Net zero targets are not feasible without a circularity strategy in place | Alessia Falsarone

I am convinced that net zero targets are not feasible without a circularity strategy in place.

In a nutshell, the feasibility of net zero targets depends on their ability to deliver regenerative outcomes while still relying on the scarce natural resources of today’s baseline.

Put it simply, investors are still working on closing the gap between building net zero portfolios that have each of their portfolio companies on a path to neutralize financed emissions. In order for them to keep building diversified portfolios while securing their own net zero goals, the starting point has been measuring the carbon footprint of investments. Most of them have probably moved to fast track collaborative engagement and stewardship efforts to meet their own climate commitments first as a way to address regulatory pressures. With carbon markets lacking the depth needed to build a financial strategy or an instrument to overlay to a portfolio and deliver a ‘synthetic’ net zero number, net zero is not within reach for the majority of investors to date. Circular economy strategies can yield a series of fully investible, innovation-oriented roadmaps for businesses to adopt and provide those regenerative solutions that investors are increasingly seeking.

With carbon markets lacking the depth needed to build a financial strategy or an instrument to overlay to a portfolio and deliver a ‘synthetic’ net zero number, net zero is not within reach for the majority of investors to date. Circular economy strategies can yield a series of fully investible, innovation-oriented roadmaps for businesses to adopt and provide those regenerative solutions that investors are increasingly seeking.

To be real players in circularity, capital allocators need to be willing to open the door to innovation financing at the R&D level. That’s what Fortune 500 companies are doing internally directing capital to develop net zero products and turn around their operations one step at the time. It’s a capital investment today with the vision of yielding higher customer acquisition, retention and ultimately gains in market share within the foreseeable future.

What if investors started by introducing a financial metric of forward earnings based on circularity to address the downside risk of business models that are not regenerative enough? Would it contribute to minimize risk per unit of capital invested today?

Within circularity, the focus has shifted from materials’ efficiency to generating top-line growth.

What if investors started by introducing a financial metric of forward earnings based on circularity to address the downside risk of business models that are not regenerative enough? Would it contribute to minimize risk per unit of capital invested today? The more I lead efforts in this space, the more I am convinced it would.

When it comes to the circular economy, the most successful initiatives have an element of innovation at their core. For traditional investors to join in, it would be helpful to borrow few of the tools that innovation funders are familiar with. Investors, those operating in the buyside as standalone entities, have struggled to innovate for a long time. With passive strategies winning over active strategies on cost and many times on less volatility return on investments, it’s time to go after the businesses that can prove to be innovators. The circular economy offers a variety of entry points of collaboration for them to innovate and stay commercially relevant in the new economy.

Let’s not forget that while VC is not a suitable strategy for everyone, it is still possible to borrow techniques to evaluate innovation – in this case at the R&D and late-stage level to fit the needs of more mature investors. The type of innovation that the science of sustainability and circularity bring, requires bigger pools of capital and go beyond the growth vs. value nature of a business that an equity analyst or a bond manager would evaluate. Government agencies across the EU and the UK have started to understand they can be a catalyst for this type of collaboration, as a way to share best practices, de-risk capital investment and drive less well-resourced businesses today to join in and grow into established platforms. The Innovate UK Investor Connect offers a promising platform for innovators in the space and investors to create connections through a secure technology developed by Floww. While the platform opens the door to opportunities beyond circularity, it is a well-designed marketplace for circular business ideas to be matched with innovation-oriented investors.

Over the past year and half I have seen close to 90 companies across 13 countries working to operationalize 20+ different use cases of circularity. None of them benefit only one domain as the circular economy requires collaborative efforts and customers are usually involved early in the implementation cycle to build awareness and collect vital feedback. Businesses can’t go circular without their customers, especially at a time when the development of service oriented offerings is part of the circularity value that companies explore most frequently. Diversified energy players as well as utilities recognize that electrification of transport and carbon capture create opportunities to introduce elements of circularity, including the reutilization of carbon itself. So revenue generation follows as well as risk mitigation – again with a customer lens in mind. The risk mitigation characteristic of circular business practices has become most visible in times of supply chain disruptions as many businesses deploy circularity where they are already co-located with the help of their value chain partners – think for example of end-of-life EV battery collection and materials reuse that a handful of automotive manufacturers are implementing with their China-based operators. I would still caution against drawing a causality relationship where it is simply not enough evidence of it. The fact that circular economy practices impact financial performance does not necessarily translate in businesses having figured it all out – rather what I have seen is businesses embracing experimentation. Let’s not be surprised then if circularity spending has not gained enough traction with the CFO community yet – including in organizations where multi-year funding may have been earmarked as green financings to support internal milestones. Circularity spend receives a rather small percentage of that overall budget allocation.

Both challenges and opportunities are quite sector specific. Nevertheless, the path to circularity comprises a handful of ubiquitous steps and decision points.

Take for example consumer goods companies. It’s dramatically easier to focus on supply chain transparency and make circular procurement part of the overall product positioning and branding campaign supporting entire product portfolios, whether we are discussing personal care lines or home goods. The value of elevating procurement practices and making circularity a transparency feature, means provenance solutions can open the door faster at the individual material level and, as a result, make switching costs higher. As such vendor relationships based on circularity become inherently more stable and a staple of sustainable procurement practices.

Manufacturing environments can be a breeding ground for circularity innovation at scale. The semiconductor industry is ripe for that. The extension of product life cycles, specifically, or the rise of second life components and materials, have benefited from intelligent manufacturing methods that increasingly underpin the semiconductor industry. But that’s not enough. The cycle of chip shortages reminds us that relatively low production efficiency within the industry can lead to severe production gaps and an inability to meet customer demand. A direct opportunity for circularity practices to enter the fabrication process as a design feature itself.

The cycle of chip shortages reminds us that relatively low production efficiency within the industry can lead to severe production gaps and an inability to meet customer demand. A direct opportunity for circularity practices to enter the fabrication process as a design feature itself.

What’s sector agnostic is that circularity has not been fast-tracked outside of operations and product teams, where it is usually housed. It is still perceived very much as a product/process roadmap rather than having a larger role as part of a company-wide strategic orientation towards innovation. Nonetheless, there’s an even bigger challenge. Going circular is still recognized as a marching order towards ‘recycling more’. To the contrary, we need new materials, new compounds, new solutions to keep products in use for longer.  Virtually all sectors that operate in environmentally challenging conditions and subject to nature-risk and biodiversity loss can find low hanging fruits in making their operations more sustainable through circularity.

Going circular is still recognized as a marching order towards ‘recycling more’. To the contrary, we need new materials, new compounds, new solutions to keep products in use for longer.

Commercially speaking, investors need to start thinking innovation. Is this worth of a patent, an R&D, do circularity features make the switching cost of consumers high enough and do they create opportunities for nearshoring all resources involved in the production ecosystem?

I believe that the most high-potential opportunities within the next few years are still in those sectors that are most exposed to supply chain disruptions, to the need for resource management and environmental safety, and that sell into value chains with players coming from the public sector as well. Tire manufacturers such as Pirelli come to mind. Their high-end tires sell into some of the highest product performance categories (think F1 race cars), and yet they could not meet their production targets without a close partnership with municipalities and local government authorities to redefine the way tire scraps get disposed of and the recovery of materials occurs at a closer distance from a manufacturing location. The more complex the value chain, the more circularity solutions can add value.

The most high-potential opportunities within the next few years are still in those sectors that are most exposed to supply chain disruptions, to the need for resource management and environmental safety, and that sell into value chains with players coming from the public sector as well.

First and foremost, they must be knowledgeable of circularity principles and the value proposition in financial and societal terms that comes with each. The solutions that circularity can bring across sectors need specialized skills to be fully evaluated. They also need to embrace an investment philosophy that seeks value-oriented businesses with a growth mindset. Circular economy solutions have sunsetted early in some economies due to the lack of effective policymaking or the distraction of closing the loop on waste management and recycling away from an innovation focus. They simply stopped there. This has happened across the UK market, for example, where circular innovation sees many early stage investors not been able to source deals because innovators have lost faith and moved on. The US market has not even been caught by the circular economy fever yet. I am not suggesting it will any time soon either until the politicization of net zero is behind us. But it has significant potential to see a broader and larger adoption since its commercial value is somewhat easier to prove. In most cases you are asking businesses to operate more effectively, innovate for long term savings, nearshore and capture value from goods that will stay in circulation for longer. Customer retention would probably see a sustained pickup in most product categories within circular designs. For traditional service oriented companies such as electric utilities, circularity offers a prime opportunity for risk mitigation from the grid into the household. Investors have a prime example of that in Latin America, where Enel Americas has long adopted a circularity approach to renewables and has also experimented with product-as-a-service models across regional service markets. An example that has a lot to offer to their North American peers.

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Alessia Falsarone is executive in residence, practitioner faculty at the University of Chicago, where she leads the Circular Economy and Sustainable Business program. Her portfolio of board positions include: (1) Independent Director, Assicurazioni Generali S.p.A. (STOXX 600 Insurance); (2) Independent Credit Committee Member, Innovate UK Loans Ltd (Government Agency); (3) Operating Board Member, OpenCorporates Ltd (Private; SaaS); (4) Board Chair; former Treasurer, iEarn-USA, World Economic Forum School of the Future (Non Profit; Education).

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