Where Elon Musk and Tesla earn real credit ‘eating the lunch’ of auto competitors

Tesla’s ability to manufacture electric vehicles without losing money has been a constant concern for investors. As renewable energy credits have played a significant role in the recent string of quarterly profits from Elon Musk’s EV company, they have been a source of some frustration for Wall Street analysts — who have struggled to get a handle on how much revenue these credits will rack up in any quarter — as well as generating skepticism from investors.

But there’s nothing dubious about the renewable energy credit market. In fact, Tesla‘s domination of zero-emission vehicle credit trading — where it is estimated to have sold more credits than any other company — is an example of a climate finance mechanism that is working as it was designed to work. Tesla, unlike traditional automakers, risked it all on making and selling EVs. Meanwhile, traditional car companies are required to pay up, by other means, for the choice of delaying their transition to battery electric or fuel cell electric zero-emission vehicles.

“The last thing a company wants to do is pay their competitor to eat their own lunch,” said Simon Mui, deputy director of the clean vehicles & fuels group at the Natural Resources Defense Council. But he added that is exactly what car makers like Fiat Chrysler Automobiles — which signed a private deal with Tesla to buy credits in the European market — have had to do. 

“Automakers are scrambling to catch up and they see that Tesla, like any other automaker who can produce more EV credits than they require, can monetize the credits. They’ve done it from the beginning and it has been a big element in terms of providing a strong tailwind,” Mui said.

The NRDC expert compared the market to the renewable portfolio standards implemented by U.S. states which have provided renewable energy companies in sectors like solar and wind power with a market to sell to utilities. “That’s how the renewable energy industry got its start. …. We will see Rivian and Lordstown and all of these other EV start-ups coming to market taking advantage,” Mui said. “Rivian is seeing it and also licking their lips.”

The recent numbers related to this trading are large. In Q2 2020, revenue from the renewable energy credit market were $428 million, and that’s revenue that comes at no-cost, unlike the challenges that an auto manufacturer faces in trying to eke out profit margins from the factory operations. It all flows down to the bottom line and the last quarter was the largest ever for these credits at Tesla.

The role of the RECs in the U.S. car market — in programs like California’s ZEV (zero-emission vehicle) credit transfers — is going to grow in the years to come. Tesla’s CFO Zachary Kirkhorn recently said that its revenue from RECs will double in 2020. That will continue to be a cause of consternation on Wall Street. Stock analysts need firm numbers to build their financial models and attempt to estimate how a company will perform in any single quarter. The lack of transparency on renewable energy credit trading has bedeviled those efforts.

“It’s probably the biggest source of their earnings beat over the last four quarters, and a line item that is so unpredictable,” said Garrett Nelson, senior equity analyst at CFRA Research.

“The market is not transparent, like an equity market or bond market,” Nelson said. “That makes it harder to model, difficult to model. As an analyst, you know that probably will be the biggest swing factor every quarter in terms of whether they meet or miss estimates, and that’s why we’ve had this wide range of massive earnings beats over the last four quarters. That line item has been larger than anyone expected.”

Renewable energy analysts agree about the lack of transparency. Unlike California’s greenhouse gas cap-and-trade market which has transparent pricing and volumes, most of the information about the ZEV trading remains obscure. “Car companies might know what these credit prices are going for, but it’s really hard to say how much information they even have when making choices,” said Benjamin Leard, an environmental economist and fellow at Resources for the Future, who has made estimates of the trading market based on California’s required disclosures. “There’s room for improvement,” he said.

But CFRA Research analyst Nelson does not begrudge Tesla the success in the climate finance market, even as it makes his job harder.

“We view the regulatory tax credits as sort of a reward for producing EVs that people want to buy. Aside from Tesla’s Models 3, X and S, only one other non-hybrid, battery EV model sold over 10,000 units in the U.S. in 2019 (the Chevy Bolt). The vast majority of other EV models haven’t sold very well at all,” Nelson said. He added that while it is impossible to accurately estimate the revenue Tesla will generate from these credits due to the lack of disclosures, he does expect it to remain strong through the end of 2021. “Other manufacturers don’t have the EV sales Tesla has right now,” he said.

CFRA expects next quarter’s revenue from the renewable energy credits to surpass $600 million and Nelson said there is a direct correlation between Tesla’s market share in EVs, which keeps growing, and the size of the regulatory credit revenue. Tesla vehicles accounted for 58% of all EVs sold in the U.S. last year, up from 14% in 2014. The credit revenue will continue to go up because Tesla will increase market share even more into 2021,” he said.

Tesla just reported a record Q3 delivery number.

“Shipments are up 30%-40% this year, while other EVs have not caught on,” Nelson said. “That will change over time, but over the next four to six quarters, Tesla will continue to increase market share.”

Tesla did not respond to requests for comment.

To date, the zero-emission vehicle credits market “is basically just Tesla selling,” said Leard, though his research shows that Nissan also benefited to a lesser extent in the early years of this program due to the Nissan Leaf. “If you look at the list of companies that have traded in every year, Tesla is one of them, and maybe the only one among sellers.” 

He expects the market will get stricter and more widespread, and for car makers, that means either selling more electric vehicles or paying up in the form of banking the credits. Ideally, the climate mechanism pushes more automakers to make the decision to invest in electric vehicle technology, and at the same time, place more pressure on the credits market.

ZEV programs similar to the California one are in place in eleven other states across the country, including most recently Colorado. Together, those states comprise 30% of the U.S. vehicle market. “Those credits, the number and volume, will go way, way up and the value may go up as well,” he said.

“We have sold these credits, and will continue to sell future credits, to automotive companies and other regulated entities who can use the credits to comply with emission standards and other regulatory requirements,” said Tesla in an annual report.

Tesla revenue from the sale of automotive regulatory credits increased from $360 million to $419 million and then $594 million in the 2017-2019 period. The Q2 2020 sales alone were above the full-year 2018 sales figure.

There is also a federal law covering greenhouse gas (“GHG”) emissions which allows Tesla to sell excess credits to other manufacturers. These programs are growing, and that is not taking into account the U.S. presidential election outcome, which could also be a significant driver of climate finance.

“We could see a huge expansion in these programs, depending on the election,” Nelson said.  “A Biden win would be bullish for EV manufacturers as he has proposed increasing number of EV charging stations by 20 times the current infrastructure, from 27,000 to over a half million.

Mui said in the years to come the ZEV programs will approach 40% of car sales, with additional states considering it. And the U.S. is just one market, with new entrants like Nio from China also to benefit, whether it enters the U.S. market in the near future or not. “All of these automakers are facing similar standards in the other largest markets, like China and Europe. … Automakers are finding themselves in make-or-break moment, either shift to innovate or become irrelevant. That’s why we see the success of Tesla in market value,” the NRDC analyst said. 

By 2025, the California ZEV program requires over 16% of sales by large manufacturers to be pure zero-emission vehicles, either battery electric or fuel cell, or comply through credits market purchases.

California also adopted a ZEV advanced truck requirement this year, which will spur the development of the credit market for Amazon-backed Rivian and Tesla’s semi truck program. And 15 U.S. governors have signaled their states will pursue ZEV requirements for commercial trucks. “These are not just blue states but red and purple states as well,” Mui said.

California Governor Gavin Newsom recently announced the state’s intention to require all new car sales be non-gasoline powered by 2035.

Today, automakers can comply with the EV sales requirements just through passenger cars, but that will be changing, and the car companies do see the writing on the wall.

“These standards are not going down, air pollution is not reduced as a problem and governments will be ratcheting up standards over time, so one or two EV products will not be enough. They will need to have a wholesale portfolio shift in each and every product line,” Mui said. 

Teslas and Rivians will not meet all of the demand so the traditional automakers will pick up the pace of innovation, especially if they want to compete in China, he said.

GM recently made a significant investment in Nikola, whose founder shortly thereafter left the electric truck company. But that big shift to innovation may continue to be a tough investment decision today for many auto players. If traditional auto companies feel more cost pressure today on the side of technology investment, they will go to the credit market to comply. And as more states add more requirements, “it will boost up the demand for these credits, which will raise the price,” Leard said.

“A company trying to make a profit and maximize profits, is can either choose tech adoption or can go to the credit market and buy from other companies, which they are already doing,” Leard said. “Definitely, in the short run, I think car companies are having a hard time justifying dumping a billion dollars into new models and the credit market is serving as way for car companies to comply and avoid large fixed investments they need to make now to bring a new car onto the market. … If car companies don’t want to introduce new models, they can just buy credits indefinitely.”

For the zero-emission credits, it will continue to be “a seller’s market,” Leard said. While he says traditional auto companies are moving in the right direction, with projects coming in future years like Ford‘s electric F150 pickup truck and the electric Mustang Mach-E, “The big boys, the Fords and GMs, these companies are still kind of far from really getting a good high-selling electric vehicle on the market.”

And that seller’s market will be Tesla’s market for the foreseeable future.

“They are far behind Tesla introducing popular, affordable electric vehicles … so Tesla and other companies introducing EVs will really be cashing in on these markets and the ZEV programs will become a lot more stringent in the next 5 to 10 years,” Leard said.

Even if the market ultimately does work to push more companies to make and sell more EVs, as it should, with the percentage of sales that have to be ZEV going up over time there will be car companies that don’t have enough sales to not buy credits, Leard said.  “They will have to go to Tesla, and say ‘we really need those credits,’ and that will bid up prices.”

In the first two quarters of 2020 combined, Tesla had $780 million in credits’ revenue, but to put that in perspective, Tesla had roughly $12 billion in revenue in the first half of the year.

With record volumes for Tesla deliveries expected in Q4 2020 as well, though much of that due to the China factory ramping up, CFRA expects Tesla to be a net seller of these credits for years to come.

Nelson is estimating $560 million for Q3 and $670 million in credits’ revenue in Q4. “Directionally, it will be up over the next two quarters, but it’s more of a guesstimate. I don’t think anyone has a really good handle where it comes in, except that it will be higher,” he said. 

“It doesn’t make-or-break revenue, but it certainly helped increase profit margins,” NRDC’s Mui added.

Ultimately, Tesla knows that depending on a credit market is not building a long-term sustainable, and solid profit margin, auto business.

“They really want to have a credit market as an extra bonus on top of other healthy profit margins,” Leard said. 

What Tesla wants to show investors is that it can make a consistent profit, or at least avoid consistent losses, without depending on the credits. Its CFO Kirkhorn has indicated as much, saying after its big Q2 credit market revenue that over time the company expects the ZEV trading to fade away as a financial resource for the company.

“Analysts complain and the bears question the earnings quality because so much is driven by RECs,” said CFRA’s Nelson. “We view the credits market as operating efficiently and it is separate issue from the lack of predictability in forecasting earnings. Tesla takes all the risk and has many other hurdles to overcome and high fixed costs and it is a capital-intensive business with high barriers to entry,” he said.

The Tesla stock analyst said Musk & Co. are approaching the business the right way: not expecting the credits to be an earnings driver in the future as other OEMs ramp up.

GM, for one, is planning to be all-EV in the future. Nelson said his view is that Tesla is buying time to lower their battery costs so they can widen their competitive gap in terms of range of EVs and cost and build a better moat versus other manufacturers.

“That’s what they are trying to do. They are not trying to run a business based on the sustainability of EV credits. They are not assuming zero-cost revenue continues going forward,” Nelson said. “Could it use more transparency? Absolutely, but that will come with time and Tesla disclosure can improve. … The entire street would agree they could do a better job providing guidance on the credits and quarterly revenue.”

On the company’s Q2 earnings call, Kirkhorn responded to the latest analyst question about RECs — focused on the fact that margins without the credit revenue would have been much lower over the prior year without them — by providing what Nelson said was more disclosure about the future of this revenue source than Tesla has given in the past, even if it remained less than detailed.

“I’ve mentioned this before in terms of regulatory credit. … we don’t manage the business with the assumption that regulatory credits will contribute in a significant way to the future. I do expect regulatory credit revenue to double in 2020 relative to 2019, and it will continue for some period of time. But eventually, the stream of regulatory credits will reduce.”

For now, at least, difficulty measuring Tesla’s success down to the dollar-of-revenue source won’t get easier when it comes to the RECs, but it will be easy to measure Tesla’s success in other automakers being forced to pay Musk’s company for selling EVs and racking up credits.

“We fully expect some automakers to take a slower path,” Mui said, but he did cite one compelling reason for car companies to move more quickly to making and selling EVs: “They won’t advertise this, but you can bet that every company, whether GM or Toyota or FCA, does not want to pay Tesla to eat their lunch.”