Japan’s bold bet on transition bonds offers new pathway for the world

The transition to a net-zero world, in order to stave off the worst effects of global warming, is not easy. The United Nations has described it as one of the greatest challenges facing humankind. But Japan’s unique take on transition financing might be a model for other countries to follow, especially in Asia.

While many economies, both in Asia and the West, have focused on adopting green taxonomies to include elements of transition financing, Japan has gone in a different direction. It is directly providing technological guidance with a range of potential transition pathways, which have been specifically developed for its own economy and the challenges it faces.

Japan’s Ministry of Economy, Trade and Industry (METI), is driving the move, having established the Green Transformation (GX) policy, along with the Ministry of Finance (MoF), to meet the market’s long-term growth and energy security objectives.

Importantly, the programme includes a ¥150tr ($1.04tr) package of long-term public-private financing to be raised over the next 10 years, of which ¥20tr will come from the sale of sovereign climate transition bonds by the MoF.

Japan made its first landmark outing early this year, raising ¥800bn on February 14 from a 10 year climate transition bond, followed by another ¥800bn five year priced on February 27. These were the world’s first sovereign climate transition bonds.

Then in May, it raised about ¥350bn from a 1% 10 year, and in July another ¥350bn from a 0.5% five year. It is slated to raise a further ¥350bn from its next 10 year auction in late October, and the same amount from a five year tranche in January 2025.

The deals have put Japan on the ESG map, making it a pioneer in transition financing. But its GX strategy was not without its critics — particularly for including natural gas and nuclear power as part of the energy decarbonisation approach, and including emerging technologies like ammonia co-firing for coal plants and fossil fuel phase-out strategies.

“What has been a challenge is that the international market is still working out what transition means,” says Tokyo-based Jason Mortimer, head of sustainable investment, fixed income, global solutions, investment department, at Nomura Asset Management. “We’re all talking about transition finance, but different people have different meanings for it.”

Mortimer adds that, in Japan, the focus is on hard-to-abate sectors that do not have a clear-cut net-zero pathway, as well as relatively untested technologies, to help with the transition.

This resonates well with other markets across Asia and in southeast Asia in particular, where countries are grappling with similar problems, given their long reliance on heavy industry, combined with a lack of access to sufficient financial and technological resources to navigate transition.

“Asia is getting there in terms of accepting the need for transition, but the global market is still hesitant because there is no agreed standard for it,” says Mortimer. “If an investor buys something that is brown but with scope for transition, their brown-green ratio still goes in the wrong direction. That is holding investors back from aggressively participating in these kinds of bonds.”

As a result, international investor interest for Japan’s maiden climate bonds was only modest — despite METI and the MoF engaging with investors on global roadshows — with domestic investors driving the deal.

Market sources say this was partially expected, as foreign investors hold only a small portion of conventional Japanese government bonds overall.

But that’s not to say international investors are not supportive of Japan’s ambitions.

Tongai Kunorubwe, head of environmental, social, and governance in the fixed income division at T Rowe Price in London, says his team “welcomed the basic premise that sat behind GX”.

“This is not least because decarbonising the Japanese power and industrial sectors remains crucial to ensuring Japan achieves real-world decarbonisation, whilst balancing just and equitable considerations,” says Kunorubwe. “Additionally, at the time, we provided feedback around several specific areas including ammonia co-firing in coal plants. We were encouraged when the inaugural issuance took on board these considerations.”

Mortimer adds: “We’re starting to hear the government really emphasise now that this is a growth strategy, and this is what we need to do to fund carbon pricing and fund the R&D to create different technologies. Some of them are not going to work out in every single situation and there is some risk here, but this is the way we can transition from brown to green.”

The path ahead is not going to be easy, especially as the transition finance market is still nascent.

Despite the world’s first transition bond coming in mid-2017 — through Castle Peak Power Finance Co, a subsidiary of a Hong Kong electric power company — and the International Capital Market Association publishing its climate transition finance handbook in December 2020, issuance has been limited.

In a note published in September, Akane Enatsu, head of the Nomura Research Centre of Sustainability, says that the total outstanding amount of transition bonds from Japanese issuers stood at $19bn at the end of June 2024 — accounting for 68% of the total global issuance of $28bn.

This shows that the transition market has not yet taken off strongly outside Japan, where issuers have tended to favour sustainability-linked bonds that are earmarked for general corporate purposes but that come with performance targets that need to be met to avail of any pricing benefit.

But to take Japan’s transition market further, corporates need to jump on the bandwagon.

The government is now the largest issuer of transition bonds in the country. Other issuers include companies with high greenhouse gas emissions, from sectors like electric power, gas and oil refining.

Japanese groups had raised $2.2bn-equivalent through 14 transition bonds between January 1 and September 24, shows Dealogic. This compares to $1.4bn-equivalent from seven deals and $2.5bn-equivalent from 12 bonds in the same period in 2023 and 2022 respectively.

This year’s deals include a ¥30bn dual-trancher from Mitsubishi Heavy Industries in August, a ¥30bn note from Mazda Motor Corp in July, a ¥45bn issue from Kansai Electric Power Co also in July, and other deals from JFE Holdings, Kyushu Electric Power Co, Osaka Gas, Chugoku Electric Power Co, Japan Airlines, Mitsubishi Materials Corp, NYK Line and Jera Co, according to Dealogic.

“What investors want to see is an ecosystem of corporate issuers so we can create a diversified portfolio out of this,” says Mortimer. “If you ask an issuer now if they want to do a green or transition bond, they would probably say green because it’s more standardised and less risky. I think the market needs more incentives to really go all in on transition finance.”

He adds: “Pledges are good to have but having a descriptive plan that investors can look at and that companies produce about their transition, that will create an ecosystem of data disclosures and pricing will become healthier off the back of that. And then the market will have a deeper understanding of why transition is important.”

Communication would be key to get the market really rolling, especially if issuers continue to tailor bonds that best serve their transition needs.

For instance, for Japan, energy sustainability and affordability are priorities, which is why it included natural gas and nuclear power within its decarbonisation approach, despite criticism from international investors.

A Singapore-based DCM banker focused on sustainability says the market “needs to recognise” that Japan and other countries in Asia will need to build their own transition finance frameworks based on their national circumstances. “There’s no one fixed template, but rather a trial-and-error process,” he says.

Kunorubwe says there seems to be growing demand for blue bonds in Japan, following the Republic of Indonesia’s repeat sovereign blue bond in the Samurai market in May.

Indonesia raised ¥200bn from its deal, split between three, five, seven, 10 and 20 year tenors.

A DCM banker in Tokyo says the blue bond concept makes sense for Japan, as it is the world’s fourth-largest island nation. But he reckons there may be limited interest in new labels for the time being, given that interest rates in Japan are rising and overall corporate bond issuance has shrunk, compared to past years.

“The concept of blue bonds resonates more than some other labels, but it may be a challenge to get this off the ground at this point in time,” says the DCM banker.

On the other hand, the transition journey will evolve as more ESG ratings providers and data providers find ways to include transition in their credit assessments and scorings.

“It’s going to be really necessary for us to move transition finance forward because the green finance market faces challenges due to political pushback and real economy constraints,” says Mortimer. “Transition bonds need to be part of the overall conversation around energy security and energy costs and Japan’s sector pathway is a good model, especially for other Asian countries.”

The global market for transition bonds may still be in its infancy, but the hope is that Japan’s efforts could serve as a catalyst for growth — both at home and abroad.