A beautiful city filled with ancient temples and surrounded by lush mountains, Kyoto was a fitting venue for the adoption of the Convention on Climate Change. The Japanese are proud of the market mechanisms for the reduction of greenhouse gas emissions established under the Convention and known as the Kyoto mechanisms. However, Japan itself has been slow to prepare for achieving its greenhouse gas emissions reduction target (a 6% reduction from 1990 levels), and now faces numerous compliance issues.

Japan's efforts so far

The Kyoto Protocol entered into force in February 2005, and in April 2005 the Japanese Cabinet adopted a plan for achieving the emissions reduction target. The plan dealt with public sector measures, use of the Kyoto mechanisms, implementation of a domestic emissions trading system, promotion of the Japan Business Federation's voluntary action plan, the consideration of environmental taxes, and other related methods.

The EU initiated its well-known emissions trading scheme in January 2005, under which greenhouse gas-emitting facilities are allocated EU allowances under national allocation plans based on a cap-and-trade principle. However, the economic and industrial sectors in Japan have strongly resisted the allocation of emission allowance caps, due to fears that excessive limits will be placed on economic activities and doubts as to whether emission allowances can be fairly allocated. To date, no legally binding total emission allowance scheme has been implemented. The economic and industrial sectors have established voluntary action plans, and are reducing greenhouse gas emissions on a voluntary basis under these plans.

At this point in time, the key measures implemented in Japan in connection with the Kyoto mechanisms include preparations for the introduction of a voluntary emissions trading scheme in April 2006, establishment of a national registry for Kyoto units, the promotion of acquiring emission reductions from overseas clean development mechanisms (CDMs), and promotion of joint implementations (JIs) through the establishment of carbon funds and other measures.

Voluntary emissions trading scheme

Under the voluntary emissions trading scheme scheduled to come into effect in April 2006, participating companies will be eligible to receive subsidies from the Japanese government for CO2 emissions abatement equipment in exchange for an undertaking to reduce emissions by a set amount. Participating companies will also be able to trade emission allowances with other participants to achieve the promised emissions reductions. However, in the period from the granting of emission allowances (in April 2006) until the date they are met, participants must regularly maintain the portion of emission allowances for the initial allocation amount minus the forecast emission reductions for 2006, in their own holding accounts. Participants that are unable to achieve their promised emission reductions in 2006 could be penalized and required to return a portion of the subsidies they have received. Certified emission reductions (CERs) issued by the CDM executive board may be used to meet emissions allowances.

Only ¥3 billion ($25 million) has been budgeted for subsidies to be granted under this scheme, which is designed as a small-scale test system. However, if Japan eventually introduces a cap-and-trade emission allowances trading system similar to the EU emissions trading scheme, it will use the knowledge obtained through the test scheme and, in that context, the voluntary scheme is attracting attention.

Participants

The voluntary emissions trading scheme allows for two types of participants: (1) target holding participants, who are granted subsidies and emission allowances in exchange for an undertaking to reduce emissions by a certain amount; and (2) trading participants, who will open registered accounts for the purpose of trading emissions allowances without themselves being granted emission allowances. A total of 34 companies in the chemical, food, retailer and other industries have so far been designated as target holding participants. Large emitters such as steel, oil and electricity concerns have not welcomed and have declined to participate in the scheme, because they believe that it will lead to the introduction of total emission allowance restrictions. Trading participants will be recruited until March 2006.

Schedule

Target holding participants were designated in May 2005, and the annual emission amounts (average amounts for the three years between 2002 and 2004) that will serve as the reduction standards should be calculated and certified by the end of 2005. In principle, subsidized GHG reduction equipment will be installed by March 2006, while emission allowances will be granted, and participants will begin implementing emission reduction measures and trading excess allowances in April 2006. The 2006 emission amounts will be calculated and certified between April and June 2007, and allowances will be retired around June 2007. It has yet to be decided whether a similar scheme will continue in 2007, but it is likely that any excess allowances existing after retirement in June 2007 will be subject to some type of banking limitation if the scheme is continued.

National registry

The Kyoto Protocol requires Annex I party nations to prepare national registries, which is one requirement of eligibility for participation in the Kyoto mechanisms. In Japan, preparations for the national registry were initiated in February 2005 through the enactment of the "Rules for the Use of a National Registry" by the Ministry of Economy, Trade and Industry and the Ministry of the Environment. The acquisition, holding, transfer, cancellation and retirement of Kyoto Protocol credits [such as assigned amount units (AAUs), emission reduction units (ERUs) issued through joint implementation, and certified emission reductions (CERs) issued through clean development mechanisms] by the Japanese government and private operators will be recorded in this national registry.

Terms and conditions

Registry accounts are divided into holding accounts (to hold the credits of the Japanese government and Japanese corporations), cancellation accounts (for the cancellation of credits due to sink activities and excess emissions), and retirement accounts (for retiring credits in compliance with the obligations of Article 3 of the Kyoto Protocol).

A party may only open one holding account. However, if the party opening the account is a trust company licensed under the Trust Business Law, or a bank or other financial institution licensed to engage in trust operations under the relevant law, it may open more than one account, when required for the performance of its trust operations.

Parties opening accounts will not be able to assign or transfer to third parties, pledge as collateral, or otherwise dispose of their status, rights and obligations as account holders, and will not be able to lend their names as account holders. Rules concerning the recording of credits from other countries' national registries and the transfer of credits to other countries' national registries will be established after the procedures for transfers between national registries have been prescribed.

Implications of the terms and conditions

As mentioned above, the Rules of Use allow trust companies and trust banks to open accounts for their trust operations. Japan's Trust Business Law was overhauled in December 2004, and under the revised law the definition of trust assets was expanded to include general property rights. The legal nature of emission reductions under Japanese law has yet to be fully clarified, but the Rules of Use presume that emission reductions are included in property rights that may be treated as trust assets under the Trust Business Law. So it is possible for trust companies and trust banks to acquire emission reductions using a trust scheme. In addition, collateral could be established on the emission reductions by placing them in trust with a trust company or trust bank and establishing a pledge on the related trust beneficiary rights.

Although the Rules of Use prohibit account holders from assigning, transferring or collateralizing their status, rights and obligations, the prohibition only applies to the establishment of collateral on the right to claim for transfer of the emission reductions to the state and on the transfer of legal status to claim for transfer of the emission right to the state. It does not prohibit the establishment of collateral on the actual emission reductions. While the legal nature of emission reductions remains unclear under Japanese law, credits or legal status held vis-à-vis the state cannot be used to establish collateral on the emission reductions. As such, collateral must be established in the emission reductions themselves, meaning that they are recognized as rights. The current unsettled legal nature of emission reductions gives rise to issues concerning the method for perfecting security rights, but one stable method for acquiring security rights would be by a conditional transfer, whereby the emission reductions would be transferred to the account of the secured party.

Trends at Japanese companies

Not a great deal of progress has been made in preparation for a legal system to achieve Japan's emission reduction obligations under the Kyoto Protocol, but Japanese companies are purchasing CERs through carbon funds or bilateral transactions. CERs may be purchased through a variety of carbon funds, but the Japanese government supports the Japan GHG Reduction Fund (JGRF) established by 31 private Japanese companies and two government-affiliated financial institutions – the Japan Bank for International Cooperation and the Development Bank of Japan. This fund, worth roughly $140 million, is managed by Japan Carbon Finance Ltd, which was established through the contributions of the Japan Bank for International Cooperation, the Development Bank of Japan and others. According to publicly available information, the Fund recently entered into an agreement to purchase emission reductions from a CDM Project in South Africa, is scheduled to enter into several emission reductions purchase agreements in 2005, and is negotiating agreements for the purchase of emission reductions produced by CDM projects in countries such as China, Malaysia, and India.

Other Japanese companies are implementing CDM projects and entering into agreements to purchase emission reductions through bilateral transactions, and have made headlines with their recent purchases of large amounts of emission reductions in Asia, and Central and South America.

Future issues

Legal nature of emission reductions

The legal nature of emission reductions under the Kyoto Protocol (ERUs, CERs, RMUs, and AAUs) and the voluntary emission allowance scheme in Japan remains uncertain. There is debate as to whether CERs and other emission reductions should be called rights, because the preamble to the Marrakech Accord states that the "Kyoto Protocol has not created or bestowed any right, title or entitlement to emissions of any kind," and because the recognition of emission reductions as legal rights might give rise to indemnity issues when they are retired by states. Nevertheless, it seems clear that emission reductions will have to be acknowledged as some type of right in that they are traded for value by private parties.

The legal nature of emission reductions may be asserted under: (1) a quantitative theory; (2) legal status theory; (3) contractual right (Saiken) theory; (4) property right (Bukken) theory; (5) intangible property right theory; or (6) an emission licensing theory.

The quantitative theory views emission reductions as nothing more than numbers that exist in national registries and the like, but because rights and legal status are based on these numbers, the view of emissions reductions as nothing more than numbers deviates from reality. Moreover, it would be impossible to create a legal relationship based on emission reductions under this view, and as such the quantitative theory is not thought to be useful. The emission licensing theory is valid with respect to relationships with states, but also fails to explain the trading of emission reductions for value between private parties. With regard to the property right theory, Japanese law generally defines property rights as "non-exclusive rights to directly control and receive benefits from a certain property," but it is difficult to think of emission reductions as property rights because they are not based on property that can be directly controlled. The understanding of the legal nature of emission reductions under Japanese law will therefore probably be based on a legal status theory, a contractual right theory, or an intangible property theory.

New legislation will be required for the widespread introduction of emission right caps in Japan and analysis of the legal nature of emission reductions will be affected by this legislation. The legal nature of emission reductions will have a big effect on the handling of emission reductions in a bankruptcy involving a company holding emission reductions, the assignment and perfection of emission reductions, the establishment of security rights over emission reductions, the extent to which financial institutions are allowed to handle emission reductions, and other issues related to the relationship between the existing legal system and the new emission reductions. As such, this issue requires in-depth consideration with a watchful eye on legislative trends.

Initiation of the voluntary emissions trading scheme

As mentioned above, the voluntary emissions trading scheme is scheduled to begin in April 2006. To assign emission allowances and initiate their trading, emission-trading agreements need to be prepared and accounting and taxation matters related to the holding and transferring of emission allowances under the scheme will need to be clarified. The scheme is experimental in nature, but it will impact the structure of any future national emission reductions trading scheme, so careful and thoughtful preparations are required.

Additional measures

At this time the question of what additional measures will be required for Japan to achieve its emissions reduction obligations under the Kyoto Protocol remains uncertain. The steps outlined above represent a positive, if cautious, approach to emissions reductions; but the government faces considerable resistance from industry bodies in a climate where Japan's gloomy economy is just starting to look up again. If it becomes impossible to meet these obligations using only the current measures, it might be necessary to introduce environmental taxes, general emission restrictions or a national emission reductions (cap-and-trade type) trading scheme. The introduction of these measures is a topic that will require long deliberation, taking into account a variety of practical and legal matters. The government seems determined to live up to its obligations under Kyoto, but in the spirit of the nation that has long thought of that ancient capital as its symbol, it is reluctant to make drastic changes too quickly, lest the still delicate economy be disturbed.

Author biography

Hideo Ohta Baker & McKenzie Tokyo Aoyama Aoki Hideo Ohta is a partner of Baker & McKenzie Tokyo Aoyama Aoki and specializes in the areas of environment and labour law. Ohta's practice focuses on providing advice and legal service for companies entering into international agreements. His areas of specialty include contract law concerning joint-venture projects, partnerships, hotel and resort management, franchising, technical assistance, marketing, licensing, joint development, plant manufacturing, and service; due diligence relating to mergers and acquisitions; international litigation and arbitration; labour law associated with corporate restructuring, early retirement packages, adjustment termination, and selective termination; environmental law; and union negotiations. Ohta is a member of the Japan Federation of Bar Associations and the Tokyo Bar Association. He graduated from the Chuo University Faculty of Law in 1972 and received an LLM from the Faculty of Law, Queen's University in Ontario, Canada, in 1981. He serves as a professor of law at the Law School of Chuo University, teaching litigation practice law and environmental law. Tsutomu Hiraishi Baker & McKenzie Tokyo Aoyama Aoki Tsutomu Hiraishi focuses his practice in the areas of structured finance, banking, financial derivatives, bank compliance matters and emission trading. His recent notable transactions include structured finance transactions for regional bank joint-data centers, international and domestic project finance deals for wind power plants, financing for MBOs, PFIs, off-balance-sheet structured financing deals for software companies, debt restructuring of project finance in Indonesia, emission trading (including the CDM and JI mechanisms, and carbon funds), and foreign investment by Japanese corporations and syndicate loans. Hiraishi worked for the Japan International Cooperation Agency in Indonesia from September 2003 until September 2004. He was a project formulation advisor of JICA in charge of legal/judicial reform in Indonesia. Hiraishi is a member of the Tokyo Bar Association (2000) and the New York Bar (1994). He received an LLM degree from the University of Pennsylvania School of Law (1993), an LLM degree in corporations from the New York University School of Law (1994), and a BLaw from the University of Tokyo Faculty of Law (1988). Elizabeth Ticehurst Baker & McKenzie Tokyo Aoyama Aoki Elizabeth Ticehurst specializes in the areas of mergers and acquisitions and corporate law. She handles a variety of corporate restructuring and M&A transactions, with particular emphasis on enviroment and employment law issues. Ticehurst is admitted as a legal practitioner in the Australian Capital Territory Supreme Court and the New South Wales Supreme Court. A member of the Australian Capital Territory Law Society, she holds a Graduate Diploma of Legal Practice from the Australian National University (2002), an LLB from the university's Faculty of Law (2000), and a BAS in Japanese studies from the university's Faculty of Asian Studies (2000).