Mind the gap… Circularity in action

During the past few years, we’ve seen increased recognition of how decarbonisation pathways can help address climate change. In contrast, we believe the circular economy idea is less well understood among investors.

The basic premise appears well known, but its interpretation varies widely. For LGIM’s Investment Stewardship team, the circular economy represents a system-wide solution to challenges such as climate change and nature loss.

2023 research from Goldman Sachs suggests circularity has the potential to cut global CO2 emissions by as much as 40%, making this critical to any net zero strategy. Yet investors’ perception of the circular economy frequently underestimates its scope, which may partly explain the lack of progress on risk factor assessment and financial materiality.

If the circular economy is to deliver environmental gains on the scale cited above, in our view more attention will need to focus on broader industry value chains, ecosystem change and economic developments.

The role of engagement

Part of the issue with the theme is its many guises, leading to difficulty in quantifying its impact, forecasting relevant financial information and assessing non-financial metrics.

The varying definitions of the circular economy make measuring success and setting minimum standards particularly difficult (unlike climate, where there is consensus on which metrics are material across sectors).

In response, LGIM’s Investment Stewardship team is pursuing two lines of action:

1. Policy engagement: Engaging with policymakers to improve related policy and regulation. For example, standardising corporate disclosure
2. Company engagement: Improving overall data disclosures and circularity of products from our investee companies – collaboratively with other investors as well as through LGIM’s annual climate engagement campaign called Climate Impact Pledge

Measuring corporate progress

At LGIM, public policy engagement remains a key tool for investment stewardship, and we are encouraged to see various regulations in recent years that aim to promote circular economy principles and regulate how the progress in this area is being reported by companies.

New reporting requirements such as the European Union taxonomy for sustainable activities and more granular data around enablement components should help investors identify companies with a direct contribution to this theme.

There are high hopes that the taxonomy will increase capital flows into circularity enablers. The expansion of environmental objectives under phase two broadens the depth of activities and industries that were not previously covered under the Climate Taxonomy.

We also look forward to the release of the final version of the Taskforce for Nature-related Financial Disclosure (TNFD) framework in September 2023, where it is anticipated recommended disclosure metrics will help sharpen analysis of nature-related risks that include circular economy principles.

As a global investor, we are supportive of the announcement that IFRS International Sustainability Standards Board (ISSB) will look to improve disclosure on nature-related risks and work closely with the TNFD to ensure the interoperability.

More specifically, ISSB should ensure that relevant existing Sustainability Accounting Standards Board (SASB) data (e.g. product design, life cycle and material sourcing) alongside integration of outcome-focused targets that sit beneath UN Sustainable Development Goal 12 (responsible consumption and production) are being incorporated in its standard. These represent a key yardstick to measure global progress.

Time to evolve our approach

While there is no universal definition of a circular economy and measuring success remains difficult, we believe it’s possible to contextually quantify its meaning and the scope of its coverage, as well as assess potential opportunities.

Circularity manifests in all levels of operations from sourcing of materials, asset utilisation and eco-product design to business model execution, capital deployment, cost mitigation and unlocking new revenue streams.

There should be opportunities for operational benefits and commercial drivers for those companies able to monetise a viable product or technology improvement aligned to a core circular premise. In our view, companies that stand out in terms of their eligibility and alignment towards the circular economy may over time see an uplift in growth rates and valuations, alongside higher capital flows.

Value maximisation will ultimately be driven by industry enablers and innovators capable of facilitating transition at scale for others. For some this will incur increased costs, typically those closest to the end-consumer in the value chain (albeit with some price pass-through), but the real financial opportunities are typically found upstream, where our research suggests these to be companies that have business to business exposure and less commoditised solutions.

Looking to facilitate transition

The mindset reboot needed to achieve more circular outcomes requires business model innovation that better aligns to environmental considerations. This reinforces a need for capital flow towards solutions that extend product life and deliver efficiency gains with reduced resource consumption and minimised ecological impact.

We also need to move away from destructive production and consumption patterns, and how we can influence behavioural change to reduce the burden on nature. One example is using the circular economy lens to assess the pros and cons of rental/subscription services versus purchases.

Greater levels of sharing, reuse, redistributing, refurbishing, regenerative practices and the remanufacturing of products/services has potential to reduce our environmental impact and create new financial opportunities for those able to innovate.

Some of these shifts are already underway, though most appear more nascent and will require continued progress. Importantly, it is likely new legislation and policy action will increase the circular economy in wider jurisdictions. Support from investors will equally be required for technologies to become economically (and technologically) feasible and commercially scalable.

In the second part of this blog, we'll share how engagement with seven companies during the first quarter of 2023 shone a light on how they are incorporating the circular economy concept into their business models.