Report: Circular economy

The concept of the circular economy is entering the mainstream and becoming better understood, but there is still misunderstanding about how to finance it, and the risks and opportunities it presents.

As the concept of sustainability becomes more deeply embedded in the fabric of society and the economy, the notion of the circular economy has started to gain traction.

But while there has been much talk of what the circular economy is and how businesses can adapt to it, one area that has not been fully explored is how it will be financed.

“Circularity has to be part of how banks go about their business, too.” Gerben Hieminga, senior economist at ING.

The move from an economy modelled based on the “take, make and waste” processes that have driven growth for more than two centuries to one focused on the ideas of “reduce, reuse and recycle” is a challenge not just for the business community but for those who fund them, too. 

Despite this, financial institutions should not ignore the circular economy but embrace it. It is not going away – and it will create significant new opportunities as well as disrupting many existing business models and affecting existing loan and investment portfolios.

The increase in prosperity started by the Industrial Revolution was founded on the basis that resources were effectively infinite, and with no thought for side effects such as pollution, loss of biodiversity and resource depletion. This is no longer tenable in a world that is heading for a population of 9 billion people, a growing number of whom are entering the consuming classes.

The old model of economic growth is running up against the limits of our planet’s ability to provide everything we need. Resources such as energy, materials, water and food are becoming constrained, while the fossil fuels that drive our growth are changing the climate in dangerous and unpredictable ways. We need to decouple economic growth from resource use. This is where the circular economy comes in.

Gerben Hieminga, ING

“The circular economy is the ultimate answer to solving the problem of the depletion and economic scarcity of resources,” summarises Gerben Hieminga senior economist at ING and one of the authors of the report by ING about the circular economy and its implications for the financial sector. “But this is not the main driver for a business to go circular; the circular economy also creates new business opportunities and increased customer intimacy. The environmental benefits are more of a ‘collateral benefit’.”

 

Adopting the principles of the circular economy

There are many ways to adopt circular economy principles. Some companies focus on recycling their own or other companies’ waste materials  – carpet tile maker Interface has started using discarded fishing nets in its products as well as its own old tiles, for example, while tomato growers in the UK use CO2 and heat from nearby power stations to increase their yields. McDonald’s collects the waste cooking oil from its restaurants and turns it into fuel for its delivery trucks.

Corporations are now starting to take account of what happens to their products at the end of their lives right from the start of the design process. Companies such as BMA Ergonomics design products that are easy to disassemble when they are disposed of, enabling them to be easily recycled. Carmakers in the EU now have to recycle or recover 95% of the material in the cars they make under the End of Life Vehicles Directive.

Others focus on extending the life of products or giving them a second life – medical equipment is a good example, where companies such as Philips and Siemens take back equipment such as MRI scanners at the end of their life, refurbish them and sell them in a thriving second-hand market to customers that need the scanners but cannot afford the latest equipment.

There is also a shift from selling products to selling services. So where lighting manufacturers used to sell lightbulbs, now they sell lighting, while carmakers sell mobility rather than cars. The idea is even being extended to clothing, with brands such as Mud Jeans leasing its products to clients.

Another feature of the circular economy is that the line between business and consumer is becoming blurred thanks to the advent of the sharing economy, which sees private citizens renting out their rooms or space in their cars through platforms such as AirBnB and BlaBlaCar. Consumers are even stepping on to bankers’ traditional territory with the growth of crowdfunding and peer-to-peer lending.

These changes could add €500 billion to the EU economy in the next decade, according to the Ellen MacArthur Foundation and TNO, the Netherlands Organisation for Applied Scientific Research but they provide a challenge not just to traditional ways of doing business but to traditional models of finance. These are based on well-established concepts of value creation, transactions, ownership and the measurement of success that do not necessarily hold true in the circular economy.

 

New challenges for banks

How do banks deal with the shift to “product as a service” business models, for example, where customers no longer make one lump sum payment for a product at the point of sale but continue to make payments for the life of the product? Cash flows become more important than the underlying value of an asset and contracts become a much more important part of doing business, as does the creditworthiness of customers.

"(...) clients who are leading in sustainability are more innovative, show better financial performance and have better credit ratings."- Leonie Schreve, global head Sustainable Lending, ING.

On the other hand, the development of second hand markets for products increases their value and prevents them being depreciated to zero, as does design for disassembly and recycling.

These are new issues for the financial sector to grapple with, but it is important that it does so, not just because clients will be looking for the capital to fund their transition to circular economy companies but also because it is a market that is predicted to generate 1%-4% growth over the next 10 years. And that is net growth, taking into account the disruption that it will cause to existing businesses – quite an achievement in today’s low growth environment.

Sustainability banks portrait Leonie

Another reason to support the circular economy is that it fits into the trend towards more sustainable finance that many banks are embracing. Banks are recognising the opportunities of sustainability more and more. “There is now evidence which shows that clients who are leading in sustainability are more innovative, show better financial performance and have better credit ratings,” says Leonie Schreve, Global Head Sustainable Lending at ING. “Directing more assets and capital to sustainable businesses therefore creates a healthy portfolio for the banks and helps them to facilitate the transformation to a low carbon economy. As a result, sustainability now is a business opportunity for the financial industry.”

Technological developments such as energy storage, advanced materials and the internet of things will help to make the circular economy a reality. Likewise, technology will also help financial institutions to gather the additional data they need to examine the viability of business cases, much of which will be data on issues traditionally seen as non-financial.

An expertise in leasing arrangements will be vital as more companies move to become providers of services rather than goods, but financing the circular economy is about more than that. “Circularity has to be part of how banks go about their business, too”, says Hieminga.

That means adopting longer time horizons and being aware of the potential of concepts such as product life extension, design for disassembly, end of life use of assets and performance-based business models. It could also mean getting involved in supply chain finance to help companies “close the loop” for their products.

When the economy is circular, you cannot consider the issues one-by-one or adopt a one size fits all approach – you need to take an integrated approach that identifies clients’ business and needs, analyses their financial supply chain and balance sheet and creates solutions that add value. The circular economy is about doing more with less. The finance community needs to be aware of both the opportunities and the risks that it will bring.

 

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