TUESDAY, 30/07/2024 - Scope Ratings GmbH

ESG considerations for rating automotive companies: energy-transition challenges weigh heavily

Addressing climate change and reducing pollution, amid growing concerns about the impact of vehicle emissions on public health, remains a long, costly and painful journey for the automotive industry, original equipment makers (OEMs) and suppliers alike.

The shift from road vehicles powered by internal combustion engines (ICEs) to zero-emission electric vehicles (ZEVs) is transforming the entire automotive value chain and reshaping the competitive landscape, Scope Ratings said in its latest study looking at the ESG considerations for rating different industrial sectors.

“This shift is putting considerable pressure on legacy automotive players, forcing them to rethink their business models and product portfolios, convert their manufacturing facilities, realign their labour structures and face economic/ strategic trade-offs, with limited visibility on their future return on investment,” said Georges Dieng, director in corporate ratings at Scope.

“We have identified the following four main themes relevant for the automotive industry as a whole and for our environmental, governance and social assessment that could affect an automotive manufacturer’s or supplier’s creditworthiness,” says Dieng.

Climate transition risks and decarbonisation strategies
Resource efficiency, circularity and product innovation
Workforce transformation, supply chain management and responsible production
Regulation, political intervention and reputational risks

For OEMs, adjusting to these changes and the associated decarbonisation commitments requires significant upfront capex and R&D spending. This includes creating new purpose-built vehicle architectures, deploying a wide range of electrified models, repurposing existing ICE factories for EV production, ensuring access to battery cell production capacity (‘gigafactories’) and securing supply of critical raw materials.

“In addition, most OEMs intend expanding their vertical integration to control a higher share of the BEV value chain (70/80% vs 45/50% for the ICE value chain). This is already visible in the substantial multi-year investment plans launched by automakers in the past few years and such spending may last for much longer than currently planned.”

Furthermore, there is limited visibility on the potential return on such investments.

First, the EV technology is still immature and subject to rapid changes which may impact battery performances and residual values of current EVs. Secondly, consumer behaviour remains unpredictable, with residual hesitancy in shifting to BEVs visible in the current slowdown in the pace of EV adoption after three years of strong uptake. Thirdly, the regulatory environment remains unstable in many regions, subject to changes in government policy depending on the electoral calendar, with much at stake given the shifting political landscape in Europe in 2024 and the US presidential election in November.

The shift to an electric world will continue to put pressure on the sector’s profitability due to the higher production costs for hybrid and electric vehicles than for ICE vehicles. Reaching ICE/VE cost parity will not be easy nor linear as it primarily hinges on lower battery-pack prices, efficient battery technology and economies of scale.

Auto manufacturers are currently stepping up their efforts to cut EV-related costs to address the slower-than-expected improvement in EV contribution margins (revenue minus variable costs), due to the price war initiated by Tesla Inc. since early 2023 and the growing competition from low-cost Chinese EV manufacturers.

The structural shift is already transforming the entire automotive industry and reshaping the competitive landscape. This will likely contribute to lowering the industry’s barriers to entry and provide new EV entrants such as Tesla and China’s EV players with an opportunity to leapfrog legacy ICE-focused OEMs.

All in all, the potential adverse credit implications for legacy automakers include downward pressure on profits and cash flow, impairment of existing projects or previously capitalised development costs and the risk of current ICE production facilities and assets turning into stranded assets.

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