Despite strong evidence showing that the circular economy offers superior financial risk-adjusted returns and improved industrial resilience, investment in the circular economy faces a severe finance gap. Sustainable finance taxonomies could help to unlock such transformative finance, but it could also risk becoming another greenwashing tool.
The circular economy financing gap
It is increasingly evident that a primary inhibitor of scaling up circular economy business models is the lack of investment.
The global finance sector is gradually adopting circular economy approaches through various private financial mechanisms, such as circular economy-themed “green bonds”, specialized circular economy funds and other financial instruments. A group of international financial institutions have also come together to launch a Circular Economy Finance Roadmap for 2030.
Despite these efforts, investment remains very low and are still considered very high risk. The poor performance of investment funds is another concern. For example, the high-profile BlackRock circular economy fund, launched in 2019, has only generated negative returns since 2021, despite growing to over $1.7 billion in net assets. To put this into perspective, billions are invested annually in circular solutions by the private and public sector, but trillions are invested each year into linear models which continue to be more profitable in financial terms, inhibiting a systemic shift of the economy.
In a recent report, Chatham House estimated the current value of government and corporate spending on circular economy initiatives in selected sectors, and in value chains with high material intensity (see next figure). It found that, worldwide, public sector spending on the circular economy totalled between $500 billion and $600 billion in 2020, compared with overall government spending of about $13 trillion. Meanwhile, the value of annual circular economy spending by the corporate sector is estimated at around $850 billion, compared with $35 trillion in linear spending. This puts the circular economy’s share of total global investment at only about 3 per cent per year. Additionally, the circular finance sector and existing circular investment funds account for an estimated $50 billion, compared with $100 trillion of financial assets under the management of the 500 largest asset managers worldwide.
A key question, therefore, is how additional finance and investment can be leveraged to accelerate the transition. Sustainable finance taxonomies that provide common frameworks for the financial sector and companies alike holds promise in this respect.
What are sustainable finance taxonomies?
Sustainable finance taxonomies are shared classification systems for defining environmentally sustainable investments. These taxonomies generally target a set of environmental objectives such as climate change mitigation, pollution reduction or circular economy. For each objective, a range of economic activities are outlined that may be considered to substantially contribute to the objective (subject to certain sustainability criteria). Equally, they can also outline activities that risk causing significant harm to these objectives.
To comply with the taxonomy requirements, a range of stakeholders (such as financial market participants, large companies and governments) must report on how their activities or investments contribute or detract from environmental objectives. With these reporting requirements, taxonomies can give stakeholders a shared understanding of which economic activities are sustainable, and helps prevent false claims (or greenwashing) by providing transparency.
More than 20 sustainable finance taxonomies have now been launched, or are being developed, worldwide. The circular economy is largely missing from most of the existing taxonomies, but it is being incorporated into some of those under development (e.g. those being developed by the European Union (EU), South Africa, the UK and the ASEAN region).
Learning from the EU taxonomy
Out of the 20 taxonomies developed or under development worldwide, the EU’s Sustainable Finance Taxonomy is arguably the most ambitious and comprehensive in integrating the circular economy. The EU taxonomy uses specific criteria to classify economic activities that may substantially contribute, or cause significant harm, to the circular economy transition. It therefore provides lessons on the opportunities and unique challenges in leveraging taxonomies to accelerate the circular economy transition.
Another Chatham House report draws on the experience of over 100 public, private and third sector stakeholders involved in the development circular economy criteria within a taxonomy and offers valuable findings for taxonomy creators and users.
The findings are also particularly timely for policymakers – such as those from South Africa, the UK and the ASEAN region – currently in the process of integrating the circular economy within a sustainable finance taxonomy. Three key lessons from the EU experience include:
Firstly, accounting for the systemic nature of the circular economy. Achieving circularity requires the transformation of entire value chains and associated material flows, and therefore cuts across all sectors and geographical regions. Yet a taxonomy, by its nature, atomizes individual economic activities in specific geographic locations, thereby, in some cases, failing to capture or encourage more transformational developments over multiple activities or along value chains.
Second, understand private sector challenges in aligning with the taxonomy. Companies will face a myriad of challenges in meeting the ambitious circular economy criteria as laid out in a taxonomy, and many will require major infrastructural and business model adjustments. They will also face reporting challenges due to (i) a lack of, or the high cost of, available value chain data; (ii) low levels of maturity of circular reporting metrics and frameworks; (iii) low uptake and (iv) lack of expertise.
Third, strengthening the enabling environment. A taxonomy cannot drive transformative change in isolation, but must be supported by an ambitious enabling policy and regulatory environment which financially incentivizes companies to adopt circular activities. Yet, the current circular economy policy and legislative landscape is becoming increasingly fragmented, lacking the ambition and clarity necessary to encourage widespread uptake of substantial contribution activities. The lack of binding international agreements or targets on the circular economy, as well as mutually recognized definitions, standards and methodologies for metrics and reporting, also make it difficult to develop widely accepted criteria for taxonomies.
Sustainable finance taxonomies show promise in helping drive investment towards circular economy activities. However, careful consideration should be given to ensure that the holistic and transformational nature of the circular economy is not lost. It should also be noted that companies will need substantial support to report on and align with taxonomy criteria. Finally, taxonomies should not be treated as a panacea. To be truly transformative, they must be developed alongside an ambitious enabling policy and regulatory environment together with globally harmonized definitions, standards and regulatory requirement.
Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).