Unloved transition bonds are big in Japan

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Welcome back. UK bank Barclays, which has come under fire over its fossil fuel lending, made waves on Friday by saying it would no longer finance new oil and gas projects, and would restrict its support for companies that are expanding their oil and gas production.

The lender also gave new details on its approach to another hotly contested field: transition finance. Noting that there was still no consensus on what this term means, Barclays laid out its own definition, focusing on technologies and activities that support emission reduction, “directly or indirectly, in high-emitting and hard-to-abate sectors”.

What role does the fixed income market have to play in this? So far, bonds explicitly earmarked for transition investment have struggled to take off in most major economies. Japan is an exception — and, some reckon, could be the harbinger of a global trend. Read on for more.

Japan takes up transition bonds — will others follow?

Japan’s government will celebrate Valentine’s Day on Wednesday by taking the country’s emerging love affair with “transition bonds” to a new stage.

The term refers to bonds that fund investments that are not necessarily “green” per se, but should result in lower emissions from polluting economic sectors. This is an asset class that has struggled to catch on in most of the world. In Japan, however, some of the nation’s largest companies have made big issuances under the transition bond label.

Now the Japanese government is joining them, with the first sovereign issuance of this sort. This ¥1.6tn ($10.7bn) of “climate transition bonds”, the first tranche of which will be issued on Wednesday, is far from the first sovereign issuance of debt aimed at climate-friendly investment. Governments from Brazil to Saudi Arabia have issued bonds variously labelled as green, sustainable or sustainability-linked.

What’s different about this bond programme is the emphasis on using the proceeds to reduce emissions from the most stubbornly dirty areas of the economy.

As I’ve written before, “transition finance” is a paradigm that needs serious scrutiny. If deployed without sufficient rigour, it could help to keep heavy polluters in business without driving real change in their practices. There’s also the risk that financiers drive too much capital towards “transitioning” big incumbents with whom they’ve enjoyed lucrative relationships for decades, and too little to fund the growth of a new generation of disruptive green companies.

There’s no question, however, that the progressive greening of currently dirty sectors, assets and companies must be a major part of any serious effort to decarbonise the global economy. And explicitly labelled transition bonds, from both sovereign and corporate issuers, could be an important means of funding this investment, argues Sean Kidney, chief executive of the Climate Bonds Initiative.

The CBI, which assesses and certifies the climate credentials of fixed-income securities, effectively “shut down” an earlier small wave of corporate transition bond issuance in Europe, Kidney said. It publicly opposed those bonds because they were aimed largely at financing natural gas plants, on the basis that these would help a “transition” away from even more polluting coal power.

In contrast, the CBI has formally endorsed Japan’s new issuance, and Kidney said he saw potential for growth in corporate transition bond issuance, notably in the US, where it could be a useful concept for industries including cement and steel.

The transition bond category is “a marketing label”, he added. “Call them pink bonds if you like. The main point is that the money is going towards things that are compatible with [limiting global warming to 1.5C].”

Japan’s Green Transformation (GX) strategy, which the new transition bond programme is designed to assist, has faced some criticism since it was unveiled last February. It includes potential support for investment to use carbon-free ammonia alongside coal in power plants, upsetting those who say coal plants should simply be closed as soon as possible. The transition bond proceeds will not go towards this part of the GX strategy — though they may support investment in other controversial areas such as hybrid petrol-electric vehicles, which to some are a distraction from pure battery-powered cars.

Noriyuki Shikata, Japan’s cabinet secretary for public affairs, told me that the focus of the government’s transition programme was on promoting technological advances, to drive decarbonisation at the same time as boosting economic growth and energy security. “Unless we come up with new technologies and technological solutions, we will not be able to achieve net zero by 2050,” he said.

Shikata added that the bond programme would serve to encourage private sector investment, with the government’s long-term financial commitment giving confidence in a predictable policy environment for the long term.

That private sector activity must account for most of any successful transition. And international companies interested in using transition bonds to help them do so can look to Japan for lessons.

Japan, together with China, has accounted for the vast bulk of corporate transition bond issuance in the past couple of years. Examples include two issuances amounting to ¥30bn by Japan Airlines, to fund investment in more fuel-efficient planes. In 2022, Kyushu Electric Power issued transition bonds worth ¥40bn, to help it replace coal-fired power stations with ones burning natural gas.

Japan’s corporate transition bond flurry, then, has helped to fund precisely the same sorts of gas investment that Kidney’s CBI resisted in Europe. Concerns about being accused of “greenwashing” — or “transition-washing” — have surely been a key factor holding back transition bond issuance in western markets.

Another is the existence of an alternative asset class that can be used to fund this kind of investment. Sustainability-linked bonds come with targets around metrics such as carbon emissions, and the promise of higher interest payments to investors if these targets are missed. Ulf Erlandsson, of the non-profit Anthropocene Fixed Income Institute, argues that this structure can give investors greater confidence in the issuer’s decarbonisation progress, and that Japan should issue SLBs alongside its transition bonds.

But the take-off of transition bonds in Japan — and the vast amount of this kind of investment that will be needed worldwide — suggests that the concept may yet be taken up by companies in other major economies.

Akane Enatsu, head of the Nomura Research Center of Sustainability, notes that official Japanese government guidelines for transition bonds were crucial for driving appetite from both issuers and investors. These official guidelines are lacking in most other major economies.

However, the International Capital Market Association, whose standards are widely followed in the bond market, has published a handbook defining best practice for this kind of finance. Such financing must be directed towards an emission strategy that’s aligned with the 2015 Paris Agreement goals, and issuers must provide proper transparency on their underlying investment programme, ICMA says.

Transition bonds could prove a useful tool for companies and investors seeking to play a role in building a cleaner world economy. But rigorous standards, effectively and transparently applied, will be essential if this asset class is to catch on worldwide.

Smart read

The Labour party, widely expected to take power in the UK later this year, has backtracked on a plan to spend £28bn ($35bn) a year on green investment. It’s a decision that party leader Sir Keir Starmer may live to regret, writes Stephen Bush.

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