Financing the circular economy sounds like a no-brainer for banks and investors focused on environmental, social and governance issues. But working out how to quantify such an amorphous concept will make this a pipe dream for some time yet.
The United Nations Environment Programme Finance Initiative last week released the first four in a series of reports to spark banks' interest in funding the transition to the circular economy — a catch-all term for reducing the use of new materials, extending products' lifespans and recycling them.
It’s an important and overlooked part of slowing climate change. Extracting and processing primary natural resources has been estimated to account for more than 55% of greenhouse gas emissions and 90% of biodiversity loss and water consumption.
UNEP FI argues banks can play a pivotal role in making the circular economy as important for the ESG effort as decarbonisation.
It’s an ambitious project from the UN and should be lauded.
For one thing, it makes intuitive sense to put recycling centre stage. The financial market is all too given to its own kinds of recycling — convoluted arrangements in which ESG finance is not even used to directly fund sustainable projects.
Refinancing a green loan and calling the new loan green is not the same as borrowing the money to pay for a wind farm in the first place, for example.
But defining and measuring the circular economy is far more difficult than tracking more familiar metrics such as greenhouse gas emissions or water extraction.
Capital markets have become conversant with the Greenhouse Gas Protocol, which categorised Scopes 1, 2 and 3 emissions. This guidebook helps the market quantify and interpret the effectiveness of a borrower’s efforts at decarbonisation.
Such a universal categorisation system does not exist for the circular economy. The European Union's Taxonomy of Sustainable Economic Activities has a chapter on the circular economy, but it's half empty, not covering crucial sectors like textiles.
This lack of a framework is a problem. Sustainability-linked bonds did not have any standards for key performance indicators when they exploded in popularity in 2021, and the structure has suffered as a result, with green investors rightly wary that deals are put in front of them with targets too easy to hit.
A PR problem
The other problem with trying to focus finance on the circular economy is less structural and more to do with image.
People in the market just don’t know or think about it. This includes investors with an explicit ESG focus, such as those running Article 9 funds that have the strictest parameters for what they can count as an ESG investment.
So the UN also needs to overcome a monumental PR problem.
Finally, there is the widespread reluctance among investors and lenders to have to consider yet another scheme of ESG classification. Transition bonds were mostly rejected by the market for this reason, with SLBs preferred.
Depending on how important the circular economy becomes, banks and investors could be forced to hire more staff to deal with it. And then they will face more chances for things to go wrong through claims of greenwashing.
Moving to a circular economy has the power to transform the prospects of beating climate change. But until some useful guidance frameworks are developed, it’s hard to see how the capital markets will take to financing it.