Why CAFE May Be Good For The Industry (Especially Detroit)

While the political battle lines over increasing CAFE standards are being drawn in Washington, with the industry taking on both environmentalists and itself, a line of analysis that’s been around since 2009 is exacerbating the industry’s internal divisions over the impact of CAFE increases. A two-year-old University of Michigan study has been exhumed and expanded upon in a new CitiGroup report which makes a bold claim: CAFE will actually improve both sales and profits for the industry. And with Detroit taking the lead in resisting CAFE increases, one might think that the industry’s “turncoats” like Toyota and Hyundai, who have made marketing-led decisions to support CAFE increases, would be the main beneficiaries of these reports. Not so. According to this battle-line-confounding analysis, the biggest beneficiary of CAFE increases will be… Detroit. Madness you say? You may well be right…

We’ve reported on the work of the UM’s Transportation Research Institute a few times before here at TTAC, most notably the 2009 McManus/Kleinbaum study Fixing Detroit: How Far, How Fast, How Fuel Efficient [ PDF here]. That study raised our eyebrows on several occasions, forwarding as it did the counter-intuitive conclusion that Detroit would be a major beneficiary of increased CAFE standards or, as the study puts it “increasing fuel economy standards encourages automakers to create a portfolio of products that is more likely to raise the profits of the Detroit 3 automakers than to lower them”). The study noted:

Our finding that Detroit 3 automakers’ profits would increase under higher fuel economy standards is very robust. We assessed the sensitivity of our prediction of Detroit 3 automakers’ profits to extreme values of 11 uncertain factors we predict for our model, and found that just three of the factors had extreme values capable of generating a drop in Detroit 3 profits: an extremely low consumer response to fuel costs relative to vehicle prices (less than one-fourth Sawhill’s (2008) statistically estimated median value), a gasoline price of $1.50 per gallon (an extremely low price not seen since 1999), or direct manufacturing costs (materials and labor) that are 2.2 times the estimates we used (Meszler) and 3 to 4 times the National Research Council (2002) estimates (adjusted for inflation). While the three factors could result in losses rather than gains in profits, the likelihood of lost profits is low. There is a 7% chance that profits would be less than zero if CAFE were increased 30% (35 MPG), a 15% chance of a loss if it were 50% (40.4 MPG).

As intuition would suggest, the larger mandate increases the downside risk. But it also offers greater upside opportunity, as the chance that increased profits could exceed $6 billion is 18% for a 50% increase in fuel economy, but only 6% for a 30% increase. The total uncertainty attached to the larger increase is greater, which means both more upside and more downside. Overall, the risk and reward profile of these scenarios is very positive, with only a small chance of losing and a very large probability of gain.

That 2009 finding was, however, put in the context of a domestic auto industry in the midst of crisis and restructuring, and as a result it focuses largely on fuel economy as a factor in a larger turnaround. At the time, GM was still emerging from the wreckage of the SUV/pickup market, still suffering from the kind of self-defeating thinking that McManus and Kleinbaum document:

For example, GM conducted internal research for decades that found customers value fuel economy far more than the company’s financial calculations assumed. As publicly reported, the company systematically discounted these research results when calculating the benefits of improving fuel economy, often by as much as two-thirds. In other words, if the research said the sales gain would be 10%, the number used to do financial calculations was 3%. In fact, the belief that fuel economy was not “worth it” became so ingrained into the culture of the company, and so institutionalized in decision making that the senior people might not even be aware that they have been ignoring their own research.

That example, combined with consumer feedback confirming that lack of fuel economy was keeping them from buying American-brand autos is the fundamental basis for the study’s assumption that significant fuel economy improvements are relatively low-hanging fruit. Or, to borrow a slide from the report:

This argument is quite like the one forwarded by the Union of Concerned Scientists recently, which holds that payback in lowered fuel bills will make consumers more likely to spend more for increased fuel economy. Whether that’s entirely true or not isn’t yet clear, although early sales of Ford’s EcoBoost F-150 seems to indicate that it’s possible. Still, whether paying more upfront for longer-term savings (essentially a front-loading of lifetime costs) will prove attractive to the mass market remains very much to be seen (and the study assumes “consumers respond the same to fuel cost as to retail price”). Moreover, the McManus/Kleinbaum study depends on a return to the previously “normal” sales levels of over 15m annual sales by 2016 and over 17m units by 2020, levels which have not proven to be sustainable over the long term without dangerous levels of subprime credit lending.

Which leads us to a Citigroup/Ceres report based on the McManus/Kleinbaum study, which looks to the 2020 period and beyond for further evidence of the UM team’s basic conclusion. That report uses the same GM price elasticity and cross-price elasticity model that the 2009 report relied upon, and assumes the same $4/gal gas price average for its baseline scenario (itself a questionable assumption, given that gas prices have already risen to $4/gal). Though the Ceres report goes into more detail about the market penetration and cost increases of different fuel-efficient drivetrains, the conclusion remains the same as it was in 2009, namely that

Under the simulation, the Detroit 3 gain relative to the industry due to a number of factors, including 1) Narrowing the historical gap between Detroit 3 fuel economy and competitors; and 2) Light trucks and larger cars, in which the Detroit 3 sport a greater share, have greater potential to add consumer value through fuel economy than do smaller cars and car-based trucks. This is because future fuel economy increases have a greater impact on the fuel economy of these larger vehicles, thereby providing more utility to the consumer, and since full-sized trucks tend to be used for commercial purposes, this is a key factor in the purchase decision. Finally, the prices–and therefore the estimated variable profits– are higher for trucks and large cars.

The question that doesn’t appear to factor into the analysis anywhere: can we really rely on trucks to maintain their volume levels in the face of steadily increasing gas prices? Just as McManus and Kleinbaum question whether fuel economy is optimized in the baseline scenario (in turn leading to the low-hanging fruit for Detroit), I would question whether or not truck demand is “optimized” in the 2020 pre-CAFE senario outlined above. After all, the last time Ford’s full-sized truck sales hit the 670,000 unit level was 2007. In order to gain the unique benefits projected in this series of reports, that volume can not continue to decline as it did in 2008-2009 or settle to just over a half-million units as it did last year. Meanwhile, with the overall truck market settling into a 30-year low, that volume (and the low-hanging-fruit profits that underpin the CAFE-is-good-for-Detroit thesis) can hardly be relied upon.

In short, this line of analysis is truly puzzling. If, as it appears, the 2009 report was intended as a justification for the bailout, the Ceres/Citigroup revisit of the theme is puzzling. After all, the thesis that Detroit stands to gain the most form CAFE increases runs directly counter to the lobbying message coming out of Detroit’s governmental affairs offices as well as the Alliance of Automotive Manufacturers. On the other hand, even accounting for the flawed assumptions of $4/gal gas, strong truck sales and the consumer’s willingness to front-load costs (something the American consumer is famously allergic to), the study still sends Detroit in the right direction. Though I wouldn’t rush to assume that CAFE increases (or even higher fuel prices) will spur marginal profitability or volume gains for the Detroit automakers, steadily rising gas prices will have more of an impact on the market than CAFE. Whether profits improve or not, Detroit has little choice but to correct for its decades of anti-fuel-economy planning as the market changes. And, as Detroit has learned all to well in recent years, profits are nice but survival is the bottom line. Survival, not a groundswell of business success, is what should be motivating the Detroit automakers to stop worrying and learn to love (or at least accept) CAFE increases.