How Automotive Regulatory Credits Benefit Tesla?
Introduction
Recently, while reading about the strategy of automotive OEMs on electric vehicles (EVs), I came across this news article on Tesla’s earnings in the second quarter of 2021. What captured my attention was 3.5% of the overall revenue of $10.21 billion, $354 million to be precise, was attributed to the “sale of regulatory credits”! This made me dig deeper into regulatory credits to understand how it impacts or might impact the EV strategy of OEMs.
In this article, I have tried to summarize my understanding and findings. After reading, you should have an understanding of the following.
- Regulatory credits, automotive emission credits in particular.
- How have these credits helped Tesla?
- What is the future of these credits?
What are regulatory credits (RCs)?
There are several ways in which governments around the world are trying to push the reduction of carbon emissions. On the demand side, these incentives often manifest in the form of government stimulus like tax breaks and sales tax exemptions on car purchases. On the supply side, automakers are given credits for manufacturing electric vehicles i.e. zero to very low carbon emitting vehicles. It is these credits which are referred to as regulatory credits.
Factors which determine credits?
In this section, I have used quite a few acronyms related to EVs. For an explanation, please refer “Types of electric vehicles” in the appendix.
Broadly speaking, the regulatory framework around ZEV credits in the prominent EV market, namely California, China and EU, awards credit based on
- type of ZEV and
- range of vehicle
For example, the mandate in California is applicable to both pure ZEVs (BEVs, FCEVs) and transitional ZEVs (PHEVs that meet certain criteria). ZEVs are valued more than TZEVs and long-range vehicles are worth more than short range vehicles. This encourages automakers to build long range EVs.
How can automakers use RCs?
Manufacturers can bank excess credits or trade them with other manufacturers who are short of minimum credits mandated by law.
As per Tesla’s annual report for the financial year 2020, filed with the United States Securities and Exchange Commission, it recognizes revenue on the sale of automotive regulatory credits at the time control of the regulatory credits is transferred to the purchasing party. This revenue is considered as automotive sales revenue in the consolidated statement of operations.
How have RCs helped Tesla?
Unlike every other automaker, every single one of Tesla’s vehicles is a long range electric vehicle, which means the company generates a ton of them. It keeps the small amount needed, while selling the rest off to companies that aren’t producing enough EVs.
Tesla doesn’t disclose who it sells credits to. Nor does the buyer of credits do. However, media reports suggest that almost all major automotive OEMs have entered into agreements with Tesla to buy credits.
For example, as reported in this CNBC story, Stellantis, a company formed through the merger of France’s PSA Group and Italy’s Fiat Chrysler Automobiles reportedly bought European and US regulatory credits worth over 2 billion Euros from Tesla between 2019 and 2021. The same story also reports that FAW-Volkswagen, Volkswagen’s JV with the state owned Chinese automaker FAW, has also agreed to buy credits from Tesla.
The graphic below shows Tesla’s revenue from Regulatory Credits from 2017 through Q2 of 2021. Notice more than 2.5 fold rise in revenue from 2019 to 2020. Even with conservative estimates, one can expect it to cross $2 billion in 2021.
To get some perspective on the aforesaid numbers, notice in the graphic below that in 2020, and expectedly in 2021, revenue due to RCs is close to 6% of the total revenue.
Disclaimer: Since Q3’19, Tesla has changed the manner in which it presents financial statements. It is much more readable for a novice like me. It was difficult for me to interpret the contribution of revenue from regulatory credits prior to 2019. Therefore, in the graph below I have excluded data from those fiscals. I hope to get better at reading P&L statements some day. That’s when I will update the graph below.
What does the future of RC revenue for Tesla look like?
In the last couple of years, automakers, both new and old, are ramping up the production of ZEVs. That means eventually fewer car makers will need to buy regulatory credits from Tesla as they accrue their own. Stellantis, as an example, has recently announced that next fiscal year onward it will meet its target without having to buy credits from Tesla.
In 2020, the sales of regulatory credits worth $1.58 billion did help Tesla to register net profit of $721 million. This suggests that the company actually lost money on its main business of selling cars. A fall in RC revenue might force the investors to reconsider their valuation of Tesla.
Appendix
Types of electric vehicles
Zero-emission vehicles (ZEVs) are primarily powered by electric drive. Depending on the market, they are called differently. For example, in China they are called “new-energy vehicles” (NEVs) while in Europe they are called “low-emission vehicles” (LEVs) or “zero low-emission vehicles” (ZLEVs). In the United States, they are called “zero-emission vehicles” (ZEVs).
In terms of technologies, battery operated electric vehicles (BEVs) and fuel cell electric vehicles (FCEVs) are considered to be pure ZEVs with higher associated incentives. Plug-in hybrid electric vehicles (PHEV) too are low emission technology, counted as ZEVs, but with lower associated incentives.