Will electric cars create shocking losses or supercharge profits?

by JAMES GAUTREY/ pic by BLOOMBERG

THE auto industry is unloved. Investors worry that profits have peaked, given a sustained period of oversupply and as vehicle demand slows into weaker economic growth.

Meanwhile, it’s becoming increasingly important for car makers to invest if they want to remain relevant in a world of electric vehicles (EVs) and autonomous driving.

Few investors have considered how the transition might look in practice and if the industry may actually stand to benefit. As investors in disruption, this is a hugely interesting idea to us.

Controversy always offers opportunity and this becomes even more valuable as bull markets grow long in the tooth.

What’s the Problem?

In Europe, the market is struggling to see how auto manufacturers can find a profitable way forward.

From 2020, the European Union (EU) will impose a fine of €95 (RM427) per gramme, per vehicle of carbon dioxide emissions over 95g/km, based on a fleet average.

This alone could wipe out the profits of most auto manufacturers if it were to be implemented without any response.

The extreme alternative is to move to fully electric powertrains. A powertrain in a car includes the engine, transmission, driveshaft and any of the internal workings of the engine. In this case, zero emissions would mean zero fines.

But this would erase profits too, as fully EVs are currently loss-making due to expensive battery packs and the lack of economies of scale.

However, there are short-term workarounds and longer-term solutions. We believe investors may be severely underestimating the ability of auto manufacturers to survive, or even thrive, using short-term fixes and as gradual a transition as costs permit.

Furthermore, government assistance is highly likely, as the importance of the sector from a revenue, employment, trade surplus and innovation perspective is under-appreciated.

Is There a Short-Term Fix?

A short-term solution mooted by automaker BMW Group is to introduce small batteries to create plug-in hybrid vehicles. Toyota Motor Corp also offers hybrid equivalents of many of its models.

These engines would still primarily rely on an internal combustion engine, but could comfortably avoid fines due to lower emissions.

Part of the saving made in avoiding the fine would, of course, be offset by the cost of the battery pack, electric motor and power convertors.

According to our figures, this option would diminish profit margins, but the outcome is still better than the “do nothing, pay the fines” route, which sees profits entirely eradicated.

What’s more, car companies are not only offering equivalent plug-in hybrid vehicles, but in general they tend to increase their prices.

What About the Longer Term?

A significant concern for investors has been how the transition to fully EVs will be profitable, given the significant current premium on electric-only cars.

This is an issue at the moment due to the high price of batteries and the concerns overlook how rapidly battery costs are falling.

Battery pack costs have been falling at an average of 22% per annum this decade, according to Bloomberg New Energy Finance, reaching US$176 (RM735) per kilowatt hour (kWh) in 2018.

By 2024, the cost is forecast to have fallen to just US$94 per kWh. Along with density improvement of 6% per year, we believe a battery pack is likely to cost around US$5,640 by 2024.

At that cost, and also removing the price of the internal combustion engine, we have found that fully electric drive trains can materially increase profitability per vehicle, in stark contrast to consensus expectations.

Can Consumers Afford to Save the World?

Naturally, many question whether consumers will be willing to pay more for EVs and if the industry will maintain sufficient pricing discipline. In attempting to answer both of these questions, it will be important to differentiate between the “mass” and “luxury” ends of the auto market.

The running costs of EVs are estimated to be one-third of vehicles with internal combustion engines.

Proponents say this offsets the higher upfront pricing. While this is true, we are sceptical that this will convince most consumers.

Human beings are typically poor at weighing cost now versus savings later (this is known as the “present bias”). That said, higher levels of absolute wealth also enable greater flexibility in thinking long term, so the luxury end should prove more receptive.

Can Governments Help?

Investors should not underestimate the importance of the sector to governments when assessing why the public would bother to convert.

According to the European Automobile Manufacturers Association, the European auto industry employs 13 million people.

This equates to 6% of the EU workforce. The industry generates an €85 billion trade surplus, yields €485 billion in tax revenue and spends €58 billion per annum on research and development (R&D), which is 28% of total EU R&D spend.

In Germany, the importance is even more pronounced. The auto sector contributes over US$500 billion of output per annum, 65% of which is exports.

It generates 15% of German GDP and much more when one considers indirect effects such as housing, general consumption, and so on. As a proportion of its home economy, the German auto sector is bigger than US tech.

Governments are therefore likely to play a much bigger role in the transition to EVs than many believe. Subsidies for EV purchases already exist in several EU markets and could be expanded.

Duties on petrol or diesel could be increased to incentivise people to switch, while financing schemes can bridge the present bias gap described above.

It is also conceivable that other sectors may be drawn in to help this effort. Why should auto manufacturers carry all of the burden? BP plc’s Annual Energy Review for 2018 noted that “electrification without decarbonisation” is meaningless — if an EV’s source of electricity is actually a coal-fired power station anyway, the net benefit to society and our environment may be zero.

This bodes well for the renewable sector, in our opinion, and we expect more positive steps to be taken, potentially lifting some of the burden from autos.

What’s Around the Corner?

The moving parts are in place. The transition to plug-in hybrid vehicles and EVs looks set to positively surprise the market.

If the industry can adjust their prices on top, the potential increase in profits could be enormous. In short, investors may be severely underestimating the ability of auto manufacturers to survive using short-term fixes and a gradual transition as much as costs permit.

Furthermore, government assistance is highly likely, as the importance of the sector from a revenue, employment, trade surplus and innovation perspective is under-appreciated.


James Gautrey is the portfolio manager for Schroders Investment Management Ltd.