Japan’s Carbon Emissions Trading: A Risk Mitigation Approach to Market-Based Decarbonization

In May 2025, Japan enacted legislation mandating the creation of a national carbon emissions trading system (ETS), scheduled to begin in fiscal year 2026. The system will require 300–400 major firms—each emitting over 100,000 metric tons of CO₂ annually—to participate in a market-based cap-and-trade program. This effort forms part of a larger policy package outlined in the Green Transformation (GX) Promotion Act, which supports Japan’s climate goals through regulatory instruments and investment incentives. The ETS is complemented by two major policy instruments: a GX-surcharge on fossil fuel suppliers (planned for FY2028) and the issuance of GX Economy Transition Bonds, with the goal of mobilizing ¥150 trillion in green investment over the next decade.

Why This Matters

• Fifth-Largest Emitter: Japan is currently the fifth-largest greenhouse gas emitter globally and heavily reliant on fossil fuels for industrial energy, power generation, and transportation. The country’s climate pledges include achieving net-zero emissions by 2050 and a 46% emissions reduction from 2013 levels by 2030. To date, Japan has primarily relied on voluntary reduction measures such as the GX League, but the shift to a mandatory ETS marks a significant policy evolution.

• Regulatory, Low Risk Mandate: This development comes at a time when international climate regulations, such as the EU’s Carbon Border Adjustment Mechanism (CBAM), are creating new trade implications for countries without robust carbon pricing systems. Japan’s ETS is therefore both a domestic environmental policy and a strategic move to maintain economic competitiveness.

Details

The legal foundation for Japan’s ETS is the GX Promotion Act, passed in May 2023, which established a long-term framework for integrating carbon pricing with industrial policy and investment promotion (Sano, 2024). The ETS will become mandatory beginning in FY2026, transitioning from the existing GX League, a voluntary emissions trading framework launched in FY2023. As of April 2024, the GX League included 747 companies accounting for over 50% of Japan’s national emissions.

The mandatory system targets companies emitting 100,000 tons or more of CO₂ per year, which includes large firms in the steel, automotive, energy, aviation, logistics, and chemical sectors. These companies collectively contribute nearly 60% of domestic greenhouse gas emissions.

The ETS operates on a cap-and-trade model. Participating companies are allocated emissions caps; if their emissions remain below the cap, they can sell unused allowances. If they exceed the cap, they must purchase credits on the market. Companies that fail to purchase sufficient credits are subject to a penalty surcharge of 10% above the prevailing market credit price.

A gradual shift from free allocation to auctioning of allowances will begin with the power generation sector in FY2033.

This market-based mechanism is reinforced by a broader investment strategy under the Pro-Growth Carbon Pricing Concept, which combines emissions regulation with targeted financial support. The Japanese government aims to issue ¥20 trillion in GX Economy Transition Bonds over 10 years, with the goal of catalyzing ¥150 trillion in public-private green investment.

The first issuance of these bonds occurred in February 2024, raising ¥1.6 trillion—marking Japan as the first country to issue sovereign transition bonds .

Investments are allocated across sectoral needs. For hard-to-abate industries—such as steelmaking, ceramics, and chemical manufacturing—¥2.8 trillion is allocated for technologies like hydrogen-based processes and carbon capture. For household and consumer-level decarbonization, such as heat pumps and building retrofits, ¥4 trillion is earmarked. Another ¥1.3 trillion will support hydrogen infrastructure and floating offshore wind energy, while ¥1 trillion will fund small- and medium-sized enterprises (SMEs) and startups.

A major technical constraint to Japan’s decarbonization effort is its reliance on industrial heat, which constitutes 66% of energy consumption in the manufacturing sector. This energy form is more difficult to decarbonize than electricity and often requires higher upfront investment in specialized technologies.

The government is therefore promoting transition finance, which allows incremental decarbonization pathways rather than requiring immediate zero-emission compliance.This transition-oriented framework is also intended to support policy harmonization with regional economies. Japan is advocating for an Asian transition finance taxonomy, with the goal of supporting decarbonization in countries facing similar industrial and energy-use profiles.

Action Items: Recommendations

• Industry: Firms expected to fall under ETS regulation should begin internal emissions tracking, set corporate decarbonization targets, and assess technology investment needs. Early participation in the GX League may provide strategic advantages in market familiarization and credit accumulation. Industries with high heat demand should prepare for transition finance applications and consider participation in public-private demonstration projects.

• Institutional Investors and Financial Institutions: The issuance of GX Bonds and sovereign transition instruments opens opportunities for climate-aligned investments. Financial actors can collaborate with firms to structure eligible transition projects and monitor sector-specific carbon pricing risks. Additionally, banks and asset managers should prepare for alignment with emerging taxonomies related to green and transitional finance.

• Stakeholders: Japan’s ETS offers a test case for carbon pricing in a mature, industrialized economy with a strong export base. Observers should evaluate the system’s interoperability potential with the EU ETS, South Korea’s K-ETS, and China’s emerging carbon markets. The impact of Japan’s transition bond model on sovereign debt markets and blended finance for developing countries is also of interest.