The circular economy (CE) was a natural state to our ancestors, and dramatic climate change events and their impact on our society are bringing it back into vogue.1 Today’s CE models aim to promote sustainable growth while maximizing material reuse and minimizing waste. However, the transition to a circular economy poses significant challenges, including how we will finance it.
This article highlights new ideas and initiatives financial institutions are using to tackle climate challenge and discusses how these actions impact their approach to the circular economy. It examines how existing and new financial instruments are being used by financial institutions and governments to tackle the climate challenge and create the circular economy. The article looks at this from several perspectives, including financial corporate markets (e.g., the bond market) and the role of governments. It concludes by examining how modern finance can be manipulated based on climate change and circularity and how financial resources can be diverted to activities to give the impression of contributing to the circular economy — when the money is doing anything but that.
Below are descriptions of financial instruments and how they’re being used to create the circular economy.
Bond & Loan Instruments
Bonds are fixed-income securities that are, essentially, IOUs issued by borrowers such as central banks and corporate institutions. A bond investor lends money to the bond issuer in return for periodic interest payments known as “coupon payments” and the return of the bond’s face value (known as the “principal”) when it matures. Green bonds are an adaptation of traditional bonds that are issued to fund sustainable and CE-related projects.2 The proceeds from green bonds can be used to finance projects specifically related to the conditions under which the bonds are offered. For example, in 2020, Daimler and Volkswagen each issued a €2 billion green bond (about US $2.1 billion) to support their transition to electric vehicles.3
Sustainability-linked bonds are a second adaptation of traditional bonds. Unlike green bonds, in which the investment return is fixed at the issuance of the bond, returns on sustainability-linked bonds are determined by the financial performance of the firm subject to its sustainability criteria. If a firm meets and exceeds its sustainability criteria, it may pay less for borrowing.
Green loans are a third adaptation. Similar to bonds, they are created between two institutions with a specific project in mind, rather than a range of projects.
National & Local Government Financing
Government financing can take place either at a regional or national level. In addition to issuing bonds, government financing can involve:
Grants and subsidies. Both local and national governments can offer financial incentives, grants, and other subsidies to encourage CE projects such as the development of recycling infrastructure.
Regional bonds. These are issued by regional councils and are focused on the needs of the region as it works to maintain sustainability features.
New financial institutions. Regional banks and credit-lending agencies create new entities that cater to the funding needs of the circular economy, often with the local government underwriting the loans.
Tax incentives. Government tax incentives act as a spur to local and regional sustainable development through public-private partnerships that would not have been possible otherwise.
Long-term financing. These loans have advantageous terms for households working to make their property energy efficient through insulation, renewable energy, and recycling.
Capital markets have been very active in creating new financial products that (at least in theory) make significant contributions to the circular economy by incorporating environmental, social, and governance (ESG) criteria as part of the product design. These innovations have resulted in significant amounts of financial capital flowing into CE ventures. Some common products are:
Exchange-traded funds (ETFs). These are similar to individual stocks and thus can be traded in a similar manner.4 ETFs can incorporate various categories of assets such as stocks, bonds, commodities, and index funds.
Index funds. These are mutual funds that mimic the performance of market indices (e.g., FTSE 100 or S&P 500). Rather than relying on management to pick individual stocks, index funds track a chosen index based on the chosen risk level of an investor. Index funds aim to provide broad exposure to the capital markets at low cost while reducing extreme investment risk. Several ETFs and index funds incorporating ESG criteria as part of their brief have been set up, including BlackRock’s iShares and Vanguard’s FTSE Social Index Funds.
Mutual funds. These are investment instruments that gather finances from many parties to invest in a diversified portfolio of assets, including stocks, bonds, commodities, derivatives, and other securities.5 A number of institutions have issued ESG-oriented mutual funds, including Vanguard, BlackRock, and UBS. Each of these funds has benefited from interest in sustainability. Unfortunately, it is not yet clear whether the ESG-based mutual funds perform better than traditional mutual funds. However, given the long period traditional mutual funds have been in existence, ESG-based mutual funds may yet promote sustainable development while providing a healthy return to investors.
Real estate investment trusts (REITs). These let individuals invest in income-generating real estate without having to buy, manage, or finance it directly. REITs have taken an active approach in adapting to the circular economy and sustainability. Examples include green building initiatives in which new environmental practices are introduced to reduce a building’s carbon footprint; properties that incorporate renewable energy sources such as solar and wind; community and social responsible projects in which community development programs align with sustainable and CE principles; and programs that require tenants and owners to work together to decrease water consumption and optimize waste management practices. For example, Hannon Armstrong Sustainable Infrastructure Capital is known for incorporating circularity and sustainability into its REITs.
Green certificates. These contribute to sustainability and the circular economy in several ways, including Renewable Energy Certificates (RECs, mainly in the US) and Guarantee of Origin (GoO) certificates (mainly in Europe).
Carbon credits. These are similar to green certificates and include certified emission reductions (CERs) under the Clean Development Mechanism (CDM). The CDM defined in the Kyoto Protocol incorporates company projects involved in CERs, including renewable energy and energy efficiency. For example, the Katingan Mentaya Project in Kalimantan, Indonesia, encourages local farmers to abstain from clearing virgin forest by helping them sell carbon credits from their land.
Decentralized finance using blockchain technology is revolutionizing the financial world and creating new ways to finance economic activities.6 Blockchain’s key strength is that information within it cannot be changed, reducing fraud risk. The technology’s data transparency and lowered risk means individuals and institutions can inexpensively set up and manage platforms that let them exchange (and advertise) products or services, leading to an overall demand for new goods. Platforms can be further expanded to include the use of smart contracts that interact with each other based on preset rules. For example, a payment and/or additional reward could be made if a particular product is recycled, without any human intervention.
Existing fintech platforms that focus on crowdfunding could be used to finance new setups focused on the circular economy. This can be done in various ways, including peer-to-peer lending, in which investors can directly connect to borrowers through the issuance of bonds or new types of financial instruments. Peer-to-peer lending’s strength lies in its ability to democratize the investment process and make it more efficient — there is no financial intermediary such as a bank to charge fees. The drawback of this approach is that, in certain circumstances, it can lead to mis-selling of financial instruments.
ESG-themed robo-advisors focus on providing investment advice based on ESG criteria. This helps investors incorporate traditional metrics for financial performance while including sustainability and the circular economy in their investment plans. Robo-advisors are inexpensive to run because they do not require human input and are likely to be impartial, so they are a creative alternative to hiring expensive fund managers.
Since fintechs are in the digital space, they can easily leverage advanced analytics. Examples include using big data to understand complex patterns to help firms optimize their recycling, creating digital token assets that enable the ownership of fractional items, and automatic compliance with rules and regulations. This rich data set could make it easier to explore alternative patterns and payments; in an ideal situation, machine learning would be used to develop innovative new financial instruments geared toward the needs of specific projects in the circular economy. By integrating fintech into the circular economy, businesses and customers can enhance recent developments in digital technology to speed up the green economy.
The most obvious challenge to developing circular finance is greenwashing, which is particularly acute in financial instruments. For example, green bonds could be issued with the intent of investing the proceeds in environmentally friendly products, but some of the proceeds could be invested in projects that are not environmentally friendly. Similarly, ETFs could be issued with an emphasis on investing in companies with green credentials, but the portfolio might end up including companies involved in environmentally harmful activities.
The ESG criteria that investors use to assess company performance also creates challenges. There is no universally accepted definition of what constitutes a financial instrument that would satisfy all ESG criteria. Thus, two financial instruments meeting ESG criteria could come onto the market with very different environmental outcomes.
It’s not clear whether ESG is the right way to develop finance for the circular economy. Indeed, one might argue that ESG benefits capital markets rather than investors, since the institutions offering these products not only charge a hefty product fee compared to traditional products, they also tend to create less robust financial products in which higher risks are transferred to the investors. Seen from this perspective, these products might be a distraction that delays the creation of the circular economy and could be the ultimate form of greenwashing.
The Way Forward
The complexity of ESG definitions, along with a lack of international agreements, numerous accounting standards, and regional differences in how financial institutions and capital markets are regulated, make it impossible to develop an all-encompassing financial mechanism to fund the circular economy.
To succeed, the circular economy must be truly global. Given the wide variety of financial institutions and financial institutions subject to different legal jurisdictions and definitions of what constitutes “green,” it is unlikely a single taxonomy can be developed.
Therefore, a local approach involving public-private collaboration is worth considering. For example, local or central governments could issue bonds that pay above a certain threshold when certain environmental criteria are met or exceeded. Governments could also consider funding any large infrastructure project that meets environmental criteria at advantageous terms.
Public-private partnerships in which both parties contribute equity at a predetermined ratio to form companies that tackle a particular sustainable issue (e.g., solar farms, wind farms, recycling plants) are another possibility. The drawback of this approach is that companies may receive funding based on strong environmental criteria and then either do the bare minimum or not do anything at all.
Escalating complexity has been a continuous theme in the drive to develop finance models to fund the circular economy. This can lead to products that cost more, contain hidden or excessive financial risk, and/or result in investors being swindled.
One major step forward would be an international agreement on what to charge for greenhouse gas emissions that could be used for both green certificates and carbon credits. This would eliminate the need to develop complex financial instruments that meet stringent ESG criteria and are based on complex, overlapping rules. Unfortunately, the political will for this does not presently exist at a global level.
Given what is at stake (the financial resources required and the financial costs that will be incurred if the climate challenge is not met quickly), it’s clear that the response so far has been anemic and uncoordinated. We may quickly return to a point of no return — and if that happens, the current financial global infrastructure may ultimately collapse and with it a sustainable future.
1 Barros, Murillo Vetroni, et al. “Circular Economy as a Driver to Sustainable Businesses.” Cleaner Environmental Systems, Vol. 2, June 2021.
2 Bhutta, Umair Saeed, et al. “Green Bonds for Sustainable Development: Review of Literature on Development and Impact of Green Bonds.” Technological Forecasting and Social Change, Vol. 175, February 2022.
3 Rocha, Priscila Azevedo, and Paul Cohen. “VW Follows Daimler with Green-Bond Cost Savings in Debut Deal.” Bloomberg, 16 September 2020.
4 Rompotis, Gerasimos G. “The ESG ETFs in the UK.” Journal of Asset Management, Vol. 23, January 2022.
5 Petridis, Konstantinos, et al. “Measuring the Efficiency of Mutual Funds: Does ESG Controversies Score Affect the Mutual Fund Performance During the COVID-19 Pandemic?” Operational Research, Vol. 23, No. 54, August 2023.
6 Siddik, Abu Bakkar, Li Yong, and Md Nafizur Rahman. “The Role of Fintech in Circular Economy Practices to Improve Sustainability Performance: A Two-Staged SEM-ANN Approach.” Environmental Science and Pollution Research, Vol. 30, February 2023.