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ESG Explainer: Zeroing-in on a Circular Economy

The throwaway culture of linear economies is slowly making way for more circular and sustainable models that support climate and biodiversity goals.

At a circular economy conference in early March, Frans Timmermans, Executive Vice-President of the European Commission, said the climate and biodiversity crises could not be tackled without a circular economy. “We know that existing consumption models are wreaking havoc on biodiversity. More than 90% of biodiversity loss and water stress comes from resource extraction and processing. And we know that half of total greenhouse gas (GHG) emissions come from resource extraction and processing. That is why the transition to a circular economy is at the heart of the European Green Deal.”

Later that month, the Commission published proposals to update EU consumer rules to incorporate circular economy principles, ensuring “consumers can take informed and environment-friendly choices when buying their products”. Under the rules, consumers will have a right to know how long a product is designed to last for and how, if at all, it can be repaired. Commissioner for Justice Didier Reynders said: “If we do not start consuming more sustainably, we will not achieve our European Green Deal goals – it is as simple as that.”

This explainer looks at what the circular economy is and what role investors can play.

What is a circular economy?

The circular economy aims to eliminate waste and pollution, keeping products and materials in use for as long as possible. It entails designing more durable, reusable, repairable and recyclable products that can be kept in circulation in the economy much longer than current, linear economy products. In a linear economy, resources are extracted, products manufactured, used and then thrown away.

In addition to how products are designed, the circular economy also involves changing the way people consume and use goods and services, rethinking the form of consumerism that exists in most Western countries in particular. The concept also encompasses restoring wilderness, building regenerative agricultural systems, using renewable materials, and shifting to renewable energy sources.

The Ellen Macarthur Foundation, which promotes the circular economy, says the concept is based on three principles: eliminate waste and pollution, circulate products and materials, and regenerate nature.

Waste and pollution should be regarded as “design flaws” rather than as “inevitable by-products” of goods and services. “By changing our mindset and harnessing new materials and technology, we can ensure they’re not created in the first place,” says the Foundation. Circulating products is made possible by designing products to be reused, repaired, or remanufactured. Finally, regenerating nature can be achieved by returning nutrients to the soil and other systems, enhancing natural resources.

A transition to renewable energy and materials underpins the circular economy, which decouples economic activity from the consumption of finite resources. “It is a resilient system that is good for business, people and the environment,” says the Foundation.

According to analysts Circle Economy, adding circular economy solutions to countries’ Nationally Determined Contributions (NDCs) to the Paris Agreement will enable global temperature rises to be kept “well below” 2⁰C. Circle Economy’s 2021 Circularity Gap Report revealed that the world economy is only 8.6% circular – two years before it was 9%. While temperatures have continued to rise, the world consumed an estimated 100 billon tonnes of material per year.

Circle Economy draws a direct link between GHG emissions and how the linear economy extracts, produces and consumes resources. By applying circular strategies to materials and emissions hotspots (such as extraction and transportation) excessive material consumption, and thereby GHGs, can be slashed, it says.

How can circular economy principles be applied across sectors?

Policy institute Chatham House says the notion of circular economy can be applied to “most areas of human economic activity”, from the way food, plastics and clothes are produced and consumed to the way waste is handled.

In food production, for example, it estimates that the area required to grow the world’s wasted food each year alone is the size of Canada and India combined. The livestock industry clears forests, losing vital carbon sinks while monoculture crops degrade soil and destroy biodiversity.

In a circular economy, food production focuses on regenerative farming practices (which rebuild soil organic matter and restore degraded soil biodiversity), changed diets that include alternative protein sources and reduced waste through better storage systems, food redistribution models and household behaviour change.

The Macarthur Foundation cites Apeel, a US-based company that has eliminated single-use shrink wrap plastic packaging on fresh fruit and veg. The company produces a layer of edible, plant-based coating that is applied to fresh products and mimics and enhances the natural defences of fruit and vegetables. This slows down water loss and oxidation. The technique designs out food waste (by preventing premature rotting), plastic waste as no manmade packaging is required, and energy and resource waste – by covering one avocado with Apeel, 23 litres of water and enough energy to charge a smartphone nine times is saved, says the Foundation.

In the clothes and textiles industry, 92 million tonnes of waste are generated every year and the industry is responsible for 8-10% of global carbon emissions, says the Foundation. In addition, the sector consumes 79 trillion litres of water annually. Circular economy solutions could hugely improve the environmental performance of textile supply chains by designing clothes which last, recycling old garments, introducing bio-based materials, and scaling business models for repair and rental.

Plastics are another product targeted for action by circular economy proponents. Plastics production is mostly dependent on the use of fossil fuels and material takes a long time to break down. Microplastics poison and choke terrestrial and marine animals. The Foundation – which was formed after yachtswoman Dame Ellen Macarthur saw at first hand the damage caused by plastic pollution – says the priority should be to reduce the use of unnecessary plastic while avoiding substitutes which have worse environmental impacts.

As well as moving away from single-use plastics towards reuse alternatives, plastics must also be captured before they become waste and pollute the environment through incentives such as deposit return schemes. Finally, plastic products should be redesigned with recycling in mind using individual polymer plastics.

Circle Economy points out that in some developing nations there is a strong tradition of repair and reuse of products at the consumer level. On a more industrial level, the ship-breaking industry in Bangladesh is an example of the “vital and highly undervalued role in global recycling” that developing nations play.

A more circular and resource-efficient economy in the EU could reduce annual EU industry GHG emissions by up to 10% by 2030 and up to 34% by 2050, according to research by German climate think tank Agora Industry. In plastics production alone, improving recycling could cut the use of fossil fuels by roughly 2.7 billion cubic metres of gas and 149 million barrels of oil per year by 2030. Since plastic production relies heavily on imported carbon-based feedstocks such as ethane, propane, and butane, enhancing the recycling of plastic materials could lower the dependency on these fossil commodities significantly.

How is public policy embracing the concept of a circular economy?

Central and local governments play a crucial role in creating and enabling conditions for a circular economy to emerge and thrive, by setting direction and driving innovation and investment.

The European Commission’s new Circular Economy Action Plan (CEAP), released in March 2020, is one of the main building blocks of the European Green Deal. The Commission says the EU’s transition to a circular economy will reduce pressure on natural resources and will create sustainable growth and jobs. It is also a prerequisite to achieve the EU’s 2050 climate neutrality target and to halt biodiversity loss.

The plan covers electronics and ICT, batteries and vehicles, packaging, plastics, textiles, construction and buildings, and food, water and nutrients. It targets how products are designed, promotes circular economy processes, encourages sustainable consumption, and aims to ensure that waste is prevented and the resources used are kept in the EU economy for as long as possible.

“A more circular and resource-efficient industrial sector enhances competitiveness and is also a major industrial policy opportunity for Europe,” says Frank Peter, Director of Agora Industry. “The EU’s new circular economy legislation is an opportunity to leverage the potential of circularity. To do so, it must spur demand for high-quality recycling while boosting collection and supply of high-quality recycled materials.”

In the UK, most of the measures outlined in the EU’s earlier Circular Economy Package have been transposed into law, with some minor amendments. The Resources and Waste Strategy sets out how the government will preserve material resources by minimising waste, promoting resource efficiency and moving towards a circular economy in England.

In the US, the Environmental Protection Agency’s National Recycling Strategy is a “part one of a series” on building a circular economy. The strategy is focused on improving the nation’s municipal solid waste recycling system. Elsewhere, the US Plastics Pact brings together businesses, not-for-profit organisations, government agencies, and research institutions to create a common vision of a circular economy for plastics. Members include Aldi US, Arizona Department of Environmental Quality, Kimberly-Clark, the US Chamber of Commerce Foundation, Unilever United States, and Walmart.

China’s 14th Five Year Plan, which covers the period 2021-2025, aims to develop a circular economy via initiatives promoting recycling, remanufacturing, green product design and renewable resources. The development of the circular economy, which has been set as a national priority, is designed to help clean the country’s environment, meet its international climate goals, and encourage green innovation.

China’s circular economy targets for 2025 include increasing resource productivity by 20% compared to 2020 levels, reducing energy consumption and water consumption per unit of GDP by 13.5% and 16%, respectively, compared to 2020 levels, and reaching a utilisation rate of 86% for crop stalks, 60% for bulk solid waste, and 60% for construction waste. Other ambitions include utilising 60 million tons of wastepaper and 320 million tons of scrap steel.

What is the impact on investors?

EC advisory group the Platform for Sustainable Finance (PSF) has outlined proposals for incorporating circular economy principles into the EU taxonomy for sustainable economic activities. The taxonomy creates an list of economic activities with technical screening criteria, which determine in which cases each activity makes a ‘substantial contribution’ to an environmental objective. The reorientation of capital flows requires a common understanding among all investors, financial institutions, and companies across the EU of what a “sustainable investment” is, says PSF.

On the circular economy, the taxonomy envisages that by 2030, economic growth is decoupled from extraction of non-renewable resources and depletion of the stock of renewable resources is reversed. By 2050, the aim is for economic activity to be largely decoupled from resource extraction, through environmental design for a circular economy.

The task of developing a converging and coherent set of activity-specific criteria for defining substantial contribution as part of the transition to a circular economy is challenging, admits the PSF, because it is a relatively new concept in scientific literature.

A “clear and robust” methodological approach to determine and define how an activity can make a substantial contribution to the transition to a circular economy was developed within the Joint Research Centre’s (JRC’s) report on defining substantial contribution. The PSF built its proposals on this work.

What are investors doing now to support the circular economy?

Shareholder action is beginning to reap results as awareness of the advantages of a circular economy grows. In February, Kraft Heinz Co., the third-largest food and beverage company in North America, agreed to set a goal to reduce total virgin plastic use, following the filing of a shareholder proposal and engagement with shareholder activist NGO As You Sow. The proposal asked Kraft Heinz to report on how the company would reduce plastic packaging, including planned reduction strategies or goals, materials redesign, substitution, or reductions in use of virgin plastic.

In response, the company said it intended to set a “substantial” virgin plastic packaging reduction goal later this year or in the first quarter of 2023. As You Sow filed similar proposals at Amazon, McDonald’s and Kroger. In 2021, five other large companies, Keurig Dr Pepper, Mondelez International, PepsiCo, Target Corp., and Walmart, agreed to reduce these plastics after shareholders supported proposals to reduce their use.

Fund solutions are also being developed to channel investment toward circular solutions. In March, discretionary investment manager Man GLG, launched its Man GLG RI Sustainable Water and Circular Economy fund. The fund applies a long-only, actively managed equity thematic investment strategy with a strong sustainability focus. It is designed to generate returns while targeting a positive environmental impact by contributing to the UN’s Sustainable Development Goals, with a focus on clean water and sanitation (goal 6); life below water (goal 14); life on land (goal 15); and responsible consumption and production (goal 12). Teun Johnston, CEO of Man GLG, said the fund was a response to “clear and growing” demand from investors for ESG-focussed investment strategies that seek to deliver attractive returns while actively protecting and improving the environment.

In October 2019, BlackRock launched a circular economy public equity fund, which aims to drive investments in publicly-listed companies already contributing to or transitioning to a circular economy. Portfolio companies include Adidas, which has committed to 100% recycled polyester in its trainers by 2024. Larry Fink, CEO and Chairman of BlackRock said the fund would be one of the manager’s “foundational products”. As of 11 April 2022, the fund was worth US$2.187 billion.

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