The concept of the circular economy is increasingly grabbing headlines. Finance professionals could be the linchpin in moving businesses to this revolutionary model
This article was first published in the November/December 2016 UK edition of Accounting and Business magazine.
Circular economies are creating a buzz as a revolutionary alternative to the traditional linear approach of ‘make, use and dispose’. The idea is that resources are used for as long as possible in order to extract maximum value, and are recovered and regenerated at the end of their life.
The World Economic Forum has forecast that shifting to circular economies will contribute US$1 trillion a year globally by 2025; and Accenture has said such a shift could unlock an additional US$4.5 trillion in growth by 2030.
Many organisations are already attempting to implement circular strategies. Examples include electrical goods provider Philips, waste manager Veolia (see box) and carpet manufacturer Interface. Even cities, such as Phoenix in the US, are getting recognition for their work in building circular strategies, targeting, for example, 40% waste reduction through a range of regenerative strategies.
But the circular economy isn’t just for environmentally sensitive sectors. Colin Tetreault, principal of S-2 Consulting and senior scholar at the Global Institute of Sustainability at Arizona State University, which has partnered with the city of Phoenix on its circular strategy, says organisations of all types are looking to this innovative model. They are increasingly realising that circular economies provide better value to the customer and society, while reducing costs and protecting resources. They can also promote financial stability by managing risks in the supply chain.
Tetreault is one of many who argue that these benefits make it essential for finance professionals to help their companies move towards circular strategies. ‘Any CFO who focuses only on the P&L, balance sheet and cashflow, ignoring circular economies, is already coming to it two or three years late,’ he says. ‘Shareholders, investors and financiers are already saying they want this.’
In May 2016, 100 investors, managing US$16 trillion of assets, and six credit rating agencies joined an initiative to look more closely at environmental issues when assessing companies’ financial health and creditworthiness. ‘Ratings agencies could be downgrading firms that are not thinking about sustainability or circular strategies,’ says Tetreault. ‘Circular approaches strengthen your financial position and ratings agencies will take note because they see depleting resources as a growing risk.’
Picking the right model
Finance departments at pioneering companies are developing tools that can identify which of the many potential circular models and practices would benefit their company.
Two of the most helpful tools are environmental profit and loss (EP&L) reports and full cost accounting, which aim to measure both direct and indirect costs of production and benefits across the supply chain.
Data and advice provider Trucost advocates natural capital accounting, which includes the use of EP&L. Trucost’s blog ‘Accounting for natural capital: how do you actually go about it?’ describes how it helped clothing company Puma and its parent company Kering publish the world’s first EP&L statement in 2011.
Kering’s methodology is now open-sourced to help others, and it links to the Natural Capital Protocol, which is a cross-sector initiative aimed at developing a global methodology for environmental accounting.
The company’s EP&L is an in-depth process that aims to measure the environmental impact of its entire supply chain, including suppliers of suppliers. Kering says that by illuminating the full cost of all these activities, the exercise has enabled better decision-making. It has supported a project to improve the measurement of waste – resulting in many different waste reduction and regeneration initiatives – and Kering is now working with a textile upcycling company to create a circular model for textiles.
Commentators have highlighted the way Kering’s EP&L reveals the complexities of material flows and chains of causality that the linear model generally overlooks. This can change relationships with suppliers for the better. And by putting a value on natural capital processes, it also incentivises companies to rethink them and move towards more regenerative systems.
Henry le Fleming, assistant director, sustainability and climate change and technical lead for the circular economy at PwC, highlights the work of a number of other organisations in helping to measure circular strategies. For example, the Ellen MacArthur Foundation has built a ‘circularity index’, which looks at the regeneration of materials in businesses. In addition, the World Business Council for Sustainable Development has developed the Natural Capital Protocol, mentioned above, and the Social Capital Protocol.
PwC uses EP&L as part of its wider Total Impact Measurement and Management (TIMM) framework, which aims to measure the full effects of an organisation’s activities in the four areas of economic, tax, social and environmental.
‘TIMM is an extension of full cost accounting techniques,’ le Fleming says. ‘By measuring and comparing environmental impacts alongside social and economic effects, we can choose the best options for building a more circular economy.’
However, there are many obstacles to this goal. ‘A circular economy works fantastically at a high level,’ he adds. ‘But there are more difficult questions in the detail.’
He refers to the trend among other circular economy pioneers to prolong the life of their products by providing them as a service not as a sold good.
‘If you look to get more use from the same resources by, for example, turning your electronic product into a service, you could keep it in use for longer. Manufacturing fewer new products would reduce environmental impact but also potentially increase it due to the reduced efficiency of older machines. Which has the greater impact?
‘There are different trade-offs like this for almost every product. But we have found with clients that methods such as EP&L can identify and unpick these trade-offs and show the best outcomes. Sometimes it even shows that the linear use of resources is still the best one, rather than the circular.’
Another challenge for accountants is that identifying beneficial circular models can require gathering and analysing huge amounts of data – some of which may not be reliable or consistent.
A report by banking group ING, Rethinking finance in a circular economy, uses the example of Prorail, which is responsible for the Netherlands railroad system. It developed a circular strategy that aims to save €15m to €35m every year by reducing the use of virgin materials by 20% and reducing lifecycle costs by 10%. But it could only do this after a huge and often difficult inventory of all its materials.
This is just the first job for the finance department, says ING. But the analysis may lead to fundamental changes in corporate models. This is one reason why most circular projects are still in pilot stage and lack a track record of profitability, says the report.
Switching to a circular model may require a fundamental change in capital structure, and businesses may need finance to bridge the gap between pilot and growth. They may also need more working capital, balance sheet extension or multiple forms of capital.
If a company switches from sales to a service or pay-per-use model, it may need to adopt leasing contracts for the first time, which could impact its accounting model significantly.
Switching to pay-per-use may affect cashflows significantly in the first few years but should become more profitable than sales after a certain point. So companies may have to focus more on the timing and optimisation of cashflows to make such models more financeable, says ING.
The company could use factoring and supply-chain finance to address this. It may also charge higher fees in the first years of contracts to reduce the risk.
If a product has value in second-hand markets or is designed for disassembly and reuse, this can improve the financials of the circular business case, adds the report.
Another potential challenge for accountants who are looking to adopt circular practices is the need to expand their horizons dramatically. ‘Circular strategies can require you to engage in different relationships with many other companies,’ says Jan Bebbington, professor of accounting and sustainable development at the University of St Andrews. ‘For example, with suppliers’ suppliers, or other companies in an ecopark where you can exchange resources such as waste materials and heat. That can make careful relationship management the most important aspect of the change, as companies often have competing needs. It’s a cultural challenge.’
However, Bebbington says that the increasing scarcity of certain resources will force accountants to adopt this outlook. ‘[Circular strategies] might not seem worth it for an individual company. But joining with others now might help save those rare materials, making each company more sustainable in future. The focus of accounting will not necessarily be on an individual product or entity level; it may be regional, national or global.
‘Some of these problems are incredibly complex. But the stakes are so high, you can’t wait until you know all the answers before you move. So finance professionals may need to improve their problem-solving skills and their comfort with uncertainty.’
Moving to a more regenerative model can be daunting for CFOs. But as pioneering efforts develop, it should give them the confidence to join the journey towards a circular economy and bring others with them.
Tim Cooper, journalist
"Circular economies offer better value to the customer and society, reducing costs and protecting resources"