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Megacities & the Future of Fuels & Transport Monthly Report to Future Fuels Outlook Members

January 2017 Key Points

• A couple of key studies last year highlighted that diesel emissions cheating from Volkswagen was just the tip of the iceberg. One study actually found that Volkswagen’s diesel vehicles were the LEAST polluting as compared to the worst offenders, though they have the most vehicles on the road.

• Last month, the European Commission announced it would take action against seven member

states for failing to set up penalty systems to deter car companies from violating car emissions legislation and/or not applying such sanctions when a breach of law has occurred.

• Adding to the diesel emissions cheating allegations is the difficulty in meeting Euro 6

emissions standards. A paper released earlier this month from ICCT has showed that in Europe, the average amount of NOx present in exhaust emissions from modern diesel passenger cars under real-world conditions is more than double the levels from modern trucks and buses.

• Car executives, consultants, bankers and others have said that diesel in passenger cars is

doomed. For example, June 2016 study by AlixPartners LLP predicted diesel car sales in Europe will fall to 9% by 2030 as electric vehicles and hybrids become more affordable.

• The auto industry may stop manufacturing diesel vehicles at some point soon for the

European market because the cost of the technology to comply with Euro 6 standards is simply too prohibitive. What will fill the gap? According to UBS, it will be EVs. But I wonder whether there is also potential for gasoline vehicles with hybridization to fill the gap as well. In fact, I think there is great potential here. Even with generous incentives and perhaps (down the road) a zero emissions vehicle (ZEV) program of some kind, without a significant leap in infrastructure development, EVs may have a hard time taking off except in highly urbanized areas.

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Introduction: Review of Diesel Emissions Cheating

It's January 2017 and the fallout from Dieselgate continues with VW having plead guilty in the emissions cheating scandal in the U.S. and prosecutors now setting their sights on the individuals involved. EPA has also turned its attention to FCA Chrysler, charging that the company violated the Clean Air Act by "installing and failing to disclose engine management software in certain light-duty diesel vehicles sold in the United States. The undisclosed software results in increased emissions of nitrogen oxides (NOx)." It seems there will be additional fall out.

A couple of key studies last year highlighted that diesel emissions cheating from Volkswagen was just the tip of the iceberg. First, a study from the NGO Transport & Environment (T&E) in Europe used emissions tests data from around 230 diesel cars gathered in tests by the British, French and Italian governments and public databases. One result was that France was the country with the most “dirty” cars on the road, with 5.5 million not reaching standards, followed by Germany at 5.3 million, Britain at 4.3 million and Italy at 3.1 million. The report noted that:

“…approvals are often done to support domestic manufacturers or as a business for the approval authority. This feeble system of approvals is exacerbated by technical services that are supposed to undertake tests but routinely only witness these in carmakers’ own labs and are paid for their assistance. Sometimes the testing and approval organisations are even the same. Once the vehicle has been approved there is virtually no independent on-road checks to verify its performance in use due to a lack of will or resources.”

In an ironic twist, the study found that Volkswagen’s diesel vehicles were the LEAST polluting as compared to the worst offenders, though they have the most vehicles on the road. Notably, the VW diesel engines in question were mostly of the previous Euro 5 era which were sold between 2011 and 2015. T&E estimates that there are around 29 million “dirty” diesel vehicles on EU roads, or about 76% of all diesel vehicles registered in the EU in the past 5 years.

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The problem is meeting tough Euro 6 NOx limits and the difference between meeting laboratory test with prescribed protocols under the diesel regulation versus real-world driving that consumers actually do. The EU is introducing a Real Driving Emissions (RDE) test and from September 2017 will ban diesels that emit double the lab limit for NOx.

Similarly, the Toulouse School of Economics TSE and UC Berkeley released a paper in September 2016 showing that it wasn’t just Volkswagen that cheated on car emissions tests. The authors said it was all major car companies in the European market and for a prolonged number of years in some cases. Using data from the Dutch fuel card service Travelcard, the academics measured real fuel consumption of vehicles on the road and compared it to car manufacturers’ claims.

Using panel data on 27 million fuel station visits from tens of thousands of drivers, they estimated that the difference between on-road fuel consumption and social laboratory tests increased from 5% before the regulation to more than 40% by 2014. This implies that 75% of the improvement in fuel economy attributed to the policy interventions is in fact due to gaming, the authors say. And it impacts most automakers, as the following figure shows, going back as far as 1998.

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The figure shows that the “gaming” really amped up in the 2007-2009 period. According to TSE’s Matthias Reynaert, this increase was clearly correlated to regulatory pressure which pushed firms to exploit loopholes in the test process: “In 2007, as the EU announced that the emissions of new car models would have to decrease to 130 grams of CO2 per km, manufacturers had to adapt to this daunting target. However, the procedure used to establish official emission ratings, the New European Driving Cycle, leaves firms a lot of leeway to game on the test results.” National environmental taxes introduced after 2007 also added to the pressure to perform.

European Commission Action against Member States on Dieselgate

Last month, the European Commission announced it would take action against seven member states for failing to set up penalty systems to deter car companies from violating car emissions legislation and/or not applying such sanctions when a breach of law has occurred. The member states include: the Czech Republic, Germany, Greece, Lithuania, Luxembourg, Spain and the United Kingdom on the grounds that they have disregarded EU vehicle-type approval rules.

The Commission charged that the Czech Republic, Greece and Lithuania failed to introduce penalties systems into their national law. It charged that Germany, Luxembourg, Spain and the

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United Kingdom did not apply their national provisions on penalties despite Volkswagen's use of illegal defeat device software in those countries. And, it charged that Germany and the UK broke the law by refusing to disclose, when requested by the Commission, all the technical information gathered in their national investigations regarding potential NOx emissions irregularities in cars by Volkswagen Group and other car manufacturers on their territories.

What’s the next step? For those of us not familiar with EU-level legal process, I’ll summarize. A letter of formal notice, which is what occurred, is a first step in an infringement procedure and constitutes an official request for information. Member states now have two months to respond to the arguments put forward by the Commission; otherwise, the Commission may decide to send a reasoned opinion. This is a formal request for the member states to comply with the law and to inform the Commission of measures taken to comply within a specified period, usually two months.

If the EU member state still doesn’t comply, the Commission may refer the matter to the Court of Justice (though most cases are settled before this point, according to the Commission). The Commission may also ask the court to impose penalties. If the court finds there was a breach of EU law, the member state must take action to comply with the court judgment.

There have been proposals for greater EU oversight of national approval systems for vehicles (which would include emissions and fuel economy). The Commission proposed empowering its Joint Research Centre to inspect vehicles separately from national authorities, which are paid by the car manufacturers they regulate. This was killed by member states, some of which are the very same countries subject to the foregoing enforcement action.

Meeting Euro 6 is a Challenge

Adding to the diesel emissions cheating allegations is the difficulty in meeting Euro 6 emissions standards. A paper released earlier this month from ICCT has showed that in Europe, the average amount of NOx present in exhaust emissions from modern diesel passenger cars under real-world conditions is more than double the levels from modern trucks and buses.

The paper shows data for 24 Euro VI buses and trucks, some tested on a chassis dynamometer by the Technical Research Centre of Finland (VTT), and others tested on-road using portable emissions testing equipment by the German type-approval agency KBA. On average, NOx emissions of the heavy-duty vehicles (HDVs) tested were approximately 210 mg/km. Currently, NOx emissions of Euro 6 diesel passenger cars under real-world driving conditions are approximately 500 mg/km, as determined by testing carried out by KBA and other European type-approval agencies.

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In addition, the average conformity factor—the ratio of the test result to the regulatory limit—for the heavy-duty engines was less than 1, meaning that on-road emissions stayed below the Euro VI engine type-approval test limits, according to ICCT. These data are shown in the table below.

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Source: ICCT, January 2017

Further, CO2 emissions for HDVs are roughly five times those of cars, shown in the figure above. In other words, on an engine-load basis, HDVs are about 10 times better than light-duty diesels at reducing NOx.

ICCT says the differences are attributable in large part to differences in how light-duty and heavy-duty vehicle emissions are regulated. Significant real-world emissions and conformity-factor reductions were accomplished in the transition from Euro V to Euro VI HDV standards.

According to ICCT, among the significant changes between Euro IV/V and Euro VI that likely contributed to that improvement were:

1. Addition of an off-cycle test during type approval.

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2. Improved type-approval test cycle that includes cold start and lower load conditions as well as transient and high-load conditions.

3. Portable emissions measurement systems (PEMS) tests for in-service conformity testing, with limited restrictions on the boundary conditions used during the test and subsequent data processing.

The significantly lower NOx emission levels of trucks and buses are most likely a result of differences in regulation, ICCT says. Official testing requirements of light-duty vehicles remain limited to laboratory measurements of carefully prepared prototype vehicles.

Similar tests with PEMS will be introduced for passenger cars beginning in September 2017, as part of the European Real-Driving Emissions (RDE) regulation. That should bring about a significant improvement in the NOx emission levels of diesel cars, the ICCT said. But further improvements in the light-duty vehicle testing protocols will be needed to truly measure and control NOx emissions.

More on the RDE Test Procedure

As background, in 2015, the EU adopted the first two pieces of legislation designed to implement the new RDE test procedure for measuring vehicle emissions. The RDE legislation has been divided into four legislative packages for enactment over several years. According to ICCT, the European Commission chose this approach because of the broad and technical nature of the text, covering various areas such as specifications for measurement equipment, trip definitions, and boundary conditions. The four packages are divided as follows and are subject to progress of the RDE working group on the final two pieces.

1. The first package, voted on in May 2015 and published in the Official Journal of the European Union in March 2016, includes the basic features of the RDE test, such as characterization of the RDE trip, the vehicle family concept, description of the data evaluation tools, technical requirement of the PEMS equipment, and reporting obligations.

2. The second package, voted on in October 2015 and published in the Official Journal of the European Union in April 2016, includes more political outcomes, such as the determination of the conformity factors and the timetable for RDE implementation. Technical features include the introduction of dynamic boundary conditions and a limit for altitude gain together with a detailed approach to calculating it.

3. The third package, voted on in December 2016, includes the introduction of the particulate number measurement along with a conformity factor of 1.5. The package also features specific legislative provisions for hybrids and a procedure to include cold starts and regeneration events in the RDE test.

4. The fourth package, still in the preliminary stages, is expected to cover in-service compliance and surveillance tests along with specific provisions for light commercial vehicles (vans).

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The chart below shows the implementation timetable for the RDE test procedure.

What's the Future of Diesel in Europe (and Elsewhere)?

Car executives, consultants, bankers and others have said that diesel in passenger cars is doomed. For example, June 2016 study by AlixPartners LLP predicted diesel car sales in Europe will fall to 9% by 2030 as electric vehicles and hybrids become more affordable. Moreover, according to a recent report from UBS obtained by the Financial Times, diesel will “almost disappear” from the global car market within 10 years as it faces a “perfect storm” of competition from cheaper electric cars and tougher stances by regulators.

UBS projects that the falling costs of electric and hybrid vehicles will strip the fuel of its once-competitive price advantage in Europe, while tighter emissions regulation and soured public sentiment towards diesel in the wake of Dieselgate will see its global share of car sales fall from 13.5% to just 4% by 2025. In diesel-dominant Europe, sales will fall from 50% to 10%, and sales declines have accelerated in the past year because of Dieselgate. UBS expects sales of 48V cars to overtake diesel sales globally in 2021, and to account for a 25% of all cars sold by 2025.

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FCA Chrysler head Sergio Marchionne in a January interview seemed to agree with this assessment. The problem is the cost of the technology to meet Euro 6 standards, which he cites at a whopping US$531 million. I reproduce his comments in their entirety because they capture the dilemma the auto industry faces so well:

"Because of events, I’m not trying to attribute blame or assign responsibility, diesel has now acquired an incredibly bad reputation.

I can tell you in some parts of the world, Europe for one, they would never have been able to make any of their emissions standards objectives in the absence of diesel.

In terms of viability of the technology it is relatively clear to me that diesels are an essential element in the mix of solutions that are required to try and meet emissions regulations. What is happening unfortunately is as we move up the level of technological intervention in diesel with Euro 6 (emissions standards) in Europe, the cost of the technology is going to push diesels right to the edges of what is (economically possible). These engines, fully loaded up with scrubbing equipment, with SCR (selective catalytic reduction) or some type of scrubbing mechanism is going to push the price of diesel solutions beyond the combination of gas and electrical. And I think the real risk of diesel is that it will actually be replaced as an economically viable solution as the result of other technologies displacing it.

I think its future in at least that segment (light vehicles) is suspect. On the industrial side (trucks, tractors and construction equipment) nobody is going to touch diesel. It will continue to be relevant. On the passenger car side, if you ask me 10 years out, I think it will have limited use. A lot of it depends on how costly the technology to clean it up is. Right now it is prohibitive.

I’m going to give you one number that should shock the living daylights out of you. If you look at the transition to move 80% of our diesel engine families to the next level of compliance for Euro 6 in Europe it’s a half-billion euro ($531 million).

These are not variable costs. These are base technology injections and the development of all the strategies to comply with Euro 6 in the final form in Europe. That’s a big number. That’s something that we don’t carry with gasoline engines. We don’t have such massive technology intervention requirements with gasoline engines that we have with diesel. What’s going to kill diesel, it seems to me, is this continuous drain on capital and this continuous skepticism about its value to society. In this latest round of events, without mentioning competitors, have made this an incredibly undesirable product although its usefulness is beyond doubt.

But it now has a (bad) reputation far in excess of its true nature. It’s not a bad thing, it was just misused.”

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Conclusion

As I read it, the auto industry may stop manufacturing diesel vehicles at some point soon for the European market because the cost of the technology to comply with Euro 6 standards is simply too prohibitive. What will fill the gap? According to UBS, it will be EVs. But I wonder whether there is also potential for gasoline vehicles with hybridization to fill the gap as well. In fact, I think there is great potential here.

Even with generous incentives and perhaps (down the road) a zero emissions vehicle (ZEV) program of some kind, without a significant leap in infrastructure development, EVs may have a hard time taking off except in highly urbanized areas. Fuels Europe has estimated that the cost to turn over the whole EU fleet of 250 million cars to EVs would be a staggering €2.5 trillion, or 15 times the EU budget. And they will not take off quickly in the more rural areas of Europe, which represents about 26% of the population, according to United Nations statistics. The petrol vehicle already comprises 54% of the fleet and does not face the same difficulty in cost and technology in meeting emission requirements. Consumers in the market for a new car may turn to these vehicles before the electric vehicle.

There will still be diesels in Europe regardless of Dieselgate and Euro 6. The passenger car fleet turnover rate in Europe, according to ACEA, is about 10 years (and that rate is increasing). Citizens are holding on to their cars longer and longer, and that means there is a substantial legacy fleet of diesel vehicles out there that will remain for some time (and most of them are not Euro 6 equivalent). That includes a substantial number of used diesel passenger cars in the market.

As the figure from ICCT shows, as of 2014 diesel commands 59% of vehicle sales in Europe, the most in the world.

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Source: ICCT, January 2017

Whatever happens with the implementation of Euro 6 and further fall out from Dieselgate, I expect there will be long-term impacts to the diesel market in Europe. What about the rest of the world? I'm not so sure. Diesel may crash in Europe at some point in the future because of Euro 6 and EV technology, but I don't know if it will affect other significant markets such as India and the Middle East where emissions standards are less advanced and where development and mobility are so critical. In fact, according to ExxonMobil's 2017 Energy Outlook, there will still be about 200 million diesel-powered vehicles on the road in 2040.It's true that diesel might be over for passenger cars in the U.S., but as the chart above shows they were a very small percentage of sales anyway in a gasoline-dominated market.

Diesel will remain dominant in heavy-duty trucks and large SUVs and keep in mind, oil demand (mainly diesel) for freight transport (globally, but also in Europe) will increase through 2040, as the figure below shows.

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