High levels of alignment with circularity principles lower risk of default and improves risk-adjusted returns among companies.
The greater a company’s adoption of circular economy principles, the lower its risk of default, and the higher the risk-adjusted returns on its stock, according to research by Italy’s Bocconi University. A circular economy is based on the principles of designing out waste and pollution, keeping products and materials in use, and regenerating natural systems.
Conducted in collaboration with Italian bank Intesa Sanpaolo and the Ellen MacArthur Foundation, the research analysed 222 European companies across 14 resource-intensive industries.
“We found a positive relationship between the degree of circularity and the risk-adjusted performance,” said Claudio Zara, Professor and Researcher at Bocconi University. “This demonstrates that the circular economy offers opportunities to investors,” speaking at a webinar held this week to highlight the research.
Circularity score
To measure the degree of circularity of each company on a yearly basis for the period 2013–2017, Bocconi University and Intesa Sanpaolo developed a Circularity Score, using existing ESG data and sustainability measures, including the Thomson Reuters Eikon ESG 2019 dataset.
Alongside the Circularity Score, a set of control variables associated with a company’s risk and return profile were considered, including company size and capitalisation, profit margin, capital structure, and R&D expenditure, among others.
The analysis results revealed that a 0.1 increase in Circularity Score reduces the probability of default on debt over a one-year horizon by 8.63% and over a five-year horizon by 4.93% – with a 95% confidence level in both analyses. The top 25% of companies in the sample with the highest Circularity Score have an average probability of default of 0.04% over a one-year time horizon, compared to 0.5% for the 25% with the lowest Circularity Score.
Over a five-year horizon, the average probability of default for the top quartile was 0.91%, compared to 2.35% for the bottom quartile.
On the return side, the analysis found an increase in a company’s circularity implied a higher Sharpe Ratio (which measures performance of mutual funds) and Treynor Ratio (which shows the risk-adjusted returns of a portfolio) for its stock, with a 99% confidence level in both cases.
With the Sharpe Ratio, a 0.1 increase in the Circularity Score results in an 0.204 increase in the absolute excess return per risk unit of a stock on a standalone basis. A similar pattern was witnessed for the relative excess return per risk unit of a stock considered in a fully diversified portfolio, with a 0.163 increase in Treynor Ratio for a 0.1 increase in the Circularity Score.
Role of the financial sector
The financial sector has a role to play in orienting investments towards a circular economy, particularly as economies recover from the Covid-19 pandemic, said Max Tellini, Head of Circular Economy at Intesa Sanpaolo. The bank has supported the development of the circular economy market as a strategic priority.
Intesa Sanpaolo has set up the Plafond, a dedicated €6 billion credit facility for innovative companies with business practices aligned to circular economy principles. The Plafond is available to all sizes of companies, with a focus on Italian small and medium-sized enterprises (SMEs).
Directing credit exposure towards circular companies and projects has enabled the bank to de-risk and stabilise its portfolio and increase resilience in the medium- to long-term. The Plafond also responds to client demand for financial products which support a low-carbon transition.
Tellini sees the development of a circular economy as a collaborative effort between financial institutions and companies. “Education is crucial as we need a new generation of thinkers to equip companies with people that can master the concepts of circularity and ensure we can support them as they design new business models.”
