The rise of transition bonds - a financial ‘bridge’ for hard-to-abate sectors

Transition bonds are rising in prominence as an avenue for ambitious and expeditious decarbonisation. They direct their Use-of-Proceeds (UoP) to transition economic sectors from carbon intensive activities to less carbon intensive activities. 

Unlike green bonds, transition bonds do not require the financed project to be classified as ‘green’. Instead, the issuer is required to use the bond’s proceeds to transition industries to a low or no carbon state. 

Under transition financing, these industries can more easily qualify for sustainable finance options, whereas green bonds depend on robust standards for what constitutes a ‘green’ project in its current state. As transition financing matures, there are increasing standards and definitions of what is suitable for transition financing, including the ICMA Transition Finance Handbook. This helps transition finance ensure alignment with industry classifications and technical indicators that empirically constitute a climate transition. 

Hence, much advocacy for transition bonds points to the growing need for companies and organisations to expeditiously transition into ‘greener’ enterprises, even when they do not qualify for traditional green bond financing. Consequently, transition bonds have the potential to fulfill increasing demand for sustainable investment opportunities that risk being unmet because of the limited supply of green bonds. 

For example, The IPCC claims that $3.5 trillion Cash-Against-Documents (CAD) financing is required annually from 2016 and 2050 to support enough green energy infrastructure to meet the world’s climate goals. However, green bonds can only provide a small amount of this funding. Therefore, transition bonds offer a vehicle to fulfill this financing gap. 

‘Green Transformation’ (GX) bonds in Japan: a case study of transition financing 

In October 2023, Tokyo hosted the Principles for Responsible Investment (PRI) in-person conference, bringing together more than 1000 experts exploring the international sustainable finance landscape. Japanese Prime Minister Fumio Kishida emphasised the importance of Japan’s hallmark Green Transformation (GX) Act. Importantly, in May 2023, Japan announced the issuance of a new type of sovereign debt, named the Green Transformation or GX bond. This is the world’s first sovereign transition bond. Over the coming decade, the Japanese government will issue 20 trillion Yen (USD 133 billion) in transition bonds to facilitate the goals of the GX. These include a focus on technologies such as hydrogen supply networks, Carbon Capture, Utilisation and Storage (CCUS), synthetic fuels and small nuclear reactors. The first auction, scheduled for mid-February, will offer USD 11 billion in transition bonds, followed by a similar auction for five-year bonds. 

Japan as a leader in climate transition finance: a model to aspire to?

As of the end of FY2022, Japan's total transition finance market reached approximately ¥1tn ($6.7bn), according to the Japanese Financial Services Agency. 

Japan's prominence in the transition finance market is underscored by the Climate Bonds Initiative, which indicates that the Japanese market is a regional leader in transition finance. The Japanese Ministry of Economy, Trade and Industry (METI) published Basic Guidelines on Climate Transition Finance, published in May 2021, which underscored the key role of transition finance in decarbonising hard-to-abate sectors in Japan, including heavy industry and transport. 

In Japan, the projects funded by the transition bond encompass emissions reduction in steel processing, in addition to the collection and recycling of scrap iron and steel. In addition to the Japanese government, many industrial actors in the utility, oil, gas and steel sectors, are issuing transition bonds for their own decarbonisation objectives, including Kyushu Electric Power and Tokyo Gas. These activities are some of the hardest to abate; demonstrating the important role transition financing plays in hard-to-abate and currently carbon intensive industries. 

APAC as a leader in transition finance

The rise of transition finance is particularly notable across the Asia-Pacific (APAC) region. The region has emerged as the largest region in terms of transition bond issuance. As outlined in the Climate Bonds Initiative's 2022 Sustainable Debt Report, this accounts for almost half of the world's cumulative total. Likewise, transition bond issuance in Asia more than doubled in value in 2022 compared to 2021. 

In addition to Japan, China has demonstrated strong transition financing activities. For example, BNP Paribas supported the Bank of China to issue a world first steel sector specific transition bond. The €300 million transition bond will drive investment into the development of the steel sector’s decarbonisation in the Hebei Province, China’s top steel province. Furthermore, Castle Peak, a power company that owns three power stations in Hong Kong issued its first energy transition bond in July 2017 for $500 million. In June 2020, the company issued its second energy transition bond to transition towards a lower carbon future.  

Challenges for transition finance moving forward 

While green activities have well-defined thresholds for specific climate or environmental objectives, transition goals still exhibit definitional variability, posing a potential risk of greenwashing. The OECD identifies asset stranding and the risks of carbon lock-in as the primary factors contributing to the greenwashing risks associated with transition finance. Given the transitory focus of transition financing, there are criticisms that such financing will prolong the use of  high-emission assets that do not become properly transitioned, thereby delaying or preventing the transition to zero-emission alternatives for different industries. 

This creates investor hesitation and reputational risk. In addition, this brings into question the climate risk associated with not transitioning - often termed ‘transition risk’, in which carbon intensive assets become stranded assets due to market shifts that move beyond carbon. 

There are also important concerns and debates around the geographic specificity in defining transition activities. For example, while the European Union (EU) typically leads in establishing green taxonomy and regulations, there are key limitations to applying European approaches in the APAC context. 

For example, this includes the fact that no existing EU taxonomy addresses critical emissions in commercial agriculture, which is vital to the greening of economies of many Asian countries. This is not only due to direct emissions from agriculture, but also the connection of commercial agriculture to deforestation and the release of carbon from cleared land. 

In the international sustainable finance landscape, transition bonds constitute a relatively small proportion of the overall labeled bond market, demonstrating further room for growth and the relatively nascent characteristic of transition finance. 

It is clear there are unique benefits to issuing transition bonds, but there are also unique challenges. In a world in need of expeditious climate action, transition bonds have a flexibility and mandate appropriate for transitioning hard-to-abate sectors. 

Moving forward, transition financing depends on more clear definitions and taxonomies of what constitutes a ‘transition’ activity, and more robust methods of credentialising and verifying the use-of-proceeds. Hopefully this can overcome concerns of greenwashing and carbon-lock in, thereby overcoming investor hesitation and criticism of transition financing. Additionally, geographically conscious definitions of transition activities need to be considered.