Talk of circular economy has exploded in the last half-decade, and is set to spread even further. The term averages over 27,000 monthly Google searches worldwide, signalling an increasing interest in the need for – and opportunities from – switching from linear selling to circular product management. Lorenzo Migliorato writes.

Though the ‘circular economy’ label has only emerged in mainstream discourse in the last few years, in a sense, the leasing industry was there before the rest of the economy even realised.

“When our business was set up, 20 years ago last year, the notion of circular economy was not known,” says Carmen Ene, chief executive officer of 3 Step IT.

“I think as a term, it was coined a couple of years ago by the EU. You had all kinds of names and words before, but people only started speaking about ‘circular economy’ with the [not-for-profit] Ellen MacArthur Foundation and the regulations the EU started to introduce.”

The way leasing was sold before then, Ene says, was focused on total cost of ownership, the capability to reduce upfront investment costs, and the advantage of off-balance assets. “That was the word on how you would present leasing. Our business started differently: the [founders] started thinking about what would happen to a piece of equipment at the end of lease. They started thinking from the end, so to speak, making their way up to the beginning of a lease.”

In a way, Ene says, 3 Step IT was circular before knowing it. “It so happened that our business model, even if it is 20 years old, has become more relevant than ever, because of things that have happened outside the [leasing] world.”

Circular economy is an umbrella concept, mostly used in contrast to the ‘linear’ asset lifecycle that we are used to. But beyond the soundbite, five distinct circular business models have actually been codified throughout the years: circular input, where circular materials take the place of fossil ones; product-as-a-service; product life extension; sharing platforms; and value recovery, which closes the loop by rescuing and reusing materials and components.

“If you start working in these five business models, in close co-operation with clients and suppliers, you will see a need for a different kind of financing, including leases and ABL,” says Petran van Heel, sector banker for construction at ABN Amro, adding that tailored solutions are especially needed in the current phase of circular economy, which is still all about innovation.

“There are not too many off-the-shelf circular products around. We learn with every deal, and we are getting there by professionalising what we do. Partly because of the fact there is little regulation on circularity, this is the time to experiment.”

Materials to the fore

The first and last circular business models both focus on materials and their reuse. Rethinking how materials can be valued, beyond their role as an asset’s substrate, is perhaps the biggest challenge required of banks and lessors that want to improve their circular portfolio.

“It is not a mature market yet,” says Van Heel. “I think the [Dutch] government is starting to expect and demand, through legislation eventually, more circularity across all industries. The market has to adapt to that and push for more reuse and recycling of materials. Pioneers are working in this field, and have huge potential for tomorrow.”

In ABN Amro’s leasing operations, rescuing materials is becoming an increasingly central concern, as equipment specialist Rick van Hemert says: “As a leasing sector, we see different sectors looking into how to recycle and upcycle materials after their use, such as the agricultural, food, construction and transport and logistics sectors.

“Leasing units have the expertise. Asset managers are aware of the latest technical developments regarding machinery and equipment. With that knowledge they can play a key role in finding new solutions for those sustainable machines.”

As awareness of materials’ circularity credentials increases, a shift in how assets are valued will also occur: “It will be possible to determine the value based on a material level, component level and of course the value of the equipment as a whole,” says Van Hemert.

Another Dutch bank, ING, also makes a crucial point of the materials side of leasing: “In a circular economy, products and their components and materials are recycled as efficiently as possible so that their value is maintained, or even enhanced,” says Leonie Schreve, ING’s head of sustainable finance.

“This does not only reduce the raw materials needed for products, it also saves money. But moving to a real circular economy is not only about sharing or recycling. We also have to design, sell, value, treat risk and finance differently.”

Schreve continues: “[Finance] customers who are transitioning to circular business models are more ‘future-proof’. Not only does this mean less risk from a financing perspective, but also more business opportunities – which in turn need financing.”

Circularity risks

As Schreve’s comments suggest, a major step towards circularity is changing the perceived risk associated with shifting paradigms.

Manufacturers’ long-term visions are often clouded by risk models that are inherently biased towards linearity, says Shiva Dustdar, head of the innovation finance advisory at the European Investment Bank (EIB), preventing them from embracing models like product-as-a-service.

“What we have is a flawed linear risk-assessment model, and no comprehensive circular risk model,” Dustdar notes. “There are very few institutions right now that have developed in-house models that actually look at things in a more comprehensive way. Therefore people immediately perceive [circularity] as riskier.”

“For example, if you turn from selling a product to leasing it, in the short term clearly you are not booking the revenue upfront, you are taking counterpart risk by getting the money over a long time. People then perceive it as high risk.”

Of course, Dustdar says, taken in isolation, the shift to circularity does involve risks. But if the change is systemic, and pushed down the supply chain, risks are actually much lower than those posed by the linear consumption model – which she defines as a “time bomb”. For example, procurement of materials and components is much easier when they are retained into a circular production system, rather than supplied through overseas shipments in a just-in-time strategy.

That is not to say that the shift does not come with a disruptive impact for a firm and its credit profile. But it is a disruption that lenders need to account and be prepared for.

“In the transition, there will be winners and losers,” says Dustdar. “If you [as a bank] have loan exposure to a number of companies, and the companies start switching their business model, that in itself requires you to be vigilant. If a company has [so far] sold products, has had revenues [upfront], and all of a sudden starts to lease them out, it has an impact.”

Some manufacturers have done this, but so far not to a scale that triggered concerns in their financiers. That will have to change if circularity is to become the new normal.

“If the circular economy scaled up and became much more rampant, then those banks providing financing [to companies making the shift] perhaps need adjustments in their portfolio,” says Dustdar.

Cornerstone lessors?

The switch to a circular economy inevitably entails a bigger focus on assets’ lifecycles, especially when it comes to manufacturers.

“The circular economy focuses on extending the lifetime of products by refurbishing them and optimising the usage of existing products,” says Schreve. “This means that the manufacturer needs to have a good grip on their supply chain, but also on the whole product lifecycle.

“If they want to refurbish the product, for example, they need to have the product returned to them after a certain time, to refurbish it and re-offer it. This is where leasing can play an important role, in its existing form as well as in new ones, where we innovate our banking offer and combine our expertise in different financial products.”

Leasing contracts, Schreve says, especially when provided through the vendor channel, are particularly suited to tracking an asset’s journey.

A partnership with a lessor can thus be all the more enticing to manufacturers that want to enhance their circular output, and which may also be looking to finance machines that allow circularity in the first place – for example to refine rescued materials.

Lessors should start to grasp the potential for partnership – the extent of which is still somewhat underestimated, according to Ene.

“If you ask me, I believe the leasing industry is missing a huge point here, because they still speak about leasing [on its own], whereas I find leasing as an enabler for the circular economy,” she says. “The leasing industry could really play a more relevant role now, based on the trends that are going on around us, and I hope it will.

“Any product that has a defined lifetime, that can be refurbished and then given a second life should be within the scope of the circular economy.”

Van Hemert’s view runs along the same lines: “It’s inevitable that this transition will force manufacturers of leasable assets to rethink design to ensure a longer economic lifespan at lower costs,” another area where lessors’ expertise can add value to the business.

Partnering with players whose business is centred on leasing can also make the transition to circularity less cost-demanding, for both banks’ finance units and manufacturers. For instance, 3 Step IT has refurbishing centres in five countries; for some companies, says Ene, it might just be more convenient to rely on 3 Step IT’s infrastructure than set up their own centres, depending on the number of assets and the lease turnover.

“I do not really see a bank needing its own refurbishing centres,” she says. “Some may have them; everyone is going to try and find their future place, and some may opt for that. But what I see, really, is people trying to find the right partner along the chain. Perhaps you just want to be an asset manager, and find a partner [to handle refurbishment].”

Experimentation first

Despite customers’ increasing openness to relying on circular assets – “More and more consumers get fed up with the ‘normal’ structures of production, take-make-waste,” says Van Heel – the circular business model is still very much in the testing phase.

Small-scale or internal experimentation remains banks’ preferred route to a more circular paradigm.

“We use our [ABN Amro’s] own offices as a ‘living lab’,” Van Heel continues. “In partnership with clients and suppliers we [explored] circular concepts, and experimented in circular business models and financing.”

He makes the example of a contract ABN Amro has with Mitsubishi to supply lifts in the bank’s buildings: not only is the cost based on pay-per-service, the contract also covers the return of the lift at the end of its lease, for Mitsubishi to reuse it in another building or strip it of its raw components.

This is inspiring as a collaboration between two economic giants – a bank and a major manufacturer – but by Van Heel’s own admission, “not all companies have deep pockets like Mitsubishi” and can afford such a radical shift to servitisation.

Partnering with a lessor is no guarantee for viable production, as Dustdar is keen to point out: “Certainly, for quite a number of companies, leasing is actually the way forward to turn their business model circular and retain ownership. [But for many companies], even the greatest leasing offer won’t help build up margins. You need capital coming in.”

The current, initial phase of the circular economy consists in the ‘circularisation’ of existing products. But in the future, assets designed specifically with circularity in mind will be needed. The development of such assets is often constrained by limited funding to startups and budding innovators – with the result that though a circular leasing structure might be in place, the asset best suited to it simply does not exist yet.

In those cases, Dustdar and others suggest forward-looking investments are often needed on part of financiers: capital, usually in the form of equity, that can kick-start production for products that may, at future, bigger scales, become the object of a vendor finance contract.

“We see that as an opportunity for us as banks,” says Van Heel. “Instead of financing a project, we might have to finance a company, or their cashflow. If we, as ABN Amro, are not able to finance these startups, we might be able to act as a ‘launch customer’, by placing an order.”

Doing so would allow smaller but innovative companies to kick-start production, and then scale up to a point where ABN Amro can finance them. Van Heemert also suggests that engaging with such companies in the early stages can lead to a lasting business relationship with a lessor, and its customer network.

“There are a lot of new business models, a lot of startups at the forefront, and a lot of pioneering,” notes Van Heel.

“In this scene, we are learning to see a lot of opportunities as well.”