The concept of a circular economy is starting to gain traction in the financial community. The concept is an appealing alternative to our current linear economy in which finite resources are being used for the manufacturing of products, which get disposed of and thus wasting a lot of value. This process often produces negative externalities such as pollution of air, soil and water, but also exploitation of people and (unnecessary) poverty.
In a circular economy, all components within that economy have their own niche. All in- and outflows are being used and produced in unique combinations, without waste and with positive total net revenue. Such a circular system is inspired by eco systems and is essentially different from our current linear system.
The need of a transition towards a circular economy is broadly recognized, as we are looking towards depletion of resources and being more and more aware of the finiteness of our planet. At the same time, circularity provides a way to do business within our planetary boundaries, while taking away the risks related to price volatility and limited availability of raw materials.
Financial institutions now face an important choice. They can be a major catalyst of the transition by funding circular businesses and engaging with their clients. However, to play this role well, the financial sector needs to adapt to the changes that are rapidly evolving.
Funding new business models
The circular economy comes with a number of new business models to increase the use of renewable energy sources, reduce dependency of (scarce) resources, extend product life and increase social capital through sharing systems. One of the upcoming business models is providing clients with access to a product or service rather than selling it. This way profitability is decoupled from selling products. For example, Rolls Royce does not sell engines, but flying hours, and Philips is leasing light instead of selling lighting equipment, stimulating them to take good care of their product and reuse components and materials after use. Consequently, the increased lifetime of products demands for longer term financing.
This also means that the products will remain on the companies’ balance sheet for a long time, which impacts its leverage ratio. For this reason they will be looking for ways to manage their assets off-balance, for example by putting a Special Purpose Vehicle in place. Additionally, they have to depreciate the assets smartly and calculate the residual value of its products, which is difficult for many companies because data about this is lacking, which in turn scares off investors. In short, financial institutions are willing to serve the circular economy, as economic opportunities are evident, but need to adapt their financial services to these new business models.
Circular businesses require risk assessments that go beyond their company profile. Currently risks are mainly based on past results rather than future oriented and systemic analysis of global impacts. The fact that many companies are in a risky position by depending on finite resources with fluctuating prices is often overlooked, and circular companies that are not depending on raw materials are often misunderstood instead of favoured.
In the discussions around financing the circular economy assumed is that money is neutral and infinitely available. This assumption deserves more attention. Our money system that is supposed to facilitate our communal household is confronted with various problems. Money flows are not circular, but money flows from people that have little money to people that have a lot of it. Although the government is trying to, artificially, reverse this flow (e.g. through taxes) its impact is marginal. Additionally, through compound interest short-termism is induced, as long-term debt is exponentially discouraged. Circularity requires a long-term vision beyond generations, but if needed to be financed through debt, economically unsustainable.
Our economy is a complex system where many stakeholders interact and influence behaviour that affects the flows of money, material, energy and information. Therefore it is essential to have the right incentives in place. If, for example, linear risk (i.e. the risk of continuing in the linear economy) is not explicitly priced, there is no incentive for the financial sector to move. Therefore, collaboration with the whole system is required.
SFL and Circle Economy are working with the sector to get ready for the transition towards a circular economy, and seek synergies between all actors to overcome barriers through systems thinking.