Introduction

Japan’s national ETS, called GX ETS, is part of a wider “package” of climate and energy policies to achieve its goal of net zero emissions by 2050 outlined in the country’s ten-year decarbonization strategy called the “Basic Policy for the Realisation of Green Transformation” (GX). Other elements of this package include a carbon tax and a carbon levy (known as the GX-Surcharge) on fossil fuels to be introduced from 2028.

The national ETS, or the GX ETS, is a cap-and-trade program with absolute targets intended to decline over time. As such it resembles the EU ETS, the two North American regional ETS (WCI and RGGI) and South Korea’s ETS more than intensity-based programs like that of China or the emerging carbon markets of Vietnam and Indonesia.

Even though it will be a “new” compliance carbon market, Japan’s ETS comes as no surprise. That the now two-year-old voluntary ETS known as the “GX League” would be made mandatory was part of an amendment to the aforementioned law on Realisation of Green Transformation submitted to Japan’s legislature (the National Diet) back in 2020. The amended version of the law has been making its way through various instances of the Diet, with approval by Japan’s cabinet in late February. It passed the lower chamber of the Diet (the house of representatives) on 15 May and the upper chamber (the house of councillors) on 28 May.

The latter act enshrined into law a planned shift in status of the GX League, under which over 700 participating entities have since March 2023 been aiming to keep their collective emissions below certain baselines, to a mandatory programme for the 300-400 entities in the country’s power and industry sectors that emit 100 thousand tonnes or more of CO2 equivalent per year. The current voluntary phase will continue through March 2026, with the mandatory phase starting in FY2026 (Japan’s 2026 financial year starts from April next year).

Market mechanisms in Japan

Under the Kyoto Protocol, Japan made use of the so-called flexible mechanisms to reach its climate targets – it bought Certified Emission Reductions (CERs) and other tradable units to stay below the emissions limitations of the protocol’s first commitment period 2008-2012. Starting in 2013, Japan developed its own version of the CDM under which credits are generated by greenhouse gas abatement projects it sponsors in other countries through bilateral technology transfer deals. The emission reductions Japan unilaterally finds to have occurred through this Joint Crediting Mechanism (JCM) are counted toward the country’s nationally determined contribution (NDC) under the Paris Agreement.

In addition to global credit trading, two linked local emission trading systems have been operating  for over a decade: the Tokyo and Saitama prefecture carbon markets cover emission from buildings and industry in those metropolitan areas. Allowances change hands among participating entities, whose emissions must remain below a historic baseline adjusted by a compliance factor.

GX ETS details

With a binding compliance obligation still nearly a year away, entities that emit over 100 thousand tonnes CO2 per year (see Table 1) will have some time to prepare. Available explanations of how allocation and compliance will work indicate that entities will be held to a predetermined emission trajectory in line with the program’s overall cap (which has not been set yet). These entities must buy credits to the extent their emissions exceed that trajectory in a given year. If emissions come in under the allocated amount, they have surplus to sell.

To what degree covered entities will be allowed to use offsets – or “credits” – to account for their shortfall if they exceed their annual permit quota remains to be seen. Most ETS limit how much covered entities can use offsets to meet their compliance obligations, such as only up to five percent in China’s program and four percent in the WCI (rising to six percent next year). Given Japan’s interest in project-based credits from its JCM program, we expect offsets to play a significant role in the emerging national ETS. A survey conducted by climate consultancy Exroad in May, supported by Tokyo Stock Exchange, indicated that Japanese firms are eager to trade JCM credits as well as their domestic counterparts “J-Credits” on exchanges. Respondents were participants in voluntary corporate climate change initiatives, however – not necessarily entities who will be covered by the mandatory programme.

Table 1: Japan’s GX ETS design elements

Source: Veyt

Unknown details

What the allowance units in the ETS will be called remains unclear, as does the annual allowance budget or cap. The cabinet decision in late Februarylarifies that allowances will be pre-allocated to covered entities annually, with those entities reporting their actual emissions in the following year. The emitters must hold an amount of allowances equal to those actual emissions, meaning that they need to guarantee sufficient allowances to fulfil compliance obligations. The legislation does not specify an annual allowance budget or cap the amounts pre-allocated to individual entities will presumably be derived.

Another uncertainty is the timeline for auctioning: draft legislation had mentioned that full auctioning was planned as of 2033 for the power sector, no recent official statements confirm this. The government plans to use revenue from auctions to partially repay Japan’s Climate Transition Bonds, which fund investments in low-carbon technologies. The government began issuing such bonds in early 2024 – it aims to reach around 150 trillion yen in the next decade to cover the cost of realising Japan’s decarbonisation targets.