16 January 2025

Japan: The case for transition bonds

A transition bond is 'beneficial' for investors, GX Acceleration Agency's Hideki Takada tells Ahren Lester

Investors would find it "beneficial" to be able to clearly differentiate between green and transition bonds, according to a senior Japanese government official – as the market grapples with the problem of how to define credible 'transition' finance investments.

Hideki Takada"My personal view is that it would be beneficial for all investors to distinguish between the green bond – which is for the pure green [assets] – and the transition bond," GX Acceleration Agency finance and sustainability director Hideki Takada tells Environmental Finance.

"Of course, there is some overlap between the two," he says. "But having the two as distinct categories helps to clarify what [transition] means. So, it would be more transparent to label transition-focused projects as transition bonds, rather than mixing up the green and transition [in green bonds]."

Takada says the strength growth of transition bonds in Japan has been helped by Japanese stakeholders "more or less" taking this approach: keeping green bonds for 'pure' green projects, rather than trying to introduce 'transition' projects into green bond structures.

Concentrated growth

The comments follow the Japanese government issuing a ground-breaking sovereign transition bond – formally the 'Climate Transition Bond' (CTB) – in 2024, which played a critical role in pushing transition bonds to a record year of issuance.

The CTB proceeds will be used to finance Japan's 'Green Transformation' (GX) plan, which outlined incentives and practical pathways to support sectors in identifying transition investments. The GX Acceleration Agency was launched by the government in June to promote and financially support investment in these activities.

According to Environmental Finance Data, more than $20 billion was raised through transition bonds in 2024 – more than four-times the previous annual issuance record set in 2021. Almost the entirety of this total was issued by Japanese issuers, led by the Japanese government which raised more than $17 billion. Other issuers in Japan during 2024 included Japan Airlines, Hokkaido Electric Power and Mazda Motor Corporation.

The first transition bond was issued in 2017 by Hong Kong power firm Castle Peak. Since then, just $35 billion has been raised through the instrument to date. But Japanese issuers have been leading the way since 2021 when the Japanese government published its 'Basic Guidelines on Climate Transition Finance'.

Acceptance growing

"Japan advocated the concept of transition finance at a very early stage," Takada says. "And, at first, there was some scepticism against the concept of transition finance, and there still is in some part of the world. But my personal perception is that, maybe in the last one or two years, acceptance of transition finance as a concept has improved across jurisdictions."

Several Asian countries have explicitly included transition in their sustainable finance frameworks and strategies, and expectations that others will follow with their own sovereign transition bonds. What is more, Takada – who previously held senior roles at the Japanese Finance Ministry and Financial Services Agency – highlighted that the EU has incorporated elements of transition into its Taxonomy and the UK has looked to promote transition finance in its own sustainable finance activities.

"So, I think transition finance, as a concept, is now very well understood across the globe," he says. "However, when it comes to the transition finance as a financial instrument – in other words, the transition bond as a financial instrument – it has not yet penetrated into the world markets so much. So far, most of the issuers of transition bonds are Japanese entities."

Legitimate investment

International investors "all agree with the concept of transition finance as being good and necessary," he claims. "But whether they purchase transition bonds or not? They are still divided.

"But I would like to encourage global investors to accept transition bonds and be positive and active about ... considering them as a legitimate investment option."

The necessity of a distinct transition bond label alongside green, sustainability and sustainability-linked bond labels remains a hotly contested subject among sustainable bond investors, however. Takada says this was evident during the discussions around revising the International Capital Market Association (ICMA)-administered Climate Transition Finance Handbook (CTFH) in 2023.

"There was some argument around whether we need a distinct transition label, or maybe whether we can put it as a subset of the green bond," he says. "Of course, that may be possible. But, still, we think that transition finance is a very important concept on its own. So, we think that the transition label is very important."

These discussions are likely to remain prominent in the coming year, after ICMA announced it has relaunched the working group on climate transition finance which had previously developed the CTFH.

As a result, Takada says the "next challenge" is to make transition bonds "more widely recognised and accepted" by investors. Yet he thinks this process is already underway in many cases.

"I think [investors] are now in the process of adapting themselves with regard to this new category of financial instrument," he says. "It is a relatively new instrument and so it may take time before it is accepted as an investment option by those investors because their [investment] mandates cannot always change so quickly."

Distinct characteristics

Takada emphasises it is important to understand the "distinct characteristics" of transition bond instruments – in particular, the clear focus on the corporate-wide transition strategy and how the proposed use-of-proceeds contribute to this strategy. This entity-based approach contrasts to the project-based approach of green bonds.

He adds that transition bonds are "dynamic, forward-looking" instruments.

"Again, this is as opposed to a green bond which is looking at whether any given project is green or not right now," he says. "But the transition bond is not about whether it is green or not now, but how it will evolve and change into the future."

As a result, transition bonds are a more "challenging" and "substantial" effort from issuers – but also for investors – to deliver robust instruments.

"In terms of the credibility and transparency when it comes to transition finance, it is an even more important thing to have continuous monitoring of the given project or the given issuer.

"And this is a bit different from the typical green bond. Typically, when you issue a green bond you will get a second party opinion, but only at the point of issuance. Of course there will be regular reporting, but that is not necessarily monitored by everyone over the [life of the bond].

"But transition finance is a dynamic concept, and so regular and continuous monitoring is needed."

To help investors and financial institutions to understand how to develop an "effective dialogue" with issuers around transition finance, Japan published follow-up guidance on transition finance in 2023.

Fundamentally, however, the "dynamic" nature of transition finance over many years means issuers and investors need to be accepting of changing circumstances – for example, a change in technology to achieve decarbonisation objectives if a more effective tool emerges.

"Transition bond issuers and investors need to be flexible, but also they need to stick to the aim or the ultimate goal [of decarbonisation]. Transition finance is a journey which may be across decades. And, so, you must have a long-term view as well as some sort of flexibility."

'Purer' than SLBs

But transition bonds are often seen as being in competition with the target-based sustainability-linked bond (SLB), which looked set to displace transition bonds as the preferred transition fixed income instrument after issuance surged following the publication of the ICMA Sustainability-Linked Bond Principles (SLBP) in 2020.

After surging to almost $100 billion issuance in 2021, however, SLB issuance has contracted significantly in recent years amid concerns about the credibility and ambitiousness of the structures coming to market. Nonetheless, the SLB market is still around 10-times larger than the transition bond market to date.

Takada agrees that SLBs can also serve as valuable transition finance instruments by providing an entity-wide, forward-looking and dynamic structure which requires continuous monitoring. The Japanese transition finance guidance clearly explains that transition finance can be delivered through sustainability-linked instruments.

Nonetheless, Takada says the existence of SLBs does not "ultimately remove the need for the transition-labelled bond".

Indeed, he argues that the need to identify fixed metrics and targets and the associated trigger conditions depending on whether a target is met introduces "unnecessary complexity" for the instrument.

In addition, Takada says the fact that SLBs can also be used for a diversity of environmental and social targets means that transition bonds are a "purer" form of decarbonisation instrument.

"Ultimately, if you are just thinking about [climate] transition finance, then just transition bonds can do," he says.