TSE's trial carbon trading project could lead to shake-up of sector

In a move that could shake up emissions trading in Japan, the Tokyo Stock Exchange launched a carbon credit demonstration project last month — the first of its kind in the nation.

It allows companies to trade carbon dioxide emission reductions as a commodity, and is one method of contributing to greater reductions in such emissions overall.

Here is what you need to know about carbon credits and the project:

What is the purpose of carbon credit markets?

Carbon credit markets came into being following two international climate change treaties that required countries to reduce their greenhouse gas emissions (GHG). The Kyoto Protocol of 1997 and the Paris Agreement of 2015 legally bound countries to specific carbon dioxide reduction goals.

Each country then laid out its own domestic emissions reduction target to meet those goals. Japan’s goal under the 2015 Paris agreement is to cut its GHG emissions by 46% from 2013 levels by 2030 and to achieve net-zero emissions by 2050.

The need to meet those national targets has, in turn, forced businesses in each country to seek new ways of reducing their own carbon footprint.

What kind of carbon credit markets are there?

There are two basic forms of carbon trading. The first is known as the cap-and-trade system. It sets a limit on the amount of carbon emissions a business or organization may produce, and allows them to purchase extra capacity from other businesses and organizations whose emissions are under the cap.

The second form is known as baseline and credit. Emissions levels are defined for individual regulated entities, and credits are issued to those that have reduced their emissions to below their respective level.

While quite similar, the main difference between a cap-and-trade system and a baseline-and-credit system is that in the former, there is an upper limit on carbon emissions. Entities above the limit must buy carbon credits from others below it, allowing them to subtract the difference on paper from their real emissions in order to get under the cap.

A baseline-and-credit system sets a generally agreed upon level of carbon emissions. Entities that reduce their emissions below this level earn carbon credits, which they can sell to others. It's more of a reward for good behavior than a mandatory goal.

Cap-and-trade systems are usually stricter about staying under the upper limit of allowable emissions. Under baseline-and-credit systems, there is usually no pressure on firms to buy credits to get under the emissions standard.

Trading is usually between businesses and entities. There are a variety of such systems worldwide, with some being essentially voluntary with no penalties for failing to reduce emissions below the standard, and others with penalties.

The TSE demonstration project is a baseline-and-credit system.

How does emissions trading work?

In a baseline-and-credit system, for example, firm A’s real GHG emissions are at a level above the goal. They want to make further efforts to reduce, on paper as well as in reality, their emissions to meet that goal. On the other hand, firm B’s real GHG emissions are now at a level under the goal.

B can sell the difference between what it emits and the goal to A. The purchase of B’s difference helps A stay under or in line with the emissions goal, giving them more time to make real reductions and appeal to stakeholders.

The ultimate aim of the baseline-and-credit system, therefore, is for companies to be further incentivized to meet the larger carbon reduction goals that are part of a country’s mandated GHG reduction goals.

How does the TSE's project work?

Carbon trading in Japan has been carried out individually between firms, but there was not a lot of activity and it was difficult for the firms to find buyers and sellers on their own. The larger-scale demonstration project, which moves carbon trading to the open market, is the next step.

The project is being conducted under the Ministry of Economy, Trade, and Industry and involves more than 140 participating companies and organizations trading emissions on the TSE.

The amount of carbon dioxide emissions reduced by a participant — such as by introducing renewable energy sources, undertaking efforts to plant trees or adopting energy saving measures, for example by installing LED lighting — is commodified and traded. Trading takes place between 9 a.m. and 3 p.m.

On Sept. 22, the first day of the program, renewable energy credits traded at ¥3,300 per ton of carbon dioxide reduced. Energy saving carbon credits, such as those for the use of LED lighting, were trading at ¥1,600 per ton.

The advantage of this experiment is that it allows companies to demonstrate to investors that they’re actively working to reduce their emissions.

The project will conclude in January, at which point the economy ministry will review how active trading was. The plan is to introduce full carbon credit trading on the TSE sometime after the start of the fiscal year beginning in April.

The current project marks the first time carbon credit trading has been done on the TSE. At the regional level, the Tokyo Metropolitan Government and Saitama Prefectural Government have conducted smaller-scale emissions trading for local firms.

Which other countries have carbon trading programs?

Currently, 38 countries and 29 regions have some form of national carbon emissions trading system, often a cap-and-trade system. These include the European Union and South Korea. Australia, by contrast, has a range of baseline-and-credit programs at the state and national level.

The EU began emissions trading in 2005 and uses a cap-and-trade system. Their market covers member states’ power plants, oil refineries and steel mills, as well as energy-intensive firms involved in producing iron, aluminum, cement, glass, ceramics and paper.

South Korea’s cap-and-trade program began in 2015 and covers 684 of the country’s emitters, accounting for 73.5% of national GHG emissions. It includes those in the waste, aviation, real estate and electric power industries. Total revenue under the program in 2021 was 294.8 billion Korean won.