Transition bonds: Could 2023 be the year we see them take off?

Transition bonds have not emerged as a widespread sustainable bond label. However, a recent proliferation of transition bond issuance in Japan could signify the emergence of several hubs for the instrument which could be much more regional in nature. Jarek Olszowka explains

The transition bond label has struggled to secure widespread adoption since it emerged in 2017 – partly due to issues around defining transition finance and the rapid growth of sustainability-linked bonds (SLBs), which appeared to be preferred by both 'transition' issuers and investors over a distinct use-of-proceeds (UoPs) transition bond label.

While green bonds require climate and other environmentally beneficial projects to be identified for financing or refinancing, transition bonds focus on UoP categories that help a company progress towards its decarbonisation goals. In other words, helping companies transition from brown to "less brown" or "greener".

While there have been a few attempts to get the label off the ground since Hong Kong's energy firm Castle Peak came to market with the first transition bond, issuance has been limited. Even well-respected issuers who have entered the market have faced challenges.

However, a potential sea change came in 2022 when the Japanese domestic market turned its gaze towards transition bonds. This came in the aftermath of the Japanese government announcing its own climate transition finance guidelines (see case study). 

While this was an encouraging development, these issuances have been placed with domestic investors and a widespread acceptance and availability of a uniform label in international markets remains out of reach – for now.

The reasons for this are manifold, says Jarek Olszowka, head of sustainable finance IBD at Nomura. Firstly, there is no universally accepted definition of what transition finance is and what is an acceptable minimum degree of transition required from individual sectors or particular issuers.

Jarek Olszowka"There is a multitude of definitions of transition out there, but none has been internationally agreed upon. This, in turn, has led to a lot of confusion among international investors as to what is meant by a transition bond. The lack of agreement on the definition is preventing market growth," says Olszowka.

Related to this is a fear of being accused of 'transition washing'. In the green bond market, by comparison, investor confidence has grown alongside the emergence of credible market guidance, product level principles, and green taxonomies. All of which have clarified and delineated what qualifies for green financing.

While Canada and reportedly Australia are working on their own transition finance definitions, virtually none of the major global economies have transition taxonomies or guidelines in place.

The EU Platform on Sustainable Finance has proposed the creation of an intermediate or 'amber' performance category as part of the EU's taxonomy, but this conceptual proposal is yet to progress, with the EU only so far opting to temporarily label gas as green in certain circumstances and keeping it firmly within the existing 'non-extended' EU taxonomy and not in a separate transitional activities bucket.

The planned introduction of an amber category was expected to cover intermediate activities which are not yet green but also not 'significantly harmful' to the environment under the Do No Significant Harm principle. "If ever, it will certainly be many years before an extension of the EU taxonomy to cover non-green activities takes any concrete form", says Olszowka. "Plenty of questions arise as to if it will ever be legislated – partly due to concerns around its complexities and reaching political consensus around the various thresholds and level of ambition across all the EU Member States.

"Usability of such an extension is a concern. Especially if you juxtapose any such brown (or rather 'amber' and 'red' in the proposal's parlance) extension versus the existing EU taxonomy – which is much more straightforward but still raises many concerns in terms of its practical usability," highlights Olszowka.

There are also fears from certain stakeholders that such an extension could divert funding away from sustainable activities and not achieve the desired effect in terms of the required real-world improvements.

Some private market initiatives, such as the Climate Bonds Initiative or the Science Based Targets initiative (SBTi) have published guidance or transition pathways. However, these are "far from being universally agreed and not really equivalent to having hard legislation or even some form of regulatory guidance in place," says Olszowka.

The absence of universally accepted taxonomies could create a fragmented market, he cautions.

"We might end up with several transition bond hubs which would be more regional in nature. As a consequence, the international capital markets are unlikely to see the issuance volumes of other established sustainable bond categories until we get a universal definition for transition bonds."

Another pressure on the transition bonds label came from the emergence of SLBs, with the former effectively being subsumed and superseded by the latter.

"When we started work on the ICMA [International Capital Market Association] Climate Transition Finance Working Group back in early 2020, the idea was to develop a transition label. Consensus quickly emerged across the majority of investors and international issuers that SLBs were the transition instrument of choice. The group decided to focus on climate transition disclosures to be added to SLBs and existing UoP bonds, rather than creating a separate label, especially in the absence of a global consensus around key definitions and components of such an instrument."

While there is a fair amount of cross-over between the two products, they seek to deal with transition in different ways.

"Transition is typically not based on qualifying assets but, by definition, tied to the overall improvement of the sustainability performance of an issuer over time. It is this fundamental structural difference that has meant SLBs have been seen as more suitable to support transition," says Olszowka.

A recent shift in sentiment against SLBs due to structural concerns and fears they are not ambitious enough to prevent accusations of greenwashing could give transition bonds a
second wind.

"With increased focus on litigation risk and greenwashing, some investors may feel they are better off investing in specific transitional technologies and CapEx in hard-to-abate sectors via UoP bonds," says Olszowka.

"Perhaps one day we will even see transition bonds which also contain KPIs and SPTs [Sustainability Performance Targets] and the associated margin variation features – thereby marrying the two types of transition-focused instruments. Although I do expect that to be the fringe, I could see it having merit for certain investors and issuers."

Could 2023 be the year?

Transition finance is an area where investors tread carefully. However, Olszowka believes that once investors become more comfortable with the transition label, its distinct categorisation could prove to be its strength.

"Having a separate label could be cleaner for some," he says. "Contrary to popular belief, it can help prevent accusations of greenwashing because it makes investors aware that it is a transition instrument, and they are not buying something marketed as green or that will become green.

"Another advantage is investors are familiar with the UoP model that is well established in green and social bonds. Plus, impact reporting provides transparency that you do not necessarily get with SLBs."

Olszowka believes investors are better placed to understand the instrument than a few years ago.

"The more sophisticated ESG-driven investor continues to invest and build out their ESG capabilities to better understand transition finance. It is a complex and context specific area.

You must make informed decisions on whether something is aligned with transitional pathways and make judgments on whether by supporting a given transitional technology you are locking it in for decades when cleaner alternatives may emerge in the interim. Many ESG investors have enhanced in-house capabilities to deal with in the past 18-24 months."

The final piece of the puzzle would be dedicated transition bond funds or ESG investment mandates focused on transition.

"We are seeing more asset managers coming out in vocal support of transition finance, highlighting the importance of stewardship over divestment, and emphasising the need to divert more capital to genuinely transitioning issuers. But we are yet to see the emergence of dedicated strategies or pools of assets focusing purely on this," he says.

"If we are to get anywhere near the Paris Agreement target, we need to look at the less green stuff as well and see how we can make meaningful decarbonisation gains.

"Will transition bonds take over from SLBs? I don't think so. Equally, their demise which was widely touted around 2019-2020, seems to have been premature. Parts of the global economy may well go down the route of transition bonds. The debate and structuring dilemmas are far from over."

For more information, see:

Japan's transition finance leadership

In May 2021, Japan's Financial Services Agency, Ministry of Economy, Trade and Industry (METI), and Ministry of the Environment, published the Basic Guidelines on Climate Transition Finance.

The aim of these was to promote transition finance in Japan, particularly in sectors where emissions are difficult to reduce.

These guidelines, while highlighting alignment with the ICMA Climate Transition Finance Handbook, also clearly spelled out that transition finance could include UoP-based transition bonds, alongside green bonds and SLBs.

Crucially, and in stark opposition to other parts of the globe, Japan also set out a series of net-zero roadmaps covering the high-emitting sectors of cement, chemicals, electricity, gas, steel, oil, and paper/pulp. These technology roadmaps provide much needed sector-level transition finance guidance on how issuers can prioritise projects to help Japan achieve its 2030 and 2050 decarbonisation targets (46% GHG reduction versus 2013 levels and carbon neutrality, respectively).

The aim was to establish how an orderly transition could support the Japanese economy and play to its competitive strengths while promoting promising technologies based on scientific grounds, says Olszowka.

"The authorities almost treated these net-zero technology roadmaps as an industrial policy, rather than a purely sustainable finance one. This could be very useful – if it is still science-based and delivered in a form which would allow finance to benchmark against," he says.

"There is an active push in Japan – equally absent in many other countries – to promote certain climate mitigation technologies that capitalise on the vast industrial expertise of Japan's real economy. The government took into consideration the market leadership in some of these areas. For example, transition pathways for ammonia combustion, coal-to-gas or hydrogen – all in hard-to-abate sectors."

Prior to the publication of the guidelines, there had been no transition bonds from Japan. Since the guidelines and subsequent roadmaps have been released, nearly 30 transition bonds have been issued from a range of sectors: shipping, power generation, heavy industry, aviation, chemicals, and steel – with many others on the horizon.

It's a model that Olszowka expects other countries could follow – especially those which are highly dependent on natural resources or where a high proportion of GDP comes from hard-to-abate sectors.

"From a power supply perspective, Japan exhibits the highest fossil fuel dependency out of all developed economies: in the aftermath of the Fukushima nuclear disaster, coal, and gas account for approximately 70% of all electricity generation, with that figure nearing 80% when you include oil. For Japan to have a shot at achieving its decarbonisation goals it needs to rely on transition finance," he says.

"Just looking at the country's mountainous geography – you can't easily roll out solar or wind at scale, either. There are simply not enough green projects to finance," he adds.

Japanese PM Kishida-san announced in May 2022 that Japan will look to issue up to JPY 20 trillion (approximately $152 billion) of sovereign transition bonds over the coming decade, making it the first sovereign to choose such an instrument rather than green, social, or sustainability bonds and SLBs.