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Circular Economy

How do financial risk and return change?

Circular business models have a different financial risk and return profile than current (linear) models. Important changes concern the timing of cash flows, creditworthiness of clients and a larger need for working capital.

Despite the opportunities, the financing of circular business models creates challenges. The main challenges are:

  • The changing nature of the cash flow of the firm;
  • Increased working capital needs to pre-finance clients and balance sheet extension;
  • Legal issues surrounding collateral and its value;
  • Increased credit risk on the clients of pay-per-use services.

ING Economics Department, 2015, p8 & p46.

Changing nature of cash flows

Circular business models often make use of pay-per-use earnings models. This changes the nature of the cash flow from handing over a sum of money at the moment of sale into a series of frequent payments during the lifespan of the product. In doing so, pay-per-use business models create a longer lasting financial relationship between the organization and the customer.

Since cash flows are spread out over time, the payback period of an investment becomes very relevant in terms of riskiness for the bank. A contract with a payback period of three years is of less risk to the client and the bank in comparison to a longer payback period (larger chance of default). Cash flow optimization becomes an integral part of financing circular business models.

ING - Cash Flow in Pay-Per-Use

ING Economics Department, 2015, p. 38

Increased working capital needs and balance sheet extension

Working capital is needed to buy new assets when new lease contracts are signed with consumers. However, since the company has to acquire the asset at the start of the lease period, long before the accumulative lease fee will be able to cover the acquiring costs, working capital requirements are exceptionally high, compared to the normal buy-sell business model.

Working Group Finance, 2016, p.87

 

Traditional product sale businesses that transition to the circular economy through product-as-a-service models will shift to a business model where physical assets are retained on the balance sheet. This creates a capital demand to finance the long-term ownership of these assets and potentially a requirement for third-party funders if internal funding solutions cannot be found.

Working Group Finance, 2016, p.83

Legal consequences

Loss of ownership through accession

Legal accession means that the owner of property 
becomes entitled to all the components of the building. When lighting for example is integrated in the ceiling of an office
 it becomes part of the superstructure of the building and therefore by law is owned by the landlord.

If, for example, Philips would want to keep ownership over the lamps in a pay-per-lux model and take responsibility for end-of-life disposal of the armatures and lamps, ownership is automatically transferred to the real estate owner.

There are practical workarounds available. Although legal ownership could be lost through accession, parties can
 remain the economic owner of the goods through binding agreements. Contracts, however, do not bring security in case of bankruptcy of the client.

ING Economics Department, 2015, p39.

 

Operational risks in lease-constructions

Product-as-a-service models suppose an extensive and prolonged contact with consumers and involve more obligations on both sides. The lessor must guarantee the functioning of the asset for the duration of the contract, which may involve repair, maintenance, or replacing the asset if it ceases to function. In return the lessee must store and use the asset with the stipulated standard of care, follow the operational requirements of the manufacturer, and respect the maintenance requirements. The legal risks deriving from these lengthier relationships increase the overall operational risk of the lessor.

Working Group Finance, 2016, p.88.

Creditworthiness

… of customers

With pay-per-use models the cash flow to the supplier is spread out over several periods. Over this period suppliers 
and financers using circular business models run the risk 
of bankruptcy of the consumer of the service. As durable products often have a lifespan of several years, this risk should not be neglected.

ING Economics Department, 2015, p40.

… of the entrepreneur

When circular businesses in need of financing are start-ups or relatively young small- and medium-sized enterprises (SMEs), they are often considered not to be sufficiently creditworthy. They are often characterized by short track records and have a limited financial position. In addition, they are either marketing existing products in new ways, for example servicing consumer goods, or have developed totally new products.

Therefore, circular businesses can be easily marked as highly risky. However, conclusions on the riskiness of circular business should be handled with care. The perceived risk can be partly down to a lack of information and the traditional ways in which financial institutions model risk.

 

Working Group Finance, 2016, p.71.

Increased financial return

Value creation in second hand markets

Second hand markets can increase the solidity and bankability of the circular business case. In a second hand market the value of a good is objectified and determines the residual value of a product. When products have a positive residual value they do not have to be written off to zero in accounting terms. This improves the financials of the circular business case and its bankability.

ING Economics Department, 2015, p41.

 

End-of-life value through design for disassembly

At a certain point in time, products reach the end of their life span. In an economy based on linear production the value of waste is not factored into business models. Financial models often write off assets completely although many products 
still represent a ‘scrap value’. Manufacturers can increase the residual value in their circular business case by designing their products for easy disassembly so that disassembly costs are low and most of the valuable resources can be retrieved. Financers can improve the financeability of circular business cases by taking into account the ‘end of life value’ in the financial business case

ING Economics Department, 2015, p42.