Circular economy: What is it, and what role do finance professionals play?

Business executives are becoming more aware that the natural resources needed to create products are not infinite. The traditional "linear" economic business model — create, sell, discard — is increasingly precarious in a world challenged by natural resources depletion, exposing companies to the risks of supply chain disruption and growing price volatility of scarce materials like copper and lithium.

That's why more CFOs are incorporating circular economy principles into their business models — a move that, they say, allows them to have more control over the raw materials needed to make their products.

"In addition to the environmental and social benefits, adopting circular economic principles helps companies become more competitive and resilient in the face of climate risks," said Michiel De Smet, the finance initiative lead at the Ellen MacArthur Foundation, a UK not-for-profit that works with businesses and governments to promote the concept of the circular economy. "That's only going to be more necessary as time goes on."

The rationale for going circular

The circular economy is based on three principles, all driven by design: eliminating waste and pollution, keeping products and materials in use, and regenerating natural systems, according to the Ellen MacArthur Foundation.

These concepts may seem simple at face value, but, in practice, incorporating circular principles often requires companies to rethink how they source, design, and sell a product and how the product can be recycled or reused at the end of its first use phase — all of which can require substantial upfront costs. Even so, there's a real business case for going circular: Not only can it allow companies to mitigate risks, for example, by having more control over essential raw materials that are becoming increasingly scarce, but it can also accelerate growth and enhance competitiveness, according to Jan Bebbington, Ph.D., a management accountant and the director of the Pentland Centre for Sustainability in Business at Lancaster University in the UK.

"Companies that go circular become much more resilient," she said. "If you can understand where your resources are in your supply and value chains, you can help to mitigate risks and keep going."

Take the example of lighting solutions company Signify (formerly called Philips Lighting), which has adopted a new circular business model pioneered by the multinational conglomerate Philips. Under its previous business model Philips sold light bulbs that consumers bought, used until the end of their life cycle, and discarded. In its new circular economy model, Philips began to sell light as a utility service, allowing retail and enterprise customers to pay the company a fixed monthly rate for the light they require. In exchange for this service, Signify designs, installs, and maintains the lighting infrastructure.

By providing light as a service, Philips has complete control of materials throughout the product's life cycle, incentivising the company to design light bulbs that are longer-lasting and reusable — and this results in less waste. At the same time, by transforming to a subscription-based model, Philips has also created long-term customers, which allows for more accurate forecasting and faster growth.

"Providing services instead of products is a circular practice, but it's also a great business model," Bebbington said. "Not only does it allow companies to recover raw materials, but it also cements long-term relationships with customers — both of which are hugely beneficial from a financial perspective."

Renault provides another good example of a large international corporation that has taken steps to integrate circular economy principles into its business model. The steps include the remanufacturing of vehicle components such as gearboxes and turbochargers, increasing the use of recycled plastic content, and creating a second life for electric batteries (see the illustration, "How Renault Puts Circular Economy Into Practice"). Earlier this year, the company announced that it would be building Europe's first "circular economy" factory, which aims to work with partners to support circular economy innovations across the entire life cycle of a vehicle.

Jean-Philippe Hermine, the vice-president of strategic environmental planning for Renault, said that while there are obvious environmental and social benefits, the decision to go circular was ultimately a decision driven by financials: While electric cars may be the vehicle of the future, building them requires raw materials that are increasingly scarce — such as cobalt and lithium — and price-volatile.

"Going circular allows us to at least partially control the supply chain and secure our transition to electric cars despite the reality of increased resource depletion," he said. "It's really an issue of resilience and competition."

The role of CFOs and management accountants

But how does a company go circular, and what role do CFOs and management accountants play in that transition? Experts share their advice:

Evaluate where a company is best suited to go circular

"Cradle-to-cradle" — the concept that a material will be used, recouped, and reused again and again — is one of the circular economy's core tenets. But while it may be a long-term goal, it's highly unlikely that a company will become circular in all aspects of its operations. That's why the first step is to look carefully at a company's business practices — including how it acquires, uses, and disposes of raw materials, and how it designs and sells products — to see where the business is best suited to incorporate circular principles. And to ensure that transition makes financial sense, management accountants need to be involved from the very beginning, according to Bebbington.

"You need the management accountant to track all material flows across a product's life cycle," she said. "How much carbon do we produce, or energy and water do we use? What materials and products do we buy and create, and where do they go? All of that can be redesigned to be circular rather than linear."

While this may seem straightforward in theory, it often requires accountants to rethink how they do their jobs in order to account for resources and trade-offs that traditional accounting practices might have missed. Examples are the costs and benefits of purchasing new materials or waste handling versus investment in recovering, recycling, and reusing materials that were previously thrown away, or the costs and benefits of designing and adopting circular technology.

This information helps CFOs determine where a company is best suited to go circular. For example, a company that previously sold carpets as a product might consider transitioning to a carpet-leasing model — allowing it to design hardier products and charge customers a fee for maintenance.

"It's a really great opportunity for management accountants to exercise imagination and to open their sphere of focus more holistically, to think of the whole value chain," Bebbington said. "It's really a whole new way of thinking."

Rethink relationships to build an industrial ecology

Often, successfully incorporating circular models requires that CFOs build new relationships with other businesses, customers, and suppliers that allow materials to be shared and recovered, which can take effort and time.

"It's about building an industrial ecology, allowing one business to pass raw materials in the form of waste to another," Bebbington said. "That requires opening up to discussions about production schedules and sacrificing some flexibility and secrecy to build trust and create these relationships."

For example, Renault built relationships with demolishers and metal waste recovery companies in order to secure access to plastics; metals like copper, iron, and aluminium; and textiles, which it redesigns and gives a second life in new vehicles. This effort requires tremendous communication and cooperation, according to Hermine of Renault.

"If you want to reincorporate material in a closed loop, you have to make sure you have the right quantity and quality at the right time," he said. "That means working together and ensuring that the incentives are properly aligned."

"It's like being an orchestra conductor," he said. "You have to secure the distribution of risks and values so it works for all partners."

Set concrete objectives, and make sure all stakeholders are on the same page

Circular business solutions can have many beneficial outcomes, such as positive environmental, social, and financial impacts. But to maximise results, it's important to get all internal stakeholders on the same page about key goals from the beginning.

Take the example of Winnow, a technology company headquartered in the UK that uses circular principles to help industrial-scale restaurants reduce food waste. To do this, chefs install devices that use artificial intelligence technology in their kitchens to weigh and track food that is thrown away at each step of the food preparation process. This may seem like an obvious and desirable goal: According to Winnow's data, most kitchens end up throwing away 4%—12% of total food purchased. By precisely measuring how and when food is thrown out, Winnow helps clients cut waste by an average of 50%.

But this solution only works if all the internal stakeholders are aligned from the start. For example, while wasting less food makes perfect sense to financial controllers, chefs might worry that measuring food waste could lead to sanctions or budget cuts in the kitchen — reducing the likelihood they would properly use the device. Finding ways to align incentives between departments and stakeholders can mean the difference between success and failure, according to David Jackson, the director of marketing and public affairs at Winnow.

"One of our most important tasks is to make sure that we are all aligned on what is the objective of the reduction programme, and what you want to do with those savings," he said. "That requires real collaboration — something like, if we can reduce our food purchasing costs, some of that savings can be used to buy higher-quality produce."

Get the data and reporting right

Measuring and tracking a company's progress is critical to the success of circular business models — something that often requires management accountants to innovate new dashboards and tools, according to De Smet of the Ellen MacArthur Foundation.

"One of the biggest challenges is breaking down circular performance into indicators," De Smet said. "How can you measure if you are making progress or transforming your business, and what data points do you need to monitor?"

Some industries will struggle with this more than others. For example, for Winnow, the goals of reducing food waste in kitchens and installing machines that collect data towards that end (how much food is wasted, and when/how that waste happens) neatly align. For others, it's more complicated. Renault's business model requires keeping track of the opportunities and costs of recovering and recycling materials that can be reused, which is far more complex. Renault is also considering moving towards a "transportation as a service model" — for example, carsharing, short-term rentals, and carpooling — all of which require measuring and tracking different indicators. Management accountants working on new circular economy projects are often in the position of having to pioneer these financial tools, according to Hermine.

"We found that the current accounting system does not reflect all the opportunities that we find in the circular economy, and the value that can be generated from it," Hermine said. "So there has to be some real entrepreneurship to capture this data."

Budget for innovation

Finally, experts recommend that CFOs budget for innovation. That might mean providing mentorship and funding to external startups or creating an internal incubator programme to nurture new circular ideas until they are commercially viable.

"When you are incubating a new idea, it's prudent to maybe relax some of the rules when it comes to procurement," Jackson said. "You need to provide space for a startup or innovation company to prove the business case without crippling that company in terms of their financials."

For example, Renault subsidises and supports the development of startups in car manufacturing, in hopes that those partnerships will lead to the next circular business opportunity. In exchange, those startups give Renault exclusive intellectual property rights for one year. While many of these startups do not succeed, those that do succeed pay for themselves, according to Hermine.

"You have to provide space to entrepreneurs because, while not all the projects will succeed, value will come from some of these projects," Hermine said. "So you have to adopt a kind of an internal venture capital approach that isn't too rigid, or you'll miss opportunities."

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How Renault puts circular economy into practice

Renault’s electric car batteries are designed to have a second life before being recycled and returned to the factory to produce new electric batteries, keeping materials in a closed loop. This illustration from the company (below) depicts the process.