International Efforts on Climate Change and Carbon Pricing in Japan

Abstract

This chapter provides an overview of international initiatives on climate change, including the Kyoto Protocol and the Paris Agreement, with an emphasis on the Japanese perspective. The Clean Development Mechanism (CDM) and how it led to the emergence of the Joint Crediting Mechanisms (JCM) will also be explained. Then the chapter considers the role of carbon pricing in reducing carbon emissions, explicating carbon taxes in Japan and regional emissions trading schemes in Tokyo and Saitama. After addressing design issues of carbon pricing, the chapter concludes with a discussion of Japan’s carbon pricing schemes and Green Transformation (GX) policies.

1 International Cooperation on Climate Change

Climate change is the greatest, most severe environmental problem confronting humankind. Of all environmental problems, climate change is the one that will affect the largest number of people and hence a challenge that must be overcome by coordinated efforts across regions and countries. The United Nations have been addressing the problem since the 1980s by setting up the Intergovernmental Panel on Climate Change (IPCC). The IPCC has released various reports on scientific findings and policy observations to lead global efforts. In its most recent report of AR 6, the IPCC urged the world to respond to the problem, concluding that “(i)t is unequivocal that human activities have heated our climate” (IPCC 2021). The section provides an overview of international initiatives on this global crisis.

1.1 International Climate Agreements: The Kyoto Protocol and the Paris Agreement

The Kyoto Protocol was the world’s first international agreement to reduce GHG emissions. In 1997, the Third Conference of the Parties (COP3) to the United Nations Convention on Climate Change was held in Kyoto and attended by 9,700 participants consisting of government delegates, NGOs, and press from across the world. The Protocol was adopted at this conference, setting binding targets of reducing emissions for developed countries by an average of 5.2% from 1990 levels over the 2008–2012 period. The targets have been set for each signatory nation (e.g., 6% for Japan, 7% for the U.S., and 8% for the EU) regarding the emissions of carbon dioxide, methane, dinitrogen monoxide, hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and hydrogen hexafluoride (SF6).

It can be quite challenging to have all signatories meet their targets in a growing economy and thus, the Protocol has offered flexible and cost-effective means of achieving the targets through three market-based mechanisms, namely, joint implementation, emissions trading, and clean development mechanism (CDM). In particular, national emissions trading and the CDM attracted attention for their innovative designs. The CDM allows developed countries to assist developing ones financially and technologically by implementing projects in developing countries to reduce or absorb emissions. Investing countries in return are credited with emission reduction units for offsetting their emissions.

As suggested in the name of the mechanism, CDM projects must promote sustainable development in developing countries. Projects use funding from multi-financial sources, including private sectors, instead of diverting official development assistance (ODA). Emissions trading is also a reasonable market-based instrument to reduce emissions as it allows countries to cut costs associated with adopting global warming countermeasures through allowance trading (see Chap. 3 for details on emissions trading).

In the first commitment period (2008–2012) of the Protocol, Japan pledged to reduce emissions by 6% from 1990 levels. Emissions in that period increased by an average of 1.4% from the 1990 levels. The nation achieved a 3.9% reduction by using carbon sinks including forest absorption and yet it was not enough to meet the target. Hence, emissions trading was introduced for further reductions. The government obtained 94.79 million tons worth of credits, contributing to a 1.5% reduction, and private sectors obtained 274 million tons worth of credits, contributing to a 4.3% reduction, resulting in a total annual reduction of 8.4% from 1990 levels. Thanks to all the above, the target was achieved successfully.

While the Kyoto Protocol made a significant contribution by offering the international community the first opportunity to address climate change at the global level, it faced some challenges that mainly stemmed from its “common but differentiated responsibilities (CBDR)” principle, which means: although all countries are GHG emitters and responsible for climate change, it is developed countries that have mainly caused the problem and they should take the initiative to reduce emissions. The principle was questioned by many parts of the world, including the U.S. who decided to withdraw from the Protocol in 2001. Even Japan, the country where the Protocol was adopted, decided not to participate in the second commitment period (2013–2020). Another problem was the Protocol’s top-down approach where reduction targets were set and assigned to developed countries. The set targets met with dissatisfaction from several signatories for not being fair enough, which in turn affected subsequent international negotiations. Furthermore, it is worth noting that China and India did not have emission reduction targets under the protocol. As a result, China has become the largest emitter of greenhouse gases since the beginning of the first commitment period.

In 2015, COP21 was held in Paris where delegates from 196 regions and countries attended. There the Paris Agreement was adopted as a new international framework for GHG emissions reduction beyond 2020. One of the characteristics of the Agreement is that it set out a goal to limit global warming to below 2 °C compared to pre-industrial levels to avoid rapid climate change. The goal was established based on scientific input provided in the IPCC Fifth Assessment Report (IPCC 2014). IPCC released a special report (IPCC 2018) subsequently on the impacts of global warming of 1.5 °C above pre-industrial levels, which fortified the international community’s effort to work toward limiting global warming to 1.5 °C.

Unlike the Kyoto Protocol that established targets for developed countries only, the Paris Agreement requires that both developed and developing countries make reduction efforts. This is because climate change action will fall short without efforts of growing economies, including China whose emissions are the largest and rapidly increasing (Fig. 9.1); if targets were imposed as in the Kyoto Protocol, it would be difficult, particularly, for developing nations to take part in the international initiatives. Hence it is obligated under the Agreement that all countries provide their climate change action plan in the Intended Nationally Determined Contributions (INDCs), which are to be reviewed by other country Parties and technical experts.

Fig. 9.1

Source EDMC Energy Statistics 2023

CO₂ emissions by countries in 2020.

Japan submitted its INDC in 2015, committing to reduce emissions by 26% from 2013 levels by 2030. Based on the input provided in the 1.5 °C special report and the Sixth Assessment Report, the nation updated the target in COP26 in Glasgow in 2021 and committed to reduce emissions by 46% from 2013 levels by 2030. When COP26 Glasgow concluded, the international community agreed to limit the rise in the global average temperature to 1.5 °C. The agreement made a big impact, having nations worldwide strive further to achieve the targets of their own by prioritizing the reduction of emissions from burning fossil fuels.

1.2 The Clean Development Mechanism

A key achievement of the CDM under the Kyoto Protocol was emissions reduction through the international coordination where developed countries invest in climate change mitigation projects in developing countries. For example, Japanese firms mainly in the steel and electric power industries invested heavily in China and India, which yielded a reduction of more than 200 million tons of CO₂ in the power industry. Various CDM projects have been implemented across regions and countries. In 2011, it was estimated that 12,507 CDM projects had been registered and a total amount of emissions reduction achieved through them by 2030 would be 22.8 billion t-CO₂.¹

At the same time, the CDM has been criticized for drawbacks, including its lengthy and laborious process for a project to be reviewed, registered, and issued with reduction credits. Once submitted, projects must undergo rigorous screening, certification, monitoring, and additional testing. All these steps contribute to long turnaround times and high workload, which might have increased transaction costs of project participants (such as firms investing in projects) and caused a decrease in the number of participating firms (Arimura et al. 2012).

Another shortcoming was the limited number of project types. Nearly half of the projects registered with the CDM Executive Board comprise wind power (25%) and hydropower (24%). In contrast, energy efficiency, which is Japan’s forte, was difficult to register, as indicated by the fact that it accounts only for 5% of the registered projects. Regional distribution was another issue of concern. Figure 9.2 shows the percentage of CDM host countries that were calculated based on the number of projects as of 2021. China hosts 49% and India hosts 21% of all CDM projects, meaning that the two countries host about 70% of the total. It could be argued that CSM projects are overly focused on China and India, despite the fact that these two countries are not the poorest. Meanwhile, CDM projects are not giving enough attention to electrification efforts in Africa.

Fig. 9.2

Source IGES “CDM Database”

Percentage of CDM Host countries.

1.3 The Joint Crediting Mechanism

Stakeholders in Japan, including businesses and government organizations also expressed concerns about the inadequacies of the CDM. The Japanese government dealt with the situation by implementing a program called the Joint Crediting Mechanism (JCM) (Sugino et al., 2017). The program aims to promote emissions reduction in countries that have signed bilateral agreements with Japan primarily by deploying Japan’s technologies. The JCM initiative is going forward, setting out rules and procedures. For example, reduction credits issued for JCM projects are to be shared between the host developing countries and Japan. The domestic trading ruels of JCM credits have also been developed.

The JCM overcomes some of the shortcomings of the CDM. It reduces transaction costs, as projects are not necessary to go through the UN’s validation and verification processes. It also allows a larger number of projects in the energy efficiency sector to be registered and conducted, thereby allowing Japanese firms to utilize their area of expertise. Starting with Mongolia, Japan has signed bilateral agreements with 30 countries as of April 2024.² JCM credits were issued for the first time for two projects hosted by Indonesia in 2016.

As of October 2023, JCM methodologies have been approved and implemented in 52 projects in Indonesia, 51 projects in Thailand, 44 projects in Vietnam, as well as in projects in many other countries including Mongolia, Ethiopia, Kenya, Cambodia, Bangladesh, Maldives, Laos, Palau, and Saudi Arabia.³ Besides the 2030 goal of reducing emissions by 46% from 2013 levels, Japan aims to reduce or absorb 50 to 100 million tons of emissions by 2030 through international contributions including JCM project activities.

1.4 Transitioning to Carbon Neutrality

The IPCC 1.5 °C special report and the Sixth Assessment Report (IPCC 2021) have led the international community to recognize the importance of achieving net zero emissions. “Carbon neutral,” i.e., having the amount of carbon released equal to the amount of carbon absorbed from the atmosphere, has become the New Gold. In December 2019, the European Commission adopted the European Green Deal to make the EU the first carbon–neutral continent in the world by 2050. When Biden assumed the U.S. presidency in 2020, the nation has set a goal to achieve carbon-free electricity by 2035 and net zero emissions economy by no later than 2050. China at the UN General Assembly in 2020 pledged to reach carbon neutrality by 2060. Russia and India also pledged to achieve net-zero carbon emissions by 2060 and 2070, respectively.

In Japan, then-Prime Minister Suga announced that the country will aim to achieve net-zero carbon emissions by 2050, which had a huge impact on Japanese industries. As of 2019, the nation’s emissions from energy sources were 1,028.8 million tons of which 37.4% was from the industrial sector (such as plants and factories), 34.3% from the household and commercial sectors (such as buildings and homes), 20.0% from the transportation sector, and 8.4% from the energy conversion sector (such as electric power suppliers). While the industrial sector has the largest share, their emissions decreased by 24% from 1990 through 2019, partly as a result of their voluntary efforts on energy efficiency. While the decline in the transportation sector was only 1.2%, the improvement is noteworthy given that the household and commercial sectors increased their emissions by 35.8%.

The results point to the importance of adopting mitigation measures in the household and commercial sectors, which directly affect people’s daily lives. As Japan aims to reduce emissions by 46% from its 2013 levels by 2030 along with its pledge for carbon neutrality by 2050, the nation is setting out strategic plans, with carbon pricing as a key instrument for fulfilling the target. The Japanese government advocated the importance of carbon pricing as drivers of economic growth, considering the initiative as opportunities to create new demand and markets. Along this line, the government promotes “Green Transformation (GX),” a transition to a carbon neutral economy by way of utilizing the innovation required to achieve zero emissions (For further discussion on GX, see Sect. 9.6).

2 The Mechanism of Carbon Pricing

Carbon pricing is gaining increasing attention as a means of achieving carbon neutrality. This section provides a brief review of the mechanism of carbon pricing—how carbon gets priced, how the market instrument promotes emissions reduction, and what impact the instrument may have on our economy both in the short and mid- to long-terms.

GHG emissions are produced by various sources (e.g., industries, transportation, and our daily activities) and as such, regulatory measures are presumably not efficient in reducing emissions. On the other hand, market-based instruments can encourage emissions reduction efficiently with minimal cost (see Chap. 3 for further details). Carbon pricing is one such instrument whereby prices are placed on carbon dioxide to curb emissions and mitigate global warming.

Although the mechanism of carbon pricing builds on the Pigouvian tax principle, the instrument does not necessarily serve as a Pigouvian tax. In the Pigouvian framework, the optimal level of carbon emissions is determined, based on which a tax is imposed equivalent to the marginal external costs. The Social Cost of Carbon (i.e., the cost of the damages caused by one additional ton of CO₂ emissions) has been used to quantify the marginal external costs of carbon.⁴ However, it is difficult, if not impossible, to obtain accurate estimates and hence, some part of the external costs may already be internalized.

While carbon pricing puts prices on carbon that is produced as a byproduct of fossil fuel combustion, the pricing is often based on carbon content of the fuels. Pricing carbon thus causes an increase in fossil fuel prices. The extent of price increase varies by fuel type because carbon content varies by fuel type. Amounts of CO₂ per unit of energy released by coal, kerosene (oil), and gas are shown in Fig. 9.3. We can see that gas releases the lowest level of emissions followed by oil and then coal.

Fig. 9.3

Source US EIA (2023)Footnote

https://www.eia.gov/environment/emissions/co2_vol_mass.php (last access date: 12/ 27/2023).

CO₂ emissions per unit of energy produced from fossil fuels (gC/per mmBtu).

2.1 Short- and Longer-Term Effects of Carbon Pricing

What are the effects of fuel cost increases resulting from carbon pricing? One of the short-term effects is: increased fuel prices will result in higher energy prices, raising electricity and gas bills for individual households, which in turn lead the households to change their behavior to save on energy bills (such as turning off lights more frequently and setting the thermostat higher in summer and lower in winter). Their consumption behavior will also be affected, as exemplified in the widespread adoption of LED lights—a highly energy-efficient lighting alternative—among households in response to the recent rise in electricity bills. Likewise, it is expected that energy-efficient home appliances such as refrigerators and air conditioners will become widely adopted in households. These kinds of behavioral changes will be observed in workplaces and thus will contribute to the emission reduction efforts in the manufacturing or service sector.

Carbon prices will also affect the individual’s choice of transportation. As gasoline prices rise, owners of fuel-inefficient vehicles will likely switch to more fuel-efficient options such as hybrids. More people may switch from conventional fuel vehicles to electric vehicles, as they run gasoline-free and produce zero emissions if the electricity is derived from renewable energy sources. Some may choose public transportation over driving cars. Friends and neighbors commuting in the same direction may start carpooling to get to their workplaces. This energy-saving practice is often adopted in the U.S. as well as Europe when gasoline prices increase.

In addition, bicycles may replace cars and motorbikes for neighborhood transportation, and bikeshare, which grew in popularity during the coronavirus pandemic, may become even more popular. All these changes in consumer lifestyles will result in decreasing emissions because less fossil fuels are to be consumed. Carpooling to and from work, for example, can halve the amount of carbon emissions. Carbon pricing is expected to accelerate emission reduction through reduced fossil fuel consumption.

Let us turn to mid- to long-term effects of pricing carbon as a climate mitigation policy. Because the carbon content of coal (natural gas) is higher (lower), its carbon price tends to be higher (lower). The difference in their carbon prices leads consumers and businesses to change their energy sources from coal to natural gas. A case in point is the U.K. power sector that went through a major shift from coal to natural gas when a Carbon Price Floor has been implemented. Another example is the U.S. shale revolution, which decreased natural gas prices and promoted the switching from coal to natural gas.

Carbon pricing is also expected to promote generating and using energy sources other than fossil fuels. If electricity and gas bills rise, renewable energy sources such as solar photovoltaic (PV) power become more economically attractive and competitive alternatives to the conventional fuels. Currently in Japan, household solar PV power generation is promoted through feed-in tariffs. Subsidies of this kind may not be needed, however, once carbon pricing is properly in place. Besides, the Japanese energy market, which has become competitive since the liberalization of the retail sector in 2016, will become even more so because the carbon pricing scheme will make renewable energy suppliers more competitive.

After the government’s pledge to achieve carbon neutrality, net-zero-energy housing (ZEH) and net-zero energy building (ZEB) have gained attention for their energy conservation and efficiency technologies in Japan. ZEH is a construction with high thermal insulation performance combined with solar power, which enables virtually zero energy use and zero carbon dioxide emissions from housing. Although the construction cost is higher compared to conventional housing, ZEH provides health benefit of reducing temperature differences inside the house in addition to the benefit of reducing electricity consumption. Green building options like these are expected to grow further in popularity upon the implementation of carbon pricing.

Businesses will invest more in energy efficiency to reduce their emissions without reducing production. Investment in energy efficiency did increase significantly among Japanese firms after the oil crisis in 1973. More recently, the Tokyo Cap-and-Trade Program, which we will discuss below, combined with rising electricity costs after the Great East Japan Earthquake, resulted in many investments in energy conservation.

Because carbon pricing will increase demand for low-emission equipment and vehicles, the scheme is expected to stimulate businesses to make energy efficiency transitions and R&D investments. Anticipating the demand increase, the automobile sector already started R&D investment, making significant improvement in fuel efficiency, electric vehicles, and fuel cell vehicles powered by hydrogen.

Although hydrogen is attracting greater interest as a viable fuel source that does not produce any CO₂ emissions, the process to make the fuel is costly, preventing it from becoming more widely adoptable. Once carbon pricing is introduced, however, hydrogen will become a competitive alternative to conventional fuels. Firms will then foresee its widespread use and expand R&D investment in hydrogen technologies. Some may also invest in infrastructure development, particularly, to increase the number of fueling stations. Increased investment will scale up technologies, bring down costs, and promote more widespread adoption of hydrogen-based fuels.

Increased hydrogen use may also help decarbonizing energy-intensive industries and sectors such as the steel industry and coal-fired power plants. As hydrogen becomes a competitive energy source, it may replace coal in steel production and significantly reduce GHG emissions produced by the steel industry, which currently accounts for more than 10% of Japan’s total emissions. Likewise, coal-fired power plants may be able to reduce emissions if they can generate power by co-firing ammonia with coal. If these transformations take place, less fuel-intensive industries will thrive, fostering technologies and skills for a green and digital economy. All these changes, by working in tandem with technological development, will serve as an efficient countermeasure against global warming.

Box 9.1 Hydrogen and Ammonia

In recent years, hydrogen has attracted considerable attention as an alternative to fossil fuels. Hydrogen, when burned, produces water but does not emit carbon dioxide, unlike fossil fuels. However, the current mainstream method of producing hydrogen uses fossil fuels, such as methane, as raw materials, leading to CO₂ emissions in the manufacturing process. Two methods are currently under consideration for mitigating CO₂ emissions during hydrogen production. First is to continue using fossil fuels as raw materials while capturing the carbon dioxide generated during production, storing it deep underground, or reusing it to reduce emissions.

The second method involves the production of hydrogen through water electrolysis. In this process, only oxygen is generated in addition to hydrogen, with no CO₂ emissions. However, electrolysis requires electricity, which can be sourced from renewable energy sources, such as solar power, making the entire hydrogen production process carbon–neutral. Therefore, renewable energy, which is difficult to store as electricity, is effectively stored as hydrogen.

Hydrogen produced by the first method is known as “blue hydrogen”, while that produced by the second is termed “green hydrogen”. Hydrogen production that generates CO₂ is called “grey hydrogen.”

However, there are various challenges associated with hydrogen storage and transportation. The predominant storage method is compression at high pressure in metal hydrogen tanks. However, the use of hydrogen can cause metals to become brittle, which requires the use of special metals for the tanks. Additionally, hydrogen needs to be stored at very low temperatures, often below minus hundreds degrees, making the storage facilities costly. Additionally, the energy required to compress hydrogen at high pressures leads to energy loss. Hydrogen also poses safety risks because of its explosive potential when mixed with oxygen.

Ammonia has emerged as a promising energy carrier alternative to hydrogen, providing a solution to the storage and transport challenges associated with hydrogen especially in Japanese Green Transformation Strategy. When combusted using especially in Japanese Green Transformation Strategy. When combusted using modified burners, ammonia can significantly reduce nitrogen oxide emissions, thereby facilitating its use in existing coal power plants. Ammonia is synthesized from hydrogen and is classified as “blue ammonia” when produced from carbon-captured hydrogen, and “green ammonia” when using hydrogen derived from renewable energy sources.

2.2 Carbon Neutrality and Emissions Trading

One may think that carbon pricing will not be needed once we realize net zero emissions. Apparently, however, emissions trading, including carbon pricing, is indispensable even in a carbon neutral world. While Japan aims to achieve carbon neutrality by 2050, all economic agents in the nation do not necessarily achieve the goal by then. One can imagine that what we call “hard-to-abate industries” such as steel, cement, and petrochemicals may struggle to achievenet-zero emissions. The government takes this possibility into account in its strategic climate action plan, assuming that industrial technology that use heat may continue to consume fossil fuels to some extent and emit carbon in 2050 and onwards.

Key measures to meet the climate goal are technological solutions, particularly, technological innovation such as carbon capture, utilization and sequestration (CCUS) and direct air capture (DAC). Natural climate solutions including forest absorption of carbon dioxide are also effective means of promoting the transition to net zero. Along with these solutions, emissions trading will play an important role; businesses and entities can realize negative emissions and earn carbon credits through CCUS, DAC, and forest carbon offsets while emitters purchase credits to offset their emissions. Adopting the combination of these technologies and solutions will be the pathway to achieve net zero emissions not only in Japan but in regions across the globe.

3 Carbon Pricing Developments Across the World

Carbon pricing has been adopted in a number of cities, states, regions, and nations. Below we discuss two major carbon pricing schemes: carbon taxes and emissions trading. Carbon taxes were introduced for the first time in North Europe, starting in Finland in 1990 and then in Norway, Switzerland, Ireland, and France. Carbon pricing in various forms has been adopted in the U.S. and Canada. For example, Canada implements the instrument by states and jurisdictions, as exemplified by the British Columbia carbon tax. In recent years, carbon taxes are widely adopted in other parts of the world, including Asian countries like Singapore and Latin American countries such as Mexico and Chile where climate policies are not as ambitious as in developed countries. Japan introduced a carbon tax called the Global Warming Countermeasure Tax in 2012, imposing JPY 289 per ton of carbon dioxide emissions as part of the Petroleum and Coal Tax.

After more than a decade from the launch of the first carbon tax program, an emissions trading scheme (ETS) was introduced for the first time in 2005 in Europe. Considering the success of the U.S. sulfur dioxide cap-and-trade program as part of the Acid Rain Programs, EU launched the European Union Emissions Trading Scheme (EU ETS). After a three-year pilot period, the scheme started to operate fully in 2008, targeting emissions particularly in the power sector and manufacturing industry. The program serves as a model for carbon trading programs around the world.

In the U.S., an emissions trading program across states called the Regional Greenhouse Gas Initiative (RGGI) launched in 2009, covering the electricity generating sector in ten northeastern states. Then in 2013, California’s cap-and-trade program that targets key sectors of the economy was introduced and later linked with the Quebec cap-and-trade scheme. Initiatives are also taken in regions other than Europe and North America. The Mexican ETS pilot program started in 2020 and China, the world’s largest emitter, introduced pilot programs in 2013 in seven cities and regions including Beijing and Shanghai. The Chinese government implemented the national ETS; a national program for the electricity generating sector launched in 2021, which is scheduled to be extended to energy-intensive industries and other sectors. Republic of Korea also introduced an emissions trading system in 2015.

Due in part to the influence of the carbon border adjustment mechanisms (CBAM: see Sect. 9.5.1 for details) proposed by the European Commission, institutional designs for putting prices on carbon are also underway in Thailand, Indonesia, Vietnam, and other ASEAN countries. EU ETS used to cover the largest volume of emissions in the world. In terms of emissions covered by a single country, Republic of Korea became the largest at once and currently, the Chinese ETS for the power generating sector has become the largest in the world.

4 Carbon Pricing in Japan

4.1 The Global Warming Countermeasure Tax

The Japanese carbon tax called the Global Warming Countermeasure Tax was introduced in 2012 and its rate is JPY 289/tCO₂ as of 2021, which corresponds to only JPY 0.76 per kilo liter of gasoline. The tax alone is not enough to induce reductions sufficiently. Thus, the government adopts a policy mix whereby the carbon tax is imposed in combination with subsidies; the tax revenues that amount to JPY 234 billion in the FY2021 budget are used to subsidize renewable energy and energy-efficient technologies. Although the tax may be considered as a burden on firms and consumers, it means an increase in the government revenue, which, if used effectively, can benefit the economy while promoting emissions reductions. It should be noted, however, that the current tax rate is too low to achieve net zero emissions by 2050. European countries have a higher level of carbon tax. For example, in 2023, the carbon tax in France is US$48.5 and it is $125.56 per in Sweden.⁶

4.2 Sub-national Emissions Trading Schemes

While the decision to implement a national ETS was postponed in Japan in 2010, emissions trading programs at the sub-national level were launched first in Tokyo and then in Saitama (Arimura and Matsumoto, 2020). Tokyo ETS, introduced by the Tokyo Metropolitan Government, was the first cap-and-trade program of CO₂ emissions in Asia. It differs from the preceding programs (such as EU ETS and RGGI) in that it is tailored to reduce urban emissions by covering commercial and service sectors. This is because large-scale power plants are rarely located in Tokyo; the program targets the 1,300 large-scale facilities, majority of which are office and commercial buildings and hotels.

Initially, when Tokyo ETS was designed, the Tokyo metropolitan government faced criticisms in Japan that emission caps would be traded for profit making purposes, causing “money game” instead of serving as a climate mitigation measure (Roppongi et al. 2017). Given the criticism, the program’s financial function was restricted, enabling emissions trading exclusively between target facilities. Besides, facilities are allowed to trade allowances only if they earn emissions reduction credits after reducing their emissions.

Reduction targets set for the first compliance period (2010–2014) were 8% for office and commercial buildings and 6% for manufacturing facilities from a base year level. The reductions went far beyond the targets at the end of the period, altogether achieving a 25% reduction. Some argued that this might not be due to the ETS but attributable to the increase in energy prices right after the Great East Japan Earthquake that affected multiple power plants and energy supply systems, which resulted in a serious energy supply shortage. To examine this possibility and clarify the factors contributed to the reductions, Arimura and Abe (2021) conducted an econometric analysis using data on office buildings and universities in Tokyo and decomposed the reductions into two components: the impacts of Tokyao ETS and of the energy price increase. They confirmed that Tokyo ETS did contribute to about 7% average annual reduction in the first four years.

The other subnational ETS program launched in 2011 in Saitama, a prefecture located north of Tokyo, targeting 600 facilities. It is linked with Tokyo ETS, but unlike Tokyo’s program, it is a conventional type of emission capping in that the target facilities are primarily in the manufacturing sector. What distinguishes Saitama ETS from other conventional programs is that it is a voluntary scheme where no financial penalty is charged for noncompliance. In Phase II which spanned from 2015 to 2019, 618 targeted faculties achieved the reduction target by emissions reduction or by credit acquisition while only 12 facilities are incompliant.⁷ This is quite distinctive compared to programs such as EU ETS and Tokyo ETS, where excess emissions and failure to obtain permits to cover emissions conventionally results in penalties. The scheme realized reductions of 22% without enforcement mechanisms in the period of four years. Hamamoto (2021) conducted an econometric analysis of Saitama ETS and found that the system promoted the adoption of energy efficient technologies in the targeted facilities. Both Tokyo and Saitama programs contributed to significant reductions at the end of the first compliance period in 2014, and they functioned well in the second period (2015–2019). As of 2024, they are now in the third period, making steady progress toward long-term reductions.

4.3 J-Credit Scheme: A Voluntary Emissions Reduction Certification Program in Japan

The Japanese government introduced a domestic credit certification scheme called the Japan Greenhouse Gas Emission Reduction Certification Scheme (J-Credit Scheme) in 2013 to promote voluntary initiatives to reduce emissions in Japan. In contrast to the cap-and-trade system described in Chap. 3, the J-credit system is a baseline and credit system. For this scheme, we first calculate the baseline emissions assuming no mitigation effort is made. Then, we calculate the emission level when mitigation efforts are implemented. Entities can receive the credits for the difference between the baseline emissions and the actual emissions. That is, domestic entities can receive and sell credits by reducing emissions through energy saving, renewable energy, and forest carbon sink. Entities can use the credits to achieve their targets set in accordance with the Keidanren⁸’s Commitment to a Low Carbon Society. They can also reduce their emissions by reporting the credits earned in the mandatory GHG Accounting and Reporting System.

The scheme achieved 9.29 million tons of CO₂ reductions, having 1,049 projects registered as of January 2024. Nonetheless, demand for J-credits is not very high because entities do not have strong incentive to earn credits because there has been no mandatory emissions reduction scheme at the national level. The low demand for credits (and hence the small number of credits being issued) decreases market liquidity, making unclear the level of carbon prices under the scheme.

5 Designing Carbon Pricing Systems

Although pricing carbon is an effective climate measure that internalizes market externalities, practical challenges exist in implementing the instrument. They can be overcome, however, by utilizing tax revenues and ETS auctioning revenues, which in turn will create opportunities for the economy. Below we explain concerns and opportunities potentially arising from carbon pricing.

5.1 Carbon Leakage and International Competitiveness

A major concern about carbon pricing is that it may cause industries to relocate to unregulated countries and result in carbon leakage, reducing domestic emissions while increasing emissions elsewhere. Besides, energy-intensive industries (such as the steel industry) may be put in a vulnerable position and lose their international competitiveness against unregulated firms. These are the concerns expressed in Japan when a national ETS was proposed and extensively discussed at the Ministry of the Environment (MOE)’s Council and the Emissions Trading Subcommittee. Facing opposition from energy-intensive industries, the cabinet decided to postpone the scheme in 2010.

Minimizing the risk of carbon leakage and safeguarding the international competitiveness of domestical industries are key to adopt the scheme successfully. As such, research has been conducted to identify the most severely affected sectors as well as emission allowance allocation to prevent carbon leakage (Dechezleprêtre and Sato 2017). So far, evidence of carbon leakage is weak or absent (Colmer et al. 2023). Meanwhile, the EU ETS has been dealing with the risk of carbon leakage by allocating allowances free of charge to energy-intensive trade-exposed (EITE) sectors.

An alternative solution to free allowance allocation is border adjustment policy known as the carbon border adjustments (CBA) by which carbon pricing is imposed on imports at the border to equalize the conditions of competition. EU first discussed CBA against the U.S. when the Bush administration withdrew from the Kyoto Protocol. The U.S. Congress also considered implementing the CBA under the Obama administration to support domestic businesses from international competitiveness, particularly against competitors in emerging countries as part of global warming countermeasures.

The CBA took a tangible form in July 2021 when the EU made a Carbon Border Adjustments Mechanism (CBAM) proposal as part of the Fit for 55 package. It was proposed that the CBAM initially apply to products made in five carbon-intensive industries: steel, cement, fertilizer, aluminum, and electricity generation (and subsequently, chemicals were included). The scheme is unique in that it utilizes emissions trading, not a carbon tax, and requires importing firms purchase allowances for the emissions generated from their products.

To what extent a CBA in Japan would be effective in preventing carbon leakage while protecting domestic industries? Takeda et al. (2012) compared border adjustment policies with regard to their impacts on carbon leakage, the economy and welfare, and the international competitiveness of domestic industries. Specifically, they compared the effects of two options: border carbon adjustments and output-based rebating. Output-based rebating, also known as Output Based Allocation (OBA), offers rebates to EITE sectors rather than adjusting prices at the border (Fischer and Fox 2007). Takeda et al. (2012) indicated that the OBA is effective in reducing carbon leakage to a certain extent, though its excessive use may result in reducing overall economic efficiency.

We should point out that CBAM or CBA in general is a controversial policy instrument. CBAM may not be compatible with trade rules of the World Trade Organization. This is especially so if a government introduces exemptions on exports. CBA may be considered as subsidies. These issues are discussed form legal perspectives (Mehling et al. 2019). Furthermore, middle-income economies such as BRICS have criticized these policies as disguised protectionism.

5.2 The Fairness and Regressivity of Carbon Pricing

Carbon pricing is often criticized for its regressivity as it can negatively affect low-income households. The Yellow Vests Protests in 2019 in France, which was a protest against the Macron administration’s deregulation measures, was driven by resentment among low-income households against the increased carbon tax, which has led to rising fuel prices. It should be noted, however, that carbon pricing is not the only policy instrument that faces the regressivity issue. The same holds for consumption taxes. One solution to the regressivity is to implement policies aimed at low-income households. Another one is a carbon dividend, or a policy that imposes a carbon tax to redistribute to low-income households (or, equally to all households). Carbon dividends are advocated recently; a group of conservative Republicans in the U.S. made a carbon dividend proposal in 2017 and in the U.S. congress, there was a proposal of bill by a Democratic representative in 2021.⁹ Moreover, British Columbia utilizes a dividend policy to address the regressivity of carbon pricing by rebating a portion of carbon tax revenues to households.

5.3 The Double Dividend of Carbon Pricing

Essentially, pricing carbon can result in imposing burdens on the economy. For one thing, it increases the costs of inputs and reduces production to mitigate GHG emissions. For another, it raises production and consumption costs as it promotes the use of green energy and technologies. Nevertheless, the measure can boost economic growth by using revenues (such as carbon tax revenues and emission auction revenues) to reduce existing taxes. This revenue recycling is the double dividend of carbon pricing (Kolstad 2010). That is, in addition to achieving emissions reduction (which can be considered as the first dividend), the scheme provides the second dividend as it decreases the burden of conventional taxes through revenue recycling.

Conventional taxes can cause market distortions and suppress economic activity. For example, income taxes may weaken individuals’ incentive to work, corporate taxes may discourage firms from investing, and the burden of social insurance cost may also discourage them from hiring new workers. Economic activity will be stimulated, on the other hand, if carbon pricing revenues are used to lower these taxes. Reduced taxes and social insurance payments are expected to result in more investment, more people working, and more firms hiring workers.

The double dividend principle has been adopted in many parts of the world, including Northern Europe and North America. Germany also adopted it when introducing an energy tax reform in 1999. As mentioned above, so did British Columbia when implementing carbon pricing; since the scheme launched in 2008, the revenue has been used to cut the corporate tax, among others, generating a 0.74% annual increase in employment over the 2007–2013 period (Yamazaki 2017). If a carbon tax is to be introduced in Japan, it is desirable to recycle the revenue and obtain double dividends. By partially distributing its revenue to lower, say, the corporate tax, a carbon tax is expected to promote the green economy and economic growth while achieving emissions reductions (see Takeda and Arimura (2021) for further discussion on prospects for carbon taxes and double dividends in Japan).

5.4 Effective Carbon Rates and Challenges of the Current Energy Taxes

With the aim of providing a comprehensive analysis of carbon pricing within and across countries, the OECD introduced the effective carbon rates (ECR), which measure the price of carbon emissions resulting from fossil fuel taxes, feed-in tariffs, as well as carbon taxes and ETS (OECD 2023). They are included as part of the carbon price because reduction incentives are provided not only through the explicit carbon pricing like a carbon tax and ETS but also through energy taxes.

In the case of Japan, incentives have been provided through fossil fuel taxes that were imposed prior to the carbon tax. Nevertheless, according to the MOE’s estimates based on the OECD (2019), Japan’s national average ECR remains relatively low among developed countries. This is partly caused by the nation’s current carbon pricing schemes. While fossil fuel taxes have been in place, the rates per carbon content considerably differ across fuel types, making emissions reduction inefficient (Fig. 9.4). As of 2021, the rate for gasoline is JPY 24,241 while for LPG is JPY 6,524, which is still high compared to those of heavy fuel oil (JPY 1,667), natural gas (JPY 1,556), and coal (JPY 998). It is desirable to standardize the rates for more effective reductions. It is also noteworthy that coal is taxed at a rate much lower than the other fuels. The lower tax rate not only results in inefficient reduction but also allows for loopholes that can increase coal demand, in turn increasing carbon emissions. It may have also caused the concerns that the electricity deregulation can lead to an increase in coal power generation in Japan.

Fig. 9.4

Source MOE (2020), adapted by the authors. Note The detailed tax rates are as follows. Tax for climate change mitigation is 289 yen for all fuel types. Petroleum and coal tax differs by fuel type: 400 yen per CO₂ ton for LNG/Natural Gas, 301 yen for Coal and 779 yen for others. Promotion of power-resources development tax varies by fuel type: 599 yen for heavy oil and kerosene, 408 yen for coal and 877 yen for natural gas

Tax rates per carbon content in Japan.

6 Carbon Pricing for Carbon Neutrality: Japan’s Green Transformation (GX)

Although Japan lagged behind Korea and China, let alone the EU, in introducing an effective national-level carbon pricing scheme, the nation is moving forward on developing the initiative since the carbon–neutral pledge has been made by Prime Minister Suga in 2020.¹⁰ The government has modified its view on climate policies, perceiving that properly designed policies will foster technological innovation and the nation’s economic growth. Based on this recognition, the government introduced the concept, “Green Transformation (GX),” and maintained that the implementation of measures against climate change provides opportunities for accelerating innovations to realize a carbon–neutral economy. In other words, the government focuses on the positive side of climate policies and considers carbon pricing not as a cost for the economy but as a driving force of economic growth.

The GX initiative involves Japanese firms that support carbon pricing and climate policy due partly to the Task Force on Climate-related Financial Disclosures (See Box 9.2 for more details on TFCD). It also led to the emergence of the GX league, a platform where firms with ambitious GHG emission targets are invited to discuss ways to develop, practice, and implement green transformation. Firms in the league can participate in the GX-ETS where they can voluntarily conduct emissions trading. Moreover, they were able to participate in rulemaking for the GX-ETS and thereby contribute to the collaborative effort of creating new markets. Anticipating a mandatory emissions trading scheme, 568 firms participated in the GX-ETS, representing more than 50% of Japanese emissions. Firms participating in the league include the nation’s major power companies and steel companies. The first phase of the GX-ETS launched in 2023 and continues until 2025. The Ministry of Economy, Trade and Industry (METI) supported this initiative by commissioning to the Tokyo Stock Exchange to set up a carbon market, and the market launched in 2023. METI also established a study group to prepare carbon credits for carbon neutrality. The group published “Carbon Credit Report¹¹” (Study Group on Preparation of Operational Environment to Ensure Proper Use of Carbon Credits toward Achieving Carbon Neutrality 2022)) in 2022 and clarified the proposed use of carbon credits in various contexts.

While METI was establishing the GX league and the GX-ETS, the government passed the GX Promotion Act in May 2023. Under this act, the government implements a carbon pricing scheme while providing funding to firms to encourage innovation to achieve carbon neutrality. The government’s approach is unique in that it gives private firms subsidies for R&D or innovation to private firms by issuing GX economy transition bond before introducing carbon pricing.

In implementing carbon pricing, the government committed to issue 20 trillion yen of GX economy transition bonds in support of private firms, hoping that it would lead to 150 trillion yen in private investment, an amount considered necessary to realize carbon neutral economy in Japan. The government plans to redeem the bonds by 2050 by using revenues from two carbon pricing mechanisms: GX-Surcharge and the GX-ETS.

GX-Surcharge is a carbon fee imposed on imported fossil fuels and will be introduced in 2028. While not a tax in a legal sense, the surcharge has effects on emissions reduction and economy equivalent to those of a carbon tax. It will be imposed on a wide range of economic agents, including households and small and medium sized firms. In contrast to GX-Surcharge, the GX-ETS targets larger emitters such as the power sectors and other energy-intensive sectors. It is stipulated that an auction of permits will be introduced under the GX-ETS for the power sector in 2033. It is natural that the power sector will pay for permits through auction as in the case of EU ETS and that the GX-ETS, initially starting on a voluntary basis, will eventually evolve into a mandatory system.

As of January 2024, the details of carbon pricing under the GX law are yet to be determined. While the national government has formulated the grand design of carbon pricing for carbon neutrality, the devil is in the details. We are yet to find out when the voluntary participation to the GX-ETS will become mandatory and what level of GX-Surcharge will be imposed. In designing carbon pricing policies, the government needs to consider how best to address various issues that we discussed in the previous section. It is important to keep an eye on the further development of carbon pricing in Japan.

Box 9.2 The Role of Non-state Actors in Climate Change Mitigation

The Trump administration in the United States marked a significant crisis in international cooperation on climate change. Adhering to a typical Republican stance, the administration quickly declared its intention to withdraw from the Paris Agreement. Additionally, it favored resolving issues through bilateral negotiations and raising tariffs over multilateral coordination through international organizations. This increase in anti-globalism has diminished the capacity of nations to resolve international issues.

During this period, non-state actors became increasingly significant as alternatives to national governments. Non-state actors are organizations other than nation-states, including corporations, NGOs, and local governments, that historically are not directly involved in international negotiations. With the increasing complexities in international affairs, the role of non-state actors in addressing various issues, including climate change, has garnered attention.

For instance, in the United States, several state governments have introduced emissions trading schemes. In the northeastern states, including New York, a system called RGGI-targeting power plants was introduced, and California implemented an emissions trading scheme. In Japan, Tokyo introduced emissions trading, followed by Saitama Prefecture. Thus, state governments, local authorities, and regional leaders have begun to play significant roles.

One symbolic figure of non-state-actor involvement is Michael Bloomberg. Known both as the former mayor of New York City and the founder of a financial information service, Bloomberg has been actively engaged in climate change mitigation. In 2014, he co-founded the “Global Covenant of Mayors for Climate and Energy” with then-UN Secretary-General Ban Ki-moon and served as the UN Secretary-General’s Special Envoy for Climate Ambition and Solutions.

Non-State actors also play a critical role in financing. Mark Carney, former Governor of the Bank of England, collaborated with Bloomberg to promote the disclosure of climate change-related risks faced by financial institutions. This initiative led to the formation of TCFD (Task Force on Climate-related Financial Disclosures), which brought significant changes to Japanese businesses and economy. With the backing of Japan’s Ministry of the Environment and Ministry of Economy, Trade, and Industry, many corporations have begun disclosing their climate change risks. In Japan, when the Tokyo Stock Exchange was reorganized, compliance with the TCFD became a requirement for listing on the new Prime Market. Alongside the scientific findings of the IPCC, TCFD has played a pivotal role in advancing climate change measures taken by businesses.

The role of global corporations extends beyond financing. Companies, such as Apple, Sony, and Google, demand their suppliers to use 100% renewable energy (RE100). Progressive companies also promote decarbonization across borders.

NGOs’ contributions are also noteworthy. NGOs such as WWF Japan play a significant role in advancing environmental policies in Japan. Their active participation is remarkable in advisory councils, such as the Tokyo Metropolis Environmental Council and the National Ministry of the Environment's policy councils.

Thus, amid the challenges posed by anti-globalism in international cooperation, the role of non-state actors has expanded. Today, corporate activities are becoming increasingly global, with production and markets extending beyond the confines of any country. NGOs and individuals can easily extend their activities beyond their borders by using social media. The influence of non-State actors is expected to increase in the future.