On 14 February 2024, Japan priced the world's first sovereign climate transition bond – the first of a series of expected issuances, with another on the way just two weeks later. Nomura's head of sustainable finance, Jarek Olszowka, discusses what this means for transition finance trends in the Asia-Pacific region and beyond
Environmental Finance: How has the story of transition finance progressed in Japan in the past year?
Jarek Olszowka: In November 2023, Japan published its Climate Transition Bond Framework, for which it received two second party opinions. They also launched their Green Transformation (GX) programme: a public private partnership which seeks to catalyse JPY 150 trillion ($1 trillion) of investment over 10 years towards reaching its nationally determined contribution to implement the Paris Agreement on climate change.
JPY 20 trillion ($133 billion) of that will include the issuance of sovereign transition bonds. Last week saw the issuance of a 10-year bond and on 27 February 2024, there will be a five-year bond – both of JPY 800 billion yen ($5.3 billion).
The market has been waiting for this moment and it has been hotly debated. The Japanese government has spent a lot of time discussing with top ESG-driven investors what a credible transition means and what parameters and guardrails need to be in place. The government has been refining the structure for some time now.
EF: How comfortable are investors with the topic of transition relative to just a few years ago?
JO: The Japanese government has done a lot of work on international outreach as most Japanese sovereign bonds have previously been bought domestically. What we are seeing is a very innovative structure. From our discussions, investors have been extremely supportive of transition overall. We have noticed a shift in the conversation compared with just three years ago. ESG-driven investors understand we are not going to meet a 1.5-degree warming scenario if we only finance green assets. There are simply not enough assets available.
"ESG-driven investors understand we are not going to meet a 1.5-degree warming scenario if we only finance green assets. There are simply not enough assets available"
The problem with transition is it is extremely fragmented. There's no universally agreed definition and the goalposts will keep moving as more ambitious targets are required over time and new commercially viable decarbonisation technologies become available. It's very dynamic versus a static point-in-time assessment when determining if something is green. While green definitions are binary, transition is a process - which can result in heightened sensitivity to greenwashing risk. It's not a one-time assessment at issuance. It is also very context and location-specific.
EF: How has the local context informed the approach in Japan?
JO: Japan has high fossil fuel dependency; more than 80% of the energy mix comes from oil, coal, and liquefied natural gas (LNG). It also has very low self-sufficiency of energy production: for example, in FY 2021, 13.3% came from self-generated sources. The war in Ukraine has further highlighted the importance of ensuring adequate energy security.
One challenge with renewables is navigating a high variability in output depending on the time of year or weather. In Europe, there is a balancing mechanism so that if there is a deficit in France and a surplus in Spain or Germany, for example, the production output can be diverted. But Japan is an island nation. It also has little land relative to a large population of over 125 million people, and 70% of the land is mountainous. The deep seas surrounding it also make offshore wind very challenging.
This confluence of factors means the Japanese government cannot simply go green in the way that Europe has. Instead, through the creation of 10 net-zero technology roadmaps developed by Japan's Ministry of Economy, Trade and Industry (METI), Ministry of Environment, and a number of other ministries, Japan has scrutinised the true meaning of what transition could look like for their economy.
In addition, the government has created a GX Implementation Council – chaired by the Prime Minister with related policy trickling down across ministries – and a GX Business League. They have also developed an overarching Basic Policy for the Realisation of GX. It will include roadmaps for the decarbonisation of 22 sub-sectors, from buildings and transportation to new areas like carbon capture.
We often hear the private sector needs more regulatory support and incentives to finance transition. Japan is showcasing a real example of a public-private partnership. It has been designed to be like an industrial plan with economic drivers, all while decarbonising an economy that is highly dependent on hard-to-abate sectors.
An innovative element of the sovereign bond framework is the introduction of 'basic conditions' for selecting how use of proceeds will be allocated. The eligibility criteria state it must be integrated with the regulatory regime and contribute to industrial competitiveness, economic growth, and crucially, emission reductions.
The structure is fully aligned with the International Capital Market Association (ICMA) Green Bond Principles and its Climate Transition Finance Handbook. The Climate Bonds Initiative (CBI) will also provide certification of the individual Climate Transition Bonds. This has several positive implications as it means that the issuances will have obtained an additional layer of credibility, benefitting from CBI's stringent standards, but also, the bonds could be eligible for green bond indices (particularly important for passive ESG-driven ETF strategies which tend to track such indices) and green bond funds.
We expect to see a halo effect from the issuances amid strong interest from the sovereign buyer base. I expect it will give us a further boost in the wider region and help popularise the concept of transition bonds.
The EU has obviously been a leader in green, but in our view Japan and the Asia-Pacific (APAC) region are significantly ahead on the topic of transition. Like Japan, many APAC economies have a very high percentage of GDP coming from hard-to-abate sectors so whether and how these are decarbonised really does matter.
EF: Do you expect the APAC approach to be mirrored in the EU to a degree?
JO: We're not expecting to see a transition taxonomy from the EU any time soon. There was a lot of political debate about whether nuclear and gas should be considered as green in the EU Taxonomy or not, and the impact of that is still being felt with ongoing litigation from several NGOs for its inclusion in the taxonomy.
Furthermore, transition will mean something very different across different EU Member States. I think it would be extremely hard for the EU to strike a political agreement for a transition taxonomy. Looking at how long it has taken to create the EU green taxonomy – which is now six or seven years in the making – there is limited appetite to embark on the more complicated topic of transition, even more so with both a European Parliament election looming in June and the Commission's term coming up for renewal.
Recently, there was an interesting recommendation from the EU in terms of how to achieve transition using the current tools and legislative pieces, such as with the Corporate Sustainability Due Diligence Directive (CSDDD) or the Corporate Sustainability Reporting Directive (CSRD) transition plans, and how transition plans could be used as a tool for structuring either transition bonds, or sustainability- linked bonds (SLBs) with transition KPIs and Sustainable Performance Targets. It was the first time the EU had officially acknowledged how important transition finance is.
EF: How do you think international investors are going to react to sovereign transition bonds more generally? How long-dated do they need to be to reassure investors of impact?
JO: Japan's Ministry of Finance has flagged that the sovereign Climate Transition Bonds will cover a spread of maturities from 2-, 5-, 10- to 20- years. A 10-year tenor is not uncommon in green bonds. I think it would be a different case if a sovereign was only planning to issue 15-to-20-year bonds, as is the case with some infrastructure-related projects in Europe. That would impact the type of investors that could buy such paper.
Close to 40% of the use of proceeds for the inaugural Climate Transition Bonds will be allocated to what CBI terms "deep green" activities. I think it will be important to international investors that by purchasing these bonds they are not only financing "brown" to "less brown", but there will also be a very significant chunk which will go towards low-carbon buildings and transportation, batteries, solar cells and wind, and also interesting research and development (R&D), such as using hydrogen in the steelmaking process.
"While investors will have differing views on the impact of different technologies, the bulk appear to be comfortable with financing R&D – as long as a country's transition plan does not bet on just one technology"
Over half of the proceeds of the initial two bonds will be allocated to R&D. While investors will have differing views on the impact of different technologies, the bulk appear to be comfortable with financing R&D – as long as a country's transition plan does not bet on just one technology e.g., carbon capture or blue hydrogen. Investors don't want to be in a position where they invest in a bond and the success of an entire country's transition strategy hinges on whether or not a particular technology materialises in time.
Another big concern is avoiding 'lock in'. For example, cargo shipping often runs on the least refined form of crude that is most harmful to the environment. Switching ships from heavy fuel oil like mazut into LNG is a true transition move as it is less harmful than continuing with businesses as usual. However, there is a concern that you could spend a lot of capex on changing how ships are fuelled and end up locking in LNG for the next 20 to 30 years – during which time, a greener option could become available.
"This is the crux of the transition debate. We are not moving to perfect solutions; we're moving to less bad solutions from an environmental perspective, and this is how we are achieving improvements in terms of real-world impact"
This is the crux of the transition debate. We are not moving to perfect solutions; we're moving to less bad solutions from an environmental perspective, and this is how we are achieving improvements in terms of real-world impact.
EF: How does that tie in with the EU's Sustainable Finance Disclosure Regulation (SFDR) coming in? Does that put more pressure on investors to be even more green?
JO: It is not yet clear how this fits under SFDR as SFDR has not been designed with transition finance in mind, but to help provide disclosure on EU Taxonomy-aligned and non-aligned investments. Furthermore, if you have a transition SLB in a fund but the issuer doesn't meet their stipulated sustainability performance targets, is that still a transition instrument? However, if all issuers meet their targets, it's a pointless market because it shows the instrument is not ambitious enough. It is an important point that needs to be resolved. It's something we will be analysing with other underwriters and investors.
If you have an EU-domiciled green bond fund, there typically is a flexibility pocket that allows a portion of the fund's assets under management to be invested in products other than green bonds. That's where a lot of the SLBs have been sitting. If an investor buys a transition bond or SLB that has enough disclosure to demonstrate impact then there is a place for such products, even without regulatory changes, especially if such a transition bond is a type of green bond – as is the case with Japan's Climate Transition Bonds. But, of course, regulatory support would be welcome to explicitly address this.
There is an ongoing consultation on how to amend SFDR and one proposal includes following the UK Sustainability Disclosure Requirements (UK SDR) fund label of a transition improvers category. For now, EU regulation is causing a problem by not recognising this category.
EF: What's next for transition finance globally?
JO: I think more issuers having credible transition plans will be a game changer. In the absence of government-led net-zero roadmaps like Japan have, entity-level credible transition plans will still provide a lot of disclosure and investors can use it as a monitoring tool.
CDP last year conducted a survey of the 16,000 companies they cover and found only 81 had a credible transition plan in place. There is a huge amount of work still to be done and it's not going to change overnight, but legislation is increasingly requiring companies to put transition plans in place. These can then be used by banks like us to structure transition finance instruments but, equally, they can be a tool for issuers and investors to assess progress.
Jarek Olszowka is the head of sustainable finance IBD at Nomura.
For more information, see: Sustainability | Nomura (nomuraconnects.com)
