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Car engine innovation is key to CO2 reduction

30-04-2015 | Insight | Evert Giesen Although there are still some climate sceptics, most scientists share the view that man-made CO2 emission leads to global warming and climate change. This has led to efforts to reduce CO2 emission levels. As the car industry is one of the largest sources of man-made CO2 emissions, car manufacturers who can deal with this challenge in an innovative way, can be attractive for us as investors.

Speed read
  • Cars are one of the main sources of man-made CO2 emission
  • Manufacturers need to reduce emissions per vehicle
  • High required R&D spending will depress corporate profitability

Cars are getting a lot of attention as one of the main sources of man-made CO2 emissions. Road transport is a significant contributor, and accounts for 16% of CO2 emission. 

Global car sales have risen substantially over the past decade. This growth was mainly driven by emerging markets, with China leading the pack. Given the still low penetration levels in most emerging countries the expectation is that car sales will continue to rise over next decade. The only way to reduce or stabilize CO2 emission is to reduce emission per vehicle.

Regulations force car manufacturers to reduce worldwide CO2 emissions
Worldwide governments are reducing the maximum CO2 emission of cars as shown in figure 2. The European Union is relatively strict in its requirements. In 2021 car manufacturers are required to comply with a maximum average emission of 95 g/km for cars sold, which is a significant reduction compared with the 135 g/km level for 2015. In case of a violation of the maximum threshold in 2015, car manufacturers will have to pay significant fines. Also in other regions governments are reducing their emission standards. The Chinese government’s CO2 emission target for 2020 is close to that of the EU. The tighter emission standards and associated fines force car manufacturers to reduce the CO2 emission of their vehicles.


‘Tighter emission standards and associated fines force car manufacturers to reduce CO2 emissions’

Innovative ways to reduce CO2 emission
Car manufacturers are investing in R&D to reduce the CO2 emissions of their cars. Although savings can be achieved in several areas, most of the efforts focus on the powertrain of cars. There are several types of innovation:

More efficient combustion engines
Several improvements have been made in recent years. Downsizing of engines in combination with turbo technology is a widely adopted technology in the European car market. Start/stop systems are also widely adopted today. Industry experts indicate that further improvements of the combustion engine are still possible.

Hybrid powertrains
In a hybrid powertrain the combustion engine is supported by an electrical engine, or in some cases the car drives fully electrically over short distances.  Toyota already introduced the Prius in 1997. Since then the initial successors have been a big success for Toyota. Part of the success is explained by tightening emission regulations in many countries combined with fiscal incentives. Toyota’s success has been copied and many car manufacturers offer hybrid cars today.

Electric powertrain
Fully electric powertrains are also gaining ground. The most prominent example of an electric car is Tesla’s Model S. Traditional car manufacturers have also entered this market. A manufacturer like BMW chooses to develop a car model like the I3 around an electric powertrain. Other manufacturers like Volkswagen and Volvo use an electric powertrain in existing models. Cars in this category reload their electricity from the electric grid, and store it in a battery pack.

Fuel cell powertrains
The latest innovation for powertrains is the introduction of fuel cells. The fuel cell uses hydrogen to generate electricity. Recently Toyota introduced the Mirai, which uses fuel cell technology. Also other manufacturers like Hyundai and BMW have introduced or are working on powertrains using fuel cell technology.

Lean and clean
As we already highlighted, there are other methods to reduce cars’ CO2 emission than developing new powertrains. Car manufacturers are reducing the weight of cars, which means less energy is needed to move the vehicle. By using alternative materials like high strength steel, aluminum or in some cases carbon fiber the weight of cars can be reduced. Ford recently introduced the new F150, which is 700 pounds lighter due to the use of alternative materials like aluminum for the vehicle body.

Get a grip
Another relatively cheap technology to reduce emissions is to decrease the rolling resistance of cars. Tire manufactures change materials used for tires. The challenge is to reduce rolling resistance, while ensuring the tire still has sufficient grip when the car’s brakes are used.

Prospects for the different powertrain technologies
In our view the current process of innovation and improvement in combustion engines and hybrid technology will continue in the coming years. As Figure 3 shows the majority of cars will probably still use a traditional combustion engine in 2020.

car-engine-innovation-graph1.jpg
Source: LMC Automotive

For alternative powertrains like electric powertrains and fuel cells the prospects are less clear. Only a small part of vehicles sold in 2020 will use these alternative powertrains. It is still uncertain if innovation will be strong enough within these technologies to beat traditional engines. We are skeptical about the prospects for electrical vehicles. Battery capacity is a problem at the moment and it remains a question how fast battery technology will develop to assure sufficient driving distance and short loading times. Further electric powertrains only reduce emissions when the electric power from the grid is generated with emission free technologies like solar.

Fuel cell looks more promising in the longer run. The energy is stored in a relatively small amount of hydrogen. You don’t need heavy battery packs and the time required to fill up will be short. The hydrogen needs to be produced with electricity that is generated free from emission. As transport and storage is less of an issue for hydrogen than for electricity you could produce the hydrogen in areas where there is abundant solar power. At the moment there is no infrastructure in place for fuel cell cars. This could be developed over the coming decades. In the coming years fuel cell technology will only play a small role.

‘This increased ESG risk needs to be compensated for by higher spreads’

Only large car manufacturers with deep pockets will be able to keep up
To comply with tightening global emission standards automotive producers will need to spend large amounts on Research & Development (R&D) in the coming years. BMW has already indicated that the increased R&D spending could have a negative impact on margins of 100-200bp. As BMW has strong profitability the company can afford this. Some producers with weaker profitability, such as Peugeot, were forced to reduce spending on R&D. This could mean that it will be difficult for Peugeot to keep up with competitors who made the technological investments.

The required R&D spending could drive further mergers and acquisitions in the industry. Bigger auto companies can spread R&D costs over a bigger amount of vehicles. Fiat CEO Sergio Marchionne once commented that you need to sell at least 6 million vehicles per year to be competitive. Some smaller producers could decide to team up or could be bought by bigger competitors.

Parts suppliers will be the winners
Parts suppliers that are active in technologies to reduce CO2 emission will be the big beneficiaries of the tightening regulations. Companies like Valeo and Robert Bosch have benefited in recent years from strong demand for their products in recent years. The companies have continued to invest in new products and will continue to grow above market growth rates in the coming years.

Conclusion
CO2 emission regulations for cars are tightening throughout the world. This means that auto producers need to reduce the CO2 emission of new vehicles. Several innovations have been introduced in recent years. The traditional combustion engine will remain important in the intermediate term. In the long term we expect most from fuel cell technology and are more skeptical about electrical powertrains using battery packs.

The high required R&D spending will have a negative impact on the industry’s profitability. This increased ESG risk needs to be compensated for by higher spreads. Smaller or less profitable players could be forced to team up with competitors. Within the supplier industry we expect companies that focus on emission reduction techniques to continue to grow above market rates.


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