Car manufacturers, often referred to as original equipment manufacturers or OEMs, are under mounting pressure to meet increasingly strict CO2 emissions reduction targets. 2020/21 European targets for new cars are set to an average of 95g CO2/km and are expected to require a sharp acceleration in OEM effort. The overall policy framework, however, is much more elusive and renders the absolute 95g CO2/km threshold less meaningful. This article aims to shed more light on these intricacies and compares OEMs’ relative position in meeting the requirements as well as their potential exposure to financial penalties if they do not. In addition, we evaluate how these ESG challenges may drive investor sentiment and auto sector (credit) performance going forward.
Since the turn of the century emissions from new passenger cars have shown a clear downward trend. However, the decrease in fleet-wide average passenger car tailpipe emissions was brought to a standstill in more recent years. In fact, as of 2017 we even observe a noticeable uptick that is mostly attributable to consumer preference moving in favor of heavier and high drag coefficient SUVs, and an overall lower share of more fuel-efficient diesel powertrains. At first glance the 2018 average of roughly 120 g/km stands in stark contrast to the 2021 target of 95 g/km. Yet this would not be a fair comparison as, in reality, the target represents an average across the universe of OEMs in which each manufacturer is assigned an individual target. The OEM-specific targets are adjusted based on the average mass of their product portfolio. In practice this means that manufacturers with a tilt towards heavier vehicles will benefit from a higher relative CO2 target and vice versa, though it should be noted that this adjustment factor will be lowered from 2020 onwards.
Figure 1: Average tail pipe emissions from new passenger cars registered in the EU; Source: European Environment Agency (EEA)
The results of adjusting the 2020/21 targets based on the most recent 2018 data for a select set of OEMs with above average exposure to European car market are depicted in figure 2. Clearly, even on a weight-adjusted basis, the gap remains sizable with the best performing OEM (Renault) still 20 g/km short of its expected individual target. Looking ahead to the publication of final 2019 emissions readings, any major improvement in CO2 scores is not to be expected as OEMs continue to steer the portfolio mix towards higher-margin SUVs and many electrified product launches are generally planned for 2020. This signals that the next 12-month period will be crucial in meeting emissions targets. Fortunately for OEMs, fiscal incentives from European governments intended to boost electric vehicle (EV) take-up are gaining momentum and the share of fleet sales, with operators often adhering to very strict self-imposed emission ceilings, is growing.
Figure 2: OEM relative positioning; Source: International Council on Clean Transportation (ICCT)
Of the three German OEMs, Daimler seems relatively weakly positioned to meet its target and has been vocal that this poses a significant threat to financial results. BMW, in turn, was an early mover in EVs and, as a result, is probably better able to scale up production of electrified vehicles. What ties Daimler and BMW together, however, is their reluctance in adopting battery electric vehicles (BEVs) and their preference for Plugin Hybrid Electric Vehicles (PHEV). This is very different from VW, whose strategy includes a very aggressive move forward in full EVs and dedicated electric platforms. While it remains to be seen how a focus on PHEVs will play out in the long run, the current decision is at least partially dictated by important details of the regulation that are discussed next.
Phase-in period to provide relief, albeit modest and short-lived
The calculation of OEMs' portfolio average for the years 2020/21 is subject to a number of leniencies. The 2021 emission targets will be phased in during 2020 as this year will mark a transition period during which 95% of an OEM's portfolio is obliged to comply with the 95 g/km limit and the 5% most polluting models are excluded. Furthermore, up until 2022 OEMs may be awarded so-called Super-Credits for every passenger car with CO2 emissions lower than 50 g/km. In calculating the fleet average these vehicles will be counted as 2, 1.67, and 1.33 in 2020, 2021 and 2022 respectively with the advantage capped at 7.5 g/km. There is also the option of forming a pool with another manufacturer. Fiat Chrysler Automobiles (FCA) is the primary example of an OEM seeking a partner to mitigate compliance headwinds as it formed an open pool with Tesla in February 2019 and agreed to purchase emission credits for several hundred million euros. Moreover, an important rationale cited for the recently announced merger between Peugeot (PSA) and FCA revolves around the latter being able to make use of PSA's comparative head start in the development of electric vehicles (EVs), thereby securing the viability of its European business.
Still, every OEM will have difficulty in complying with the new 2020 regulation, as even Renault has pointed to the higher than budgeted cost of transition in its recent profit warning. Despite this, all OEMs have communicated that paying fines is simply not an option. Figure 3 provides an estimate of the magnitude of hypothetical penalties and how this compares to the operating income of each OEM.
Figure 3: Impact Analysis of non-compliance on 2021/21 CO2 targets by OEM, Source: European Commission, Company data
In examining the impact, a few things stand out. First and foremost, OEMs have a clear incentive to meet the EU requirements as even a modest shortfall of five grams translates into a significant hit on operating earnings. Secondly, while the shortfall between current emissions and the 2020/21 target is a main risk factor, the potential fine in case of non-compliance is also proportional to an OEM's exposure to European car sales. For that reason, the OEM fine per gram of exceedance, calculated as the €95 penalty per gram of exceedance set by the European Commission times the new car registrations in Europe, compares unfavorably for PSA and Renault.
Investor concerns to remain
Generally speaking, investor opinion is very much divided on whether or not OEMs will be able to comply with the 2020/21 CO2 regulation. We believe that manufacturers will try to avoid non-compliance at all cost and will even consider the option of pushing (PH)EVs into the market at substantial discounts. Incumbent OEMs are also increasingly at risk of losing investor confidence when it comes to their comparative advantage. While the 2020/21 targets are still relatively benign thanks to Super-Credits and weight-adjusted individual targets, the tailwind of these leniencies will fade quickly over time. With the expectation of even stricter 2025 and 2030 CO2 targets that aim for reductions of 15% and 37.5% respectively relative to the 2021 baseline, non-compliance during the 2020/21 period will almost certainly raise investor concerns and call into question the feasibility of meeting future targets.
In the next few years OEMs face a real conundrum in having to strike a delicate balance between the application and integration of new and often costly (PH)EV technologies, and successfully navigating the evolving emissions policy environment. In the process, we expect further sector consolidation and partnership announcements as OEMs attempt to manage the transition. All in all, we believe CO2 performance and inherent ESG risks are a key determinant of both auto sector and individual OEM credit performance and will remain in focus with investors for many years to come.