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Steering change: sustainable automotive credit

Steering change: sustainable automotive credit

18-07-2019 | Visión

The automotive industry still relies heavily on old-school business models and dirty technology. That makes it a useful case study for illustrating how we integrate the United Nations Sustainable Development Goals (UN SDGs) into our credits investment process.

  • Evert Giesen
    Evert
    Giesen
    Credit analyst

Speed read

  • The automotive industry poses some challenges from an SDG perspective
  • This implies risk for the sector’s medium-term investment performance
  • Companies adopting clean technology could qualify for our SDG universe

Introduction

Careful screening and ongoing monitoring is needed to identify those credit assets in the global automotive sector that can boost not only the short-term financial performance of an investment portfolio, but also contribute to positive long-term outcomes for investors and society.

Most of the companies in the automotive sector are in good financial health, with decent profitability and strong balance sheets. From an SDG perspective, though, the sector presents some challenges.

The transport industry contributes to approximately one quarter of greenhouse gas emissions worldwide. The industry has also seen the fastest increase in emissions, triggering a strong response from regulators in key markets such as the EU and China, to curb fleet emissions and promote the adoption of low to zero-emissions passenger vehicles.

With the highly punitive nature of this emissions-busting regulation, these sustainability concerns have a direct bearing on the financial performance and business case of carmakers, or the so-called ‘original equipment manufacturers’ (OEMs).

Despite these concerns, the sector is by no means a no-go area for our credits team: a handful of original equipment manufacturers (OEMs) have taken convincing steps towards adopting new technology that would position them to meet SDG criteria, thus qualifying them for inclusion in our investable universe.

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Sustainability as a financial factor

The UN SDGs take the quest for sustainability to the next level by making integration tangible and measurable. Investors are becoming increasingly interested in investment products that contribute to the realization of these goals and which at the same time offer attractive returns.

The financial consequences – in the form of fines, compensation and potential license withdrawals – can be very material for companies that fail to act in accordance with the SDGs. Ignoring the SDGs could therefore ultimately affect every investor, reinforcing the relevance of SDG-linked investment strategies.

The Robeco Credits team manages these risks by applying our SDG screening methodology to create a universe of eligible securities. This is then followed by fundamental analysis to identify securities within this universe which are financially attractive, with the aim of optimizing the risk-return profile of the portfolio.

Risky business

The automotive sector performs poorly in the SDG screening framework. In particular, because of the emissions-heavy engineering embedded in their products, the OEMs score negatively on Sustainable Development Goal 11: Make cities inclusive, safe, resilient and sustainable. This negative score is also a red flag for the implied financial and business risks associated with polluting technology.

Ever-stricter country and regional regulations governing emissions, particularly of CO2 but also of other pollutants such as toxic particulates, have a direct bearing on financial performance. OEMs who fail to adapt their engineering to meet CO2 emissions standards face the prospect of business-crippling fines and censure.

Figure 1: Average CO2 compliance cost per vehicle (USD)

These standards seem especially onerous in the light of more stringent testing procedures aimed at reducing emissions under real-world driving conditions. The EU has the most stringent regulatory targets and implied penalties. Japan and China also have punitive measures in place, while US regulation seems to be relatively light by comparison.

Factoring in the assumed impact of emissions regulations in the EU, the US, Japan and China, the CDP estimates that the average compliance cost per vehicle could by 2021 be double the costs calculated for 2015 (see Figure 1). This could climb by a further 50% by 2025.

Not automatically excluded

Viewed in light of the SDG framework, the automotive industry has a negative starting point. The screening doesn’t end there, though, as we evaluate stocks at an individual-issuer level. And, indeed, a core of automotive-related credit securities, including some of the traditional OEMs, do meet the threshold requirements for inclusion in an eligible universe.

OEMs who demonstrate a clear shift towards new technology are potentially eligible for consideration in the next phase of the credit analysis. Rather than relying on abstract targets and ambitious plans for transformation that companies may have issued, our credit analysts look for tangible change.

In particular, OEMs are required to reach a defined threshold of electric vehicle sales as a proportion of total sales in order to qualify for consideration.

Figure 2: Comparison of global CO2 emissions for passenger cars

An electrifying challenge

The trade-off for the industry, then, is committing now to massive investment in new technology in order to avoid future fines and business-crippling censure. The related costs, which include the bill for R&D and for new factories, are substantial and inevitably will dilute margins.

Margins will be knocked further by the fact that electric vehicles are likely to be less profitable than traditional cars in the beginning, partly owing to scale of production being relatively small at first. At this early stage of development, the shift to new technology is mainly towards electric technology. Two or three traditional OEMs have already made considerable progress in this direction.

Conclusion

The costs for companies of not complying with the SDGs can be high. These costs could become an operational and financial burden with serious consequences for investors exposed to these companies’ credit assets. The application of our SDG screening process is a key first step in identifying such investment risks.

The automotive sector is a case in point. Its low SDG score is an important warning signal for investors – and for the industry: new emissions regulations soon to be in force carry high penalties for non-compliance.

OEMs can prepare for these requirements by committing to the necessary transformation costs. Though these costs are also onerous, they are necessary for the long-term viability of the industry. Companies with tangible evidence of having adopted new technology would meet the minimum criteria for being included in a universe of eligible credit stocks.

This ultimately could result in more OEMs becoming eligible – from an SDG perspective – for inclusion in an investment portfolio.

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