November 8, 2021

The death of cars as we know them?

written by Ayrat Maksyutov, Young Hun Kwak & Christian Paul
The death of cars as we know them?

What would the new EU7 emissions standard mean for the automotive sector and its (carbon) strategy?

To achieve the climate goals in line with the Paris Climate agreement, EU countries are in discussions to set a new emissions standard for cars. The new EU-7 regulation is the most stringent one to date, requiring significant technical changes to vehicles to achieve emission reductions. Significant costs and technological innovation required to meet the challenge of the century raises questions as to how the automotive industry can best respond to it. The decisions that OEMs will make will determine their ultimate survival as taking the wrong route might lead to inability to sell cars in the future and in some cases possibly result in bankruptcies.

Changing emissions regulations will shape the automotive sector

Most of the cars on the roads today release a range of polluting gases by burning fuel in the combustion engines. The by-products of the invention that has allowed society to take a leap forward at the end of the 19th century is now causing significant harm to the environment and the society at large. The European Union is now in the process of debating and incorporating more stringent regulations to mitigate the impact of automotive sector tailpipe emissions.

One of the key regulations in the fight against climate change is the limit on vehicle exhaust emissions. European emission standards were designed to eventually reduce tailpipe emissions to zero, with first regulations – Euro 1 – incorporated in 1992.  The discussions are now in place for the 7th iteration of the standard, to take effect from 2025.

With the increasing focus on the environment, also strengthened by the recent events, such as the diesel scandal that shook the industry, the incremental changes in emissions standards are becoming ever more ambitious. The industry is being asked to reduce fuel consumption by 20% from the EU-6 to EU-7 regulation. Over the last 18 years, 6 engine evolutions advancing automotive engineering have only managed a 15% improvement.

It will be even more difficult to test under the new set of standards that will have to be met. Before cars were tested in laboratories, with largely unrealistic conditions. From 2025, the emissions regulations will have to be met, for things such as, driving uphill or starting the engine in the morning and while it is still cold. This puts further pressure on the engineering teams working to provide a lifeline for the combustion engines.

EU-7 – the industry game changer?

The main concern about the EU-7 is the risk that it may lead to an even earlier combustion engine phase out, starting as soon as 2025. Despite the great efforts from automotive engineers, the industry predicts that most of the manufacturers may not be able to reduce vehicle fuel consumption by the required amounts and will have to resort to alternative options. This will create an earlier than expected shift to electric vehicles rather than sticking with improving ICE technology. If the strategy is to accept penalties for breaking the emissions regulations, the fines might increase significantly, raising concerns of companies’ profitability.

Although the regulation will come into force in Europe first, there are signs that other regions would follow suit as the climate movement is gaining momentum across the world. This might also inhibit the strategies of adjusting to the regulations by focusing production and sales activities on other regions.

All in all, this might indicate the start of the end for the companies unable to respond to the CO2-related legislative challenge. With many industries affected, the automotive sector, in particular, seems to be the most vulnerable.

The legislative aspect is also only one pressure point – investors and customers clearly realise that should the automotive firms make a full switch to electric vehicles, it would not imply carbon neutrality. The race for truly “green” cars is yet to begin.

Necessary reform to secure future production

The main question remains as to how the automotive players can address the potential changes brought by the upcoming EU-7 emissions standards. There are a number of options available but most of them can be classified into two categories:

  1. Adjust to the changing environment by making strategic decisions relating to your business operations (e.g. market entry and exit strategy)
  2. Re-organise to incorporate a holistic CO2 system that will help not only address the changing tailpipe emissions regulations but also prepare the business for the bigger challenge of reducing supply chain and operations emissions (also in BEV production)

Market entry & exit strategy will prove key

The first option relates directly to the firm’s market entry & exit strategy based on how competition is reacting and how regulations are evolving. This is perhaps one of the most exciting game theory and strategic interaction questions of the 21st century – namely, how can a firm adjust to the changing landscape without having to spend an extraordinary amount of resources and rescue the revenue streams from declining markets.

Consider an example where an EU-7 regulation applies only to the EU countries. An automotive firm, for example, might decide against opening a combustion engine plant in Europe but instead focus on countries that do not have the risk of a changing regulatory landscape. The firm’s decision would also depend on the actions of the competitors and regulators. The interaction between the strategic decisions of multiple agents is the key aspect that can be solved using game theory. The field of game theory is a branch of economics that investigates strategic interactions between decision makers and helps determine the most optimal course of action.

Establish a functioning CO2 system allowing trade-offs

Firms adjusting to regulations will need to re-think their CO2 strategy for the long-term. This involves creating a holistic mechanism that allows the industry to find the lowest path of CO2 reduction and promote engineering innovation. Reducing CO2 will not only come from tailpipes, but also from the supply chain, operations and design affecting the cars’ energy consumption.

Starting from carbon accounting and carbon target-setting, we need to ensure that the right decision-making tools are in place to incentivise efficient carbon reduction. Mechanisms such as carbon pricing in the form of internal market shaping and supply chain evaluation are key to reducing the costs of CO2. Supply chain evaluation in sourcing decisions will prove to be a key step with the phase out of combustion engines. The shifting focus to BEV will require more efficient production and use of materials.

Incentivising carbon innovation is a key problem for many organisations due to the engineering-driven limitations. The central challenge of addressing innovation can be solved by implementing the right behavioural incentives both internally and externally, applying the latest insight from the fields of behavioural economics and social psychology. More often than not, CO2 reduction requires a significant upfront investment. Effective management of this means considering trade-offs between different parameters by establishing a competition and robust evaluation for the funding.

The path that car makers will take will prove critical to their success (and possibly ongoing existence) in the near and distant future. The problem arising from CO2 is now an imperative that needs to be addressed sooner rather than later. The way organisations will approach this must take into account the strategic implications and consider the respective impact on cost to ensure not only survival but also success in the new “green world”.