The Volkswagen-scandal and its effect on diesel markets

Global dieselization will not end because of the scandal, but probably less people will buy diesel cars in Europe. The following post is our early take on the potential results, focusing on the economic and energy market effects.

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By Peter Simon Vargha and Csaba Gábor Pogonyi.

Here is the quick summary:

• Volkswagen seriously cheated on diesel car emission tests. At least 11 million diesel cars are affected worldwide

• There are indications that the scandal might reach other carmakers, but this is not certain at this point

• No easy and cheap solution exists at the moment for Volkswagen

• Diesel regulation will change in Europe. The scandal adds to already increasing concerns about diesel’s environmental effects. This might lead to higher diesel excise taxes in Europe in the longer run as well as other measures, e.g. congestion charges

• Global dieselization has not been driven by European cars. Moreover, 100 million diesel cars will not vanish overnight in Europe: thus the effect of the VW-scandal on demand change will likely be slow

• Dieselization may still halt in the next couple of years, due to other factors, primarily slower growth in emerging economies

• In the medium run, a rebalancing towards gasoline from diesel in European car sales could actually help European refineries in general, as both their gasoline surplus and diesel deficit would shrink

• In the longer run, fossil fuel demand faces an increased risk, as the scandal may bring forward the spread of plug-in hybrids and electric vehicles. This may happen if there is a wider loss of reputation of carmakers or if regulation changes dramatically
  

The scandal might reach other carmakers, too

Volkswagen decided to cheat because installing an effective filter device would have been too costly, making some of its cars (especially the smaller, cheaper ones) uncompetitive. In effect, they wanted low consumption, high power and low emissions, all of which was not possible at the same time.

However, independent emissions tests of other diesel carmakers also show wide discrepancies versus the stringent limits (see chart below). This suggests that others might have cheated, too, and not just on NOX, but on other emissions tests as well. Some independent testing organizations (involved in uncovering the case) think the VW case is just the tip of the iceberg.

The scandal has reached the stage where new scrutiny might bring up other findings in the coming weeks or months. Tests will be brought closer to real-life conditions and harder to game (there have been other, already well-known ‘tricks’ as well to bring down CO2-emissions, like overinflating tires, disconnecting the battery during tests or taping parts of the car body).

This is a European story

The vast majority of diesel passenger cars have been sold in Europe. In 2014, 53% of the cars sold in Europe were diesel, compared to only a few percent elsewhere. Outside Europe, diesel is mainly used in freight transport, i.e. trucking. Thus, despite the fact that the scandal started in the US, the biggest question is what happens in Europe (from the 11 million cars currently affected worldwide over 8 million cars were sold in Europe). It seems to be sure now that diesel passenger carmakers can forget the US market, for which they had high hopes.

Why did diesel cars spread in Europe in the first place?

The dieselization of European passenger car fleet in the last decades has been due to a number of factors, including favorable regulation and a push from manufacturers (see vox.com’s summary, and the 2013 paper it cites). But there is a third factor, which got less attention even though it was equally important: the generally high fuel excise taxes in Europe helped diesel a lot. That’s a fantastic read for you.

Diesel cars consume roughly 25-30% less fuel (in volume terms) for the same performance as a comparable gasoline car. If excise taxes are high then the cost of fuel is a relatively large chunk of the total cost of ownership. And that makes fuel-efficient diesels relatively cheaper to gasoline cars. This is why you will often see business fleets being composed mainly of diesel vans and trucks. Company car tips for businesses often mention diesel as being the financially wise move. The more cars in your fleet, the more you save from being on diesel. This explains why most diesel vehicles are “on the clock” as they say.

The following two charts make this point clear. The first shows a rough comparison of simplified ownership costs of gasoline versus diesel Ford Focus, here in Hungary, as a function of annual distance traveled. Diesel cars cost more, but the fuel cost is less. Thus if one travels a lot, it is worth buying a diesel car. The breakeven in this example is around 16000 kilometers. The breakeven point depends on the actual car, consumption figures and interest rate used, so this may differ car by car, but the general tendency is similar.

*: simplified total cost of ownership (car price+fuel cost only), current Hungarian end user prices, 3% real discount rate Source: own calculations, spritmonitor.de (actual fuel consumptions ), ford.hu

Now let’s change the fuel prices to USA price levels (where excise taxes are much lower) – this is shown in the next chart (with the axes unchanged for better comparability). Apart from fuel prices, all other factors are kept equal to those on the previous chart. With the lower fuel prices the breakeven is around 30000 kilometers, double the Hungarian level.

*: simplified total cost of ownership (car price+fuel cost only), 3% real discount rate. Source: own calculations, spritmonitor.de (actual fuel consumptions ), ford.hu, eia.gov.us

This example shows that the high level of excise taxes makes diesel cars much more competitive in Europe. It also suggests that if diesel car costs increase then the threshold where diesel cars break even increases, thus less people would opt for diesel. The big question going forward will be exactly this: by how much will the cost of diesel cars go up in the aftermath of the VW-scandal.

No easy and cheap solution exists at the moment

So far it has proven costly and difficult to reduce NOx emissions in diesel cars, and the cheaper the car the larger are the relative costs. This motivated the cheating.

There are two basic possibilities for new diesel cars entering the market: 1) that Volkswagen (and potentially others) find a way to reduce their diesel emission levels by installing new devices at relatively low cost and not much reduction in performance now that the even lower cost option, fiddling with the software, is no longer available 2) that these devices would be so costly that diesel-fuelled passenger cars significantly lose market share in Europe.

It is certain that the current scandal already affects the diesel share of new car sales, and it seems unlikely that diesels could spread outside Europe. This is despite the fact that Volkswagen has said that the cheating does not affect its newest models. It is too early to tell whether this is actually the case.

We would not rule out a case where diesel passenger cars are driven out from the European market by the 2020s. A more likely scenario is that the cost of efficient emission controls relegate diesel engines to larger cars/SUVs even in the European markets.

The scandal might lead to higher diesel excise taxes in Europe in the longer run

Diesels, especially older models emit a lot more small particulate matter and NOX than gasoline cars (although new direct injection gasoline cars also need filters because of high particulate matter emissions). Up until now, European regulation has favored diesel cars: its registration and excise taxes are lower in many countries.

But even before the VW-scandal, the policy stance towards diesel had been starting to change, due to its higher emissions. France, for example has announced it would reverse its policy and the VW-scandal may create a momentum in this (actually by far the biggest source of emissions are old diesel cars, trucks and buses, not the new cars.) Higher relative price of diesel can increase the incentive to switch: in the passenger car market it can lead to a switch to gasoline or hybrid cars, whereas in the light- and heavy-duty market it increases the incentive to switch to other fuel-types (like natural gas).

Particulate matter and NOX are local pollutants. Hence the scandal may also give a boost to movements which want to ban diesel from highly polluted city centers or want to introduce congestion charges.

Global dieselization has not been driven by European cars

Many have already started talking about the ‘end of diesel’. These fears are unwarranted in the short and medium run. One should not forget that recent global dieselization has been rather a result of the rapid growth of emerging markets (see chart below). The vast majority in diesel growth and consumption itself in fact came from trucking and not passenger cars.

Source: IEA

In fact even in Europe, only around a third of the diesel is consumed by passenger cars, while two third is used by freight transport. In trucking, emission limits are less strict and the relative costs of abatement seem lower, the cost of filters, etc. are smaller compared to the cost of a truck.

100 million diesel cars will not vanish overnight in Europe: the effect of the VW-scandal on demand will likely be slow

Even if diesel cars lose market share in Europe, the effect on demand will be very slow. This is because each year only a fraction of cars are replaced, and in fact the diesel car fleet (more than 100 million cars in the EU) is on average younger than the gasoline one (due to an increasing trend in diesel sales). The diesel cars currently on the streets are unlikely to be banned outright (although they may be banned from congested centers in some places and their resale value might suffer).

Because of the slow change in stock, despite the fact that European diesel cars represent a non-negligible part of global diesel demand (7% according to our estimates, see chart below), the VW-scandal is likely to have only a small global impact in the next few years on the diesel balance.

Source: own estimates based on IEA

Global dieselization may still halt in the next couple of years, due to other factors

Among oil products, diesel saw by far the strongest absolute global growth in the last 15 years. This strong growth may face a cyclical headwind in the next 5 years, but not because of the VW-scandal. Diesel growth has been closely tied to economic growth, especially in emerging markets and China. Thus a marked global slowdown or a recession in China could reduce diesel growth or actually lead to a decline.

Apart from this cyclical component, it is also likely that with the shift away from investment-led growth in China, diesel consumption there will be a lot weaker than until recently even in the longer term.

While diesel demand is closely related to economic growth, gasoline, used mainly in passenger cars globally, is more sensitive to prices. Recent lower oil prices have boosted global gasoline demand, which is much more responsive to lower prices than diesel (especially in the US, where taxes are lower, too).

European refineries have long found it impossible to produce enough diesel and get rid of their surplus gasoline (Europe imports over 12% of its gasoil consumption, 0.75 mbpd). In fact, a rebalancing towards gasoline from diesel in European car sales could help European refineries in general. Nevertheless, considering the slow change in car stock, Europe will still be a net diesel importer and a net gasoline exporter in 2025, even in the unlikely event that diesel car sales drop to zero.

Will there still be diesel (and gasoline) cars sold in 2050?

In the longer run, competition from alternatives (e.g. electric, natural gas vehicles, etc.) will also slow down the rate of growth compared to previous bullish forecasts.

The cost of electric car batteries has been declining rapidly. If this tendency continues, internal combustion engines will face more and more competition. Toyota has recently said that by 2050 it will hardly sell any gasoline- and diesel-engine powered cars.

This scandal might push manufacturers as well as regulators towards alternative engine technologies even further. Whether this will be the case depends a lot on how the scandal evolves over the next months.

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Tags: cars, electric cars, EU, Volkswagen