Long before Russia ratified the Kyoto Protocol To The UN
Framework Convention On Climate Change, many Japanese
companies, particularly those more environmentally conscious
ones, began focusing on emissions trading. They were concerned
that Japan would not meet its targeted 6% reduction of
greenhouse gas emissions without an effective emissions trading
With the Protocol to enter into force on February 16 2005,
the government is under pressure to prepare for the first
commitment period beginning in 2008 by developing its
infrastructure to support a domestic emissions trading market.
In particular, there is a need to confirm accounting practices
for emissions trading and the legal nature of an emissions
Yet the Japanese government's delay in implementing any
specific or comprehensive measures for a domestic emissions
trading market has led many companies to predict that the
government will sidestep its obligations under the Protocol,
and impose them instead on the private sector. Several
companies have already initiated forward transactions on a
bilateral basis with entities in eastern European countries
expecting abundant surplus allowances due to their economic
stagnation since 1990. Other companies are investing in
credit-yielding overseas projects.
Emissions trading in Japan
Japan's emissions trading is mainly based on the system
envisioned under the Protocol and further elaborated on in the
Marrakech Accord, which set a rule to implement the scheme
provided by the Kyoto Protocol (the Kyoto Mechanism).
The Kyoto Mechanism
The Protocol obligates parties listed in Annex B to reduce
their greenhouse gas emissions by 5% (6% for Japan) from their
1990 levels. However, instead of reducing emissions, the
Protocol allows Annex B parties to use three supplemental
measures to meet their commitment: joint implementation; the
clean development mechanism (CDM); and emissions trading. An
Annex B party may add emissions credits gained through any one
of these measures to its originally assigned emissions
allowances under the Protocol. The certified emission reduction
(CER), a type of emission credit generated through a CDM
project, is most significant to emissions trading in Japan.
What is a CDM?
A CDM is when the government of, or a private sector entity
from, an Annex B party invests money in, or contributes
emission-saving technologies to, a non-Annex B party, leading
to reduced emissions of greenhouse gases benefiting the
non-Annex B party. The Annex B party or private sector entity
is entitled to acquire a portion of the CERs issued by a
sub-entity of the UN once the greenhouse gas emissions
reduction is verified and certified.
Japanese companies are keen on CDM projects for three main
reasons. First, the companies can provide developing countries
with eco-technologies at a low price compared with the
estimated cost of a one-ton equivalent reduction of carbon
dioxide emissions from their operations in Japan. Secondly, the
companies can receive CERs from past investments in CDM
projects as far back as 2000 and, therefore, acquire them
before the start of the first commitment period in 2008.
Thirdly, there are no other available emissions credits under
the Protocol that private sector entities may count on with
certainty. They can ensure that their CERs appear as credits in
the CDM registry that the UN will set up and they can
accumulate CERs in their CDM registry accounts while the
Japanese national registry is being set up.
The biggest players in emissions trading can roughly be
divided into four categories: (i) power, oil and steel
companies, which are expected to need a lot of emissions
allowances to cover their own greenhouse emissions once the
Japanese government imposes emissions allowance obligations on
the private sector; (ii) trading companies; (iii) brokers
handling forward transactions and providing market information
and consultancy services in relation to emissions trading; and
(iv) public sector entities (for example, the Japan Bank for
International Cooperation (JBIC), the Development Bank of Japan
(DBJ), the Ministry of Economy Trade and Industry and the
Ministry of Environment).
Not only are the above category (i) companies, which are
likely to be most affected, making efforts to reduce their
greenhouse gas emissions in line with voluntary emissions
reduction plans. But they are also investing in CDM projects
and forward transactions with foreign companies, intermediated
by brokers, to stockpile emissions credits to meet future
demands as well as insure against price increases. The ultimate
goal is to avoid possible sanctions from the government.
Trading companies, which are not usually concerned with
potential high demand, envision business opportunities in
emissions trading rather than regarding it simply as a method
to avoid future sanctions. Presumably, such trading is an
opportunity to use their expertise and resources: discovering,
investing in and making a profit from promising projects all
over the world.
JBIC and DBJ also are in positions to use their expertise
nurtured and developed from traditional project finance.
Thirty-five Japanese companies (most under category (i)), led
by JBIC, DBJ and several trading companies, have decided to
co-establish a $137 million fund through which they will invest
in large CDM projects and then claim future emission credits in
proportion to their contributions.
Potential market players
A fifth type of market player is expected to emerge.
Financial institutions, such as banks and securities companies,
whose businesses are strictly regulated, also see big business
opportunities in emissions trading. These include risk-hedging
derivative products and methods for reducing transaction costs
or saving VAT expenses.
However, whether and to what extent financial institutions
will be involved in this new market depends on the nature of
emissions credits and the applicable regulations. Such
uncertainty is creating big issues for the development of
With the Kyoto Protocol's February 2005 deadline looming,
the move towards full emissions trading in Japan is
accelerating. But many hurdles must be overcome before an
infrastructure for emissions trading can be created.
Rights under Japanese law
Is an emissions credit under the Protocol the same as a
right under Japanese law? The answer is no, although an
emissions credit under the Protocol does have economic value of
its own. However, under Japanese law, an emissions credit
constitutes a right if the private sector either enjoys a
privilege or risks government sanctions as a result of owning
or not owning an emissions credit, even without the government
publicly pronouncing that it constitutes a property right.
Until this problem is resolved, questions such as "what is
an emissions credit?" and "does the Civil Code or the
Bankruptcy Code (which literally only covers property rights)
apply to an emissions credit?" will go unanswered.
Legal nature of emissions
If an emissions credit under the Protocol is considered a
property right, another question arises as to how this right is
characterized: what is the legal nature of the emissions
credit? The answer is significant to such issues as: whether it
is a commodity under the Commodity Exchange Law, a security
under the Securities Exchange Law, or some other kind of asset;
choosing a method of creating a security interest over an
emissions credit; and choosing a remedy for a buyer of an
emissions credit when a seller fails to deliver.
The Financial Accounting Standards Foundation (FASF), the
authority on Japanese Gaap, announced in its pro
tempore policy of September 2004 that it will treat
emissions credits as quasi-intangible assets, not financial
instruments, partly because the credits lack similarity to
traditional financial instruments as well as broad
Because both a security and commodity are specifically
provided for in the law, an emissions credit is neither of
these. However, these concepts determine not only the
applicable marketplace for the object but also the range of
permitted businesses of financial institutions.
If an emissions credit is considered a security under the
Securities Exchange Law, financial institutions will be
permitted to buy and sell emissions credits in their business.
On the other hand, if an emissions credit is regarded as a
commodity under the Commodity Exchange Law, financial
institutions will not be allowed to buy and sell emissions
credits (except for certain derivative products in relation to
such credits) because their permitted businesses are strictly
confined by relevant laws (the Banking Law, Securities Exchange
Law and Insurance Business Law and others). Although no
theoretical contradiction would exist if an emissions credit
were considered both a security and a commodity, there has been
neither precedent nor any discussion as to the practical
inconvenience such arrangements would entail.
Registry for emissions credits
The official registry will play the most important role in
emissions trading because the emissions credit itself is
intangible and incapable of physical possession. To a large
extent, a party to an emissions trade has no choice but to rely
on the entries of record in the other party's registry
In relation to a national registry, the Marrakech Accord
prescribes that each Annex B party must set up a national
registry that records the issuance, holding, transfer,
acquisition, cancellation and retirement of emissions credits
under the Protocol. However, the Accord merely provides a
skeletal outline with little regard to the mechanics of
emissions trading and many details from a transaction point of
view are left un-prescribed.
For example, what legal effect does a record of the
equivalent amount of credit one ton of carbon dioxide in the
registry have? Does such an entry merely evidence that the
account holder is credited with such amount for purposes of
complying with permitted emission levels without attesting in
any way to its ownership, or does the entry carry with it all
of the features and legal effects necessary to prove ownership?
Does a credit entry after an account holder buys a credit cause
the transfer to achieve perfection such that the account holder
is entitled to priority over another buyer of the same credit,
before or after, who fails to record?
A preliminary set of terms and conditions for Japan's
national registry was published in December 2003 by the
government based on the requirements of the Marrakech Accord,
but did not answer the questions above.
The rapid development of e-commerce and IT innovations have
changed the nature and means for property transfers and new
transaction rules for emissions trading should take this into
consideration. Until recently, it was impossible to trade
various deeds and securities without imposing a legal fiction
that such paper documents existed to conform to traditional
legal theories, although, in practice, ownership of such deeds
and securities were only registered electronically. However,
some deeds and securities have been allowed to be traded
electronically. The paperless transfer of these intangible
properties is now governed by a new rule, the Law concerning
Book-Entry Transfer of Corporate and Other Debt Securities and
Stocks (Shasai Kabushiki-tou Hurikae Hou) (the Transfer Law),
without any conceptual notion of possession as originally
provided for tangible assets.
Under the Transfer Law, a paperless transfer of the
intangible asset (as specified in the law) does not become
effective until a book-entry record in the transferee's account
is made. Creating a pledge interest over such assets also must
adhere to a similar rule; a pledge does not take effect until
the pledge is recorded in the relevant pledgee's account.
Although no one knows what policy the government will adopt for
emissions trading, there is no doubt that the arrangements
mentioned above and the experiences derived from them under the
Transfer Law would provide ideas for designing a full-fledged
national registry for emissions credits, which are intangible
The path for emissions trading
While emissions trading in Japan is occurring in relation to
CDM projects, more transactions, supplemented by various kinds
of derivative products, are necessary to exploit the market's
potential. It will also be desirable to link the domestic
market with overseas markets to strengthen the number of
players and increase trading volumes.
The concept of emissions trading was introduced by modern
economics as a way to internalize an external diseconomy to
accomplish the most cost effective solution to controlling
emissions by way of a market mechanism. To achieve this,
emissions trading will require a certain size of marketplace,
consisting of enough buyers and sellers and a continuous supply
and demand of emissions credits.
However, when it comes to the question of which marketplace
emissions credits will be best positioned in (for example,
securities exchange market, commodity exchange market or
another market, including a new market for emissions credits),
it is hard to predict an answer because of the emissions
credit's novel character as property (if admitted as a right).
More specifically, an emissions credit bears no similarity to
the current list of objects defined as securities or
quasi-securities under the Securities and Exchange Law. And
while an emissions credit is intangible by nature, it does not
fall under the list of objects defined as commodities under the
Commodity Exchange Law.
As seen in the Sulphur Dioxide Allowance Trading Programme
under the US' Clean Air Act Amendments of 1990, margin
transactions, emissions vintage swaps, spread transactions,
put/call options and other derivative products related to
emissions credits will appear on the market and supplement the
market mechanism by providing liquidity. At this stage, there
is room for financial institutions to handle such derivative
products as part of their permitted businesses, regardless of
whether an emission credit is traded in the commodity exchange
Linking with overseas schemes
If an emissions trading market is created in Japan, the
liquidity of emissions credits may be low because only a CDM
registry, which itself is not yet set up, would provide the
domestic market with emissions credits under the Protocol. As
mentioned above, the liquidity of the market is essential to
accomplish cost effective emission reductions successfully.
It will be necessary, therefore, to assure a stable supply
and demand of emissions credits by linking the domestic market
with foreign emissions-credits markets. The Japanese government
must consider the treatment of emissions credits overseas when
designing the domestic system, to make emissions credits under
foreign schemes compatible with Japanese emissions credits.
Minoru Ota is a partner of Nagashima Ohno & Tsunematsu.
Admitted to the Bar in Japan in 1987, Ota specializes in
several fields, including commercial banking, corporate
finance, multinational transactions, compliance and
environmental matters. He frequently assists clients such as
Japanese financial institutions in structuring and negotiating
complex financings. His inbound practice often comprises
serving international clients in the planning and execution of
their investment and operational goals in Japan.
Yoshitoshi Imoto is an associate with Nagashima Ohno &
Tsunematsu. His main areas of practice are banking, trade
finance, environmental regulations, consumer finance and
general corporate matters. He is a graduate of the University
of Tokyo (LLB 2001) and has been admitted to the Bar in Japan
since 2002. He is a member of the Dai-ichi Tokyo Bar
Association. He speaks Japanese and English.
Nagashima Ohno & Tsunematsu
3-12, Kioicho, Chiyoda-ku
Tokyo 102-0094, Japan
Tel: +81 3 3288 7000
Fax: +81 3 5213 7800
Web site: http://www.noandt.com/