Calculating the cost of the emissions scandal

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Authorities and investors have all been on high alert in the wake of the Volkswagen emissions manipulation turmoil that emerged in September last year. In January 2016, police raids at Renault’s head office and R&D centers in the Paris region sparked new fears that more car makers could be embroiled in similar troubles. Yet, even if no fraudulent behavior was demonstrated, the wave of enquiries in France shows that emissions of pollutants and fuel consumption levels are still center stage for the automotive industry, and risks remain that further revelations in the industry could emerge.

Standard & Poor’s Ratings Services considers emissions-related issues from a financial perspective, but they also influence our assessment of a company’s competitive positioning and its management and governance. For individual issuers, we factor into our forecasts the cost of recalls, technical fixes, penalties, litigation, or other indemnities, and consider how they could affect their credit measures.

We also gauge their commercial impact on companies: a poor track-record on emissions can easily translate into a tarnished reputation and brand perception, loss of market share, reduced earnings, and a weakened competitive profile in an automotive industry that is already fast-changing.

We believe greater regulatory and public scrutiny on auto emissions will raise a number of issues for the automotive industry over the next few years. The VW example has starkly demonstrated that company-specific developments can rapidly erode a company’s credit standing when emissions-related liabilities run into billions of dollars or euros. Even if no fraud is involved, recent emissions tests show there is a persistent gap between performance data reported by car manufacturing companies themselves on fuel consumption and pollutant emissions, and that collected through independent test runs.

This undermines public trust in measures of engine performance and efficiency. As a result, we expect regulators will heighten scrutiny on pollutant emissions and fuel-consumption measures, especially in Europe. We also expect a new impetus in the European Union (EU) for initiatives to test engines’ efficiency under realistic driving conditions and to enforce independent monitoring.

For many years, automotive experts from the EU, Japan, and India have been working on Worldwide Harmonized Light Vehicles Test Procedures (WLTP), a global standard for determining the levels of pollutants and CO? emissions from light-duty vehicles (passenger cars and light commercial vans). The EU adopted a final version in late 2015, with first application scheduled for 2017. Even if finally amended to make it less demanding, the use of WLTP in the EU should better represent real-world driving conditions, and thus lessen differences between on-road and laboratory measurement of emissions in the near future.

Over time, we anticipate the percentage of diesel engines in total sales will also likely shrink in Europe, at least for small vehicles. The performance track-record of diesel engines is strong on fuel consumption, as measured through carbon dioxide (CO?) emissions. Fuel consumption generates the bulk of CO? emissions for any vehicle, and there is a direct and overwhelming correlation between the two. So when authorities are regulating CO? emissions, they are effectively regulating fuel consumption. However, diesel engines’ track record is less impressive in terms of other emissions, such as nitrogen oxide or particulate matter, unless costly additional exhaust emission treatment systems are fitted on vehicles. In some European countries, we are also likely to see a new impetus in favor of alternative powertrains, such as electric vehicles and hybrids.

Overall, we believe that the investment effort necessary to achieve these environmental aims between now and the end of the decade, as well as the impact of recalls and wider controls surrounding emissions, will limit free operating cash flow generation in the industry as high Capex for auto makers will keep their funding needs elevated. This, in turn, could limit credit quality improvements for OEMs in 2016 and 2017.

April 19, 2016

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