How to identify the winners in the $25 trillion circular economy transition

The transition to a circular economy will be one of the defining long-term growth trends of the coming decades. It is driven by the need to decouple economic growth from resource consumption.

Overconsumption creates two existential issues facing the planet and the economy today – lack of resources and climate change.  

Demand for resources is exceeding supply. Our economy consumes resources today as if we had 1.7 planet Earths, and is on track to hit the need for three planets by 2050 as we push the planet into further natural capital deficits.

• Read more: Earth Overshoot Day 2023: how financial deficits aren’t the only ones investors need to worry about

Secondly, c. 45% of global greenhouse gas (GHG) emissions come from the way we make and use things, including agriculture. Given these cannot all be directly addressed by renewable energy, the need to transition to a circular economy becomes more urgent. There is no path to net zero without the circular economy.

$25 trillion opportunity for investors

The circular economy opportunity is not a “feel good” theme; it’s very much an economic one.

This gives us reason for optimism. As Michael Porter said, “when a social need can be tackled with a profitable business model, the magic of capitalism is unleashed”.

Accenture estimates that the “resource gap” (the difference between supply and demand) opening up over the coming decades will create a $25 trillion opportunity by 2050 for circular economy business models.

Companies that can provide solutions to our overconsumption problem and close the resource gap will have an opportunity to generate higher revenue and profits. As investors we want to back these companies.

This led to the development of our “Circular Score” framework  to ensure that we are identifying the pure play winners of the circular economy transition.

Circular Score - a focused approach to the circular economy

Our Circular Score is a proprietary approach to assessing a company across its entire operations – from strategy to inputs/outputs and everything in-between. This analysis is the same regardless of industry or geography.

At Schroders, we believe that sustainability assessment is far too important to outsource.

There are numerous third party services like MSCI or Sustainalytics that provide good data that investors can use to understand a company’s sustainability credentials. But in the same way we don’t outsource our stock picking to Bloomberg, we don’t outsource such a key component of our investment process to third parties.

Similarly, with our approach to the circular economy opportunity, we believe that that a bottom-up approach is required.  Our Circular Score framework will be critical in helping us identify future circular economy winners.

We focus on three areas: alignment; furthering the circular economy; and externalities and risks.

Each company is scored out of 100, with only companies scoring above 50 being eligible for investment. 50 is not a low bar given we have very demanding standards - the best a company has scored so far is 81.

This approach is as much about economics as it is about sustainability. Companies that have enduring growth opportunities, along with better control over their input costs and supply chain, whether that be from cheaper renewable energy or security of raw materials, are more likely to enjoy outsized profit opportunities in the future.

This is the opportunity we are looking to capitalise on and is why investors really need to dig beneath the surface to truly understand what the company sells and what resources are used in that process.  

Alignment

We look at how the company is aligned with the aims of the circular economy, what targets it is setting and whether its success will contribute to a successful transition. Understanding management incentives here is also important – are they paid according to the success of achieving their environmental goals or are ESG goals simply a nice page in the annual report?

Capital allocation is a further key element of alignment. We look to see where capex is being spent and what types of businesses are being acquired, if any.

Furthering the circular economy

This is the most significant element of the circular score. We examine the products and/or services companies provide, along with how they go about producing them. These will be the key drivers of circularity. 

While important, we believe that investors need to look beyond just revenue alignment and really understand a company’s operational footprint.

Where are the raw material inputs coming from? What energy sources are being used? What is the company doing about emissions? How is waste treated? How does the company treat water?

These are just some of the questions we are asking in order to get a true 360 degree view of a company and its footprint.

Externalities and risks

This final section incorporates the need to recognise that there are risks in delivering on a circular economy.  This could be around scaling an unproven novel technology or the risks around operating in a potential hazardous industry. We also incorporate a view on any controversies that surround the company.

We feel the need to recognise that good execution of a strategy is not always guaranteed and so it’s important that this risk is reflected in the overall score.

Engagement – improving a company’s Circular Score

Engagement is a key focus when it comes to investing in the circular economy. We want our companies to be able to benefit from structural growth trends, as well as maintaining the resilience that comes with greater control over the cost base and supply chain. We see engagement as an important tool in helping to future-proof our investments.

Our circular economy framework helps us to understand key engagement priorities as it highlights where companies can improve across their operational footprint (as well as beyond it).

We take a unique approach in focusing on those companies we invest in that have the lowest circular scores and aim to work with them in order to improve these over time.

The end result of all this is the creation of a portfolio of exciting companies that can genuinely contribute to the transition to a circular economy, with the potential to deliver attractive returns along the way.