, potentially leading to economic instability. 

Similarly, if there is a high price differential between the carbon tax and allowable carbon credits, companies may opt to purchase credits rather than pay carbon tax, potentially undermining the intended impact of the tax. Policymakers can mitigate this risk by limiting the proportion of carbon credits that can be accepted.

1. Strengthening policy and regulatory frameworks: Developing and implementing clear and consistent policies and regulations are critical for the integration and success of carbon markets under the carbon taxing mechanism.

Defining clear objectives for the use of carbon credits is crucial. This includes being clear about how carbon credits support a company's transition plans, creating standardised criteria for valid carbon credits, establishing limits to carbon credit use, and engaging in robust monitoring. There needs to be consideration over how carbon credits are disclosed under the recently announced National Sustainability Reporting Framework, accompanied by policies to prevent double accounting. These will be critical to guide effective crediting mechanisms, ensure market integrity, enable regular assessment of progress and compliance enforcement, and maintain the effectiveness of carbon crediting systems.

Equally important in ensuring market integrity is the development of a robust regulatory framework that governs the operation of carbon markets. This includes rules for carbon credits, financial protection for market participants, taking into account a clear definition of the role of capital markets, verification processes, and penalties for non-compliance.

The designed policies should be adaptive, with the ability to respond to changing conditions, ensuring the effectiveness of carbon pricing mechanisms.

2. Making decisions on the use of domestic vs regional vs international carbon markets: Making the right assessment on the coverage and scope of the carbon market is critical to shape the framework for achieving national climate objectives. Domestic markets can enhance regulatory consistency and facilitate targeted investments in local emerging and green technologies, supporting job creation while ensuring that emissions reductions are directly aligned with national priorities. This can provide policymakers with greater oversight on environmental stability and integrity, allowing for responsive adjustment to local economic conditions. 

Integrating ASEAN regional carbon markets by way of embedding carbon pricing within a wider policy structure will involve establishing harmonising regulations and shared trading platforms, enhancing capacity building and fostering cooperation on emissions reduction projects. On the other hand, linking regional markets by enabling the buying and selling of credits with one another can create a larger, more efficient system due to increased market liquidity and reduction in cost. 

3. Strengthening institutional capacity: Grants or incentives to help cover the costs of training/  upskilling around carbon market mechanisms as well as verification will be essential to strengthen institutional capacity. This is part of broader efforts to ensure integration with the impending carbon tax while accounting for its expansion in the long run

Integrating carbon markets and carbon taxes presents a unique opportunity for Malaysia in pursuing a just energy transition. By learning from successful case studies and external forums, policymakers can design effective carbon pricing mechanisms that not only reduce emissions but also stimulate inclusive economic growth. To be effective, it is essential to ensure a well-regulated carbon market, with carbon tax set at an appropriate level, while ensuring that both systems are integrated smoothly to maximise their benefits.

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