ZEV Mandate Series Part 4: Flexibilities in the Scheme

This piece is the third in a six-part series New AutoMotive is releasing during the ongoing consultation period for the UK’s Zero Emissions (ZEV) Mandate, over April-May. This series will examine the current government proposals around the Mandate in detail, as well as putting the policy framework into its broader context. In addition to publishing this blog series and submitting a formal consultation response, New AutoMotive will be hosting a webinar event around the ZEV Mandate and the current consultation in the coming weeks. If you are interested in attending this webinar event, you can register your details here.

To successfully change behaviour, government policy often tries to use a balance between carrots and sticks. This is a difficult balance for civil servants to strike. Too wilfully employed, a stick can provoke perverse outcomes. Too freely given, carrots can lead to glutinous inefficiency and inaction. And when the Treasury has a firm hand on the supply of carrots, the balance can tip too far in one direction. A former Home Secretary once joked that his officials would usually bring him a mixture of sticks and sticks painted orange. 

The government’s latest proposals for a Zero Emissions Vehicle mandate (ZEV mandate) are an attempt to change the behaviour of companies that make cars and vans. The aim is to get them to make and sell more electric vehicles. The clever bit is that market forces allocate the carrots and sticks. This way, the civil servants create a framework of obligations, targets, rules and credits, and step back and let the system run itself. 

At its heart, the ZEV mandate is just a market like any other market, governed by the forces of supply and demand. Credits (aka ‘allowances’) are the commodity that is being traded. The legal obligations (i.e. the mandate) created in the regulations are the source of demand for credits. The regulations also create a supply of credits, principally through the diminishing number of credits distributed by the Department for Transport, or by selling more electric vehicles, or by making use of a ‘flexibility’. 

There are other ways to obtain credits in the scheme: trading, borrowing, banking, transferring overperformance against fuel efficiency targets, and through selling vehicles into special use cases or with certain characteristics. These mechanisms can provide additional or temporary increases (or decreases) in the overall supply of credits, which can ease (or increase) the tension between supply and demand in some years. Hence they’re known as flexibilities. 

Designed well, these ‘flexibilities’ - which are the subject of this week’s blog - should enable the ZEV mandate to adapt to market and industry conditions. Designed poorly, they will oversupply the market with credits and weaken the mandate’s impact on the market. First, we’ll take a look at the flexibilities on offer, then we’ll discuss the likely impact of these flexibilities on the future market for allowances.

Flexibilities that increase the supply of allowances

First, we’ll consider the case of a fictional car company, CarCo, over the course of 2024-2028. CarCo’s production plans would see it bringing a mix of ZEV and non-ZEV models to the UK that would leave it facing a shortfall in allowances after its allocation, and ZEV sales. In each year, CarCo has to obtain as many allowances as its total car sales (in blue). How can it make up the allowance shortfall?

Graph 1: Sales & Allowances for Fictional Manufacturer “Carco”

There are essentially three options (discounting selling more ZEVs or trading): pay the buy-out, convert excess CO2 performance allowances, or borrow allowances. Trading has been covered in previous blog posts, so let’s explore the other options in turn.

1) Pay the buy-out

DfT are proposing that the buy-out price should be £15,000. This is the amount that is paid to DfT where a company needs to surrender an allowance but does not have one. CarCo’s average RRP on its petrol and diesel model is £30,000, and its margin on those vehicles is 5%, or £1,500. Adding a £15,000 per car cost would see CarCo make a loss on each petrol or diesel car that incurs a need to make a buy-out payment. It would be better for CarCo to simply reduce petrol and diesel sales rather than paying the buy-out, so this is not an attractive option. 

2) Sell more fuel efficient cars

In part two of this series, we discussed how the CO2 performance of new cars is to be regulated in tandem with the ZEV mandate. Essentially, car manufacturers will need to ensure that the average efficiency, expressed as a CO2 rating (how many grams of carbon are emitted per kilometre driven) is below a particular target, based on their sales in 2021. If a manufacturer makes their cars sufficiently more efficient that they exceed their target, they will be able to convert some of this excess into extra ZEV mandate allowances. 

This conversion works on the principle that the overall improvement in efficiency should be equivalent to registering an additional zero emissions vehicle before it can be rewarded by a ZEV mandate allowance. To see how this might work, let’s consider an example. Let’s say that in 2021, a manufacturer sells 10 non-ZEV cars, which each have an efficiency rating of 200gCO2/km. Now let’s consider two alternative scenarios. 

In the first scenario, in 2024, the fuel efficiency has improved, and each of its 10 cars are now 183.3gCO2/km. Altogether, every time these cars drive 1 km, they are emitting 167gCO2 less than the ten cars registered in 2021. Since 167gCO2/km is the typical efficiency for ICE cars, DfT is proposing to allow this efficiency improvement to be recognised with a ZEV mandate allowance. 

In the alternative scenario, the manufacturer sells 9 non-ZEV cars with no fuel efficiency improvement, but also sells a zero emissions model. The fleet-wide average fuel economy would be 180g/km (9 cars at 200gCO2/km and 1 car at 0gCO2/km). In this scenario they would have one ZEV mandate allowance resulting from the sale of a ZEV. This flexibility could be attractive, but hard to engineer unless CarCo had already planned to improve the fuel efficiency of its polluting vehicles. This flexibility will only be available until the end of 2026, in any case, so it does not really solve CarCo’s problems. 

3) Borrow allowances

A final option for CarCo would be to borrow allowances. DfT are proposing to allow companies to borrow allowances from future years, on the promise that they will be able to obtain additional allowances in future years to repay the debt. But borrowing is limited: it is only available in 2024, 2025, and 2026 and the amount of allowances that may be borrowed is limited, too. Lastly, it is penalised with a 3.5% compounding interest rate, and every credit must be repaid in 2027.

Graph 2: ZEV Mandate Compliance Through Allowances for Fictional Manufacturer “Carco”

Let’s imagine that CarCo tries to make up as much of its shortfall from borrowing. It can only borrow 75% of its target in 2024, 50% in year 2, and 25% in year 3, meaning that borrowing can’t make up the whole shortfall for CarCo. But what is interesting is what happens in 2027 - there is a sudden requirement to repay the deficit (in green), plus a compounded 3.5% interest rate. That creates a stiff regulatory requirement that should deter most companies from making extensive use of borrowing.

Flexibilities that increase demand for credits

There are just two flexibilities that increase demand for credits: the transferability of ZEV mandate credits into the CO2 performance regime, and the ability to bank credits

Graph 3: Manufacturer Car CO2 Performance Against 2021 Average - 12 Month Rolling Average

1) Transfers from ZEV mandate to CO2 regime

This flexibility is essentially the reverse of what we saw above - if a car company was to sell more EVs than they needed to meet the target, but was struggling to keep the efficiency of its vehicles down, it could transfer some ZEV mandate credits into the CO2 regime. This is unlikely to be used extensively, since we estimate that the CO2 regime will be oversupplied with credits, as most of the top 20 manufacturers’ average CO2 values are already well below the 2021 baseline.

2) Banking

Banking is the ability to store excess ZEV mandate allowances and to use them in future years. DfT proposes that this flexibility should be unlimited. This should enable the market for credits to play a role in helping the scheme adapt to fluctuations in vehicle supply and - given that there are future years where flexibilities end - allows companies to prepare for future reductions in the supply of credits.

Conclusion

An effective ZEV mandate should see sufficient demand for credits that drives changes in manufacturers’ behaviour without forcing the car market into a place that is unnatural and creates perverse incentives. Something that was striking to us at New AutoMotive when reading the latest proposals was just how many flexibilities there are. It makes for a complex system which reduces the importance and simplicity of the annual targets. We cannot look at the 22% target for 2024 and simply track EV registrations to judge whether the market will hit the targets.

New AutoMotive is currently analysing the details of the government’s proposals, and preparing its formal response to the ZEV Mandate consultation. Submissions to this consultation can be made here. In addition to this blog series and a formal consultation response, New AutoMotive will be hosting a webinar event around the ZEV Mandate and the current consultation in the coming weeks. If you are interested in attending this webinar event, you can register your details at the link here, and we will reach out to you with more details as they develop.