Japan sold the world's first sovereign transition bond on Wednesday, taking an alternative path to net zero compared to many other countries, but the auction was not as strong as anticipated.
The ministry of finance auctioned ¥800bn (US$5.3bn) of 10-year climate transition bonds. The Dutch auction stopped at 0.74%, on a compound yield basis, just 0.5bp lower than where the regular 10-year benchmark bond had traded before the bidding deadline. The coupon was set at 0.7%.
The greenium was a lot smaller than imagined. Sources said the transition bond had not traded in the grey market, but the yield had been quoted 4.6bp–6.6bp lower than the 10-year benchmark in the days before the auction. The pricing benefit in the end was even smaller than the 2bp greenium observed in the municipal bond market.
The bid-to-cover ratio was 2.90, a lot lower than the average of 4.17 for traditional 10-year auctions last year.
"We are happy that the greenium was reasonable," said a source at a Japanese life insurer. "It is tough for life insurers to buy a 10-year bond and would have been even tougher if the greenium was 2bp." The source said he would not have invested if the greenium had been 4bp to 6bp.
A dealer at a Japanese securities firm echoed these sentiments, saying he was actually glad the auction was weak. "All our clients sighed when the auction results came out, but I told them we made a good start for the five-year auction," he said. "I think this level of greenium would bring in many more investors."
The government plans to raise an additional ¥800bn from an auction of five-year transition bonds on February 27.
In the fiscal year ending on March 31, only five and 10-year climate transition bonds will be sold, but the sovereign will also look at tenors of two and 20 years going forward.
Two non-life insurers and at least seven Japanese lifers, including Japan Post Insurance, said they had bought the bond. The aforementioned dealer said he also saw orders from central cooperatives and pension funds, but that each order was small.
It is uncertain whether foreign investors bought the bonds, but the auction took place in Tokyo hours, making it hard for many of them to participate.
The transition bond closed that day at 0.729%, versus 0.75% for the conventional 10-year bond. The following day, it closed at 0.69%, with the greenium widening in secondary to 3.1bp as some investors switched from the traditional 10-year to the transition bond.
Whole-economy plan
Japan intends to sell ¥20trn of climate transition bonds in the next 10 years under its green transformation programme, which it hopes will help generate ¥150trn of private and public investments to facilitate the country's targets of reducing its emissions by 46% by 2030 from its 2013 levels and reaching carbon neutrality by 2050, as well as growing the economy. It expects the pioneering bonds will also serve as a catalyst for transition initiatives in Japan and throughout Asia.
The government plans to use 55% of the proceeds from this month's bond offerings to support research and development of innovative technologies and 45% for subsidies to projects including storage batteries, clean energy vehicles and home insulation.
"The issuance will be used to invest in technologies where expected emission reductions or economic viability are unclear, affirming Japan's intention to pursue an alternative path to net-zero than in other developed economies and regional Asian peers," Nneka Chike-Obi, head of APAC ESG ratings and research at Sustainable Fitch, said in a note.
Prior to the introduction of such bonds, the government formulated a framework last November and obtained second-party opinions from Japanese rating agency JCR and Norway's DNV about the alignment of its framework with international standards.
"I would say that this is the most sophisticated whole-economy plan that we've seen so far in terms of transition and going beyond focusing on green certainly," said the head of sustainable finance at a Japanese bank. "The whole purpose is to decarbonise all the hard-to-abate sectors that have a very high contribution not only to emissions but also to Japan's GDP."
The government said over 1,500 market participants from over 700 entities attended the seminars it held for Japanese investors. It also visited about 40 investors in Europe and the US in January and February.
A banker who went to Europe with government officials said the roadshows were productive as the investors he met understood the reasons behind Japan's transition framework.
"As opposed to Germany for example, where you can install wind turbines because there are many windy flat lands, Japan has limited land availability for renewable power plants and cannot install lots of wind turbines on mountains," said Toshiaki Otani, head of capital markets at BNP Paribas.
"Some countries cannot shut down coal fired [power plants] right away, but transition finance will open the way for those countries," he said. "Green bonds have been only issued by 'environmentally straight-A students' and no lights have been shed on those who cannot, but Japan believes transition is needed for the sectors that were not in the spotlight and for Asia in order to achieve net zero."
Otani said his team received many tough questions during the roadshows about Japan's plans for ammonia co-firing and nuclear power, but the nearly 20 investors he met in Europe seemed to understand Japan's strategies.
Ammonia co-firing
Ammonia co-firing, which replaces some of the coal used in coal-fired power plants with ammonia, is seen as one of the key technologies for Japan to achieve zero emissions, and it has included facilitating the introduction of hydrogen and ammonia as one of the eligibility criteria under its bond framework.
When large power generator JERA sold its first transition bond in 2022, it allocated 9% of the proceeds to ammonia and hydrogen co-firing development. The METI picked this bond as a model case for its climate transition finance model project a few years ago.
However, environmentalists overseas are not keen on ammonia co-firing because it makes a minimal reduction in carbon emissions and most ammonia is made using hydrogen produced by fossil fuels.
"Some of the most credible ESG investors are saying [research and development on ammonia co-firing, hydrogen and carbon capture] is exactly what the government should be doing if these technologies are to be deployed at scale, but some investors want to see emissions reduction straight away," said the sustainable finance head.
Ammonia co-firing is not included in the use of the proceeds for the first round of Japan's transition bonds.
"The bond strictly delineates its use of proceeds, excluding any allocation towards gas-fired power generation or operational activities involving ammonia co-firing in coal-fired plants," pointed out the Climate Bonds Initiative, which has certified the bond under its Climate Bonds Standard, indicating that it aligns with global standards.
Government officials denied that ammonia co-firing was intentionally excluded from the use of proceeds in order for the inaugural sale to go smoothly.
"Ammonia co-firing and the related technologies have already been funded by the Green Innovation Fund, and these technologies look near ready, so we didn't include them [as eligible projects]," said an official at the METI. The GIF was established by the METI in 2021 to provide support over the following 10 years to companies that are committed to addressing challenges for the 2030 climate target ranging from research and development to demonstration and social implementation.
Other labelled bonds
Anthropocene Fixed Income Institute, a non-profit research organisation, recommends Japan issue complementary sustainability-linked bonds alongside its transition bond to lower the cost of capital, attract global investors and progress towards net zero.
However, this is apparently not the plan. A ministry of finance official told IFR that issuing additional bonds under a different label might lower market liquidity.
To keep the transition bond liquid, the MoF will discuss whether to conduct tap offerings in the future, but there is one hurdle to overcome.
"We did specify the use of proceeds for the ¥1.6trn issuance, so that I think will make it difficult to reopen," said the MoF official. Future transition bonds may have different uses of proceeds. "ESG investors told us the more specific use of proceeds the better, but JGB investors told us the more liquid the better."
(Additional reporting by DealWatch's Azumi Kuboki and IFR's Tessa Walsh)