17 October, 2019
As the world faces increasing concern about looming shortages of non-renewable critical raw materials on the one hand, and the waste crisis on the other, societies are slowly but surely seeking to become more resource efficient, and are turning away from the current linear “take-make-dispose” economy, and shifting towards a more sustainable circular economy model. This article provides an overview of what a circular economy is, and some of the considerations for financing the transition to a circular economy.
The transition to a circular economy is no longer just an abstract concept. Many businesses around the world have already adopted circular business models.1 In 2009, China passed the Circular Economy Promotion Law, the world’s first national law to proclaim the promotion of a circular economy an important strategy for its national economic and social development and to facilitate a shift towards it. Regionally, the EU identified the circular economy as an opportunity for resource-poor Europe to secure access to vital resources, maintain global competitiveness, and ensure a high quality environment, and launched its Circular Economy Package in 2015 to look into waste management, and explore synergies with other policies such as product legislation and the development of markets for secondary raw materials and by-products. The package launch was followed inter alia by a revision of its waste legislative framework and introduced mandatory product design and marking processes under the framework of its Ecodesign Directive. The EU has also led circular missions to communicate and promote sustainable and resource-efficient policies to other countries, including Singapore, which it visited in June 2019. In July last year, China and the EU entered into a Memorandum of Understanding on Circular Economy to align their management systems and policy tools to support the transition to a circular economy. The cooperation and alignment between both markets is a major development for a global systemic shift towards a circular economic model. Then in September this year, the Scottish government announced plans to table a Circular Economy Bill in the coming year.
At home, Singapore introduced its inaugural Zero Waste Masterplan in August this year, with the aim of turning Singapore towards a zero waste nation, by taking the first steps towards incorporating a circular economic model in its waste and resource management practices. Legislatively, the Resource Sustainability Bill was also passed in Parliament in September to support the Masterplan.2
The Circular Economy Explained
A useful and often cited definition of the circular economy is that “new products and assets are designed and produced in a way that reduces virgin material consumption and waste generation; new business models and strategies are applied that optimise capacity utilisation and extend useful life of products and assets; and resource and material loops are closed through recycling of end-of-life products and materials”3 Put simply, it maximises the value of the resources in question, at all parts of the value chain. Waste is “designed out” at various stages of the product cycle. Correspondingly, the materials used in product design are either consumable (biodegradable) or durable (reusable or designed for upgrade). To complete the equation, renewable energy is used to fuel such product cycles in order to decrease resource dependency.
The Three Phases of a Circular Business Model
In the circular economy, during the production phase, products are designed to be more durable, upgradeable, repairable and reusable using resource inputs that are renewable, recyclable, or biodegradable. In the use phase, products are managed in a way that maximises their utilisation capacity and useful life. Product users collaborate to facilitate sharing of over-produced or underutilised products. Producers adopt circular business models to generate revenue streams from the provision of services rather than products. Under such models, known as “Product-as-a-Service” (“PSS”) models, ownership of the product stays with the producer and is ‘leased out’ as
a service to the user. This gives the producer greater incentive and control over the repair and upgrading of the product and its recovery for secondary use or recycling at the end of its useful life – and also incentivises the producer to design their products accordingly to facilitate such activities. The value proposition for the customer paying for a service rather than a product is that it no longer needs to pay a high upfront cost to acquire the product and is relieved from the additional costs or product maintenance, repair, disposal, and replacement, and the associated administration and logistics involved. In the recovery phase at the end of a product cycle, businesses close the resource loop through recycling and/or reusing end-of-life products and materials to feed into a new product cycle. This can either be done in-house or outsourced.
Financing Circular Business Models
The transition to a circular economy will require the concerted action of the various stakeholders, including financial institutions and investors. In particular, producers will need new financing models to finance the increase in working capital to grow the underlying inventory used for producing services for its customers rather than roll inventory for outright sale. The upfront cost of producing assets that are more durable and modular will also be higher. The revenue structure will change. Revenue will be spread out over the duration of service rather than collected upfront at the point of sale or delivery of product. More and more banks are recognising that while circular business models may carry the inherent risks that accompany anything that is complex or unfamiliar, financing circular business models may also reduce ESG risks and present business opportunities for financiers. Here again, the EU is ahead of the curve, and has established an expert group on circular economy financing to formulate recommendations to the financial sector,4 project promoters, and policy makers to improve access to finance for circular economy projects.5 To provide guidance on circular economy risk financing, the European Investment Bank (“EIB”) has published circularity categories6 and specific circularity criteria7 considered by the EIB as contributing to the circular economy; and risk assessment considerations relating to supply chain risks and market and commercial risks arising from the new financing models.8
Circular Economy Finance Guidelines
Having circular economy adapted products, production technologies and processes are considered one of the funding eligibility criteria under the Green Loan Principles.9 Sustainability-linked loans would also lend themselves well to funding companies who are transitioning to circular economy. However, a shift towards a circular economy will necessitate a change in how banks and other lenders operate when financing “circular” businesses.
To facilitate a common understanding and approach towards circular economy financing, a number of Dutch banks have pioneered voluntary process guidelines known as Circular Economy Finance Guidelines (“the Guidelines”).10 These guidelines serve a similar role to what the various green financing principles have done for green financing.
The Guidelines define “circular economy finance” as “any type of instrument where the investments will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible companies or projects in the circular economy”.11 It is thus intended to apply to all equity and debt products that are ring-fenced to a specific circular economy project or project component, or support the transition to a circular economy, or lend to or take an equity stake in a company that can be classified as a circular company. The four core components of the Guidelines are:
a service to the user. This gives the producer greater incentive and control over the repair and upgrading of the product and its recovery for secondary use or recycling at the end of its useful life – and also incentivises the producer to design their products accordingly to facilitate such activities. The value proposition for the customer paying for a service rather than a product is that it no longer needs to pay a high upfront cost to acquire the product and is relieved from the additional costs or product maintenance, repair, disposal, and replacement, and the associated administration and logistics involved. In the recovery phase at the end of a product cycle, businesses close the resource loop through recycling and/or reusing end-of-life products and materials to feed into a new product cycle. This can either be done in-house or outsourced.
Financing Circular Business Models
The transition to a circular economy will require the concerted action of the various stakeholders, including financial institutions and investors. In particular, producers will need new financing models to finance the increase in working capital to grow the underlying inventory used for producing services for its customers rather than roll inventory for outright sale. The upfront cost of producing assets that are more durable and modular will also be higher. The revenue structure will change. Revenue will be spread out over the duration of service rather than collected upfront at the point of sale or delivery of product. More and more banks are recognising that while circular business models may carry the inherent risks that accompany anything that is complex or unfamiliar, financing circular business models may also reduce ESG risks and present business opportunities for financiers. Here again, the EU is ahead of the curve, and has established an expert group on circular economy financing to formulate recommendations to the financial sector,4 project promoters, and policy makers to improve access to finance for circular economy projects.5 To provide guidance on circular economy risk financing, the European Investment Bank (“EIB”) has published circularity categories6 and specific circularity criteria7 considered by the EIB as contributing to the circular economy; and risk assessment considerations relating to supply chain risks and market and commercial risks arising from the new financing models.8
Circular Economy Finance Guidelines
Having circular economy adapted products, production technologies and processes are considered one of the funding eligibility criteria under the Green Loan Principles.9 Sustainability-linked loans would also lend themselves well to funding companies who are transitioning to circular economy. However, a shift towards a circular economy will necessitate a change in how banks and other lenders operate when financing “circular” businesses.
To facilitate a common understanding and approach towards circular economy financing, a number of Dutch banks have pioneered voluntary process guidelines known as Circular Economy Finance Guidelines (“the Guidelines”).10 These guidelines serve a similar role to what the various green financing principles have done for green financing.
The Guidelines define “circular economy finance” as “any type of instrument where the investments will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible companies or projects in the circular economy”.11 It is thus intended to apply to all equity and debt products that are ring-fenced to a specific circular economy project or project component, or support the transition to a circular economy, or lend to or take an equity stake in a company that can be classified as a circular company. The four core components of the Guidelines are:
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Use of Investments;
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Process for Project Evaluation and Selection;
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Management of Investments; and
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Reporting
Under use of investments, the Guidelines propose the assessment of three elements: whether the business model is circular;12 whether the projects generate long-term positive socio-economic (including environmental) impacts;13 and whether the projects falls outside an exclusion list.14
Legal Issues
From a bankability and lending perspective of circular business models, financiers need to re-think their financing matrix and valuation models for traditional banking products. The shift from financing tangible assets in a linear economy to financing services in a service-based circular economy would inter alia mean a reduction in emphasis on taking security on inventory, a significant portion of which may be located in the borrower’s customers and affixed onto the customers’ land or other larger physical assets, and the borrower and therefore the lender may be exposed to the risk of loss of ownership and loss of security through legal accession. When taking security over a company’s receivables, additional guarantees, and the assignment of contracts, with the inherent risk of contractual defaults, consideration also has to be given not only the collateral value of the receivable, but also the quality of the borrower’s customers. At the same time, it is worth noting that the receivable financing model of the circular economy will also present opportunities for the securitisation of receivables, which is the most common form of asset securitisation. This has the potential to not just provide an alternative form of financing, but it will also diversify the composition of the investors in the financing of the circular economy.
Conclusion
As the world moves away from a linear economy and towards a global circular economy, Singapore and the rest of this region will inevitably be part of the transition. Access to finance is an indispensable enabler for this transition to succeed, and the financial sector in Singapore can benefit by being the first movers in the region to facilitate the transition. In any case, to thrive in and even survive the disruption, banks will have to start directing more assets and capital towards sustainable businesses. Banks must begin by understanding what circular economy is and what its associated risks and benefits are, and then identify the novel issues and develop adjustments to their risk assessments and innovate financial solutions to appropriately appraise and finance circular business propositions.
1 See Ellen MacArthur Foundation, “Case Studies”, <https://www.ellenmacarthurfoundation.org/case-studies> for examples.
2 See our Client Update, “The Resource Sustainability Bill – Are We Going in Circles?”, (August 2019), <https://www.shooklin.com/images/publications/2019/August/The-Resource-Sustainability-Bill-Are-We-Going-in-Circles.pdf>.
3 European Investment Bank, The EIB Circular Economy Guide – Supporting the Circular Transition (January 2019), p 5.
4 The recommendations of the European Commission Expert Group on Circular Economy Financing are to develop definitions, taxonomy and tools to measure the circularity of projects; analyse the risk of counterfactual linear business models and adjust distortions and bias in credit risk assessment methods to take these risks into account; establish risk-sharing financial instruments and develop expertise for assessing the technological risk of innovative circular technologies; and clearly label financial instruments fit for financing circular economy projects and increase awareness of the circular economy within the financial sector.
5 European Commission, Accelerating the Transition to the Circular Economy: Improving Access to Finance for Circular Economy Projects (March 2019).
6 The categories are circular design and production; circular use and life extension; circular value recovery; and circular support.
7 These relate to leasing and leasing models, financing of secondhand assets, rehabilitation, and other means of life extension, resource efficiency, recycling, and energy recovery.
8 European Investment Bank, The EIB Circular Economy Guide (January 2019), pp 11-13.
9 See our Client Update, “Green Financing — The State of Play in Singapore”, (March 2019), <https://www.shooklin.com/images/publications/2019/March/Green-Financing-The-State-of-Play-in-Singapore.pdf>. 10 ABN Amro, ING, Rabobank, Circular Economy Finance Guidelines (July 2018).
11 Ibid, p 2.
4 The recommendations of the European Commission Expert Group on Circular Economy Financing are to develop definitions, taxonomy and tools to measure the circularity of projects; analyse the risk of counterfactual linear business models and adjust distortions and bias in credit risk assessment methods to take these risks into account; establish risk-sharing financial instruments and develop expertise for assessing the technological risk of innovative circular technologies; and clearly label financial instruments fit for financing circular economy projects and increase awareness of the circular economy within the financial sector.
5 European Commission, Accelerating the Transition to the Circular Economy: Improving Access to Finance for Circular Economy Projects (March 2019).
6 The categories are circular design and production; circular use and life extension; circular value recovery; and circular support.
7 These relate to leasing and leasing models, financing of secondhand assets, rehabilitation, and other means of life extension, resource efficiency, recycling, and energy recovery.
8 European Investment Bank, The EIB Circular Economy Guide (January 2019), pp 11-13.
9 See our Client Update, “Green Financing — The State of Play in Singapore”, (March 2019), <https://www.shooklin.com/images/publications/2019/March/Green-Financing-The-State-of-Play-in-Singapore.pdf>. 10 ABN Amro, ING, Rabobank, Circular Economy Finance Guidelines (July 2018).
11 Ibid, p 2.
12 A list of typical circular economy business models is included in the Guidelines – circular inputs, circular design, sharing business models, lifetime extension, product-as-a-service, material/resource recovery, circular facilitators and enablers.
13 Apart from the environmental impacts of the company or project, consideration is also given to working conditions, human rights, gender equality, health and other determinants of wellbeing.
14 Notably, waste projects that use landfill techniques, without divert recyclable materials that are economically and technically feasible to recycle are excluded. Also excluded are projects that monetise by-products of fossil fuels and create further lock-in for fossil usage.