By Liesbet Goovaerts and Arnold Verbeek
Imagine that when you are tired of your side table, you pop it in your car and go to the 3D printing merchant at your local shopping centre, who promptly throws it into a hopper to grind it down into new raw material. Then you select the new table design you want from the merchant’s terminal, and press “Print.” When you come back from your grocery shopping, your brand new table is ready and waiting for you.
To most of us that sounds like a future high-tech development. But in fact, this is the circular economy we are already working at: one in which material resources are (re-) used more effectively, and where, ultimately, no waste exists anymore. It contrasts with the linear economy where we take resources, make stuff out of them – to then throw them away after use.
This change requires a new mind-set and a number of innovations, from new ways of designing and producing products like the 3D printer, to tracking all of the products and materials that are in use. Developing and launching these innovations requires financing. The financing would typically come through retained earnings, but young, fast growing firms (which dominate the circular economy) are usually dependent on external financing.
It is thus of major importance for circular economy businesses to understand how financiers take decisions, and how circular economy business models fare in the traditional – predominantly linear – framework in which financiers look at risks and returns.
Equally, it is worth considering how financiers need to adapt their frameworks to the realities of the circular economy.
Here are five things that need to change:
1. Yes, circular economy is risky, but what about the linear economy!?
Companies that follow the linear model are under pressure from global trends such as resource scarcity and associated price fluctuations, environmental uncertainty, tightening regulations, consumer sentiment turning towards more sustainable solutions, and the disruption by the circular economy businesses.
As a result, investments in these companies are exposed to a great deal of linear risk (Circle Economy 2017). Commodity price uncertainty is just one example. As commodity prices increase, so will the demand for innovations that increase resource efficiency. Currently, these linear risks are accounted for in banks risks assessment tools only to a limited extent. To create a level playing field for circular business with long established linear ones, these linear risks should to be better taken into consideration.
2. From valuing assets to valuing contracts
To make the circular economy business model work, companies should remain the owner of its products or materials in order to ensure they get the product or materials back and enable a next cycle. This is a tried and tested model for durable assets, like airplanes or big agricultural machines, for example. In the circular economy, this leasing or rental model will now be applied to new asset classes, like lower value consumer products. An example of this would be not selling a washing machine, but selling washing cycles. The machine remains on the company’s balance sheet.
More assets on the balance sheet should allow the company to offer more security to the lender (and decrease borrowing costs). But this would mean that the lender would need to keep track of the actual value of the asset – which would be in the hands of the company’s client – as well as the client’s loyalty’ to using the service or product. This will require both ‘fair use policies’ and customer incentives - to make sure the asset maintains it value and the clients stay loyal. Here banks can support companies in developing solid contracts and conditions that satisfy all parties – clients, company and banks.
3. Factor the cash flows
As mentioned above, in a circular economy the end-user is less likely to be the end-buyer or ultimate owner, which results in completely different cash flow models: instead of getting the full price at sales, the manufacturer will now get smaller monthly payments and need significant cash buffers to buy stock of materials/products and deal with not getting all the cash back at time of sales. Banks might be reluctant to lend – for exactly this reason: not enough or delayed cash flows.
Factoring could help reduce the impact of a subscription-based service on cash flows. This means the financier essentially buys up the future revenues at a slight discount, providing the company the money immediately. Reverse factoring (supply chain finance) would settle the service provider’s accounts with its suppliers immediately, with the bank getting its payments in chunks more compatible with cash flows coming in from clients.
4. Embrace collaborative value chains
A manufacturer of a recyclable product may not be in the best position to collect it after use, disassemble it, and/or reuse the components. In order to take full advantage of the opportunity, the manufacturer could extend the boundaries of its value chain by entering into a collaborative business relation with others.
Once a business enters into a collaborative model, the borrower’s creditworthiness will be strongly correlated with the solidity and reliability of the value chain. In general, collaboration with partners with solid financing structures mitigates risks and influences cash flows, as they guarantee take-back or residual value of products at end of life. However, as the number of value chain actors increases, so does the challenge in aligning interests and incentives. The selection and assessment of each of the actors, and the coordination mechanisms among them become a critical process for the success and longevity of the entire value network.
Banks could play an important role in this network development and assessment: as a trusted partner, companies will more easily share financials, costs, and benefits with banks rather than to share this with all partners involved. This information is crucial to define the value proposition and make sure that all partners can receive a fair share for their input.
5. Find the bank that understands circular economy
We fear the unknown. Or in banker’s terms: we consider the unknown risky. Risk means higher premiums, which will tax the business, and will eventually have to be passed on to the consumer. This can therefore reduce the competitiveness of budding circular companies.
It is therefore imperative that banks increase their understanding of the opportunities and issues circular economy brings. In order to provide the right financing structures, banks and other financial institutions will have to better understand these new (secondary) markets, supply chain structures, and the underlying assets. Equally, circular companies need to educate financiers, and seek out financiers with already existing specialist knowledge – the dogmas of the linear economy are often too deeply engrained.
But it is all worth it. McKinsey&Company and The Ellen MacArthur Foundation calculated that the circular economy, stimulated by technological innovation, could increase the resource productivity by 3% (McKinsey 2013, Ellen MacArthur Foundation 2012). For the EU-27 this could generate 1 to 4 % economic growth over a ten-year period (ING 2015). In today’s low growth environment, this would be quite an achievement.
Adapted from the chapter “Sustainable banking – finance in the circular economy” contributed by the authors to ‘Investing in Resource Efficiency: The Economics and Political Economy of Resource Efficiency Investments’ edited by the University College London.
Liesbet Goovaerts is an engineer in the EIB’s Advanced Materials division. Arnold Verbeek is a senior advisor in the EIB’s Innovation Finance Advisory division.