In September 2015, the industry – and VW in particular – was dealt a seismic shock when it became clear that VW had sought to cheat US emission testing procedures with its diesel vehicles. Since then there has been much debate as to the impact this revelation – and other subsequent revelations – will have on diesel demand and on the company. In terms of diesel demand, the focus is on the European situation, as the market accounts for over 50% of worldwide light vehicle diesel volume. After considering the diesel market, the attention then switches to examining the particular impact on VW as a company.
The European diesel market
To begin consideration needs to be given to the drivers that dictate diesel demand in Europe, what their influence on demand is currently and how their influence might have changed as a consequence of the VW scandal.
Usage and total cost of ownership
Usage, shorthand for miles driven, and total cost of ownership are a significant component of diesel demand. Research from the UK's Automobile Association has modelled the cost per mile of diesel and petrol passenger cars at various vehicle price points and annual mileages. Costs in the analysis include initial purchase price, insurance, fuel, servicing and depreciation. The table summarises the difference in pence per mile costs for diesel and petrol cars resulting from the AA's research. It shows that typically for smaller/cheaper cars diesel is not a cost effective fuel as the initial incremental cost of the diesel powertrain compared to petrol is a bigger proportion of purchase price and therefore difficult to amortise unless really big annual miles are done.
Tax regimes are a really important component of diesel demand in Europe particularly as many countries now tie vehicle taxation to CO2 emissions, due to Europe's primary environmental focus being on greenhouse gases to slow global warming. Taxing by CO2 favours the diesel market, because diesel engines are inherently more fuel efficient. CO2 registration taxes are in use in 15 out of 27 countries in Europe, while ownership taxes tied to CO2 are in use in 13 out of 27 EU countries.
One of the best, or most extreme, examples of CO2 registration taxation has been in place in France since 2008 when a bonus/malus scheme was introduced. Upon introduction in 2008 individuals purchasing cars emitting less than 130g of CO2 per km received a payment of anything between EUR200 and EUR5000 depending on CO2 emissions. Those buying cars emitting between 130g and 160g were in a neutral position, and those buying cars over 160g had to make a registration payment anywhere between EUR200 and EUR2600. The scheme has been modified over the years with the aim of ratcheting down CO2 emissions of new cars.
The scheme transformed the CO2 profile of the French market almost overnight with CO2 g per km falling 11% in two years between 2007 and 2009, to a position in 2014 when the new vehicle fleet emitted 114g of CO2 per km.
As well as taxes on acquisition taxes on ownership are a significant component – for example both in Germany and in the UK they are CO2 based. However, led by Paris, many cities in Europe are either discussing or implementing bans or taxes on diesel usage in urban environments, which has generated significant news coverage over the last 12-18 months. With the revelations regarding VW's diesel NOx emissions this debate is sure to intensify.
As shown in the total cost of ownership discussion, diesel cars are more expensive to purchase than petrol cars, mainly because diesel engines are more costly to manufacture than petrol engines – even without consideration for the increased cost of exhaust aftertreatment that is necessary for diesel cars to meet European exhaust pipe emissions. The comparative costs for petrol and diesel cars to meet EU4 to EU6 limits are shown in the chart.
However, what has happened in Europe is that because of deflationary pricing in the EU car market – compared to the European consumer price index – and competitive pressures, it is not always possible for OEMs to pass the cost on to consumer.
It's about to get worse for the OEMs too, as late in October it was confirmed that real driving emissions would be phased in from September 2017 as part of the EU6c regulation. In real world testing NOx emissions have been found to be on average four times higher than those certified so legislators are clamping down on the disparity. Initially legislators will allow NOx emissions to be 110% over the current limit, but the limit will be cut to 50% more from 2020. This will, in all probability, introduce further costs for the OEMs and there is a possibility these costs will have to be fully absorbed by consumers this time.
The vehicle end market is also an important component of diesel demand in Europe. In the UK, fleets and company cars account for about 40% of new vehicle registrations, while in Germany it is around one-third of the market and in France it is about a quarter of the market. The fleet market is more diesel biased; fleets tend to include higher annual mileage drivers and on a total cost of ownership basis diesel often makes the most sense. Indeed, within Europe diesel penetration in fleets is estimated at 80%, some 30% higher than the total market.
However, evidence has emerged that the fleet market is beginning to move slowly away from diesel. The UK based CLM Fleet Management company has reported that while in Q4 2014 diesel accounted for 90% of its fleet, this had fallen to 86% from Q1 2015 with petrol being the beneficiary of this decline.
As evidence from CLM shows, petrol engines are beginning to make inroads in Europe and that is mainly due to petrol engines becoming real alternatives to diesel in efficiency terms. The main enabler of this shift has been downsizing, the process of reducing engine displacement but making up for the smaller displacement by introducing turbocharging. This is a global phenomenon that is resulting in a global turbocharger market that is turbocharged itself, with a 2015-30 growth CAGR of 6% compared to the total industry's 3% CAGR.
In addition, hybrid and electric vehicle technology is moving on a pace and starting to emerge as a more significant challenge to diesel's hegemony in Europe.
Diesel has already peaked in Europe
The diesel demand components surveyed already negatively impact diesel. If we look at diesel volume and share in the Big 5 European markets – Germany, France, UK, Spain and Italy – we can see diesel is starting to move off its 2011 peak of over 56%.
So with diesel already on the decline in Europe how does the VW scandal affect each of the individual drivers?
In terms of usage/TCO we see a minor impact, though there's a suspicion that diesel car residual values could be negatively impacted. Evidence thus far is scarce and contradictory, UK residual value experts have opposing points of view on the topic. In the medium-term, the introduction of RDE has the potential to increase prices of diesel cars.
We do not anticipate European countries' approach to registration taxes in Europe to change because of the VW diesel crisis – countries still need to promote lower CO2 cars be they diesel, petrol or alternative fuel vehicles. However, usage taxes could be significantly affected with European cities and towns lining up behind Paris and London and introducing urban usage cost or outright bans on diesel in urban areas. The Parisian viewpoint has been brought sharply into focus with the affirmation that NOx emissions are an issue even under EU6 legislation.
The appeal of alternatives to diesel such as downsized petrol engines and hybrid vehicles will rise due to the VW imbroglio, although developments in gasoline technology and hybrid technology – particularly the coming new advanced mild hybrids – will nudge this trend along further.
In fleets there might be increased Corporate Social Responsibility issues for fleet managers to consider on top of existing TCO monitoring.
Due to the above considerations, we adjusted our diesel fuel forecast in our last round of forecast updates in October. While it is still very early to say we estimate that the impact could be as much as 5% out of West European take rates for diesel in our near- and medium-term forecast window. This embellishes the decline in diesel penetration in West Europe we had already factored.
Why should this be a concern for the industry?
Why should this all matter? Well Martin Winterkorn – VW's deposed CEO – gave us some guidance back in March 2015. Then he was on record saying, "Let me be very clear about one point: those who talk down diesel are jeopardizing CO2 targets".
Diesel has been a significant contributor in European OEMs collectively meeting their 2015 CO2 target of 130g a year early in 2014. However, the need to improve is relentless and the next target of 95g begins to phase in from 2020. So if diesel does suffer which companies are going to be most affected? It will be those OEMs with the highest penetration of diesel – BMW, Mercedes, PSA and VW from EEA figures – and those with the biggest gap from 2014 to the 2020/21 target.
It will mean more hybrids and EVs in the mix to meet CO2 target – and those vehicles will have to be made at lower cost or further incentivised. If the OEMs are not successful in altering their fuel mix to meet target the OEMs will have to pay fines for each gram of CO2 their fleet exceeds the CO2 target. Moreover, from 2019 the fines will be EUR95 for each gram over the limit. Therefore, hypothetically for example, if BMW, which has a 2020/21 fleet target of 102g, was to come up short with a 105g average it would potentially have to pay a fine of over just over EUR216 million based on its 2013 registrations.
The impact on VW
Much of the opprobrium that VW has attracted since its admission that it installed defeat devices in its cars has centred on the culture that the company's Strategy 2018 objectives helped nurture. Despite Strategy 2018's four objectives: the most satisfied employees and customers in the world; sell more than 10 million vehicles a year (achieved in 2014), and a profit margin of more than eight per cent, the company's focus was seemingly on one unmentioned goal: toppling Toyota and GM and becoming the world's number one automaker at all costs.
This goal has a history of causing upset in the automotive industry as Jim Womack, co-author of the seminal work on lean-thinking in automotive "The Machine that changed the world", reminded us in a piece written for Planet Lean in September 2015. Womack wrote this: "In 1999 Toyota adopted a new strategy called Global 15. It stated that the objective of the firm was to capture 15% of the global motor vehicle market by 2010 (to make Toyota Number One in market share) and that managers should do what it took to get there. This to me was a complete reversal of 60 years of lean thinking. It was now: Toyota First rather than Customer First. (And, as with VW, no customer – not one – cared about this restated purpose)." Most in the industry trace back the quality issues that engulfed Toyota in the late 2000s to the company's collective desire to meet the challenge of Global 15.
VW has issued a couple of strategic missives since the scandal unfolded, among them the following list of actions that demonstrated it's taking the emissions issue seriously and speeding the development of alternative powertrains, but acknowledging that investments will have to be reduced by EUR1 billion a year to pay for the emissions fixes:
- SCR only for future North American and European diesels
- MEB electric toolkit
- MQB development for alternative powertrains
- Next Phaeton all-electric
- Investments to be reduced by EUR1 billion per year compared with planning – combined with prioritisation of projects for the future
Cost of capital
Following the diesel revelations there was an expectation that VW's cost of capital would increase markedly, which is of central importance to any investment decisions VW will make as it will change the internal rate of return requirements for investment on a project by project basis.
Thus far, it has had no problem securitising its car finance and issued EUR875 million of Asset Backed Securities in late October 2015, which were accompanied with the usual risk spread.
However, there have been negatives. Both Moody's and Standard & Poor's downgraded VW's credit rating by 2 points early in October and, in early November, Fitch joined them by downgrading by 2 points. VW's 5yr credit default swop spreads have also reacted negatively to the crisis.
Overall, it seems the cost of capital outlook is stabilising, but as the story continues to unfold it still seems susceptible to shocks as illustrated by credit default spreads spiking again in the first week of November when VW admitted problems with the CO2 ratings of its cars in Europe.
As we have seen the fleet market is an important consideration in the wider European market, so how are fleet managers in Germany likely to respond? In October 2015, German automotive fleet consultants Dataforce carried out a survey of 553 German fleet managers.
From the results, it seems that the impact on VW sales might not be as negative as one would think; 70% reported no change in their purchasing; 7% would reduce their purchasing of VW vehicles, while 1% saw an opportunity to increase their VW purchases presumably on the thought that there will be some attractive incentives to purchase VW vehicles.
However, a sizeable 22% could not commit either way and their decisions will surely be based on VW's handling of the crisis and if there any further revelations, so VW has considerable market volume at stake here.
In terms of the impact on sales in Europe for VW it is too early for major inferences due to lead times between customer order and delivery. However, as we can see the VW brand has underperformed the market in both Germany and the UK in October. It also seems probable that presently VW branded vehicles (as opposed to Audi, SEAT or Skoda) might be disproportionately affected as the scandal has seen the name VW bandied around widely in the press. Consumers might thus focus on the VW brand rather than the wider corporate entity, which could explain Audi outperforming the market in Germany and the UK in October 2015.
Big investment decisions looming?
While the big decisions regarding strategy will depend on the extent of the recall costs, fines and litigation costs that VW ends up paying – estimates vary between US$7 and US$83 billion – the company itself seems to acknowledge that all options are on the table. In November 2015, Matthias Mueller, new VW Group CEO, stated "In the present difficult situation we must jointly factor in economics just as much as employment…I attach great importance to the views and experience of our works councils."
While there are endless possibilities as to the actions open to VW the "elephant in the room" so to speak is SEAT. Looking at VW Group's operating margins by brand for the first 9 months of 2015 compared with the prior year shows SEAT as barely profitable this year while being loss-making in the prior period.
SEAT's Martorell home, which has capacity of some 550,000 cars a year, has already taken on some wider VW Group production responsibility with the Audi Q3 being built there since 2011 and Martorell could be turned over to manufacturing group vehicles (if incremental capacity remains a requirement) while letting the brand itself wither on the vine by restricting future investment.
Results from just-auto's annual confidence survey
Finally, as part of just-auto's annual confidence survey we asked our readership – consisting of automotive industry professionals from around the world – what their thoughts were on the crisis for VW. The vast majority see the business surviving the crisis but they are clear that the corporate culture drastically needs to change. Around a quarter thought VW would just brush off the crisis, while 17% thought the crisis threatened the company's very existence.