How Digital Transformation is Accelerating Carbon Trading and Carbon Neutrality

As climate change and weather disasters become more severe each year due to global warming, there is a growing focus on greenhouse gas reduction and carbon neutrality initiatives by companies and governments to achieve a decarbonized society.

Under the 2015 Paris Agreement, countries around the world agreed on a long-term goal of limiting global temperature increases to below 2°C by 2030. n response to the IPCC (Intergovernmental Panel on Climate Change) report, Europe, the United States, Japan, and other countries have set a goal of achieving carbon neutrality by 2050 to limit the temperature increase to 1.5°C. The movement toward the realization of a decarbonized society is accelerating worldwide. In Japan, the then Kan Cabinet declared in its policy speech in October 2020 that the country would achieve carbon neutrality by 2050, and indicated that it would focus its maximum efforts on realizing a green society.

Under such circumstances, carbon pricing and emissions trading, which impose a burden on greenhouse gas emissions, have been attracting attention as a method to achieve carbon neutrality. In September of this year, the Tokyo Stock Exchange and the Ministry of Economy, Trade and Industry (METI) launched a demonstration experiment for a carbon credit market, in which J-credits, which the government certifies as reductions from the introduction of renewable energy facilities and CO2 absorption through afforestation, are traded on the market. There are also reports that the government has begun making adjustments toward the full-scale introduction of carbon pricing in the 2030s. In addition, as examples of companies such as Tesla Inc. (discussed below) making a profit from emissions trading have become prominent, not only major companies but also startups are becoming active in the market. On the other hand, it is not easy to accurately understand the definitions and the overall picture of this field because there are many academic terms and similar terms (carbon neutral, carbon negative, carbon offset, carbon pricing, etc.), and because updates and new rules are frequently introduced. This article will provide an overview and specific examples of carbon pricing and emissions trading, as well as a discussion of green innovation expected in the future.

What is Carbon Pricing?

Carbon pricing is a policy approach that encourages emitters to change their behavior by putting a price on carbon. There are various methods of carbon pricing depending on its application, and the following are typical examples ¹.

Carbon Tax
. This mechanism involves taxing CO2 emissions at a set rate by attaching a price to carbon as a tax base. In Japan, a type of carbon tax, the Global Warming Prevention Tax, has already been introduced to tax the use of fossil fuels such as oil, natural gas, and coal according to their CO2 emissions. However, the tax rate is very low, less than 1/10th that of the carbon tax introduced in Europe and other countries. This fall, the introduction of a carbon tax was considered for the 2023 tax reform, but was postponed in order to avoid a further increase in the burden on the public under the current high energy price environment².

Emissions Trading

Credit Trading

Carbon Border Adjustment Measures

Carbon Accounting
<br Carbon accounting is an initiative to calculate and aggregate the contribution of business activities to the emission or reduction of greenhouse gases. There is a lot of discussion about standardization of accounting standards, such as the GHG Protocol, an international standard, and PCAF, a carbon accounting partnership for financial institutions.

Emissions Trading System and History

Within the aforementioned carbon pricing, systems and business models related to emissions trading have attracted particular attention. WWF Japan defines emissions trading as follows⁴.

Emissions trading is a system in which the amount of greenhouse gases that can be emitted by each company, country, etc. is set in the form of emission allowances, and where emissions exceed the allowances, allowances can be purchased from other companies that have actually emitted less than the allowances, so that the emissions can be deemed to have been reduced. The system is called the "emissions cap and trade system". （The English name is "Emissions Trading," which can be translated as "emission rights trading," "emission permit trading," etc., but the meaning is the same.

Emissions trading can be broadly divided into two types of schemes: baseline and credit schemes and cap-and-trade schemes. The baseline and credit system is based on the concept of trading the difference (credits) between the emission reductions achieved by companies through energy conservation and decarbonization efforts and the assumed emissions if these efforts were not implemented (baseline)⁵. The baseline and credit method is also used in J-credits.

In the cap-and-trade system, the government sets a cap on emissions for companies, and these 'allowances' can be traded among them. Companies whose emissions exceed their allotted caps can purchase the rights to any surplus emission allowances from other companies that have allowances to spare. Companies with high emissions can actively reduce their emissions to cut costs, while companies that have enough allowances can use more renewable energy and install energy-saving equipment to earn profits, thus providing incentives for both parties to reduce greenhouse gases. A typical example is the EU-ETS.

The Emissions Trading Scheme (ETS) was first introduced in the EU in 2005. In China, the world's largest emitter of greenhouse gases (accounting for 28% of global CO2 emissions), the system was introduced in 2013 in some provinces and states, including Beijing and Shanghai, and was later launched on a national level in July 2021. In Japan, the system has been introduced at the prefectural level in Tokyo, Saitama, and other prefectures. According to the World Bank, emissions trading schemes have been introduced in about 30 countries around the world, including Japan ⁶.

Market trading of J-credits

In September 2022, Japan Exchange Group and the Ministry of Economy, Trade, and Industry (METI) launched a demonstration experiment for market trading of J-credits, as mentioned earlier in this article. Until now, J-credit trading has been criticized for its lack of price visibility due to the fact that it was based on relative trading, but this experiment aims to make transactions transparent through market participants. As a result, it is expected to increase the number of market participants and encourage companies to reduce their greenhouse gas emissions.

On the other hand, the current market has some liquidity issues in terms of the number of participants and trading volume. Since participation in the current demonstration experiment is voluntary, the number of participating players is limited (as of September, approximately 145 companies and municipalities, mainly large corporations, were participating). The transaction amount on September 22, the first day of the experiment, was a small amount of approximately 1.7 million yen, and expanding the scale of transactions in the market is also an issue for the future⁷. Some have pointed out that, because emission reductions in Japan are currently voluntary targets, there is insufficient incentive for companies to actively reduce their emissions. The government has indicated that it will study the possibility of introducing a European-style system that would require individual companies to set emission quotas and reduce their emissions.

In fact, in the EU, which accounts for about 90% of the world's emissions trading, companies in target industries are required to participate in the Emissions Trading Scheme (EU-ETS). Since companies are fined if they exceed the pre-approved emission levels, companies that are short of reductions are forced to purchase emission allowances on the market, resulting in active market trading (trading value in 2021 was 682.5 billion euros (approximately 97 trillion yen)) and high emission reduction effects⁷. The successful attraction of investment money is another reason why emissions trading is growing in the EU. Futures and options trading of emission allowances exist, hedge funds and other players are participating in market trading, and listed investment trusts have appeared, showing the development of emission allowance trading as a financial product⁸. Although it has been pointed out that the inflow of investment money has the side effect of causing volatility in the price of emission credits and adversely affecting the carbon reduction strategies and efforts of companies, the market has gained depth by having a variety of participants trading in the market, thereby encouraging companies to actively reduce their emissions.

While it is important to create a market that leads to a decarbonized society by encouraging as many companies and investors as possible to participate in Japan's emissions trading, which is expected to be fully implemented in the future, it is often pointed out that Japan is already lagging behind other developed countries in its efforts to introduce such a market, and that it is necessary to move forward with a sense of urgency. It is therefore imperative to move forward with a sense of urgency.

Carbon credits support Tesla's profitability

A well-known example of the use of emission credits is Tesla, a U.S. manufacturer specializing in electric vehicles (EVs).

In regions such as the EU and the state of California in the U.S., emission regulations are imposed on automakers, such as requiring a certain percentage of zero-emission vehicles (ZEVs)⁹. However, because development and mass production require a considerable amount of investment and time, it was inevitable that the target values would not be met and fines would have to be paid. Under these circumstances, Tesla seized the business opportunity. Since all of Tesla's vehicles are EVs, Tesla is an important and valuable seller of emission credits, and automakers such as Fiat Chrysler Automobiles (FCA) formed an open pool with Tesla (an alliance of automakers working together to reduce CO2 emissions) to purchase the company's emission credits held by Tesla for a fee in order to meet targets and avoid paying fines. Under current accounting standards, credit revenue is generally reported as profit since it incurs no cost of sales.

Tesla 10-K: Automotive Regulatory Credits¹⁰. > We earn tradable credits in the operation of our business under various regulations related to zero-emission vehicles ("ZEVs We sell these credits to other regulated entities who can use the credits to comply with Sales of these credits are recognized within automotive regulatory credits revenue in our Consolidated financial statements included elsewhere in this Annual Report on Form 10-K

Under current accounting standards, credit revenue has no cost of sales, so the same amount of revenue is generally reported as profit. As the graph above shows, from the fourth quarter of 2019 through the first quarter of 2021, credit revenues have exceeded net income. This indicates that Tesla in the past few quarters could have been in the red if not for the credit income.

CNBC: Tesla's sale of environmental credits help drive profitability¹¹ > Without zero-emission vehicles (ZEVs) and other regulatory credits, Tesla would not have been able to report four consecutive quarters of GAAP profitability, a milestone it reported Wednesday that meets the qualifications for Tesla to join the S&P 500.

FCA and others are said to have purchased tens of billions of yen in emission credits from Tesla at times, and there is no doubt that this was a major cost pressure factor. It is not a good business strategy for automakers to purchase credits from EV-specialized manufacturers, which pose a threat to their own companies in the future, and this is thought to have provided an incentive for automakers to desperately increase production of EVs with low CO2 emissions.

Compared to the pre-2021 period, the current accelerated introduction of EVs, especially by European automakers, is now seeing their own efforts to meet environmental standards, and the benefit of the credit income Tesla has received so far seems to be decreasing. In fact, the company has acknowledged a gradual decrease in credit revenues (Automotive regulatory credits revenue) from $679 million in the first quarter of 2022, down to $286 million in the third quarter of 2022[^ 12][^13]. However, the company's success in using credit revenues to weather the loss phase and alleviate the increasing pressure from shareholders may be a successful example of carbon finance.

Carbon neutrality driven by climate tech

To solve the extremely large worldwide challenge of achieving carbon neutrality and protecting the future of the earth for future generations, government-led carbon pricing and emissions trading schemes such as those introduced so far are not expected to be sufficient. Against this backdrop, in addition to the growing sustainability and ethical awareness of individuals and the active engagement of prominent business leaders such as Bill Gates in the environmental field, in recent years we have seen many examples of start-ups using innovative technologies and innovations to solve this challenge. Trends in the financial markets are also driving carbon neutrality efforts. Institutional investors nowadays are focusing on the concept of ESG investment, in which they select companies that take into account the three aspects of "environment," "society," and "corporate governance. There are also many examples of major companies collaborating with start-ups and creating innovations and new businesses in a wide range of fields, such as power generation, manufacturing, transportation, and agriculture. Climate tech is now considered one of the most attractive areas for innovation and investment.

This chapter introduces some of the areas of particular interest for the realization of carbon neutrality.

Visualization and Management of Greenhouse Gas Emissions

The need to visualize and manage greenhouse gas emissions, including supply chain emissions, is increasing, as companies are increasingly required to disclose the greenhouse gas emissions of not only themselves, but also their supply chain and customers in the near future. Sustainability Standards Board (ISSB), which is responsible for setting standards at the IFRS Foundation, made headlines in October 2022 when it included Scope 3 emissions (e.g., supply chain and customer use of products) in the disclosure requirements it is currently considering for companies. Regulatory authorities in major developed countries such as Europe, the U.K., and the U.S. are preparing the content of disclosure requirements for companies, and there are reports that the above policy by the ISSB may have a significant impact ¹⁴. In Japan, the Tokyo Stock Exchange (TSE) is requiring prime listed companies to disclose information based on the TCFD (Task Force on Climate-related Financial Disclosure) recommendations in its draft revised Corporate Governance Code, and is also considering making disclosure mandatory for all listed companies¹⁵. and Scope 2, while the TCFD recommendation only recommends enhanced disclosure of Scope 3.

It is not easy to understand the amount of greenhouse gas emissions in the supply chain. Many companies that are currently engaged in Scope 3 disclosure ask their suppliers to collect GHG emissions data or collect the data themselves, but there are many problems, such as the heavy burden of responding to surveys from suppliers and the lack of timely reflection of each company's reduction efforts¹⁶. In response to these needs, we have been working to develop a system that can be used for the entire supply chain.] In response to these needs, a number of startups have emerged that provide services for collecting, calculating, visualizing, and centrally managing greenhouse gas emissions throughout the supply chain through API and data linkage. Considering the increasing number of companies that will be involved in disclosure in the future, further increase in demand is expected. It is also my impression that many players are using this type of visualization service as an entry point to develop services such as emissions reduction consulting and offsetting using credits.

One of the leading players is Patch Technologies, a U.S. startup that develops APIs for carbon offsetting. Patch Technologies calculates and visualizes emissions from corporate activities based on data such as electricity consumption, air and car travel, and credit card usage history, and provides carbon credits to offset emissions. By incorporating the company's code, companies can track and calculate their own emissions from employee business flights and travel, and purchase and manage carbon credits to offset carbon emissions. ¹⁷

carbon-offset matching platform

An area of interest among various climate change businesses is carbon offset matching platforms. Carbon offsetting is the concept of indirectly absorbing CO2 and other greenhouse gas emissions from a specific location, event, or project by investing in activities that contribute to greenhouse gas reduction, even if the emissions cannot necessarily be reduced within the related company or community alone.

The matching platform lists a variety of offset projects, including reforestation and conservation projects and CO2 capture technologies around the world. Companies can purchase credits created by projects that match their own in order to offset greenhouse gases that they cannot reduce through their own efforts alone. However, the reliability of such offset projects and the fact that many reforestation projects are invested through intermediaries makes project credibility uncertain, carbon credits are double counted and sold, and there is no established method for verifying forest growth and CO2 absorption. How to ensure the validity and accuracy of carbon credits has been said to be a major challenge ¹⁸.

In this context, the U.S. startup Pachama, which operates a marketplace for forest-based carbon offsets, is showing promise. Despite only being in its first year of operation, Pachama has received funding from several investors, including prominent executives such as Microsoft founder Bill Gates (Breakthrough Energy Ventures) and Amazon founder Jeff Bezos (Climate Pledge Fund). The company is a highly regarded startup that has raised a total of $15 million from several investors, including prominent executives such as Microsoft founder Bill Gates (Breakthrough Energy Ventures) and Amazon founder Jeff Bezos (Climate Pledge Fund).

Introducing Pachama Originals, the Next Generation of Nature-Based Projects²⁰. > We started Pachama with the mission of restoring nature to solve climate change, harnessing the latest advancements in satellite data and machine learning to ensure the quality of nature-based projects. With Pachama Originals, you can invest in your very own high-quality forest With Pachama Originals, you can invest in your very own high-quality forest projects from the ground up, secure credits to reach Net Zero, and make a transformative impact on communities and ecosystems for generations to come. Pachama Originals enables real climate leaders to Go Beyond.

Pachama Originals is a technology company that not only operates a marketplace, but also provides a solution to calculate and verify how much CO2 is actually captured in the forests that qualify for carbon credits by using proprietary machine learning to analyze 3D data from sanitary images and drones. Pachama's services contribute significantly to ensuring the credibility and effectiveness of projects ¹⁸. Restoring and preserving the world's forests is one of the simplest and most effective ways to reduce greenhouse gases in the atmosphere, and Pachama is one of the startups to watch as a leader in this effort. The visionary, impactful, and socially-driven aspects of Pachama’s business have attracted talent from global tech companies like Google, Meta, SpaceX, Tesla, and Microsoft. Major companies like Microsoft and Shopify have also become clients. The company is expected to continue to grow in the future¹⁹.

Conclusion

This article has provided an overview and specific examples of carbon pricing and emissions trading to realize a decarbonized society. Although there are still issues to be addressed in terms of legal regulations and accounting and taxation in Japan and abroad, it is expected that governments, major companies, and start-ups around the world will accelerate their efforts toward carbon neutrality. We hope that this article will help those who are considering business in related fields to organize their arguments and consider their strategies.