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How will carmakers deal with the end of diesel?

How will carmakers deal with the end of diesel?

16-11-2017 | Insight

High NOx emissions and diesel gates are precipitating the end of the diesel era. To meet stricter regulations, carmakers will have to invest in low-emission engines, such as electric vehicles. As these will not immediately take over the entire car fleet, car manufacturers will also still have to invest in technologies to reduce emissions of fossil fuel cars. This requires scale.

  • Cristina Cedillo Torres
    Cristina
    Cedillo Torres
    Engagement Specialist
  • Evert Giesen
    Evert
    Giesen
    Credit analyst

Speed read

  • Diesel engines are bound to be phased out 
  • Carmakers and suppliers have to invest in new low-emission technologies
  • We prefer companies with enough scale to make such investments

Allegations of a cartel agreement among German carmakers to set the price and pace of innovation of - among other things - clean diesel technologies, have become the last crisis shaking the auto industry. It follows the diesel gate scandal of 2015 and the subsequent government investigations finding that 97% of modern diesel cars tested exceed legal limits of nitrogen oxide (NOx) emissions in real-world driving conditions.

Recent announcements of potential diesel bans in some European cities may be early warning signs of a technology in decline. As no other market outside of Europe has a significant share of diesel vehicles, their fate will be significantly influenced by European regulators.

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EU regulators’ affair with diesel is over

With the aim of reducing carbon dioxide (CO2) emissions in the 1990s, Europe supported a switch from petrol to diesel cars, believing that diesel was kinder to the environment. Twenty years later, this move has backfired as air pollution rises. Diesel emits less CO2 and contains more energy than petrol, but emits four times more NOx. Emissions of NOx pose high risks to human health. It is estimated that an alarming number of premature deaths, reaching 38,000 people worldwide in 2015, are attributable to air pollution, mainly affecting Europe, India and China.

Diesel cars still account for about half of total vehicle sales in the EU. In order to tackle both air pollution and climate change, governments are increasingly focusing on hybrid and electric cars. The UK, France and Norway have already announced that only electric or hybrid car sales will be allowed as of 2040.

Consumer trust is declining

Following the discovery of the use of defeat devices by Volkswagen, investigations by regulators in the EU and the US found that there is a significant discrepancy between official laboratory test results and tests conducted on the road. These findings have damaged the reputation of diesel cars.

Sales of new diesel cars in the top four European markets – Germany, Italy, Spain and the UK – have started to drop. In the UK, diesel car sales have decreased by a fifth in comparison with 2016, while sales of hybrids and electric vehicles (EVs) reached record highs in July this year.

Increasing costs to comply with new emission rules

The strengthening of emissions standards and tests are increasing carmakers’ costs to comply with emission regulation. The targets envisioned for 2021, 2025 and 2030 will require more drastic changes to carmakers’ strategies, which should increasingly rely on hybrids and all-electric vehicles. Advancing emissions control technologies further is expected to become more expensive, and they face the risk of becoming a stranded investment if the shift towards electrification accelerates.

Towards an electric future?

Electric vehicles are still a tiny part of the total global car market. Battery costs will need to decline a lot more before electric cars become cost-competitive. Also, battery building capacity is still low. A lot of investments are required in battery production facilities, but not many plans have been announced so far. Also some commodities like cobalt, lithium and nickel could become scarce. Starting new mining operations could take several years.

Although we expect electric vehicles to increase their market share, they will still account for only a small part of industry sales in 2025.

The increase in electric car sales will not be enough to comply with emissions regulations. The emissions of non-electric vehicles will also need to improve in the coming years. Hybrid technology and further investments in combustion technology are needed to improve fuel efficiency of non-electric cars.

The investor perspective: scale

We see challenging times for car manufactures in the coming years. They will need to invest a lot of money in several technologies to comply with emissions regulation. Only the big car companies will probably have the scale to make all the necessary investments. All the required investments will most likely have a negative impact on car manufacturers’ profitability in the short to medium term. The degree to which carmakers have the scale to make such investments is one of the factors considered in our investment decisions.

Within the auto supplier space we long favored companies which were active in engine and transmission technology, as these benefited most from the emission reduction trend. We believe these companies will continue to benefit in the coming years, but will lose market share when electric cars take a big part of the market. We have a clear preference for the larger suppliers which have the capabilities and resources to also develop products for electric cars.

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