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The increasing momentum building behind ‘circular economy’ initiatives should make this an exciting area for investors over the coming decade

Arguably since the Industrial Revolution and certainly over recent decades, the prevailing human instinct has been to buy, to consume and then to throw away. It is growing ever clearer, however, this consumption model has profound and damaging implications for the planet – from plastic pollution to fatbergs to greenhouse gas emissions. For many, the solution is equally clear – replace this ‘linear economy’ with a circular one.

The Ellen MacArthur Foundation has led the way in defining the ‘circular economy’. It talks about a ‘restorative’ economy, where products are ‘made to be made again’ in a system powered by renewable energy. This is more than simply recycling – it is about considering how a product will be recreated at the point of design. As such, it needs to be embedded in the manufacturing process.

The advantages of this approach are not only that valuable resources are preserved and toxic waste eliminated, it should also end up saving costs for companies – after all, resources are expensive so reusing them will be more cost-effective. Research from Accenture, for example, estimates the value of the circular economy could be as high as $4.5trn (£3.3trn) by 2030 – equivalent to between 4% and 5% of projected global gross domestic product.

That research also indicates the potential savings for key industries – the consumer goods industry, for example, could capture up to $110bn in value by 2030 by creating ‘circular’ packaging. The electricity industry is another clear beneficiary, with Accenture estimating that by investing in cheaper and newer ways to produce, manage and transmit renewable sources of electricity, it could capture up to $250bn of value by 2030.

There is stick as well as carrot at play here. The EU’s Circular Economy Action Plan was introduced in March 2020, bringing in legislative and non-legislative measures to encourage companies to embrace a more sustainable approach to product development. This includes a strategy for sustainable textiles, action on waste shipments and a review of organic pollutants in waste. While early progress has been slow, this is now building momentum, potentially creating a significant headwind for companies that are behind the curve.

Investors are also starting to take a close interest in the circular economy – and it is naturally an increasing focus for ESG teams. Legal & General Investment Management (LGIM) senior sustainability analyst Yasmine Svan says it is now a routine part of its company engagement and analysis, while at M&G it is one of three key components of the group’s Climate Solutions Fund, managed by Randeep Somel. For their part, BlackRock and BNP Paribas operate dedicated funds in this area.

All of which means some businesses have made significant strides but, inevitably, much more needs to be done. As the World Economic Forum puts it: “Numerous leading organisations around the globe have proven the business case for circularity by successfully adopting circular business models and leveraging disruptive technologies. However, these efforts have generally focused on small-scale initiatives or programmes that can be retrofitted into business-as-usual environments, limiting their transformative impact and scalability.”

Acknowledging the strong progress made in some sectors, M&G head of sustainable and impact investing Ben Constable-Maxwell highlights the packaging industry. “The widespread use of disposable packaging has contributed to highly visible environmental challenges, including plastic waste,” he says. “The sustainable practices adopted by one of the world’s largest producers of corrugated boxes illustrates how innovation can transform a challenge into an opportunity.”

Packaging giant DS Smith has, continues Constable-Maxwell, been an industry leader in ‘closed-loop recycling’ – a process where waste is collected, recycled and then used again to make the same product it came from. “After collecting corrugated paper from retailers and other businesses, the company processes the recycled material in its own paper mills to create new corrugated boxes,” he explains.

“By recycling paper fibres, the company estimates it can save more than 360,000 trees a year from being cut down.”

For her part, LGIM’s Svan points to the progress made among European car makers, which are increasingly following market leader Tesla in employing lifecycle analysts to build circularity into their production processes. This has produced some significant innovation – for example, lithium components are now frozen with liquid nitrogen to prevent further chemical reactions and are then separated into fluff, cobalt, copper and slurry for reuse.

Innovation can also be spotted in ancillary businesses. As an example, the World Economic Forum highlights Goodyear’s new concept tyre, Oxygene, which has been designed so that moss grows within its sidewall by absorbing moisture from the road, improving traction and also helping to remove carbon dioxide from the air. The moss’s photosynthesis then creates energy that can be used to power electronic sensors in the tyre that exchange data with other vehicles to support the transport infrastructure and enable smart mobility.

If the car industry is among those leading the way, other industries are lagging. “Areas such as real estate investment trusts are some way behind,” says Svan. “That sector is at an early stage of understanding what carbon is embedded in their buildings.”

In a similar vein, the steel industry needs to work far harder to increase the percentage of steel that is recycled, which ought to make a significant impact on emissions. Housebuilders are also laggards, Svan adds, and need to work harder to improve the circularity of their products.

Daniele Cat Berro, a director at ESG advisory and portfolio analytics specialist MainStreet Partners, expects regulation will provide a significant push over the next few years. “One of the additional objectives of the EU Taxonomy that is – hopefully – coming into force in 2024 is the transition to a circular economy,” he says. “This objective will push disclosure of metrics related to the pursuit of a circular economy and increases the focus on a theme strongly supported via the European Green Deal.

“We see the circular economy as both a standalone theme – looking at companies working in the recycling and/or reusing business – as well as a transversal concept that companies should apply in their own production processes, product design and disposal. Few dedicated funds are currently available on the market, but we expect strong capital flows into companies that could profit from this megatrend in the future.”

This theme is building from a low base. A recent survey by the World Business Council for Sustainable Development and DNV has found that, while half of companies surveyed are beginning to explore the issue of circularity and may adopt at least one model within the next three to five years, only one in eight (12%) report circularity being core to their business strategy while half that amount (5.9%) can be said to have a mature approach. At the moment, the drivers are internal – for example, reduction of costs and extending product lifecycles – rather than external, such as brand or regulation. This is likely to change over time as consumer and regulatory pressure increases.

Barriers to the adoption of circular economy models exist, too – for example, there is often a skills shortage within organisations, which can hinder progress. Equally, performance measurement is immature and companies will often use their own metrics, making comparison difficult. In its survey, DNV notes: “The lack of structured performance metrics and measurement, and known, transparent models poses both a threat to the ability to identify successful models that can be scaled and to the ability to communicate efforts in a trusted and traceable way toward customers and consumers alike.”

Nevertheless, as investors have learnt from their experience with other ESG metrics, with enough regulatory and investor will, these problems can be overcome. The increasing momentum now building behind circular economy initiatives should make this an exciting area for investors over the next decade.