The Auto Industry's Second-Biggest Fear

What bothers carmakers most after the threat of recession? How to adhere to CAFE fuel rules without losing customers.

Ask auto executives what keeps them up at night, and right after the 50-50 chance that the U.S. economy will slide into a recession is the new set of fuel-economy rules handed down by Uncle Sam in December. They all say that they will meet the new rules, but the question is how? What scares them is that to meet the new rules, they will have to make automobiles either more expensive or smaller and less powerful, two types of cars that have traditionally been about as popular as a Greenpeace delegation at a National Rifle Assn. convention.

The source of their discomfort is the new energy bill that Congress passed in December mandating that carmakers achieve a corporate fleet average fuel economy (CAFE) rating of 35 miles per gallon by 2020, up from 22.2 for trucks and 27.5 for passenger cars.

Passing Costs to Consumers
The federal government has long preferred regulations that force carmakers to improve fuel economy, instead of gasoline taxes that would give consumers incentive to buy more efficient vehicles. The conventional wisdom behind this stance is that consumers won't vote for public officials who levy taxes at the pump.

Of course, automakers bear their share of the blame for the situation in which they find themselves by not having diverted enough resources to develop more fuel-efficient vehicles sooner. Still, they know that by passing the burden onto them, Washington is not only interfering in the marketplace, it is running the risk of causing an even greater rift between carmakers and their customers.

"There will be some cost to someone," says Jesse Toprak, executive director of industry analysis for Edmunds.com, which tracks car prices. "The cost to manufacturers could go up $2,000 a vehicle. But I don't think they will be able to pass it all on to consumers."

But they will have to pass on some of it. How much is a subject of some debate. Automakers, most of which opposed the tougher fuel-economy rules, say the new law will be very expensive. General Motors' (GM) Vice-Chairman Robert Lutz, GM's product development chief, said in an interview at the 2008 North American International Auto Show in Detroit (BusinessWeek.com, 1/10/08) on Jan. 15 that the company could hit the new CAFE rules soon, but not without radically altering the nation's current choice of vehicles or adding $6,000 a car in cost. Some cars could become as much as $10,000 more expensive, Lutz says.

Incremental Effects
"We think that with $6,000 to $8,000 per car, we can meet 35 mpg without changing a vehicle spectrum like we have today," Lutz told journalists. "We will have to make choices."

Already, Lutz says, GM has had to reconsider making the next-generation Chevrolet Impala a midsize car with rear-wheel drive and a V8 engine. Both are less efficient options. GM is also studying whether it should build a premium small car like the Mini Cooper or BMW 1 Series. "It's worth looking at," says GM Chairman and CEO G. Richard Wagoner Jr..

Others say $6,000 is too high, since the standards call for a gradual climb to 35 mpg and technology will get cheaper by then. Still, AutoNation (AN) CEO Mike Jackson says using hybrid technology will cost $5,000 to $10,000 a car, diesel is a $3,000 add-on, and improving existing gasoline engines costs about $500. "This is going to cost someone," Jackson says.

Since automakers don't know how much more consumers will want to pay for fuel economy, the carmakers figure they should try to downsize first. Lutz says cars with big V8 engines will get downsized to V6 motors. And the V6s will get 4-cylinder engines.

Uncomfortable Compromises
All of this amounts to a product planning conundrum for carmakers. They need to boost efficiency while still delivering what consumers want. Every company will have to try to strike a balance between costly technologies that force fewer compromises on Americans—who love roomy cabins and brawny engines—and keeping prices down.

"The trend in the world is going toward strict emissions regulations," Ikuo Mori, president and CEO of Subaru parent Fuji Heavy Industries (FUJHF), said through an interpreter. "Our responsibility is to do our best to reduce the investment needed to meet the new regulations, but we will need to ask customers to some extent to bear such costs."

Even hybrid king Toyota (TM) will face a tough challenge. The company wants to sell 1 million hybrids globally early in the next decade, with about 400,000 sales coming from the U.S. market.

To hit that, Toyota needs to cut the hybrid premium, which runs from $1,500 to $7,000, depending on the model. President Katsuaki Watanabe says that his engineers will have to work hard to meet CAFE regulations, which do ramp up gradually by 2020, without costing customers too much money.

Hybrid Approach
"Price is very important to our customers," Watanabe said through an interpreter. "We are trying to reduce the size and weight by half, which will reduce the cost."

In a perverse way, gasoline prices that have soared above $3 a gallon will help carmakers hit fuel-economy rules while making fewer changes. Nissan (NSANY) says fuel prices have helped sales of its Versa subcompact), launched last year. The company sold nearly 80,000 of them, accounting for most of the 0.4 percentage points that Nissan gained in market share.

Gasoline prices already have moved customers into smaller, more efficient vehicles, says Dominique Thormann, Nissan North America's senior vice-president of administration and finance. He says that buyers of Nissan's 15-mpg Pathfinder SUV have traded the gas hog for the 19-mpg Murano crossover or the smaller, 23-mpg Rogue.

But car prices could rise to pay for new technology. In 2010, Thormann says, Nissan will sell a diesel version of its Maxima sedan and bring out an all-new hybrid system. Both could add a few thousand dollars to the cost of the cars. Nissan's hybrid Altima sedan gets 34 mpg, almost meeting the federal government standard. The car costs $2,400 more than the standard $20,080, 24-mpg Altima.

European-Style Taxes
The auto industry's real problem would come if oil prices were to drop from today's prices of more than $90 a barrel to, say, $50 a barrel. American consumers have shown after oil shocks that when gasoline prices subside, they return to their guzzlers.

"If gasoline goes to $1.80 a gallon, you won't stop the American public from buying large V8 engines," Lutz says. "That would rapidly point out the lack of wisdom of the current CAFE regulations."

Europe may have a better system. European nations have elected to tax cars based on how much carbon dioxide they spew. In Spain, for example, any car that belches more than 120 grams of CO2 per kilometer (which is a modest V6 engine) gets taxed 5%. Cars that emit more than 160 grams per kilometer get taxed 10%; and above 200 grams, 20%.

"Customers are reacting super fast," says GM-Europe President Carl-Peter Forster. "The tax will rapidly change consumer behavior. It will drive the use of diesel up."

Americans, on the other hand, have no incentive to pay for efficiency. But they may get stuck with the bill anyway.