(Japanese original published on 13 May 2025)
Japan’s National Diet is currently discussing a bill to amend the Act on the Promotion of Smooth Transition to a Decarbonized, Growth-Oriented Economic Structure (GX Promotion Act). The focus of the proposed amendment is the GX-ETS, an emission trading system that took effect on a voluntary basis in FY2023. Japan Climate Initiative (JCI) and other parties have suggested making it mandatory to participate in the GX-ETS and reduce emissions in order to increase the effectiveness of the system. The proposed amendment addresses these concerns and includes certain institutional improvements.
The introduction of an emission trading system (ETS) has now been studied in Japan for a quarter of a century, ever since the Ministry of the Environment set up the “Study Group on Designing an Emissions Trading System” in 2000. Meanwhile in other countries, the EU Emissions Trading System (EU ETS) was adopted in 2005 as the first such system in the world. And as of January 2025, a total of 38 ETS systems were in operation worldwide, in North American states, China, South Korea, and other countries and regions (in addition to Europe). In Japan, the “Tokyo Cap-and-Trade Program” created by the Tokyo Metropolitan Government (TMG) with the amendment of an ordinance in 2008, has been operating for 15 years since taking effect in April 2010.
The present author was in charge of introducing the TMG’s program and has since participated in several national study groups on a national ETS. Based on these experiences and lessons from Europe, where an ETS has been in effect for a long time, I would like to put forward three proposals for ensuring that the proposed GX-ETS genuinely contributes to emission reductions and the goal of decarbonization.
|
Ideally, these proposals should be incorporated into amendments to the bill. However, many details of the GX-ETS system are expected to be determined through implementation guidelines that will be developed in the future. I hope that these proposals, including the European examples outlined below, will serve as a valuable reference for strengthening the system’s effectiveness moving forward. (See also the Info Pack “Overview of Carbon Pricing and Issues with the Bill to Amend the GX Promotion Act.” *in Japanese)
Proposal 1. Set upper limit (cap) on the total emission allowances of participating companies that are consistent with the reduction target (the Nationally Determined Contribution: NDC) for the whole country
Under the emission trading system (hereinafter referred to as ETS), a maximum limit on emissions, referred to as emission allowances, is established annually (or over multiple years) for companies or facilities subject to the system. As will be discussed in the following section, the process of setting these emission allowances is crucial. For the ETS to function effectively as a mechanism for reducing emissions, it is essential to set a astrict cap on the total volume of emission allowances across all participating companies. This cap should then be progressively tightened to align with the overall national (or regional) emissions reduction targets.
As the cap is gradually tightened or reduced, the emission allowances allocated to individual companies will decrease. Consequently, as each company limits its emissions to within the allowed amount, the overall reduction target of the system can be reliably achieved. This is the fundamental principle of an ETS. In this regard, the term “Emissions Trading System” does not fully convey the purpose of the system. In the U.S. and other countries, the system is more commonly referred to as a “cap and trade system,” a term that more clearly expresses it’s objective.
The EU ETS, introduced in Europe in 2005, was not sufficiently effective in achieving emission reductions until the cap was tightened in Phase 3 (2013 to 2020) and Phase 4 (from 2021 onward). The main reason for this was that excessively generous emission allowances in Phases 1 and 2 failed to create strong incentives for reducing emissions. As Fig. 1 shows, in Phases 1 and 2, the total volume of emission allowances, including international credits treated as allowances, exceeded the amount of emissions generated, as indicated by the orange line.
Fig. 1 Emission allowance supply and demand trend for stationary installations subject to EU-ETS (2005–2022)
The amendment bill currently submitted to the Diet include provisions on the allocation of emission allowances to companies, but it does not establish how the total amount will be determined, nor does it introduce a cap.
While the amendment bill should ideally be revised, the next best option would be to explicitly stipulate in the implementation guidelines (Article 32 of the amendment bill), which are intended to define the “essential requirements concerning the allocation of emission allowances”, that cap should be set and gradually strengthened in line with NDC reduction targets. Incidentally, in the case of the Tokyo ETS, the cap is not defined in the main body of the ordinance authorizing the introduction of the system (“Ordinance on Environmental Preservation to Secure the Health and Safety of Citizens of the Tokyo Metropolitan Area”), but rather in the “Tokyo Metropolitan Global Warming Countermeasures Guidelines” established under the ordinance. The cap has been gradually strengthened with each five-year reduction planning period.
Proposal 2. The current bill limits the allocation of emission allowances to power generators. Allocation of emission allowances to all companies participating in the system will be gradually transitioned to auctioning in phases. Additionally, the timeline for this transition should be moved forward from the current target of 2033
The allocation of emission allowances to companies subject to an ETS can be done in three ways: (1) grandfathering, where allowances are allocated based on the actual emissions of the company; (2) benchmarking, where allowances are determined based on the standard emissions intensity of the industry in which the company operates; and (3) auctioning, where companies purchase the allowances they need through a market-based mechanism. In both (1) and (2), allowances are typically provided free of charge, whereas in (3) companies must pay for them. This marks a fundamental distinction between the approaches.
Auctioning (3) is considered the most just method, as it ensures that the burden imposed on companies that generate emissions is proportional to their environmental impact, measured in terms of CO2 emissions. However, it is difficult to get approval for a system that suddenly imposes charges on something that was previously free of charge. As a result, many ETS systems have initially adopted free allocations and transitioned to paid allocations gradually. It is therefore understandable that when the revised GX-ETS, set to take effect in FY2026, will begin with free allocation, even under a benchmarking approach.
The issue lies in the fact that the amendment bill explicitly states (in Article 34) that emission allowances to companies other than specified business operators will be allocated free of charge. Furthermore, the bill (Article 2) defines “specified business operators” as power producers (as defined by the Electricity Business Act) that generate large volumes of emissions. As a result, the amendment bill effectively limits paid allocation (auctioning) to major power generators, even in the long term.
Under the EU ETS, beginning with Phase 3 in 2013, all emission allowances for the power generation sector were allocated through auctioning. In Phase 4, which began in 2021, auctioning was gradually extended to the shipping and industrial sectors as well. As of 2023, approximately 50% of all emission allowances were auctioned. According to the European Commission, up to 57% of general allowances are expected to be auctioned during Phase 4.
In its 2020 report “Implementing Effective Emissions Trading Systems,” the International Energy Agency (IEA) asserted that emission allowances should be “phased down” from free to paid allocation, citing the following three reasons.
(1) Paid allocation can help correct potential market distributional distortions.
(2) Paid allocation can generate and reuse revenues from auctioning.
(3) Free allocation can lower the emissions reduction effectiveness of emissions trading systems.
In relation to reason (2), the EU ETS generated €43.6 billion in revenue from auctions in 2023. (This is approximately ¥7 trillion at €1 = ¥160.) Within the EU, these auction revenues are used to support investments needed to decarbonize the steel sector, for example. Regardomg reason (3), the difference in effectiveness can be seen through real-world examples. As Fig. 2 shows, emission reductions in the EU have been significantly greater in the power generation sector, the first to adopt auctioning, than in other sectors (“combustion” in the original Figure).
Fig. 2 Emission reduction trends under the EU ETS
Even in traditionally hard-to-abate- sectors such as the steel industry and other heavy and chemical industries, technological advancements are paving the way toward decarbonization. There is no good reason to restrict paid allocation of emission allowances solely to the power generation sector. Allowances in the steel industry and other sectors should be gradually transitioned to auctioning, with the resulting revenue used to support decarbonization efforts within those industries.
Under current government plans, emissions auctions in the power generation sector are scheduled to begin in fiscal year 2033 or later. However, in light of the urgent need to achieve significant emission reductions by 2030 and 2035, this timeline should not be delayed until 2033, it should be brought forward.
Proposal 3. The upper limit of the carbon price should be set at a level that ensures its effectiveness in driving emissions reductions
The amendment bill stipulates the setting of a ceiling price , referred to as the “reference ceiling transaction price,” to prevent emission allowance prices from rising excessively (Article 39). Similar upper and lower carbon price limits have been adopted in other countries, drawing on lessons learned from the operation of existing ETS systems.
A bigger concern with the GX-ETS is whether the carbon price will be sufficiently high to drive meaningful emissions reductions. In the EU ETS, for example, the emissions cap in Phases 1 and 2 was overly generous (i.e., too high), resulting in a weak carbon price and limited impact on emissions. During the early part of Phase 3, the price remained around €4–8, offering little incentive for change. It was not until 2018 that the price began to climb, contributing to more effective emissions reductions. In 2022–2023, the price rose to around €80, partly due to large-scale shutdowns caused by nuclear power plant outages in France. By 2024, the price had declined to the €50–60 range.
One reason to be concerned about whether the GX-ETS will result in a sufficiently high carbon price is, as mentioned above, that the current legislation does not explicitly set a cap. Another reason is that the GX-ETS is not directly designed with the aim of reducing emissions.
In the case of the EU-ETS, the purpose of the system is clearly stated as “for the reductions of greenhouse gas emissions to be increased so as to contribute to the levels of reductions that are considered scientifically necessary to avoid dangerous climate change.” (Article 1 of the EU ETS Directive). The carbon price is likewise intended to be set at a level sufficient to meet the reduction targets that are consistent with the goal of the system.
However, in contrast to the goal of other countries’ ETS systems, which is to reduce emissions, the Japanese government explains that the GX-ETS is intended “to promote a smooth transition to a decarbonized growth-oriented economic structure.” It is unclear from the government’s explanation what kind of carbon price the government will aim at. What is clear is that the revenue from auctions for power producers, along with fossil fuel levies that will be introduced separately, will be a source of funds to cover the ¥20 trillion worth of GX Economic Transition Bonds. A carbon price that is set only to finance ¥20 trillion in bonds will not be high enough to achieve effective emission reductions.
To achieve a carbon price that is effective in reducing emissions, the cap should be set (as explained above). At the same time, however, reference should be made to carbon price levels identified by the Intergovernmental Panel on Climate Change (IPCC) as necessary for achieving the 1.5°C target when determining the cap.
Making the GX-ETS a functioning system with the cooperation of pioneering companies and municipalities
While Japan’s efforts to introduce an ETS have lagged far behind those of the rest of the world, companies and local governments on the frontlines of the decarbonization battle have not been waiting idly for the government to act on carbon pricing. Many companies have been adopting internal carbon pricing. In fact, 63% of CDP respondents (mostly companies listed on the TSE Prime Market) have already introduced internal carbon pricing, or plan to do so within two years. As for local governments, the Tokyo Metropolitan Government introduced the cap-and-trade system (the Tokyo Cap-and-Trade Program) in 2008 through the amendment of an ordinance (as described above). Neighboring Saitama Prefecture has also adopted a similar system.
To ensure that the GX-ETS genuinely contributes to decarbonization, the government should learn from the pioneering efforts of these companies and local governments, making sure that the results of their efforts can be usefully incorporated into the operation of the GX-ETS. Under no circumstances should the efforts of companies and local governments that have taken the initiative to pursue emission reduction measures independently be undermined.
If an ETS is well designed , effectively implemented, and continually improved, it can serve as a powerful tool for decarbonization. However, if poorly managed, there is a risk that the system will fail to deliver meaningful emission reductions and instead burden participating companies with excessive administrative tasks.
I sincerely hope that with the cooperation of companies and local governments, the national government will be able to develop the GX-ETS into a truly effective system for achieving decarbonization.
