The road to the institutional design of the GX-ETS

Japan has historically lagged behind Europe in carbon pricing, with its 2012 Tax for Climate Change Mitigation set at just JPY 289 per ton of CO₂. Following the Paris Agreement and Japan’s 2020 commitment to carbon neutrality, the government introduced the Green Transformation (GX) framework. This led to the GX Promotion Act in May 2023, which established the legal basis for a fossil fuel levy beginning in 2028 and a specified operator contribution system for power sector auctions. The GX Emissions Trading Scheme (GX-ETS) was introduced voluntarily in fiscal year 2023, overseen by the Ministry of Economy, Trade and Industry (METI). To catalyse investment, the government issued JPY 20 trillion in GX Economy Transition Bonds, part of an estimated JPY 150 trillion needed for decarbonisation.

Phase I of the GX-ETS

Phase I (fiscal years 2023–2025) was organised at the company level, a significant departure from previous industry-wide voluntary initiatives. It utilised a reduction credit approach where tradable credits were issued ex-post to firms exceeding their targets. These targets were aligned with Japan’s Nationally Determined Contribution (NDC) trajectory, requiring reductions of 27.0% in 2023, 29.7% in 2024, and 32.4% in 2025 relative to 2013 levels. A dedicated carbon credit market was established on the Tokyo Stock Exchange in October 2023 to support liquidity.

Phase II of the GX-ETS

Participation becomes mandatory in April 2026. Unlike systems that regulate facilities, the GX-ETS continues to regulate at the company level for administrative feasibility and compliance flexibility. The scheme covers a broad range of sectors, including power, manufacturing, transport, and real estate, applying to any company emitting at least 100,000 tons of CO₂ annually. It regulates only Scope 1 CO₂ emissions from fossil-fuel combustion and industrial processes.

Allocation of allowances

In Phase II, free allowances are allocated to all covered companies, with approximately 90% of emissions regulated through benchmarking and 10% through grandfathering. Benchmarking uses a bottom-up approach based on technological feasibility. For the first year (2026), benchmarks are set at the emissions intensity of the top 50% of firms in an industry, tightening to the top 32.5% by 2030. Grandfathered sectors face a fixed annual reduction factor of 1.7%, reflecting an assumed 8.5% reduction over the five-year period.

In the power sector, allocation will transition from fuel-specific benchmarks (for coal and natural gas) toward an all-thermal benchmark. A weighting parameter, α, will move from zero to 0.4 by 2030, meaning 40% of free allocation will eventually be determined by the more stringent all-thermal standard to incentivise fuel switching.

Compliance-related rules

Firms can bank allowances, though METI is considering volume limits to prevent liquidity issues seen in other regions. Offsets, such as J-Credits and Joint Crediting Mechanism (JCM) credits, are capped at 10% of a company’s emissions. The system incorporates a price corridor for fiscal year 2026 with a floor of JPY 1,700 per ton and a ceiling of JPY 4,300 per ton. A 3% annual real increase in price bounds is proposed to provide a predictable investment signal. If prices hit the ceiling, firms can pay the government the upper bound price to satisfy compliance. Conversely, the government plans to use reverse auctions to support the price floor.

Measures addressing international competitiveness

To prevent carbon leakage, sectors with a trade share above 0.1 are eligible for additional allowances. If allowance procurement costs exceed 4% of operating profit, firms can receive additional allocations capped at 50% of their shortfall. Allocation adjustments also occur if activity levels change by more than 7.5% over two consecutive years. Furthermore, the GX-ETS uniquely promotes innovation by offering additional allowances to firms whose GX-related R&D expenditure exceeds the sectoral average, though this is capped at 10% of the allowance shortfall.

Next steps for the GX-ETS

Phase III, beginning in 2033, will introduce mandatory auctioning for the power sector. Revenues from these auctions and the 2028 fossil fuel levy will fund the redemption of GX Economy Transition Bonds. Key future challenges include aligning the system’s stringency more closely with Japan’s NDC and developing a liquid secondary market that permits participation from non-regulated entities with market experience.