Despite the importance of the circular economy in fostering economic resilience, social prosperity, and environmental renewal, investment in circular activities remains quite limited. Circular economy initiatives face a significant funding gap, with annual global corporate spending on this economic model estimated at around $850 billion. This is in stark contrast to the approximately $35 trillion spent on current “linear” economic models.
This disparity can be attributed to the generally low awareness of the circular economy among investors and within the financial sector. There is also a shortage of tools available to identify and measure activities that significantly contribute to advancing the circular economy, alongside challenges in identifying investment opportunities and understanding the risks associated with these activities.
Sustainable finance classifications, which serve as a common system for identifying environmentally sustainable investments, could play a vital role in securing the necessary investments for the circular economy. The European Union’s sustainable finance classification is currently the most ambitious and comprehensive, and it explicitly includes the transition to a circular economy as one of its main objectives.
In this context, Jack Parry, Patrick Schroeder, and Susanna Sherman present a research paper titled “Harnessing Sustainable Finance Classifications for the Circular Economy.” Published by Chatham House in June 2023, the paper includes a detailed case study on the EU classification system, highlighting the various challenges associated with integrating the circular economy, with the aim of using these insights to develop similar classifications in other parts of the world.
The Importance of the Circular Economy:
The extraction, processing, and use of natural resources, along with the disposal of related waste, are responsible for approximately half of global greenhouse gas emissions, 90% of land-related biodiversity loss and water stress, and one-third of global pollution. In contrast, shifting toward a circular economy represents an essential industrial strategy for mitigating the impacts of material production and consumption by preemptively designing out waste and pollution, recycling products and materials (at their highest value), and regenerating natural systems. Additionally, the circular economy offers an alternative strategy for economic prosperity amid supply chain disruptions, increasing geopolitical tensions, and looming economic recessions.
Circular solutions are expected to generate global growth opportunities nearing $4.5 trillion by 2030. Research conducted by Bocconi University, the Ellen MacArthur Foundation, and Intesa Sanpaolo in 2021, based on a sample of 222 companies, showed that businesses can deliver superior risk-adjusted returns by adopting circular approaches.
Over the past decade, the circular economy has evolved from a concept to an integral part of national and regional economic strategies, with the most prominent example being the European Union’s launch of its Circular Economy Action Plan in 2020. Furthermore, more than 450 policies and laws related to the circular economy have been introduced, along with 54 national roadmaps or strategies in over 100 countries, while a wide range of standards is being developed. However, despite these advancements, the circularity of the global economy has actually declined in the last five years, from 9.1% in 2018 to 7.2% in 2023.
Financing Gap
In most sectors, circular models still represent a small share of the overall market. As a result, funding for circular economy initiatives has been scarce. While billions of dollars are being invested in circular solutions by both public and private sectors, trillions of dollars are still being invested each year in traditional “linear” models, preventing a systematic shift in the economy. Initial estimates from Chatham House and Just Economics show that the circular economy’s share of total global investment does not exceed 3% annually.
The circular economy also faces a significant gap in the availability of funding sources. The circular finance sector and existing circular investment funds are estimated to be around $50 billion, compared to $100 trillion in financial assets managed by the top 500 asset managers worldwide. This is partly due to the fact that the circular economy is a relatively new topic for investors and the financial sector in general. Awareness of the circular economy remains low, and there is a lack of tools to evaluate activities that contribute significantly to it.
However, sustainable finance frameworks, tools, and standards have recently proliferated at national and regional levels. The launch of the International Sustainability Standards Board (ISSB) under the International Financial Reporting Standards (IFRS) Foundation during the 2021 Climate Conference was a pivotal moment for sustainable finance. The ISSB will develop a global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.
The European Union’s Case
Given the rapid conceptual and operational development and adoption of the circular economy in both public and private sectors, the key question is how these new sustainable finance frameworks and tools can be leveraged to accelerate the transition towards a circular economy. One of the most important developments in this regard has been the emergence of sustainable finance classifications, which ensure that all stakeholders understand what sustainable economic activities are and help prevent “greenwashing.” Greenwashing refers to practices where companies create a misleading impression or provide false information about their products or services’ environmental compliance. Over 20 sustainable finance classifications have been launched and developed worldwide to date.
In light of this, the European Union’s sustainable finance classification is one of the first in the world to include the circular economy as a core objective. It is also the most ambitious and comprehensive in scope, particularly regarding its inclusion of the circular economy. However, political challenges did not go unnoticed during the development of the EU classification. One such challenge was the Delegated Act, which came into effect on January 1, 2023, and includes nuclear energy and natural gas as “transitional activities contributing to climate change mitigation.” The inclusion and classification of nuclear energy and natural gas in this category undermines the credibility of the EU classification as a science-based investment tool and threatens to hinder the achievement of a circular economy.
Nevertheless, the EU classification offers valuable lessons on the political, technical, and procedural challenges of future classifications. The EU launched its sustainable finance framework in 2018 and its sustainable finance strategy in 2021. The framework includes three complementary components:
First Component: A mandatory disclosure system for both financial and non-financial companies, aimed at providing investors with the necessary information to make sustainable investment decisions. Companies must disclose information about the impact of their activities on the environment and society, and report on the business and financial risks they face due to their exposure to sustainability.
Second Component: The development of tools that cover standards, performance evaluation criteria, and nomenclatures. These tools make it easier for financial market participants to align their investment strategies with the EU’s climate and environmental goals.
Third Component: The EU sustainable finance classification, which aims to provide a robust science-based classification system, allowing both financial and non-financial companies to use a shared definition of sustainability and thus protect against greenwashing. It also aims to help investors and companies plan and report on their transition towards sustainability.
The EU classification sets out six key environmental objectives, with each objective including a set of economic activities and standards aimed at ensuring that the activity contributes significantly to the objective without harming the others. The circular economy is an integral part of the EU classification in two main ways. First, it is one of the six primary environmental objectives. Second, it outlines criteria ensuring that circular economy activities do “no significant harm” to the other five objectives and comply with minimum social safeguards.
The EU classification is the only initiative so far to explicitly include the circular economy, although South Africa and the United Kingdom have announced that circularity will be a core objective in their classifications, which are still under development. According to the classification, the “circular economy” refers to an economic system in which the value of products, materials, and other resources is maintained in the economy for as long as possible. This promotes efficient use of these resources in production and consumption, thereby reducing the environmental impact of their use, and minimizing waste and the release of hazardous substances at all stages of their lifecycle. A significant contribution to the circular economy is determined by combining the primary ambition of the circular economy objective with specific technical screening criteria for each economic activity.
Integrating the Circular Economy
Researchers have examined a series of lessons learned from the EU’s efforts to integrate the circular economy into its sustainable finance classification. These lessons fall into three main areas:
1) Classification Structure: The structure plays a critical role in its success. Given the comprehensive nature of the circular economy, integrating circularity into the classification structure remains one of the biggest challenges. The EU’s circular economy objective is highly ambitious, aiming to decouple economic growth from the extraction of non-renewable resources and halt the depletion of renewable resource stocks by 2030. However, significant procedural and political challenges remain in achieving these ambitions, including specific challenges related to the transition to a circular economy, such as the lack of international agreements on the circular economy and its comprehensive nature.
2) Usability: The classification must remain usable by the relevant stakeholders. Several conditions must be met to make the classification usable in reports by companies and financial institutions, including:
- There must be a clear purpose and benefit to reporting. Accurate standards should be established to make data collection across supply chains more efficient, reducing the burden of multiple data requests and providing transparency requirements that allow corporate actors to explore new resource opportunities.
- Stakeholders can begin planning a phased transition from qualitative to quantitative circularity disclosures. Qualitative disclosures will be needed where quantitative data cannot be revealed during companies’ circular learning phases, but material flows and quantitative systems will be required in the long term.
- Increasing transparency and traceability of supply chain data can eliminate some of the uncertainty around what happens to products after they leave the factory. Solutions to understand product impacts after sale, as well as the fate of materials after their first use, are still being developed. In many cases, corporate sustainability reports on the circular economy can make informed assumptions about the fate of materials once they enter the market.
3) Enabling Environment: It is crucial to consider the broader financial and non-financial policy and legislative enabling environment. This environment is necessary to encourage and facilitate organizations in adopting activities that contribute significantly to the circular economy. Achieving global environmental goals while building economic resilience requires a large-scale transition to a circular economy. However, due to its systemic nature, early development stage, limited data availability, and low awareness among the financial sector about circular business models, the adoption of circular practices remains low.
Current classifications are limited as they do not equally consider the need to shift away from significantly harmful linear activities or the need to encourage transitional activities in sectors where a significant contribution to the circular economy cannot yet be achieved. They also fail to account for the ongoing need to finance activities that currently “do no harm,” which are important enablers of the circular economic transition.
Finally, the complexity of circular economy reporting should not be underestimated. Levels of maturity in terms of metrics and methodologies remain low, while access to the relevant data needed for reporting is limited. The lack of available data and the cost associated with gathering such data may reduce enthusiasm and engagement among companies.
Source: Jack Barrie, Patrick Schröder and Suzannah Sherman, Making sustainable finance taxonomies work for the circular economy: Lessons from the EU Taxonomy, Environment and Society Programme, Research Paper, Chatham House, June 2023.
