De-risking circular economy investments through fiscal policy support

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The circular economy (CE) stimulates frugal and efficient use of resources by designing out waste and maintaining value of goods and materials through regenerative business practices. CE forms an alternative to the linear economy ‘take-make-throw away’ that generates increasing volumes of waste and in some instances puts critical pressure on resource availability. Finance volumes favour the less complex linear business model, but change is underway. 

About the Authors

Dr. Patrick Schröder

Patrick Schröder is a senior research fellow in the Energy, Environment and Resources Programme at Chatham House, specializing in the global transition to an inclusive circular economy. His current research focuses on identifying collaborative opportunities between key countries to support the implementation of the SDGs, closing the investment gap, and building an evidence base for trade in the circular economy.

Jan Raes

Jan Raes works as global sustainability advisor for ABN AMRO Bank’s Corporate Strategy & Sustainability department. Jan is an expert in the integration of social, environmental and economic aspects in banking. He is actively contributing to the development of science-based methods for the finance sector to tackle climate, biodiversity and circular economy challenges. For Chatham House, he is a member of the advisory board of the circular economy project.

In our recently published Chatham House research paper “Financing an inclusive circular economy,”  we write about de-risking investments for circular economy business models and the Sustainable Development Goals. We show that the speed and volume of adoption of circular economy finance instruments remains very modest when compared to the amount of money that goes to the linear global economy on a yearly basis.

To date, investing in circular economy solutions and business models is still considered high risk for most financiers. To de-risk investments, existing policy instruments and financial instruments need to be adapted.

Investments in circular economy innovations and new business models, especially in developing countries, are still considered to be high risk or even un-bankable despite ongoing and growing finance experiments with circular economy business models in industrialized economies. The initial investments required for the build-up of circular economy infrastructures (such as eco-industrial parks, waste collection, sorting and recycling systems, or clean water and sanitation solutions based on circular technologies) can pose a substantial challenge for low- and middle-income countries. The many medium- and long-term problems associated with waste and future resources shortages are traditionally weighed against short term profits offered by the linear economy.

One way to de-risk and grow circular economy finance is to make resource efficiency standards and environmental and social criteria an ‘opt-out’ rather than an ‘opt-in’. This ‘opt-out’ means that regulators adapt public policy to ‘nudge’ investors and entrepreneurs towards making more sustainable and ethical investment decisions. The taxation and fiscal policy domains are particularly fit for circular economy ‘nudging’. Other policy domain examples are extended producer responsibility (EPR) schemes, product eco-design policies, institutional capacity-building, green investment policies and public-sector skills development.

Fiscal policies for circularity

In their pursuit of the circular economy, countries can structure their fiscal policies according to their national critical resource priorities (e.g. recovery and efficiency standards). These policies are also a way for countries to address social and environmental externalities (e.g. decent work, cleaner air, water and soil).

The alignment of taxation and economic incentives makes sense for countries that lack within their territory certain critical resources crucial for their economic development – for example, rare earths and metals for battery components. Taxation can also be used in solving pressing environmental issues related to waste streams, as in the case of plastics.

On EU level, the Green Deal acknowledges the crucial role played by taxation in the transition towards greener and more sustainable growth.  The EU Green Deal also proposes to ramp down fossil fuel subsidies, in line with SDG 12 targets. Phasing out these subsidies is not only relevant for climate change mitigation, but also for plastic production, which depends heavily on cheap fossil fuel feedstocks and energy. The coming phase-out of fossil fuels will require plastic producers to bear more of their upstream costs, which will increase the investment risk facing their production facilities.

For financial institutions, it is important to have clarity about taxes to which their clients are subject, as this relates to profitability. Taxation is part of any economic due diligence and informs pricing of capital, which in turn influences risk-adjusted returns and the appetite of investors.

A tax shift to support circularity would include both tax cuts and tax hikes. A circular economy taxation framework could include a combination of a raw material resource taxes, tax relief for reuse and repair activities, and a waste hierarchy tax at the end of life of products (see Figure 1). These environmentally targeted tax cuts favour circular economy practices, making repair, recovery and reuse of products and resources more attractive.  Simultaneously, the tax burden on primary resource extraction and polluting energy generation will increase. 

FIGURE 1

Circular Economy Taxation Framework combining (1) a natural raw material resource tax such as virgin plastics, (2) reuse/repair tax relief and (3) tax based on the waste hierarchy tax for the end of use phase.

Based on Milios, 2021 

Taxes on virgin plastics or bans of “free” single-use plastics

In order to reduce plastic waste and promote a transition to a circular plastics economy, various policy proposals have included different forms of taxation on single-use plastics.

Thus far, in most countries these reforms have concentrated on applying taxes at the consumer level. For example, taxing sales of plastic carrier bags in supermarkets. In Portugal, Wales, Ireland and the Netherlands such plastic bag policies have resulted in a decrease of around 70% of plastic bag usage with increasing consumer approval levels. Namibia’s Ministry of Finance issued a plastic bag levy of N$0,50 in 2019, with the money collected from the levy allocated to the Environmental Investment Fund (EIF) that is used to improve waste management.

Plastics taxes can also be targeted at the production level, for instance taxing the use in the production process of virgin plastic as opposed to recycled materials. In the UK, for example, HM Treasury announced plans in 2018 to introduce a new tax on the manufacture and import of all plastic packaging containing less than 30 per cent recycled content, to come into effect by April 2022. 

Taxes on raw materials extraction

Taxes on the extraction of sand, gravel and aggregates used in the construction industry have been introduced by various EU member states, as well as the UK, generating incentives for the recycling of construction and demolition waste. Comprehensive fiscal regimes already exist around extractives production – these already guide mining sector investment decisions. Developing countries typically offer lower tax burdens, and any attempts to raise these taxes can result in capital flight. Furthermore, international dynamics may prevent countries from imposing such tools, despite a desire to do so.

Fiscal support for reuse and repair business models

A circular economy taxation framework that can be applied across the life cycle of products would need to include fiscal support for reuse and repair activities, such as via government subsidies or VAT reductions as implemented in Sweden since 2017. Relevant relief policies for repair businesses have been proposed to EU member states and in the UK as an economic policy instrument in favour of the circular economy. Some flanking regulations are required to make these fiscal measures a success. In July 2021, President Biden issued an executive order that will bring about new regulations limiting device manufacturers’ ability to restrict independent repairs of their products. Previously, several US state-level right to repair bills were issues to increase information exchange related to repairs between producers and regional repair shops and consumers.

Shifting the tax burden from labour to material inputs

The collection, recovery and processing of secondary materials are labour-intensive, and therefore incur more tax than using virgin materials. Shifting taxation from labour would reduce costs for the collection, filtering and sorting of waste, making secondary materials of a higher quality so they become cheaper and more competitive with primary materials. Similarly, the remanufacturing and refurbishing of products is relatively labour-intensive in comparison to the manufacture of new products, especially given the increasing use of automation in manufacturing activities. These processes require a specific skill set, which means that shortages of skilled professional labour can also be an issue. Fiscal incentives that support training and hiring in circular economy businesses could be considered by policymakers.

Taxation shows great variations around the world and especially between developed and developing countries. The wrong tax incentives can potentially increase inequality by undermining natural and social capital. But introducing the right taxation and fiscal measures can create a virtuous cycle of change that will nudge business and investors from the take-make-use-waste paradigm to a resource efficient circular economy, based on new innovations and business models for reuse, repair, remanufacture and recycling.