Small and medium-sized enterprises can drive the circular economy

Creating a circular economy requires innovation and a transformation of current business models. Firms must review all their strategic choices, looking not only at new products, but also at new processes and organisational models capable of applying the operating principles of the circular revolution in a more concrete way.1

In the broader concept of sustainability, the circular economy represents a key tool in the sustainability toolbox by closing the loops in production processes and redesigning the economy to reduce or (ideally) eliminate waste. It is also crucial to accomplishing net zero greenhouse gas (GHG) targets, with new evidence indicating that 45 per cent of global GHG emissions are attributable to how we produce and use materials and goods.2 Circular economy also helps preserve biodiversity; the evidence suggests that more than 90% of biodiversity loss is due to the extraction and processing of natural resources.3

In this context, SMEs – being generally more flexible and responsive – can play a leading role as drivers of change. Although there is considerable heterogeneity among SMEs in different sectors, their responses and their ability to adopt a “green solution” seem to be vibrant, despite the inherent challenges in transitioning to a circular economy, because they are seeing a positive relationship between environmental benefits and profits, resulting in increased competitiveness.

Analysing the strategic choices of SMEs, and their decision to invest in green research and development, can help design a coherent mix of innovation, industry and environmental regulations. The data from a survey of more than 4,000 Italian SMEs in the manufacturing sector, conducted by the University of Ferrara over two two-year periods (2017–2018 and 2019–2020), shows that there are some innovative choices at the centre of firms’ strategic trajectories. As shown in the chart below, reducing electricity use, reducing raw material use and reducing waste are the three most common innovations among businesses surveyed.

Companies have also shown an increased focus on eco-design for new products, with the potential to reduce raw material consumption and increase product life. The share of firms adopting specific circular economy (and more general climate friendly) practices is decreasing but remain at reasonable levels, indicating that we are in a transition phase where a substantial number of companies and innovations are covered, but maturity has not yet been reached (see next figure).

It is worth noting that crises, such as recessions, energy shocks and pandemics, produce immediate costs but are also potential drivers of short-term business changes. The short-term evidence from 3,000 firms across 26 developing countries shows that those who experienced input shortages at the height of the pandemic were more likely, on average, to respond by pursuing transformational changes, such as the introduction of new equipment, business repurposing and the release of new products to meet changing demand.4 However, SMEs may suffer structural barriers that slow down the introduction of innovations. These may be social/institutional, economic/financial or technological (see next figure).

Barriers to eco innovation

A recent study analyses the effects of circularity-oriented innovations on firm’s economic performance.5 Using an original dataset on thousands of Italian manufacturing firms, it shows that, in the short run, it is difficult to obtain economic gains from circular economy-related innovations when taken in isolation, especially for SMEs. Furthermore, the introduction of individual practices (as opposed to a bundle of circular business practices and innovations) may not be sufficient – neither for leading to strong environmental effects nor for improving firms’ economic performance.

However, the simultaneous implementation of a fully-fledged circular business model requires dedicated competences and capabilities6 building upon corporate social sustainability practices, environmental research and development and green market sensing to address consumer needs. Compared to large firms, SMEs have a disadvantage in adopting circular economy and more in general sustainable innovation and business practices as the inadequate financial resources, stakeholders support, awareness and competencies.7

To overcome the frequent lack of resources, policies may be directly aimed at supporting innovation through public funding or public procurement. Through appropriate institutional frameworks, policies can also support collaboration among firms to share knowledge and learn from different sources.8 Training and education investments are also very relevant for raising awareness and building competency to support the transformation of societies and productive systems, knowing that the evolution of economic systems is highly non-linear. A just transition needs substantial investments in innovation and education together.

In the aftermath of health, energy and ongoing geopolitical crises, the most optimistic expectation is a period of renaissance, where creation and destruction will lead to innovation and transformation in the economy. Whereas the Green Deal sets the basis for a strong impulse to innovation and a green and circular transition in Europe, developing countries are traditionally less active and suffer lack of capacities in designing and implementing industrial policies9 integrated with policies pertaining to social and environmental domains. The good news emerging from empirical evidence is that even in small and medium enterprises that are traditionally more vulnerable and fragile the transition is already happening. However, a strong impulse of policies especially in developing countries will be needed to overcome the structural and temporal barriers they may face.