By Dr. Maximilian Martin
An epochal transformation of mobility is under way—comparable to replacing horses a century ago. Cars are becoming clean-energy powered computers that transport passengers. On July 5, 2017 Volvo’s CEO Håkan Samuelsson set 2019 as the date for the total phase-out of combustion-engine-only models. From then on, the Chinese-owned Scandinavian carmaker will make all of its cars electric or hybrid. Companies that fail to adapt to the shift toward sustainable business will carry higher levels of environmental, social and governance (ESG) risk. The question is, how soon will this affect their cost of capital?
In Germany, home to Europe’s largest auto industry, a consortium of 17 German firms and research institutes unveiled plans for a new lithium-ion battery plant designed to rival Tesla Inc.’s Gigafactory a few weeks ago. In the U.S. luxury car market, Mercedes-Benz, BMW and Audi all had a market share over ten percent in 2016.
As they strive to stay competitive in the new clean mobility paradigm, there is a dark cloud. What do dieselgate and its aftermath mean for the car industry? How do the approximately 8.6 million diesel vehicles currently registered in Germany that fall into the Euro 5 emission class or the concerned part of the Euro 6 class fit in?
On Track to Stranded Consumer Assets
The 2015 Volkswagen “dieselgate” emissions scandal has put Germany’s car industry on the defensive. Recent accusations are raising the temperature. Germany’s leading automakers may have been colluding to minimize the costly cleaning of nitrogen oxides responsible for air pollution stemming from diesel engines. And those who did not may still suffer from the overall loss of confidence.
To find solutions, the German government convened the country’s auto industry leaders at a “Diesel Summit” on August 2, 2017. Instead of providing a powerful new argument to invest in a bright low-carbon, low-pollution future, the Summit looked like an exercise in damage control.
Among diesel car owners and the public, emotions are running high. In Germany and elsewhere, they want to know how their cars fit in with the future of mobility. Since the first Euro emissions standards for diesel cars to reduce harmful pollutants from vehicle exhausts were set in 1992, the European Union tightened the screw with every subsequent directive. Introduced in 2015, Euro 6 further reduces levels of harmful car and van exhaust emissions in petrol and diesel cars, covering nitrogen oxide (NOx), carbon monoxide, hydrocarbons and particulate matter (basically, soot from diesel engines). Under the new Euro 6 standards, the maximum admissible level for NOx in diesel models drops from 180mg/km under Euro 5 to 80mg/km.
Mechanical retrofitting with Selective Catalytic Reduction (SCR) active emissions control technology is costly—but could bring NOx emissions down to the required levels. In lieu, the automakers propose installing a new software patch in more than five million diesel cars, counting in the 2.5 million Volkswagen vehicles where work is already in progress.
As a result, people’s second largest ticket item after buying a house risks becoming a stranded consumer asset. With bans on driving looming, drivers may soon no longer be able to circulate in all cities as they please. The Diesel Summit also called for retiring some of these assets by getting owners of vehicles falling into the even dirtier older Euro 1 to 4 emission classes to buy new cars, offering a premium.
Raise the Curtain for Sustainable Long/Short Strategies
To capitalize on the shift toward sustainable business models and laggards’ higher exposure to ESG risk, moving beyond long-only equity strategies on capital markets a logical next step.
Backing the sustainability winners and betting against the losers would send a powerful signal—and can secure attractive financial returns. After six consecutive quarters of net outflows, according to data firm HFR, the hedge fund industry has stabilized, with allocations to hedge funds outweighing redemptions by USD 1.2bn in the second quarter of 2017, bringing total assets under management to USD 3.1tn by the end of June. Hedge fund performance is expected to continue to be dampened by low volatility though.
Notwithstanding, conditions are now moving into place that could see the hedge fund industry giving sustainable investing a helping hand in a not too distant future. The Diesel Summit’s inaction could be catalytic. Because of their ability to sell short, hedge funds can generate a part of their performance from the return differential between their long and short positions. High stock dispersion helps generate returns, and is characteristic of the sectors of interest to sustainable investors. For example, the FTSE Russell 3000 Index covers the 3,000 largest publicly held companies in America as measured by total market cap and represents approximately 98% of the US public equity market. Energy, healthcare, and technology are the high dispersion sectors on the Index. These are also sectors that investors consider when they are looking for sustainable investments. Modern finance can now help them direct capital away from unsustainable business models.
The Great Sustainability Game Is On
Increasingly, sustainability related company data is becoming more sophisticated, available, and therefore market relevant. There is growing clarity in terms of which firms are successfully embracing the new sustainable business models that disrupt industries, and who are the laggards.
What will happen to the concerned German automakers when the established hedge funds discover sustainability? Will “guilt by association” also undermine sales of the ones who played by the rules? The stakes are huge. According to the RWI – Leibniz-Institute for Economic Research, 1.76 million German jobs depend directly or indirectly on the auto industry. If diesel sales keep tanking, automakers will not be able to fulfill the European Union car fleet target value of 95 g/km of CO2 from 2021 on. Billions of Euros in fines would provide a blow to company valuations.
This will create volatility and return differentials that can be translated into value. As an unintended consequence, by doing too little, the Diesel Summit may well end up helping fast track sustainable investing. Backing the likes of Tesla, Volvo or shorting the horse—the great game is on.
[Dr. Maximilian Martin is the Founder and President of the Board of Impact Economy and the Founder and President of the Board of the Impact Pledge Foundation. Always interested in anticipating what is next, he has led and participated in numerous projects and innovations in the impact space and co-created the contingent returns model that forms the basis of the Social Impact Bond (SIB), a major innovation in public finance. His more than one hundred articles and position papers have helped define the trajectory of market-based solutions and the impact revolution in finance, business and philanthropy.]
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