Emissions trading

Author: | Published: 12 Jan 2005
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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 scheme.

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 credit.

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.

Why CDM?

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.

Market players

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 emissions trading.

Legal challenges

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 credit

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 marketability.

Financial institutions

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 account.

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 by nature.

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.

Market-based transactions

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.

Derivative transactions

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 market.

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.

Author biographies

Minoru Ota

Nagashima Ohno & Tsunematsu

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

Nagashima Ohno & Tsunematsu

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.



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