Sustainable Finance: A Step Toward the Circular Economy

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Sustainability is on everyone’s lips and now impacts all regions and sectors of the global economy. Increasingly, financial industry stakeholders, including customers, investors, suppliers and regulators, expect financial services providers to play an active role in financing the transition from a linear economy to a circular economy. ESG criteria are a tool for companies to become more sustainable and to comply with the regulatory efforts of policymakers and regulators.

Financial institutions are currently looking at embedding sustainability in both their business and their products. One driver of this transformation is regulation by supervisory authorities. However, it is far from the only one. The numerically largest customer group of financial services providers, millennials, expect credible change. The Covid-19 pandemic in particular has helped to highlight the fragility of our economic system, social inequalities and the consequences of our resource consumption. In order to respond to these developments, financial services providers must set the right tone at the top and then back up their words with actions. These actions include integrating sustainability into the corporate culture. This means focusing on a sustainable corporate purpose, individual responsibility for achieving sustainability goals, remuneration that incentivizes sustainable behavior, and diversity. Furthermore, sustainability should be integrated into the corporate strategy instead of being regarded as a “nice to have”. [1]

Circular Economy Definition

The circular economy is characterized by the efficient use of raw materials for as long as possible. In this way, this form of economy differs from the linear economic system that is currently still widespread. In the latter, products are manufactured, sold, consumed and then thrown away. Figure 1 below shows the linear production process.

Figure 1: Linear production process.
Source: Federal Office for the Environment (FOEN), n.d.  [2]

In the long term, this process leads to a shortage of raw materials, emissions, large quantities of waste and associated environmental pollution.

In the circular economy, on the other hand, products and materials are kept in circulation and the raw materials can be used again and again. This means that fewer primary raw materials are consumed, less waste is produced and the value of the products is retained for a longer period of time. The following figure illustrates the circular economy.

Figure 2: Circular economy
Source: Unchanged from FOEN, n.d.  [2]

The circular economy is thus a holistic approach, which includes the entire life cycle of a product, from the extraction of raw materials, through the product’s design, production and distribution, to the longest possible use phase and recycling. [2]

ESG Criteria Strengthen Resilience

A term that has become increasingly important in recent years is Environment, Social and Governance (ESG), which refers to the systematic consideration of these factors in the selection of investments. The following figure shows examples of the three categories. [3]

Figure 3: Exemplary Overview of ESG Criteria
Source: Own representation based on Vargas, M.; Sommer, F. [4].

In the environmental perspective, environmental pollution or hazards, greenhouse gas emissions or energy efficiency issues play a role. Social issues include topics such as occupational safety, health protection, diversity and social commitment (also known as corporate social responsibility). Governance is primarily understood to mean sustainable corporate management. This includes topics such as corporate values or management and control processes (corporate governance).

These factors can be used, above all, in the analysis of companies to uncover risks that would have been overlooked in a traditional financial analysis. The Covid-19 pandemic has now brought many of these risks to light. These include problematic circumstances in employee health and safety, inadequate measures for operational stability in exceptional situations, and crisis management in general. It is not surprising, then, that many companies that have previously paid attention to ESG factors have been more resilient to the current impact of the Covid-19 pandemic than those companies that have not previously addressed ESG.[5]

EU Sustainability Agenda on Track

The Covid-19 pandemic has had a major economic impact, but fortunately no impact on the sustainability agenda of policymakers and regulators. The EU, in particular, is moving forward with ambitious climate policy targets, and by adapting capital market regulations, is underlining the responsibility of all parties involved to drive the development towards a carbon-free economy. As the main objective of the action plan, which was launched in March 2018, the EU describes the sustainable, and thus climate-friendly, design of financial flows and the promotion of sustainable investments. This is intended to make Europe a catalyst for global investments in green economy and technologies. In this context, this also shows that regulations are a dominant driver of sustainable finance. [5] [6]

Dimensions for Advancing Sustainable Finance

Sustainable Finance can be promoted in different ways, both by the company itself and from outside by regulators or customers. The five main drivers of sustainable finance are: Culture, ESG due diligence, regulation, the next generation, and digitalization. [5]

1) Culture                           

In order to achieve long-lasting change in companies, it is essential to take cultural drivers into account. The anchoring of sustainable behavior throughout the company depends above all on the company’s purpose, individual responsibility, financial incentives and diversity.

2) ESG due diligence        

In the past, ESG due diligence has focused primarily on risk assessment. In the future, sustainability considerations could also be used as an impetus to rethink business and operating models and thus discover long-term optimization opportunities.

3) Regulation                     

The Swiss Federal Council advocates responsible corporate governance and the EU makes adjustments to its regulatory framework for capital markets. The focus is on a clear emphasis on the role of the private sector in achieving a circular economy.

4) Next generation           

Millennials and Generation Z have clear expectations of convenience, transparency and, above all, the credibility of financial products. Social networks confirm that in today’s world, reputation is one of the most decisive criteria for success.

5) Digitalization                

Digitalization serves as an important driver to create new connections between investors and sustainable finance through improved interaction possibilities thereby allowing larger asset flows into this area. This includes digital finance in particular, which encompasses a range of tools based on current trends such as big data, machine learning, AI, blockchain and IoT.

Conclusion and Outlook

In summary, “do nothing” must no longer be an option for financial institutions.  The demands of the stakeholders are clear and will probably intensify in the coming years. The circular economy describes the target picture that should be aimed at by all players in the economic system once the new mindset has been adopted. Besides the prospect of sustainable and success-oriented business activity, the drivers of sustainability described above provide the corresponding incentive for financial institutions to deeply root the topic of sustainability in their companies.

Sources

[1] KPMG. (no date). Clarity on Sustainable Finance. Retrieved from https://home.kpmg/ch/de/home/themen/2020/06/clarity-on-sustainable-finance.html

[2] Federal Office for the Environment FOEN. (no date). Circular economy. Retrieved from https://www.bafu.admin.ch/bafu/en/home/topics/economy-consumption/info-specialists/circular-economy.html

[3] Haberstock, P. (no date). ESG Kriterien. Gabler Wirtschaftslexikon. Retrieved from https://wirt schaftslexikon.gabler.de/definition/esg-kriterien-120056

[4] Vargas, M.; Sommer, F. (2018). Nachhaltige Kapitalanalagen – Chancen nachhaltig nutzen. Retrieved from http://docplayer.org/6872763-Nachhaltige-kapitalanlagen-chancen-nachhaltig-nutzen.html

[5] Sprenger, P.; Schmucki, P.; Tatest, L. et al. (2020). Clarity on Sustainable Finance. [PDF] Available at https://home.kpmg/ch/en/home/insights/2020/06/clarity-on-sustainable-finance.html

[6] Economiesuisse. (03.10.2019). EU-Aktionsplan zu Sustainable Finance. Retrieved from https://www.economiesuisse.ch/de/dossier-politik/eu-aktionsplan-zu-sustainable-finance

Stefan Knaus
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