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November 15, 2006
Merrill Lynch and World Resources Institute Issue Second Auto Sector Climate Change Report
by Bill Baue
The report again balances stock picking and investment analysis with in-depth discussion of
regulatory and market developments in response to global warming and energy security concerns.
Last week Merrill Lynch (ticker: MER) and the World Resources
Institute (WRI) issued their second joint auto
sector report in the Energy
Security and Climate Change series, this time subtitled Alternatives for the Clean Car
Evolution. As with the first, the report harnesses the
strengths of both organizations. Fred Wellington and Britt Childs of WRI's Capital Markets Research team provide a comprehensive,
in-depth overview of recent regulatory and market developments. Merrill analysts John Murphy and
Pamela Yi in the US and Thomas Besson and Stephen Reitman in the UK offer perceptive investment
insights and recommend specific stock plays in the auto sector in light of energy security and
Two of the stock picks from last year's report remain: BorgWarner
products offering higher fuel efficiency and/or lower emissions, and Magna International (MGA) for its
high-pressure hydroforming business that helps create lighter vehicles with higher fuel economy.
France-based Valeo (VLEEF) is a "direct play on fuel
economy" according to the report, which highlights two products: a system that silently stops and
restarts the engine in traffic or at red lights to save fuel, and a cam-less engine that reduces
fuel use and emissions 20 percent.
The report's handling of biofuels blends WRI's and
Merrill's strengths best. One table lists US Congressional bills related to biofuels, most of
which address flexible fuel vehicles (FFVs) that run on petroleum gasoline as well as bio-based
"Broadly speaking, these policies are either aimed at developing the supply of
biofuels available for transport use (so called 'supply-side push') or are focused on encouraging
the production of vehicles that can accept multiple fuels, i.e. FFVs (so called 'demand side
pull')," the report states. "This dual approach to regulation creates something of a 'chicken and
egg' dilemma around biofuel policy."
"Encouraging the production of FFVs does not
necessarily get you the energy savings or reduced emissions unless the new fuel is used--and that
fuel is still available in only limited quantities," it continues. "Conversely, increased
production of biofuels does not become economic unless there is adequate consumer demand for
alternative fuels from users of FFVs or biofuel vehicles."
The report also notes another
dilemma. Federal biofuel regulation favors E85, which blends 85 percent ethanol with 15 percent
gasoline to significantly reduce greenhouse gas (GHG) emissions but requires new delivery
infrastructure (E85 corrodes current systems) and FFVs. State regulation, listed in another table,
favors E10, a lower percentage blend with reduced--but more immediate--environmental benefits, as
it can be delivered via current infrastructure and burn in standard automobiles.
this regulatory uncertainty makes it difficult to predict whether E85 or E10 will predominate,
investors can benefit either way by investing in biofuel producers. Yet another table, contributed
by Merrill Lynch oil sector analysts, lists direct biofuel plays, including US-based Pacific
Verasun Energy (VSE), and Aventine Renewable Energy
Europe-based Abengoa (ABG.MC) and Biopetrol (B2I.DE).
The seemingly capricious regulatory scene is compounded by fickle consumer markets, making it
difficult to predict which technology for reducing fuel consumption and emissions will become the
standard--fuel cells, hybrids, biofuel, or diesel.
"Although many global automakers often
highlight specific powertrain strategies, most are exploring a number of options as the ultimate
winner is unclear," the report states. "Most [original equipment manufacturers] point to fuel
cells as the holy grail of powertrain technology, but considering the timing to introduction (10+
years), it is a dubious solution, and another technology could emerge."
"In the interim
the alternatives being explored are increased diesel penetration, increased ethanol and biofuel
use, and the popular hybrid," the report continues.
To explain the responses of the "Big
Six" auto companies--GM (GM), Ford (F), DaimlerChrysler (DCX), Toyota (TM), Honda (HMC), and Nissan
report uses a table to encapsulate their strategies and one-page discussions in the body of the
report. The report also discusses responses by European companies--such as BMW (BMW), VW (VOW), and Renault (RNO)--that focus on
the region's traditional commitment to diesel.
Both investors and lay readers will
find the first section of the report indispensable reading for understanding how climate change and
energy security are converging to drive the regulatory and policy scene, especially as it relates
to auto companies. One of the most significant developments to watch is whether the US Supreme
Court allows carbon dioxide (CO2--the primary GHG) to be classified as a pollutant under the Clean
Air Act in its decision on the Massachusetts v. EPA case,
expected in June 2007.
State-level developments to watch are focused in California, where
the California Air Resources Board approved the Pavley law in 2004 requiring passenger vehicles to
reduce emissions 30 percent. Two auto industry organizations filed a federal lawsuit against the
Pavley law, contending that the federal government regulates fuel economy, not states. Adding fuel
to the fire, two months ago California Attorney General Bill Lockyer filed a lawsuit against the Big Six holding them
liable for the environmental damages caused by their products' GHG emissions.
remains unclear how California Air Resources Board (CARB) will specifically implement the various GHG requirements
that that have been signed into law, what is clear is that these requirements are, in fact, law,"
the report states. "Lawsuits or not, the auto industry will likely be impacted by this regulatory
In the end, the charts and tables eclipse the textual discussion in illustrating
the dilemma posed by climate change. One WRI chart shows that transport sector CO2 emissions from
the US are almost double that of the second largest regional emitter, the European Union. Another
WRI chart traces almost a third of US GHG emissions to the transport sector, with 83 percent of
these emissions pegged to road transport. No wonder why the report focuses on the auto sector!
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