Avoiding a baseline bubble: truck edition

The European Automobile Manufacturers’ Association (ACEA) recently published an insightful report on the CO2 emissions of European trucks. The report covers vehicles manufactured in the second half of 2019 with CO2 emissions certified using the new simulation-based method called VECTO. Although this sounds like an oddly specific and small sample of data, these values are quite a big deal.

Last year, the European Union adopted its first-ever CO2 standards for trucks, which mandate a fleet-wide reduction of 15% in 2025 and 30% in 2030 relative to a fixed, yet currently unknown, baseline. This baseline will be defined by the CO2 emissions of VECTO-certified trucks registered in the second half of 2019 and the first half of 2020. This approach for defining a baseline does raise some concerns.

Let’s start with the elephant in the room: An inflated CO2 baseline would reduce the burden on manufacturers to meet the CO2 standards. This creates a perverse incentive for manufacturers to influence the baseline, a strategy that is not unheard of. So, let us examine more closely the incentives and mechanisms for truck manufacturers to report inflated CO2 values.

First, let’s examine the incentives. Manufacturers are quick to point out that a deliberate increase in reported CO2 emissions to inflate the baseline would be counterproductive, as it could hamper a manufacturer’s position in the competitive European market. To contest this simplistic reasoning, one does not need to imagine the idea of anti-competitive practices. The €3.8 billion fine in the recent truck cartel case ought to have set manufacturers straight.

Taking actions to inflate the baseline could be an economically rational decision, as it could enable lower compliance efforts without the risk of heavy fines. The figure below shows the compliance performance of a hypothetical manufacturer declaring its real CO2 emissions (left) and reporting inflated values (right) during the baselining period. The black dot in the vertical axis is the baseline value determined from the reported CO2 emissions from all manufacturers. The red step line represents the manufacturer’s fleet CO2 emissions, assuming a linear reduction from year to year. While the CO2 target is enforced from 2025 onwards, manufacturers can accumulate early credits from 2019 to 2024. The black step line represents the threshold for the accumulation of those early-credits (see here for more details on the credit/debt system). The green blocks represent the credits accrued by the manufacturer, and the red blocks represent the debt accrued in 2025.

Figure: baseline

In the hypothetical scenario without an inflated baseline (left), the credits accumulated in 2019 and 2020 are not sufficient to compensate for the debt caused by under-compliance in 2025. This is the compliance gap. On the other hand, if the manufacturer were to over-report the CO2 emissions of its vehicles (right), it would close the compliance gap in 2025 with the same actual CO2 reduction effort. Although the manufacture would compromise its competitive position during the baselining period and would forego the credits in 2019, it would increase the credits accrued in 2020 and 2021 while reducing its debt in 2025. The net effect in the case shown above would be to close the compliance gap.

This thought experiment raises two important questions. One, how much market power is required for a single manufacturer to be able to significantly influence the overall baseline? And, two, how does the above-mentioned compliance gap translate into a financial incentive?

To answer these questions, I used the preliminary CO2 data from ACEA’s report and combined it with the truck registration data for 2019 from IHS Markit. As there is no data available to quantify the relative CO2 performance of each manufacturer compared to their competitors, I assumed that all manufacturers have the same average CO2 emissions in each vehicle subgroup. I then assessed the over-reporting required during the baselining period for each manufacturer to reduce its effective CO2 reduction requirement from 15% to 14%, assuming that other manufacturers do not over-report. The results of this analysis are shown in the table below.

Table 1

If VW’s subsidiary TRATON, manufacturer of the MAN and Scania brands, were to inflate its CO2 emissions by only 1.6% during the baselining period, it would reduce its 2025 compliance effort by a full percentage point from 15% to 14% CO2 reduction. If TRATON were to only achieve a 14% reduction without baseline inflation, it would incur a penalty of around €200 million in 2025. This strong return-on-inflation is quite the incentive.

So far, we have established that individual manufacturers could have a large impact on the baseline emissions and that the financial penalties set by the CO2 standards are a strong incentive for large manufacturers to put their market power to use. But what are the actual mechanisms available to manufacturers to inflate the baseline?

The regulatory provisions around VECTO were designed to reduce the likelihood that manufacturers certify their products for better CO2 performance than reality, not to prevent manufacturers from certifying a worse-than-real CO2 performance. As a result, a number of avenues are available for manufacturers to legally report higher CO2 emissions during the baselining period.

Manufacturers may choose to use the standard values defined in the regulation when conducting VECTO simulations for the certification of CO2 emissions. These standard values, intended to reduce the certification cost for small manufacturers, typically represent the worst-case CO2 performance to encourage detailed component testing. ACEA states in its latest report that more than 90% of the VECTO CO2 values are based on component tests, but it is not clear how the remaining 10% of vehicles using default values affect the baseline. This statistic does not negate the possibility of other testing flexibilities being exploited.

Fortunately, none of this is news to regulators. The European Commission has been busy putting in place provisions that will help them identify undue increases to the baseline and enable its correction. It is to be hoped that these active policy interventions and the watchful eyes of independent institutions will serve as a strong enough deterrent.

The lack of reliable CO2 data forced the hand of regulators to put a lot of eggs in the 2019/2020 basket during the design of the CO2 standards for trucks. However, the central message of this blog is one of cautious optimism. While ACEA’s preliminary results are somewhat encouraging, they also show that there is a large spread in the reported CO2 emissions, which does not rule out the exploitation of the flexibilities in VECTO. At any rate, the official baseline values—to be published in April 2021—are what counts. Only then will we be able to judge the integrity of the baseline and have certainty on the absolute benefits that the truck CO2 standards will deliver.