The long-dominant internal combustion engine is rapidly taking a back seat to electric vehicles, as regulation drives innovation in the automotive sector, according to the latest Credit Spectrum. In the paper, Ilana Elbim, Credit Analyst at Hermes Investment Management, assesses how this represents a step change for traditional automotive manufacturers and has important implications for credit investors in both the short and longer term.
Regulation puts EVs in the driving seat
Concern about climate change and air pollution is driving governments to focus increasingly on the environmental impact of the automotive sector. Regulation has become a key driver of innovation, accelerating the move away from the internal combustion engine (ICE) with electric vehicles (EVs) rapidly emerging as the key alternative.
Elbim explains: “Environmental concerns are driving demand for alternative fuels on a global scale. Air pollution is a major issue not only in the West, but also in emerging markets, including India and most significantly China, which produced 43% of global EVs in 2016 and overtook the US for having the highest number of EVs on the road1.
“China has rolled out incentives and regulations, including consumer grants and subsidised charging stations, as well as requiring manufacturers producing or importing more than 30,000 cars to make EV sales 10% of their total in 20192. Meanwhile, the EU has the strictest rules governing the use of ICEs, which are responsible for more than 10% of CO2 emissions across the bloc.”
The EV tipping point
Until recently, many producers remained focused on improving the efficiency of their ICE vehicles in order to reduce average fleet emissions. However, Elbim argues several factors are combining to make this approach less tenable, even in the medium term.
Elbim says: “In Europe, the popularity of diesel cars is being undermined by the aftermath of the VW emissions scandal and increasing concerns over air pollution. Diesel sales in Europe – which have been far higher than in the US and China – are predicted to drop from 50% of the market in 2016 to 30% in 2025, while global sales are set to plummet from 13.5% to 4%3. This threatens manufacturers’ ability to meet the EU 2021 regulation for average fleet emissions and elevates EVs as a more viable means of achieving the target and avoiding large fines.
“Moreover, in the wake of the VW scandal, new regulation mandates that diesel car emissions tests are performed on the road instead of in a laboratory. This scrutiny, plus the growing awareness that diesel cars are no longer considered more environmentally friendly, should further incentivise manufacturers to invest in electrified motoring.
Furthermore, the lower oil price and auto dealers' sales incentives have helped sustain the long-running consumer trend for SUVs ‘crossovers’ –– impeding manufacturers’ ability to reduce emissions across their fleets.”
As a result of these factors, Elbim believes the tipping point for EVs, which was once far down the road, is drawing rapidly closer: in 2017 Exxon Mobil revised its figures from 65m to 100m for EVs on the road by 2040, while OPEC raised its forecast from 46m to 266m. Meanwhile, the International Energy Agency more than doubled its central forecast, raising its 2030 EV fleet size estimate to 58m from 23m4.
Manufacturers shift gears
Behind the Tesla-driven headlines, Elbim says mainstream manufacturers such as Renault, Nissan, Honda, Toyota and BMW have long been pursuing the development of alternative power sources for their vehicles. However, regulatory change and consumer pressures are causing a step change in approach.
Elbim explains: “Confronted by the potential cost in terms of regulatory fines – and the reputational damage such breaches will incur – the more forward-looking mainstream producers are making significant bets on EVs. Virtually every major manufacturer is trumpeting a commitment to EVs: in the US, GM plans to introduce 20 EV models by 2023; Ford has announced an $11bn investment in the technology and aims to launch 16 EV models by 20225,6. This mass market momentum, driven by ongoing reductions in the cost of producing pure EVs, is critical to the growth of the market.”
Road blocks ahead?
While the EV outlook is positive, there are barriers to domination. A significant issue is cost. EVs remain relatively expensive to make compared to their ICE counterparts. However, McKinsey indicates that the price of a complete automotive lithium-ion battery pack could fall from $500-600 per kWh to about $160 per kWh by 2025 – cheap enough to make EVs a mass market, rather than premium, product7.
Other impediments to greater EV use are the twin issues of range anxiety and charging. However, Elbim explains several factors may combine to alleviate this issue in the near term. First, advances in battery technology are rapidly improving range: for example, Nissan claims a range of more than 300 miles for the 2018 Leaf89. Second, charging times are declining almost as fast as range is going up: Tesla claims its superchargers can replenish 170 miles of range in half-an-hour.
Elbim says: “Barriers to EV uptake in terms of economics and convenience may still tend to trump any environmental rationale for most buyers. However, the expected shifts in the landscape, coupled with the declining cost curve and financing structures such as battery leasing, which reduce upfront cost, are likely to change consumer behaviour in the near to medium term.”
Implications for investors
Elbim believes there are significant synergies between EVs, autonomous driving, shared mobility and connectivity that must be assessed by credit investors. These, she says, need to be considered in tandem to enable a deeper understanding of how the automotive market will evolve.
Elbim explains: “We have recently seen a significant acceleration in investment plans and dialogues about EVs from OEMs and auto parts suppliers; investors need to consider which companies risk being left behind.
“In the US auto industry, we favour General Motors (GM) over Ford, and hold GM in our credit portfolio. GM has recovered from bankruptcy in 2009 to become an investment grade company; and now has a deeper exposure to motoring trends and stronger geographical diversification than Ford. It also already has a mass market EV, the Chevy Bolt, on the road, which was the second-most popular EV in the US behind Tesla in 2017.”
GM is in the EV fast lane
Ford seems to be in GM’s rear-view mirror in harnessing innovation, according to Elbim: “While its new CEO announced a significant boost in EV investment, we still need to see how it delivers on this promise, given limited experience in producing EVs. Credit profiles for the two companies are broadly comparable: both have significantly lowered fixed costs since the financial crisis, reducing the sales volumes required to reach breakeven, while also achieving investment grade ratings. While cash generation from both companies is healthy, GM seems more robust with a stronger operating margin and free cash flow generation.
“Overall, we prefer GM’s long-term strategy and commitment to future mobility. Until recently, Ford seemed to have been thinking more medium term and may struggle to catch up. GM CDS was trading wider relative to Ford despite its stronger business and financial profile, but this trend has now reversed after GM announced better-than-expected Q4 2017 and 2018 guidance at the Detroit auto show in January 2018, while Ford’s 2018 expectations were disappointing. We believe this trend will persist, and GM should continue to trade inside Ford.”
1 "China's electric vehicle market plugs in," published by McKinsey & Co. in July 2017
2 China's new energy vehicle mandate policy (final review), published by the International Council of Clean Transportation in January 2018
3 “America’s diesel car market gets even smaller,” by Ryan Beene. Published by Bloomberg on 10 May 2017
4 “Big oil just woke up to threat of rising electric car demand,” by Jess Shankleman. Published by Bloomberg on 14 July 2017
5 “GM plans 20 all‐electric models by 2023,” by David Welch. Published by Bloomberg on 2 October 2017
6 “Ford plans $11 billion investment, 40 electrified vehicles by 2022,” by Nick Carey and Joseph White. Published by Reuters on 14 January 2018
7 “Battery technology charges ahead,” by Russell Hensley, John Newman and Matt Rogers. Published by McKinsey & Company in July 2012
8 “The 10 electric cars with the most driving range,” by Zachary Shahan. Published by CleanTechnica on 24 December 2017
9 Nissan throws down gauntlet to Tesla on electric car range,” by Peter Wells. Published by the Financial Times on 6 September 2017