The race to electrify the way we get around is about to get more expensive. The price of raw materials used in batteries for electric vehicles (EVs) is rising. Consequently, this is reversing a long-term trend for declining battery prices. Battery suppliers are seeking to shield their profitability from the spike in lithium, cobalt, and nickel. Supply disruptions are set to ease and will help material and battery prices moderate in 2023. However, strong market demand and tight supply will ensure prices remain higher than they were in 2021. In our view, this will change the way automakers do business. On the one hand, they will explore more tie-ups; and the other, they'll seek to widen their supplier networks and potentially cut out the middleman by directly entering the upstream supply chain. And as EVs increase their presence in the market, this effort to control costs will also involve a willingness to explore different technology options over the next two years.

Meanwhile, we anticipate that the battery suppliers we rate--all of whom are recognized global market leaders--will maintain their dominance over the next two to four years, at least. Their battery capacities and technology will continue to be a vital element for automakers and their production of EVs. The cost volatility that has occurred since the second half of 2021 leads us to believe that battery suppliers will seek to alleviate pressure on profitability by taking a stricter stance on passing on costs.

High Material Costs Delay EV Cost Parity

We anticipate 2022 will be the year in which battery prices halt their long-running decline (chart 1). The penetration into the market of EVs has been rapid. And demand for raw materials has consequently surged. The Russia-Ukraine conflict has also exacerbated the existing supply-chain disruptions and materials shortages--and this against the backdrop of COVID-19 outbreaks. Prices of cathode materials, which normally represent at least 30%-40% of battery costs, more than doubled over the past 12 months up to March 2022. This spike in cost has triggered a pass-through mechanism between battery suppliers and automakers, which has contributed to an increase in battery prices of at least 20%-30% between the second half of 2021 and March 2022.

Chart 1

Raw materials contribute to 60%-70% of the costs of battery packs. Material supply should remain tight because of the time it takes for new mining permits to be granted. And in the case of Chinese battery suppliers, the outbreak of COVID-19 has added a layer of uncertainty to existing logistical disruptions. After seeing their gross margin eroded by four to 12 percentage points in the first quarter of 2022, major battery suppliers will seek to apply their pass-through mechanism more stringently and pass on higher input costs to protect their profitability. Material costs and battery prices may moderate in 2023 as supply chain disruptions ease and the impact of the pandemic subsides. However, the combination of supply shortages and accelerating electrification should nevertheless keep the material cost and battery prices at a higher level than we saw in 2021.

We may see a more meaningful price drop in 2024 as increasing economies of scale lead to higher production efficiency. But what becomes highly uncertain is the inflection point of US$100 per kilowatt hour (kWh) whereby EVs reach cost parity with internal combustion engine (ICE) vehicles. Parity could be thus delayed to the second half of the decade.

Despite The Cost Surge, Decarbonization Initiatives Will Continue And Drive Demand

According to S&P Global Mobility, global EV battery installation will reach 1.0-1.1 terawatt hours (TWh) in 2025 (chart 2). This represents a compound annual growth rate of 30%-40% over 2022-2025. The above-average battery capacity should help maintain EV penetration, which S&P Global Ratings projects will reach 15%-20% globally by 2025, up from 8% in 2021. Many countries are using various decarbonization regulations to encourage automakers to electrify their products. Such schemes include carbon taxes in Europe and a dual-credit scheme in China. Regulators in China, Europe, and the U.S. are also using purchase subsidies or tax deduction schemes to woo customers. As such, the global EV market posted sales growth of 108% in 2021. Together with increasing customer acceptance, this growth momentum should continue, albeit at less buoyant rates.

Despite the surge in battery prices, automakers are committing more to their EV investment. This is aimed not only at adhering to regulatory pressure to electrify their fleets but also at increasing their market presence by offering more EV models across different segments. Global automakers such as Volkswagen AG and BMW AG are aiming for 50% of EV sales by 2030. Toyota Motor Corp., has also joined the fray, aiming to achieve annual EV sales of 3.5 million by 2030. These long-term goals (table 1) should help the battery market grow sustainably over the next few years.

Chart 2

Table 1

Impeding this is the delay in ICE-EV cost parity. This could weigh on the profitability of automakers, especially if we assume that incentives will taper off with volume growth (as has occurred in China and in the UK). The combination of more EV development and greater substitution of ICE vehicles for EVs before the effect of economies of scale kicks in will erode automakers' margins. The contribution margins from new EV models should remain below the current ICE engine portfolio for at least the next few years. As competition intensifies, the pace at which battery costs decrease (below $100/kWh) will determine the success of global automakers' EV strategies. As such, we believe more automakers will strive to secure a stronger battery supply chain (including new battery plants and agreements to procure key components; table 2). Battery supply chain stability will have a cost in terms of higher capital needs. However, we don't view this as credit negative at this stage because it could enable automakers to eliminate supply-chain risk and scale-up production over the long term.

Table 2

Widening The Battery Supplier Network To Mitigate Pricing Pressure

By diversifying their supplier network, automakers could increase their chance of securing sufficient resources and strengthen their bargaining power in the supply chain over the mid- to long-term, in our view. They could increase their pricing power over smaller suppliers by placing big orders on batteries with relatively more mature technology, for example, the NCM523. Over the next two to four years, we expect small-scale battery suppliers to engage in aggressive capacity expansion to capture the emerging growth opportunity (chart 3). According to S&P Global Mobility, smaller players could see meaningful compound annual revenue growth during this period. Estimates include:

• Envision AESC Group Ltd.: 75%;
• Eve Energy Co Ltd.: 60%;
• Svolt Energy Technology Co., Ltd.: 51%;
• Gotion High-Tech Co Ltd.: 41%

Chart 3

Cutting Out The Middleman Will Make A Material Difference

Faced with the limited supply and increasing cost of raw materials, vertical integration with upstream players will become more common. Global automakers such as Volkswagen, Tesla Inc., and BMW are taking matters into their hands by entering the supply chain to secure what they need for production. By cutting out intermediaries, automakers can better control the stability of material supply and cut costs at the same time. Their exposure to the supply chain may not only be limited to securing long-term procurement contracts. Another option they're resorting to is the formation of joint ventures for vertical integration with upstream suppliers.

Similarly, battery makers are also seeking further cooperation with upstream players. China's Contemporary Amperex Technology Co. Ltd. (CATL) and LG Chem Ltd. (LG Chem)--the world's No. 1 and No. 2 EV battery makers respectively--have both signed billion-dollar deals with Indonesian counterparties for domestic investment to build mines-to-manufacturing supply chains over the next few years.

Automakers To Unite To Drive Down EV Costs

We believe more automakers will opt for EV tie-ups to achieve economies of scale. Small-scale production is a key reason for the low profitability of EV businesses. To improve production efficiency, more automakers are sharing their EV production platforms. Over 2023-2028, Ford Motor Co. plans to produce two EV models, with a projected volume of up to 1.2 million units, for the European market based on Volkswagen's modular electric toolkit platform. General Motors Co. and Honda Motor Co. Ltd. announced in April 2022 to jointly develop affordable compact EVs, which are expected to go on sale in North America from 2027.

Cheaper Battery Tech On The Charge But Ternary To Prevail

Lithium iron phosphate (LFP) batteries are at least 10%-20% cheaper than ternary batteries and are free of costly materials such as nickel and cobalt. Recent technology breakthroughs at the battery-pack level have increased the driving range of these batteries without compromising on price or safety. The popularity of LFP batteries follows two recent developments: Tesla's announcement in April that almost half of the EVs it manufactured in the first quarter of 2022 used LFP batteries; and the 388% year-on-year EV sales growth in the first four months of 2022 for BYD Co. Ltd.--a major advocate of the technology and the No.1 EV player in China. Volkswagen, Ford, and Mercedes-Benz Group AG have also announced plans to embrace the technology in their entry models. However, its relatively low energy density prevents it from being dominant in the market. Ternary batteries, like the NCA series and the NCM811, which support longer ranges, will likely continue to be the top picks of automakers over the long term (chart 4). The question is which battery type will be able to achieve lower costs, higher energy density, and more stable performance.

Chart 4

Top Battery Suppliers To Maintain Their Dominance

Chart 5

We believe our rated battery issuers, which are among the top industry players, should continue to lead the global battery market over the next two to four years, at least. The top three global players--CATL, LG Chem, and Panasonic Holdings Corp.--should continue to account for more than 50% of market share during this period (chart 5). Although we see increasing competition from smaller players, tight battery supply means automakers will likely have to rely on the extensive battery capacities and reliable products of our rated issuers for EV production. A potential technology shift to solid-state batteries or other emerging technology may disrupt the current market dynamic. However, we believe our rated issuers will likely be able to mitigate such risk with their top-class technological innovation capabilities over the long term. In addition, they will likely take a more cautious approach to profitability management and become more stringent on the execution of cost pass-through mechanism to automakers after seeing profitability deterioration in the first quarter of 2022.

Where The World's Biggest Battery Makers Stand

Contemporary Amperex Technology Co. Ltd. (CATL; BBB+/Stable/--) (primary analyst: Stephen Chan)

We expect CATL to remain the global No. 1 over the next two to four years, at least. It is the dominant player in China, with just over 50% market share and an expanding international market presence. We believe the company will start mass production outside of China by the end of 2022 with an initial 8 gigawatt-hours (GWh) of annual capacity in Germany. Nonetheless, its adjusted debt-to-EBITDA turned to 0.7x in 2021 from net cash in 2020 because of significant capital expenditure (capex). Higher input costs also caused its EBTIDA margin to deteriorate by an estimated 9.0-10.0 percentage points in the first quarter of 2022 from 18.8% in 2021. We estimate its EBITDA margin should return to 14%-18% because of higher battery prices and operating efficiency improvement over the next two years. However, we see its rating buffer as narrowing due to the margin deterioration, versus our rating downgrade trigger of 15%.

LG Chem Ltd. (LG Chem; BBB+/Positive/--) (primary analyst: Minjib Kim)

LG Chem's battery subsidiary, LG Energy Solution, should remain as one of the leading players in the European and North American market. We anticipate it will be able to maintain its regional market share at 30%-50% over the next two to four years. The company will likely incur aggressive investment on its expansion of EV battery production during the period. It should also see potential profitability swings at its petrochemical businesses due to the dynamic market environment in the sector. That said, it has secured sizable proceeds through the initial public offering of LG Energy Solution. This should support LG Chem's overall credit profile improvements over the next two years.

Panasonic Holdings Corp. (Panasonic; A-/Stable/A-2) (primary analyst: Kei Ishikawa)

Panasonic will likely continue to work closely with Tesla in North America. We anticipate its global market share will decline to 3%-8% in 2022-2025 from 11% in 2021 mainly due to its single-customer focus at its battery businesses. That said, auto businesses only represent about 15% of its revenue. We believe Panasonic can generate stable profit because its business portfolio is highly diversified with relatively low correlation to each other, including home appliances, electrical construction materials for housing, business-to-business products and services, electric components and devices as well as automotive products and batteries. Panasonic's prudent financial management should keep its debt-to-EBITDA at about 1.0x in 2022 and 2023.

SK Innovation Co. Ltd. (SKI; BBB-/Negative/--) (primary analyst: Minjib Kim)

SKI has been aggressively expanding its EV battery production business in recent years. We believe it will enhance its competitiveness and capture the growth potential in the battery market. Increasing oil prices and recovering product spreads have helped the company to recover its earnings over the past few quarters. However, the company's significant capex and working capital swings could keep its ratio of debt to EBITDA over our downgrade trigger of 4.0x in 2022-2023.

Related Research

• COVID Curbs Are Adding Downside Risk To China's Auto Sales, April 14, 2022
• Global Auto Sales Forecasts: Russia-Ukraine Conflict Imperils Recovery, March 23, 2022
• High-Flying Battery Makers Have Much To Win And Lose, June 20, 2021
• The Hydrogen Economy: For Light Vehicles, Hydrogen Is Not For this Decade, April 22, 2021
• The Future Is Electric: Auto Suppliers And The Emergence Of EVs, Feb. 21, 2019

Digital design: Halie Mustow; Writing: Lex Hall