The world's automakers, already straining under the pressure of saturated demand in major markets and intense global competition, now face a longer term threat to their financial performance: stringent environmental legislation to reduce vehicle emissions and increase fuel efficiency. In April this year, the U.S. Supreme Court removed potential legal and political roadblocks to stricter rules when it said the Environmental Protection Agency (EPA) must regulate greenhouse gas emissions from vehicles unless it had a scientific basis to avoid doing so. This followed the Bush Administration's "Twenty in Ten" plan, launched in January, to cut gasoline consumption by 20% over the next 10 years (see charts 1 and 2). In Europe, in February, the EU proposed tough legislation to limit emissions of carbon dioxide (CO2) from new cars to 120 grams per kilogram (g/km) by 2012, from the current average 160g/km. This would equate to a gasoline consumption cut of up to about one-quarter. And in Japan, the world's third-largest auto market, the government is considering tightening fuel efficiency standards by nearly 30% as of 2015. (Listen to the related podcast titled, "Can Global Automakers Deal With Stricter Emissions Limits?" dated May 21, 2007.)

Chart 1

Chart 2

The potential cost of meeting these proposed standards is difficult to assess, but a preliminary analysis by the U.S. National Highway Transportation Safety Administration has reportedly estimated the new standards would raise the manufacturing cost--if not the price--of light trucks by $1,900 and cars by $1,300 by 2017. In Europe, industry estimates put the costs at between €600 and €3,000 per vehicle based purely on vehicle efficiency improvements. To meet the targets, automakers will likely have to make further developments in hybrids, ethanol, biofuels, compressed natural gas, hydrogen, and fuel cells.

Standard & Poor's Ratings Services considers that the proposed regulations pose a real risk to global automakers' financial performance, particularly as some are already under pressure from razor-thin margins. While BMW AG (A+/Stable/A-1), the most profitable automaker, generates about €2,200 in operating profits per vehicle, it may also be confronted with higher costs to meet the proposed new standards due to the high CO2 emissions of its fleet. On the other hand, many European volume automakers achieve less than €500, but are already closer to the proposed future emissions target (see chart 3; all figures exclude the contribution from the companies' financial services operations). The U.S. automakers General Motors Corp. (GM; B/Negative/B-3) and Ford Motor Co. (B/Negative/B-3), as well as the Chrysler unit of DaimlerChrysler AG (BBB/Stable/A-2) are struggling with the more immediate concerns of reducing legacy costs and stemming huge cash losses from their North American automotive operations. Only once substantial progress is made in their respective turnarounds will shifts on the much longer-term regulatory horizon become a key factor in the credit ratings. What's more, their ability to make the massive investments necessary for cleaner or more fuel-efficient vehicles will depend to a great degree on how successful they are in returning to sustained profitability over the next few years.

Chart 3

Cars Are Major Producers Of Greenhouse Gases

World greenhouse gas emissions, responsible for global warming, are currently out of step with the 2010 target level set by the Kyoto Protocol. Under the Protocol, developed countries that ratified the treaty committed to an overall 5% reduction in emissions of six major greenhouse gases from the 1990 level by 2008-2012--including CO2, considered the most problematic with respect to global warming. Yet global CO2 emissions from fossil fuel combustion are predicted to rise by more than 40% between 2000 and 2030. The U.S., the world's largest CO2 producer, did not ratify the Protocol. And as a developing country, China, the world's second-largest CO2 producer, is excluded from the current round of emissions cuts (see table 1).

Table 1

Road transport is estimated to account for about one-fifth of total emissions: And they are still rising, particularly those of CO2. This is fueling the debate about the contribution of the auto industry to global warming.

The auto industry, however, argues the current regulatory focus on CO2 emissions, which are directly correlated to the amount of gasoline and diesel a vehicle burns, detracts from advances already made in reducing other emissions from auto tailpipes, which are mainly aimed at improving air quality. Among the substances are carbon monoxide (CO), hydrocarbons (HC), nitrogen oxides (NOx), and particulate matter (PM). The European Automobile Manufacturers Association (ACEA) says there is a trade-off between emissions reduction and fuel consumption, and hence CO2. For example, engineering advances made to reduce NOx emissions to meet the Euro 5 emission regulations planned to take effect in Europe in 2009, could increase fuel consumption, and therefore CO2 emissions, by several percentage points.

U.S. Regulation Has Failed To Cut Average Fuel Efficiency

In the U.S., the world's largest automotive market with more than 240 million registered vehicles, the centerpiece of environmental regulation for passenger vehicles since the late 1970s has been the Corporate Average Fuel Economy (CAFE) standards. From their outset, the CAFE standards created a perverse incentive for automakers to sell more large pickups and SUVs, as they are subject to a separate fuel-economy calculation than passenger cars. In addition, any vehicles weighing more than 8,500 pounds are exempt from the standards entirely, although light trucks between 8,500 and 10,000 pounds will be included beginning in 2011. The result has been a dramatic increase in sales of pickup trucks and SUVs (see chart 4). This has prevented any improvement in total average fuel economy over the past 20 years (see chart 5). This is despite the waning popularity of SUVs in recent years, which has been minimal compared with the previous run-up. Under the current CAFE standards, each automaker must maintain an average of 27.5 miles per gallon (mpg; equivalent to 8.6 liters/100 km) for all passenger cars sold in the U.S., a level which has remained the same since 1990. The standard is 22.2 mpg for light trucks as of the 2007 model year, increasing gradually in the next few years to 23.5 mpg.

Chart 4

Chart 5

The Supreme Court ruling in April that the EPA must regulate greenhouse gas emissions ensures that the regulatory landscape facing automakers will eventually change. It may take years for the EPA to draft and implement new rules, however, and several more before these rules are phased in entirely.

Standard & Poor's believes any new regulations would likely represent some combination of more stringent fuel-economy standards, which have been the regulatory tool of choice in the U.S. for nearly three decades, as well as broader emissions standards that would affect automotive and other industries together, such as a cap and trade (emissions trading) framework. Other possible, but less likely tools would be sharply increased gasoline taxes or regulations targeting specific C02 emissions per vehicle, akin to the approach discussed in Europe.

Before the Supreme Court decision, the EPA's refusal to regulate greenhouse gas emissions prompted several U.S. states to take matters into their own hands. In 2004, California became the first state to pass a law regulating tailpipe emissions, and at least 10 other states have followed suit. But so far the need to obtain waivers from the EPA, which have not yet been forthcoming, and federal lawsuits filed by the automotive industry have barred the states from imposing their own regulations. Congress has also entered the mix following the creation of a global warming advisory panel earlier this year.

Bush Administration plan aims to promote alternative fuels

The Bush administration "Twenty in Ten" plan to cut gasoline consumption by 20% over the next 10 years relies on mandated increases in alternative fuel usage for a 15% reduction in total gasoline consumption. The remaining 5% reduction would come from increases to the CAFE standards between 2011 and 2017. The standards for passenger cars would increase by about 4% each year, reaching 34 mpg in 2017 and saving an estimated 8.5 billion gallons of gas annually. The administration plan calls for light truck fuel economy standards to vary based on several different weight classes.

Although the new Democratic majority in Congress is unlikely to pass the Bush proposal without significant changes, it is worth noting that several Democratic and Republican lawmakers have submitted legislation calling for similar increases to the CAFE standards.

Federal regulators are currently conducting an in-depth analysis of how much these increases to CAFE would cost the automakers. Depending on the health of the auto market and gas prices at that time, some but not all of the costs may be passed on to consumers. Just as important in determining the financial impact of new CAFE legislation will be the degree to which the domestic automakers will still be able sell larger, higher-margin trucks, SUVs, and crossovers, segments in which they still enjoy sizable market shares (see table 2).

Table 2

Europe Gets Tough On CO2

Meeting the EU's proposed legislation on CO2 emissions would require a significant concerted effort by the auto industry and other parties. For now, EU emissions legislation currently comprises the Euro 5 and Euro 6 emission standards, due to take effect in 2009 and 2014, respectively. These standards focus on improved air quality through the reduction of nitrogen oxides (NOx) and particulate matter (PM), rather than CO2 emissions. For the latter, the EU and ACEA concluded a voluntary agreement in 1998 to collectively reduce average CO2 emissions from new car sales in the EU to 140g/km by 2008. This represents about a 25% reduction over 1995 levels and is equivalent to a fuel consumption level of 5.8 liters/100 km for gasoline-engine cars and 5.2 liters/100 km for diesel-engine cars, which now represent just over 50% of new car sales in Europe.

To date, progress toward the voluntary target has been slow: Although emission levels have declined by 13% during the past decade, they still amounted to an average of 160g/km for new cars built in 2005. This equates to a fuel consumption level of 6.7 liters/100 km for gasoline engines and 5.9 liters/100 km for diesel cars. According to a study commissioned by the European Federation for Transport and Environment, 75% of automakers are failing to cut emissions fast enough (see table 3).

Table 3

Recognizing that the voluntary CO2 emissions target will not be met, the new EU proposal sets a mandatory limit for new cars of 120g/km on average, to be met by 2012. Specifically, it calls for emissions of 130g/km to be reached by technological improvements on the vehicles themselves, with the remaining 10g/km reduction achieved through complementary measures. These measures include the partial substitution of gasoline and diesel with biofuels, EU energy ministers having agreed a mandatory target for these fuels of 10% of total fuel usage in the EU by 2020. This in itself is a challenging goal, as the recent significant rise in feedstock prices will make it increasingly difficult for European biofuel producers to reach their profitability targets. Other complementary measures that may contribute to reduced CO2 emissions are more fuel-efficient tires and air conditioning units, and changes in driver behavior arising from a more economical driving style.

Japanese OEMs On Track To Meet Fuel And Emission Targets At Home…

The Japanese auto industry is well on the way to meeting the country's stringent fuel efficiency and exhaust emission targets. In 2005, 86% of new cars sold in Japan had already achieved the 2010 fuel efficiency target of 15.1km/liter for gasoline vehicles, corresponding to 6.6 liters/100 km and CO2 emissions of 153g/km. Overall, CO2 emissions in the Japanese transport sector have declined significantly after peaking at 268 million tons in 2001, and are on track to reach the target of 250 million tons in 2010. However, new fuel efficiency standards, which the Japanese government finalized earlier this year and expects to pass this summer, will require OEMs to further improve fuel efficiency of passenger vehicles (gasoline and diesel) by 29.2% from the 2010 standards by 2015.

Current regulations on exhaust emissions, in force since 2005, are more stringent than the present regulations in the U.S. and Europe. For example, emissions standards for diesel passenger cars are NOx below 0.15g/km and PM below 0.014g/km. New standards, due in 2009, will be even stricter: In diesel-powered passenger cars and certain models of gasoline powered vehicles, will be limited to below 0.08g/km and PM to below 0.005g/km.

…But plan more diesel cars to meet EU emission norms

Aided largely by their strength in producing and selling fuel-efficient small and midsize vehicles, Japanese OEMs are expected to largely satisfy emissions regulations in Japan. Yet stricter emissions standards around the world are putting pressure on Japanese OEMs. Planned CO2 emissions regulation in the EU, in particular, may not be achievable without increasing the proportion of diesel-engine vehicles, currently 20%-30% of the vehicle mix compared with more than 50% in the EU. Most Japanese makers of light vehicles have limited success in diesel vehicle sales to date, due primarily to low social acceptance in Japan and their limited competitive position in the diesel-dominated European passenger car market. Virtually all Japanese OEMs are placing greater emphasis on strengthening their diesel vehicle line-up.

…And aim to share technology costs through R&D alliances

The increasing importance of environmental technology looks set to further accelerate collaborative efforts and alliances in the industry seen in recent years. Toyota Motor Corp. (AAA/Stable/A-1+) and Honda Motor Co. Ltd. (A+/Stable/A-1) are ahead of peers in developing their own advanced technology as they can allocate large operational and financial resources to R&D. Toyota's successful commercialization and leading sales of hybrid vehicles at home and abroad make it a technological leader in the global auto industry. Honda also is a leader in developing clean diesel and hybrid engines. Smaller OEMs, however, are being forced to pursue alliances with larger peers to fund technology development. For example, Suzuki Motor Corp. (A-/Stable/--) has maintained its alliance with GM in various project developments, even after GM's decreased its stake in Suzuki to 3% from 20% about a year ago.

Korean Automakers Plan Shift To Smaller Cars To Meet EU Rules

Korean auto emission regulations currently focus on CO, NOx, and HC emissions. Since January 2006, new gasoline vehicles must not exceed emission targets of 1.06g/km of carbon monoxide (CO), 0.031g/km of NOx, and 0.025g/km of hydrocarbons. Diesel passenger cars must not exceed CO emission levels of 0.5g/km, NOx of 0.25g/km, and hydrocarbons of 0.3g/km. These standards pose no threat to Korea's five domestic carmakers, including rated players Hyundai Motor Co. (BBB-/Stable/--) and Kia Motors Corp. (BBB-/Stable/--), which together hold 70% of the market. The Ministry of Environment is considering stricter measures that would include restrictions on CO2 emissions, but it hasn't yet set target levels. Such regulations might be passed this year and come into effect in 2010 at the earliest.

To cope with changing regulation, particularly in the European market, Hyundai and Kia Motors aim to shift their product portfolio further toward small passenger cars in the short term and invest in developing more efficient engines and lighter bodies in the longer term. But this would weigh on margins. The Korean Automobile Manufacturers Association estimates that for exports to meet the new EU CO2 target of 120g/km by 2012, the cost would be about $4,000 (€3,000) per vehicle. This would put profitability in the European export markets under heavy pressure.

Emerging Markets: How Far Behind Are China, India, And Russia?

China and India are already the world's second and fourth-largest producers of greenhouse gases. And with the number of cars on the road expected to increase 13-fold in the next 30 years to 190 million in China and 80 million in India, emissions from road vehicles are also predicted to grow enormously (see chart 6).

Chart 6

Both countries are working to harmonize emissions regulations with international standards--first, to combat climate change and second, to develop competitive exports. Regulatory efforts are mainly aligned to European Euro standards that currently focus on reducing NOx and PM rather than CO2 emissions (see table 4 for Euro-standard specifications). China is presently using China II, equivalent to Euro II. Certain big cities, such as Beijing, Shanghai, and Guangzhou, have already adopted the Euro III equivalent, and Beijing will adopt Euro IV by 2008, when the city hosts the Olympic Games. The State Environmental Protection Administration aims for the whole country to adopt Euro III and IV equivalents in 2007 and 2010, respectively. An analysis by the State Environment Protection Administration suggests the implementation of these two sets of standards could reduce road-vehicle emissions by 1.8 million tons of NOx, 2.2 million tons of hydrocarbons, and 16 million tons of CO between 2008 and 2012. We expect China to have narrowed its gap to international European norms to five years by 2010.

Similarly, in India, four-wheel vehicles met Euro III norms in 11 metropolitan cities by 2005, and the government will introduce them nationwide by 2010. It will adopt Euro IV norms in 11 cities by 2010.

Standard & Poor's believes further regulations in export markets such as Europe to meet planned CO2 requirements could represent a significant additional hurdle to the export ambitions of burgeoning auto industries in China and India.

Russia's planned staged introduction of Euro norms will lead to Euro V by 2014. Nevertheless, Russian automakers are expected to continue losing market shares to foreign manufacturers. No Russian brands are represented among the top 10 auto marques in Russia and only one--the Lada produced by AvtoVaz--is currently in a favorable position for longer term success.

Table 4

Table 5

Will Emissions Regulations Turn Car Buyers Green?

How, then, will global automakers fare under tightening worldwide emissions regulations? While we are concerned about the effects of the regulations on the profitability of rated global automakers, we also believe that a workable compromise can be reached. Much will depend on the details of any final legislation after industry lobbying. The car industry is likely to press for the costs to be spread more evenly among other industries. In the U.S., top executives from GM, Ford, and Chrysler have recently told Congress they support a federal cap and trade system. Within the auto industry, the question will be how to share the burden of regulations equitably, given that some manufacturers are heavier polluters than others. While some volume car makers such as Fiat SpA (BB/Positive/B), Peugeot S.A. (BBB+/Negative/A-2), or Renault S.A. (BBB+/Stable/A-2) are already well positioned to meet emissions targets, premium carmakers such as Volvo (part of Ford) with average 2005 CO2 emissions of 195g/km, or BMW (192g/km) will find it more difficult (see Table 3).

A greater uncertainty for automakers is how consumers will react to the growing debate over the impact of auto emissions on climate change. In the past, car buyers have let their hearts rule their heads and largely opted for luxury and performance over economy. But changing consumer preferences have already hit the U.S. automakers that have been highly dependent on fuel-thirsty SUVs and pickups. A greater shift in preference for environmentally friendly, fuel-efficient vehicles than consumers have so far demonstrated could weigh heavily on automakers' profits: Such vehicles are typically smaller, lower priced, and carry lower margins than larger, generally thirstier models.

If regulators increasingly target consumers directly by further linking auto emissions to car tax incentives, congestion charges, or speed restrictions, car buyers may increasingly choose environmentalism over engine performance. So despite the threat to financial performance, automakers may have little choice but to continue to find ways to reduce emissions without doing too much damage to the bottom line.

Writer: Jennie Brookman

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