The Financial Impact of the Circular Economy: What Treasurers Need to Know

COP26 has shone a spotlight on the concept of a circular economy. While the shift away from a linear model will have profound – and necessary – impacts on physical supply chains, there will also be inevitable consequences in terms of P&L and the balance sheet.

After analysing the basic aspects of the circular economy in a previous TMI article, and the differences with the linear model, we will now analyse the impacts of the circular economy on the company’s strategic financial components through the economic value added (EVA) model, an important performance indicator calculated as the difference between the net operating income (difference between revenues and costs of production) and the cost of capital used to produce that income (weighted average cost of capital, WACC). It is useful for understanding whether a company is producing value (EVA>0) or destroying value (EVA<0) against certain investments and business practices.

This model emphasises asset turnover (total revenues ÷ total assets), that measures the company’s ability to improve productivity with a reduced use of resources and that is useful to determine shareholders’ value.

The EVA model examines the profit and loss statement (P&L being sales and revenues, cost of goods sold, taxation) and the balance sheet of the company (WACC, being inventory expenses, accounts payable, accounts receivable); they will be analysed individually to assess their advantages and concerns.

Breaking down the balance sheet

Sales/Revenues
The circular economy involves the possibility of reusing a product or material after their initial intended use has been fulfilled, providing the company with important business perspectives:

However, this model entails a problem: the product offered is not sold to the customer, remaining the property of the company and, therefore, recorded in the budget, resulting in high fixed assets with negative repercussions on the cost of capital.

This is balanced by the positive cash flows that the company achieves: this model binds the client (and the clients after him) to the company for an ample time span (usually a few years) and therefore he will pay not only upon transfer but will provide the company with a periodic fee that will cover the costs (mainly, maintenance and inventory). In addition, since the company maintains control of the product, it reduces risks and further costs for unexpected circumstances.

Lastly, according to recent studies^[1] millennial^[2] and Gen Z^[3] consumers make quality a prerequisite to purchase and prefer to buy sustainable products with a willingness to spend even more^[4]. As estimated by Merrill Lynch^[5], in the coming decades the resources that will potentially be injected into companies with high ESG ^[6] elements will range between $15tr. and $20tr. 

Cost of goods sold
The circular economy sets in motion a potentially infinite production cycle: thanks to this innovation, dependence on raw materials is reduced, whose scarcity is constantly increasing, with important advantages in terms of cost reduction^[7].

Research shows that doubling the global rate of circularity (from the current 9% to 17%) can reduce the consumption of raw materials from the current 100 gigatons to around 80, reducing the associated costs of collection, treatment, and disposal. In addition, by making the world economy more circular, it is possible to cut emissions by 40% per year, generating substantial savings^[8].

These costs are reflected on the price of the final product: reducing them allows companies to carry out favourable and competitive pricing policies, increase the marginality on sales, and obtain an important competitive advantage.

Circular production, therefore, benefits from a relatively high substitution effect of virgin materials as they compensate for upstream process inefficiencies in the linear chain (availability, costs, procurement timelines, costs, and processing times). This comparative advantage is at the core of the increased economic value creation potential of the circular economy: where the costs of collecting, reprocessing, end-of-life treatment, and returning a product, component, or material are lower than the linear alternative, thus mitigating the impact of cost volatility, the economic advantage is clear. Moreover, as these metrics continue to increase, the advantage grows. This is particularly the case early on when the economies of scale of cyclical economics generate higher returns in terms of resource and labour productivity^[9].

Taxes
At the European level, studies are underway to establish innovative taxation systems to incentivise the transition to the circular economy^[10].

Economic theory assumes that human beings respond positively to economic stimuli, so a system of incentive taxation may be a viable option, in the form of tax relief, for example. However, these rewards are one-off and cover costs only partially. On the other hand, applying a tax reduction against the sale of every single circular product would allow a return on the investment in the medium-long term and would encourage companies to keep the circular chain alive.

Such a system requires efficient collaboration between companies, financial institutions, and tax authorities, but the expected results can be worthwhile.

Investing in a circular approach today also enables companies to anticipate future stricter regulations in terms of free export of low-sustainable products and extended producer responsibility (EPR), thus reducing the risks of high duty and taxation for substandard products.

Breaking down the balance sheet

Inventory
The circular economy is a model that involves the reuse of materials in a potentially infinite cycle. This has repercussions on the company’s inventory. Reprocessing the components of an existing product reduces the risks and uncertainties associated with the availability of production inputs.

Involving customers through awareness campaigns is key. For example, a discount on a future purchase could be given for the return of a previously purchased item, so that the company obtains the materials needed to make new products that meet customers’ needs, even by diversifying production. The advantage is twofold: lower storage and insurance costs are borne, and the risk of unsold or returned products is mitigated.

This must be accompanied, on the one hand, by an efficient system of tracing and visibility of the warehouse. This is vital for a real-time vision of the available stocks and of the relative location in order to be able to plan new productions. And, on the other hand, this must also be accompanied by an efficient communication network to mobilise the stocks in case of more productive units, to avoid defect or excess of stocks, improving productive efficiency and rapid deliveries to the client.

WACC
As mentioned above, WACC is a component for calculating EVA.

An important factor in calculating WACC is the cost of debt, which is proportional to the company’s level of risk. The main risk factors are:

Accounts payable
The transition to a virtuous supply chain necessarily requires collaboration upstream (with suppliers) and downstream (with clients).

Upstream, granting financial incentives or in terms of visibility for the achievement of ESG standards with a view to sustainability and circularity, can be a win-win approach. In this way, the company creates a relationship of close collaboration and trust with its suppliers. They will have every interest in maintaining the business relationship with the company, which can also negotiate more favorable payment terms, such as payment extensions in view of the future incentive, introducing supply-chain finance programmes that allow the suppliers to access advantageous financing conditions if they demonstrate compliance with sustainability programmes^[12]; blockchain technology can also help in this regard.

Accounts receivable
Downstream, collaboration with customers becomes the main objective, since they are the driving force behind the entire circular chain. Only through their propensity to consume circular products will the chain have any reason to exist.

Implementing virtuous practices that meet consumers’ needs offers a wide range of revenue possibilities in terms of customer satisfaction and brand loyalty. Clients, be they companies or individuals, are much concerned with reliability of information (delivery terms, composition of the products they purchase) from their suppliers. Circular economy practices, supported by efficient collateral services (eg IT services to certify supply chain steps and product composition), on the one hand, improve production planning, which enables the provision of increasingly reliable information to the customer (available-to-promise) improving the customer experience. And, on the other hand, these practices lead to increased customer loyalty, resulting in a willingness to do more business with the company in the future.

In turn, the loyalty achieved can enable the firm to negotiate more advantageous payment terms with the client in return for a much more efficient service, and to obtain liquidity more quickly.

Speaking of new forms of financing, factoring is an example. The company transfers to a financial institution (factor) the receivables not yet due from its customers, obtaining immediate liquidity against the payment of a premium, which will be calculated based on certain factors, such as the creditworthiness of the company.

Key takeaways

The transition towards a more virtuous way of doing business is no longer just a possibility. A change in mindset is imperative for everyone: governments, companies and individuals alike.

As discussed, this requires new business models and uncertainty persists, but the profitable business opportunities ahead are worth the risk. Indeed, it is just a matter of time before such practices will be mandatory for everyone and many may find themselves unprepared. Getting ready now may help save your business and help position treasury at the heart of ESG discussions.

_{Notes
1 https://www.ilsole24ore.com/art/sostenibilita-millennials-e-generazione-z-prima-linea-acquisti-e-investimenti--AERNkDOG?refresh_ce=1
2 Those born between mid-Eighties and mid-Nineties
3 Those born between 1995 and 2010
4 22% of respondents of Gen Z are willing to spend 5% more to buy sustainable products and 17% are willing to spend as much as 10% more.
5 https://www.privatebank.bankofamerica.com/articles/2018-us-trust-study-of-high-net-worth-philanthropy.html
6 It is a set of criteria for measuring a company's environmental (E), social (S), and governance (G) impact to evaluate responsible investments.
7 https://www.researchgate.net/publication/350458581_RAW_MATERIAL_PRICES_INCREASE
8 https://www.circle-economy.com/resources/circularity-gap-report-2021 - Gas emissions costs are around €43 per ton and GHG emissions are expected to grow by about 1.5 billion tons.
9 http://www.comitatoscientifico.org/temi%20SD/documents/Green%20economy/FEDERICO%20Appunti%20di%20economia%20circolare%20250315.pdf
10 https://eur-lex.europa.eu/legal-content/IT/TXT/HTML/?uri=CELEX:52020DC0098&from=PT – paragraph 6.2
11 https://emf.thirdlight.com/link/29wifcw68gx1-yw31dj/@/preview/1?o
12 https://www.levistrauss.com/2020/01/27/ifc-releases-levi-strauss-co-case-study/}