Investing in circular economy solutions and business models is still considered high risk for financiers. To de-risk investments, both policy instruments and financial instruments are needed.
Investments in circular economy innovations and new business models, especially in developing countries, are still considered to be high risk compared to ongoing and growing finance experiments in industrialized economies. The initial investments required for the build-up of circular economy infrastructures such as eco-industrial developments, waste collection and recycling systems, or clean water and sanitation solutions based on circular technologies, can pose a substantial challenge for low- and middle-income countries.
The use of ODA to mobilize private finance is increasingly regarded as essential to meet the SDGs. A significant number of development agencies and DFIs have set up diverse de-risking initiatives with the goal of attracting private investment to international development projects. These initiatives and measures to decrease investors’ capital costs aim to address the underlying sources of investment risk (in what is termed policy de-risking) or shifting risk away from private sector investors (financial de-risking).
Policy de-risking instruments can help to remove the underlying barriers to circular economy business models. These instruments include, for example, support for circular economy policies beyond waste management: these might include EPR, product eco-design polices, institutional capacity-building, assessments about taxation reforms, green investment policies and public-sector skills development.
Financial de-risking instruments can help to transfer some of the risks that investors face to public actors, such as DFIs. These instruments can include, for example, loan guarantees, PRI, public equity co-investments or public–private blended finance.
De-risking through policy development
As discussed above, the voluntary adoption of circular economy finance into the financial services industry is taking shape through the actions of leaders in the sustainable finance space. However, the speed and volume of adoption remains very modest when compared to the amount of money that goes to the linear global economy on a yearly basis.
One way to de-risk and grow circular economy finance is to make it an ‘opt-out’ rather than an ‘opt-in’, through setting relevant standards and criteria. This means that regulators and policymakers on multiple domains would need to nudge financial intermediaries towards making more sustainable and ethical investment decisions. (The environmental objectives of the EU taxonomy for sustainable finance can be considered a regulatory nudge.) It also requires a ‘connecting of the dots’ on various policy terrains to increase the volume of circular economy finance as part of mainstream sustainable finance. In addition, the recognition of embodied greenhouse gas emissions of used materials and resources can facilitate the integration of circular economy solutions into net zero climate policy goals. Policymakers would need to make efforts to ensure that policy and regulations around climate finance converge with policies governing the materials and resource agenda of circular economy finance. This can be achieved, in a way that helps with implementation, by tackling policies that do not explicitly carry the circular economy label, but which support the adoption of the circular economy (e.g. fiscal policies or product eco-design policies). The advantage is that policymakers can remain in their field of expertise, rather than overburdening national policymakers and their international partners with circular economy terminology.
Circular economy finance will benefit from a level playing field in a number of specific policy areas:
National circular economy roadmaps and strategies: Many governments around the world have included circular economy elements in their national development plans, as well as their policy frameworks for environment and climate, including Nationally Determined Contributions (NDCs), submitted in accordance with the Paris Agreement. These strategies include targets for the recycling and reuse of waste materials as well as plans for linking the circular economy and climate action, and plans to stimulate innovation and job creation through the shift to a circular economy. Circular economy roadmaps often include stakeholder processes to bring together important national players, including the finance sector. For example, the Finnish government created new financial instruments and investment subsidy arrangements as part of the implementation of the country’s national circular economy roadmap. Investments by national banks and institutional investors such as pension funds have been steered and utilized to promote circular economy solutions. Such government plans will work best if they are based on concrete targets for sustainable resource use and include investment proposals. Furthermore, aligning circular economy principles with public procurement can create positive dynamics, as circular procurement criteria can be used in investment proposals aimed at circular resource use and sustainability performance. At the international level, the integration of resource efficiency, circularity and embodied greenhouse gas emissions targets in consumption and production as part of the long-term strategies (LTSs) and NDCs under the Paris Agreement would be serving both the climate and circular economy agenda. But the signs are that when it comes to COP26, scheduled to be held in Glasgow in November 2021, the extent and programming of the circular economy track within the conference will once again expand, compared to its earlier iterations.
At the international level, the integration of resource efficiency, circularity and embodied greenhouse gas emissions targets in consumption and production as part of the long-term strategies and NDCs under the Paris Agreement would be serving both the climate and circular economy agenda.
Material resource efficiency and recycling targets for industrial activity: Resource efficiency covers a range of resources, including materials, water, energy, biodiversity and land. It refers to the sustainable use of these resources through reduced use, optimization and recycling to reduce material intensity – with the focus on producing the same level of output with fewer material inputs. Resource efficiency can be supported through adopting practices such as ‘lean’ manufacturing and product lifetime optimization, which in many industrial sectors are not being used at anywhere near their full potential.
The International Resource Panel estimates that, through material resource efficiency, significant emission reductions can be achieved in the use of materials in the building and mobility sectors: these range between 60 per cent and 80 per cent across the G7, India and China. Arguably, policies that address resource efficiency only through the lower-end 9R solutions (e.g. materials recycling) can potentially lead to a further linear ‘lock-in’. Still, because of its dominance and size, the further optimization of a linear economy can make sense financially as well as providing a transitional pathway towards circular systems.
Extended producer responsibility: EPR is a financial and/or operational instrument that aims to internalize environmental externalities related to end-of-life management. According to the OECD, under this policy approach producers of goods are given a significant responsibility for the recovery, treatment or disposal of post-consumer products and waste. This approach shifts responsibility away from national, subnational or local authorities. The aim is to incentivize waste minimization at source, promote more environmentally conscious product design (see below), and support the management of waste by the public sector. If producers of goods take on increased responsibility for the recovery of materials or repair of products further along the value chain, then changes in production methods will favour materials and goods that are more easily recovered, remanufactured, repurposed, repaired and reused. These extended responsibilities can compromise the financial attractiveness and profitability of linear industries and level the playing field for circular businesses.
Product policies (including eco-design, bans on single-use products and product lifetime extensions): Eco-design is an approach to products that considers environmental impacts during a product’s whole life cycle. Eco-design can also facilitate easier repair and optimize remanufacturing processes, further saving resources. For new products, the design process needs to include principles such as designing for energy efficiency, reparability, recyclability, the minimization of packaging, and chemical safety. Product design policies – as they currently exist – need to change considerably in order to enable a circular economy. Eco-design policies have mostly focused on energy efficiency but will need to take a wider material focus. At a national policy level, the UK is in the process of designing a new regulation to govern eco-design and energy efficiency requirements.
Fiscal policies and taxation regimes are considered key policy tools that can help create markets for circular business models, address social and environmental externalities and generate public funds to finance the transitions. The transformation of taxation systems on both international and national levels is key to shifting to an inclusive circular economy. Tax regimes – in some cases, the absence of taxes – are a way for national governments to attract companies to establish operations in their country. In terms of the circular economy, countries can reap an economic advantage by structuring their tax incentives according to their national resource priorities. The alignment of tax incentives makes sense for countries lacking within their territory certain critical resources crucial for their economic development (for example, rare earths for battery components) or for solving awkward environmental issues related to waste streams, as in the case of plastics. Specific measures include cutting taxes on labour and long-term investment returns, as well as increasing the tax burden on primary resource extraction and polluting energy generation. For financial institutions, it is important to have clarity about the taxes to which their clients are subject, as this relates to the profitability of the companies that they finance. Taxation is part of any economic analysis and informs risk-adjusted returns, which in turn inform the decision to invest.
Various taxation measures have been suggested as ways to promote the transition to a circular economy:
- Taxes on virgin plastics: In order to reduce plastic waste and to promote a transition to a circular economy for plastics, various policy proposals have included different forms of taxation on single-use plastics. Thus far, in most countries these reforms have concentrated on applying taxes at the consumer level (for example, taxing sales of plastic carrier bags in supermarkets). Plastics taxes can also be targeted at the production level, for instance taxing the use in the production process of virgin plastic as opposed to recycled materials. In the UK, for example, HM Treasury announced plans in 2018 to introduce a new tax on the manufacture and import of all plastic packaging containing less than 30 per cent recycled content, to come into effect by April 2022. Taxation on plastics production in low- and middle-income countries can complement existing goods and services tax regimes, and should be considered as part of ongoing tax reforms. Although tax revenues are not generally earmarked by national governments for specific purposes, revenues from plastics taxes could be allocated to enhancing plastics collection and recycling infrastructure as well as to improving working conditions for people in the informal waste and recycling sectors.
- Taxes on raw materials extraction: Taxes on the extraction of sand, gravel and aggregates used in the construction industry have been introduced by various EU member states, as well as the UK, generating incentives for the recycling of construction and demolition waste. Comprehensive fiscal regimes already exist around extractives production – these guide mining sector investment, and are core to investment decisions in the sector. Developing countries typically offer lower tax burdens, and any attempts to raise these taxes can result in capital flight. Furthermore international dynamics may prevent countries from imposing such tools, despite a desire to do so.
- Value added tax (VAT) reductions for reuse and repair: A circular economy taxation framework that can be applied across the life cycle of products would need to include tax relief on reuse and repair activities, as well as VAT reductions for the use of recycled content and secondary materials, and for the reselling of products. Relevant relief policies for repair businesses have been proposed to EU member states and in the UK, and have been implemented in Sweden since 2017, as an economic policy instrument in favour of the circular economy.
- Shifting the tax burden from labour or education to material inputs: The collection, recovery and processing of secondary materials are labour-intensive, and therefore incur more tax than using virgin materials. Shifting taxation from labour would reduce costs for the collection and sorting of waste, making secondary materials more competitive with primary materials. Similarly, the remanufacturing and refurbishing of products is relatively labour-intensive in comparison to the manufacture of new products, especially given the increasing use of automation in manufacturing activities. These processes require a specific skill set, which means that shortages of skilled professional labour can also be an issue. Fiscal incentives that support training and hiring in circular economy businesses could be considered by policymakers.
- Active labour market policies reformulate laws to protect against hyperflexible employment protection contracts, the use of which is sometimes referred to as ‘Uberization’ under product-as-a-service or sharing economy business models of the circular economy. Staffing these new optimal-use services can bring about unintended consequences in terms of the lowering of employee protection standards. Amended social policies can prevent the erosion of basic employment protection measures such as a minimum wage, health insurance, or the right to paid sick leave. Recent developments around the ride-hailing companies Uber and Lyft in California around the treatment of their drivers as employees, and agreeing to basic rights for workers in the UK in March 2021, constitute an important legal verdict that is expected to drive and inspire the evolution of these policies on an international scale.
- Investment policies to attract FDI will be important for low- and middle-income country economies that have seen a contraction in FDI inflows since the outbreak of the COVID-19 pandemic. Reduced flows of FDI to developing countries due to the pandemic have specifically affected export-oriented and commodity-linked investments. However, many pre-pandemic policies that promoted and governed FDI have been largely inadequate for preventing environmental harms and advancing progress on environmental protection. Investment policies tend to involve reducing the fiscal and regulatory burden for FDI – precisely the opposite of what is required for advancing circular business models. Linking FDI to market access, product premiums and value creation is key. Although they are difficult to define, several concepts, such as ‘low-carbon FDI’ or ‘green FDI’, which concern greenfield investments in renewable energy or environmental goods and services, is important to ensure FDI does not do harm and, instead, generates benefits. Green FDI agreements between countries can be expanded to include provisions for circular economy investments.
Financial de-risking instruments
Private sector capital is urgently needed, as current levels of development financing are not sufficient. A number of de-risking instruments could be applied to finance circular economy projects and provide access to funds for SMEs in developing countries. The authors of this paper identified four instruments (loan guarantee schemes, political risk insurance, public equity co-investments and public–private blended finance) as potential instruments for de-risking and scaling up investments for circular solutions (see Table 5).