The ability of companies to develop products that help the world achieve net-zero carbon emissions plays an increasingly critical role in credit selection. A case in point is yet another ambitious proposal put forward by the European Commission this month. Known as Fit for 55, the proposal introduces an effective ban on the sale of diesel and petrol vehicles by 2035. While we believe most auto manufacturers are on track to meet the new targets, this post identifies those carmakers that are better positioned for the transformation required to gain a market edge in the net-zero world.
In essence, the latest EU proposal presents the following timeline for passenger cars in Europe:
- 2025: 15% reduction in average CO2 emissions vs. 2021 levels (unchanged from current law). The EU accepted concerns from the auto industry that it would be an insurmountable challenge for manufacturers to further cut emissions at such short notice.
- 2030: 55% reduction vs. 2021 levels (up from 37.5% under current law). While this target will be challenging for the industry, the market was expecting a potential reduction of up to 60%-65% by then.
- 2035: 100% reduction vs. 2021 levels (new target), effectively banning petrol and diesel vehicles, albeit subject to review with a report due in 2028 that will assess the readiness of the industry.
Figure 1 puts these proposed changes into perspective. The average new European passenger car emitted 107g of CO2 per km at the end of 2020. If Fit for 55 is adopted, emissions need to fall to 43 g/km by 2030, which compares to the previous target of 59 g/km. Any non-compliant manufacturer must pay a fine of €95 per vehicle per gram over the target.
FIGURE 1
Historic Average EU Passenger Car CO2 Emissions and EU Targets
PGIM Fixed Income; European Commission proposal.
Implications of the Proposal
Such an ambitious timeline for eliminating carbon emissions in vehicles has immense ramifications for battery-powered electric vehicles (BEVs). We estimate that the new target would imply an increase of BEV market penetration in Europe from around 10% currently to 45-55% by 2030 and 100% by 2035. While the 2030 target still allows for the existence of hybrid and plug-in hybrid electric vehicles (HEVs and PHEVs), the complete ban by 2035 makes further investments into hybrid drivetrains and flexible platforms somewhat questionable at this point.
Another regulatory threat to hybrids lies in Euro 7, a new set of engine standards set to come into force as early as 2025 that levies stringent regulations on internal combustion engines (ICEs), including hybrid vehicles. We expect manufacturers relying more heavily on hybrid strategies (broadly speaking, German premium manufacturers and Japanese mass market players) to be impacted the most by the introduction of the regulation.
As such, we consider firms that are committed to a pure BEV strategy as the best-positioned for the sea change. Apart from the new targets set by the proposal, a key reason for our conviction is our belief that additional investments needed to meet these targets will be more expensive than the European Commission’s projections in the proposal. The Commission estimates a 3% – 4% increase in investments needed to meet the new proposed CO2 emissions standards, which appears somewhat optimistic to us and likely masks the substantial variations in investments required across firms. Although most manufacturers have substantial cash balances and will likely be able to finance the incremental investments, some are better suited than others for the ongoing transition.
Who is Best Positioned?
After surveying the latest production targets set by various manufacturers during the first quarter this year (Figure 2) and analyzing the firms’ respective balance sheets, we identified Volkswagen Group and Stellantis as the most likely to emerge ahead in this decades-long transformation due to their ambitious internal EV product targets and their relatively well-capitalized balance sheets.
FIGURE 2
Production Targets of Various Auto Manufacturers
PGIM Fixed Income; Company reports and presentations.
VW aims for BEVs to make up more than 70% of its European sales by 2030, and its current strategy is based on a dedicated BEV architecture and a product line-up that will see at least one new BEV model each year. Additionally, the company aims to stop selling internal combustion engine vehicles in Europe by 2035, hence already in line with the current EU proposal. Within the group, we expect mass-market, smaller vehicles to transition more slowly than the premium brands until around 2025, at which point tighter regulations and cheaper batteries will allow smaller vehicles to accelerate to nearly full electrification by 2030. Meanwhile, the premium brands are likely to lead the move to battery electric at first, but are set to see penetration slow in the second half of the decade as EVs saturate the market.
Similarly, Stellantis recently set a 70% European market share target for electronic vehicles and plug-in hybrids combined (most likely with a 80:20 BEV:PHEV split) by 2030. For mass-market brands, such as FIAT and OPEL, Stellantis aims for 100% BEVs by 2030. While internal combustion engines are still in the mix, the group will have at least one BEV option for all vehicle models, which will likely be an effective product strategy to convert consumers into BEV drivers.
The more premium manufacturers, such as BMW and Daimler, have made substantial up-front investments in platforms that can carry ICE, BEV, or PHEV variants, giving them the flexibility to adapt to changing demands from high-end consumers. But the potential ban on ICEs may mean they also face the greatest challenge pivoting to the new regulatory paradigm. Nevertheless, consumers’ willingness to pay for costly EVs has accelerated BEV penetration and carmakers’ conversion to dedicated “Electric Only” strategies from flexible “Electric First” approaches.
Since the latest EU proposal pose significant risks and opportunities to automakers in the long run, we expect impact on credit spreads to also manifest over a long investment horizon. Credit spreads of automakers almost universally compressed to historical levels on the back of the economic recovery, but we expect differentiations in spread performance will play out going forward, with firms’ product adaptability and balance sheet positions coming under closer scrutiny following a period of substantial yield compressions.
Conclusion
The latest carbon emissions proposal by the European Commission—particularly the ban on internal combustion engines by 2035—has the potential to further distinguish winners and losers in the race to zero auto carbon emission. BEV-focused manufacturers appear better positioned for the continuously tightening regulations while firms that were too invested in hybrids potentially face difficulties transitioning in the next few years. After the substantial market-wide rally off the depths of the COVID troughs, this differentiation is especially important considering issuer selection will be key to excess returns going forward. Looking ahead, we will closely watch for revisions to carbon-emission legislation as any changes may reveal policymakers’ assessment of the pace of consumer adoption, the life-cycle of current technologies, and the industry’s readiness to go fully electric.
