German cars have the most to lose from a changing auto industry

GERMAN carmakers have much in common with the self-confident roadhogs who favour their vehicles. The cars they produce, with sleek design, doors that close with a satisfying thunk and roomy interiors swagged with leather and technology, are the dominant force at the upper end of the car market worldwide. At home, too, they are the purring engine of the economy; carmaking is by far Germany’s biggest industrial sector.

But cars are changing. Electric power and autonomous vehicles will alter radically the way they are used (see special report). The difficulty in adapting threatens not only future revenues and profits at the big three—Daimler, BMW and Volkswagen (VW)–but also Germany’s status as a mean economic machine.

For now they are ahead. Brands built on unmatched quality mean four-fifths of the world’s premium cars have German badges. BMW and Daimler’s Mercedes-Benz both make over 2.2m cars a year. VW vies with Toyota and the Renault-Nissan-Mitsubishi alliance as the world’s biggest carmaker. It knocks out some 10m vehicles annually but relies on selling around 2m Audis and Porsches for 65% of its profits. The three companies’ total output of over 15m vehicles in 2016 represented around a fifth of the global total. “We are still the best car producers in the world”, brags Matthias Machnig, a deputy economy minister.

Yet the industry has three big problems. The first is one of public trust. VW’s emissions scandal in 2015, when it admitted it installed software in cars to trick tests of emissions, and accusations last year of collusion on diesel standards on a vast scale, have damaged carmakers’ reputations and also their political backing. A reminder of the seriousness of the issue came on February 27th when a federal court in Leipzig said that authorities in Stuttgart and Düsseldorf can prohibit entry of diesel cars, a ruling relevant to some 70 German cities. The prospect of city bans across Europe on polluting cars is drawing closer. Anti-diesel sentiments are spreading beyond Germany, with other cities, such as Paris and London, imposing bans.

Second, the industry is woefully behind in designing and selling electric vehicles (EVs), which consumers are increasingly taking to. It is not the Germans, supposedly the leading innovators in cars, but Renault-Nissan-Mitsubishi, a mass-market rival, that makes the world’s bestselling EV, the Nissan Leaf, sales of which have reached some 300,000 since the car’s launch in 2010. Chinese carmakers are streets ahead (see chart).

Third, the complex mechanical machines at which the country’s engineers excel are gradually transforming into (battery-powered) computers on wheels that will drive themselves. Superior mechanical-engineering technology has been the industry’s foundation, but there is no guarantee that it will lead in the electronic engineering and IT data-processing capabilities that will count most in future. Matthias Wissmann, president of the German Automobile Industry Association, concedes that such developments together mean his members face a “challenging moment”.

The tyre tread of its carmakers has left a big impression on Germany. Cars are worldwide road-going adverts for the national brand. “Made in Germany” has become a guarantee of engineering prowess that has helped to promote the country’s exports of industrial equipment and a myriad of niche products from the Mittelstand of medium-sized firms. Around four-fifths of all cars made in Germany, worth €256bn ($283bn) in 2016, are exported. A workforce of around 800,000 is employed directly or by suppliers. And these are plum jobs, with high pay and lots of perks (including, for some, big company cars).

The industry’s success comes in part because the premium segment has long been growing faster than the car market as a whole. As motorists get richer they tend to trade up to a nicer set of wheels. The Germans have also cannily expanded what counts as a premium car. Once they specialised in big saloons. But a decade or so ago they put their badges on smaller, cheaper cars, such as BMW’s 1-Series or the Mercedes A-Class. For a little extra drivers could have a prestigious German marque, a step up from mass-market models, which ceded market share.

Scale and strong brands have kept competitors at bay. Toyota’s Lexus division and Jaguar Land Rover (JLR), a British-based Indian-owned firm with, not coincidentally, a former BMW executive in charge, have mounted the most successful challenge but are still minnows in comparison. They sold over 670,000 and 610,000 cars respectively in 2017. The premium brands of other carmakers have made even less of a dent. Only Tesla’s swish electric cars have given the Germans cause to lose sleep.

The Institute for Economic Research (IFO) says that carmakers account for 13% of industrial value creation in Germany. Cars are a spur of the technological innovation for which the country is famed. In 2016 the industry spent nearly €22bn on research and development, over a third of Germany’s total. Serving the car industry is a key part of the businesses of industrial giants such as Bosch and Siemens.

Germany, company town for carmakers

This economic power has in turn given the car manufacturers plenty of political heft. The Christian Democratic Union (CDU) is heavily supported by the car companies; the Social Democrats by trade unions at the big three. Winfried Kretschmann, leader of Baden-Württemberg, home to many car producers, is from the Green Party. Even he has defended the long-term production of diesel cars.

Critics complain of a revolving door that has led carmakers to believe that they could get away with bad behaviour. A recent president of Germany, the previous chancellor and the current deputy chancellor have all served on VW’s board. Eckart von Klaeden, once a senior official in the CDU, became Daimler’s chief lobbyist in Berlin in 2013. Mr Wissmann, the boss of Germany’s leading car-lobbyist group, also held a senior position in the CDU, and was transport minister in the 1990s. And so the list goes on.

These links have bestowed seeming advantages. “Free driving for free citizens” runs one German saying. Bosses and politicians flit between cities on autobahns with no speed limits. Germans pay no road tax. Tax policy keeps diesel substantially cheaper at the pump than petrol, nudging consumers to prefer big cars that rely on diesel engines to meet emissions regulations. Other tax rules also encourage companies to provide workers with premium cars and fuel allowances.

Germany’s current chancellor, Angela Merkel, has been only too willing to help. She pressed the EU to block an agreement on toughening carbon-dioxide emissions in 2013 (big German cars remain heavy emitters, although diesel produces less carbon dioxide than petrol). German politicians lobbied the European Commission to temper the severity of the latest set of emissions rules, for 2020 and beyond, announced in November. As Lutz Meier, a motor journalist in Berlin puts it, cars, and the policies that favour them, have helped to “determine our national psyche”.

Yet consumers, especially younger ones, are increasingly doubtful about diesel-powered cars. The share of diesel sales has tumbled in Germany from a peak of 48% in 2012 to 33% this year and is plummeting elsewhere in Europe too. Germany’s car firms are heavily reliant on diesel sales in Europe; they make up well over a third of global sales for Daimler and for BMW and a quarter for VW. So if German cities do impose driving bans on diesel cars, in response to evidence that pollution threatens residents’ health, that could prove to be a “Fukushima moment” for the industry, suggests Christian Hochfeld, of Agora, a Berlin think-tank focused on energy and transport, referring to the fact that Germany’s nuclear business collapsed following the disaster in Japan in 2011. He also notes that resale values of diesel cars are tumbling. If carmakers are obliged to retrofit diesel vehicles with hardware to reduce nitrogen oxide emissions, as many people are now calling for, the cost to them would run to billions of euros in Germany alone.

Coddling of the industry by politicians is likely to decline. Mrs Merkel told bosses of the main car firms in September that “a lot of trust has been destroyed” in recent scandals. In November she warned the industry that it is running out of time to react to public worries over air pollution from their cars. As political opponents grow more outspoken in favour of bans—the Greens in parliament suggest sending petrol and diesel cars to the scrapyard nationwide by 2030—even Mrs Merkel’s ruling party is adjusting its position on diesel. Last week a junior minister suggested that temporary driving restrictions on some routes might be introduced in an effort to limit the worst episodes of urban smog.

Political support in past years helped the industry in the short term but is widely felt to have contributed to complacency and to German manufacturers’ lagging position in the EV race. Getting the cold shoulder from government might be beneficial if it spurred firms to act faster in responding to changing consumer tastes, producing electric or cleaner vehicles and keeping up with changing demand from abroad. But carmakers will fret that they are losing support, and if the mesh of rules and incentives that keep consumers driving their national treasures change, it could have a sharply detrimental effect on the industry.

Electric shock

Today it is Tesla that dominates the luxury market for EVs. This year JLR will be the first premium carmaker to start selling a direct competitor to Tesla’s Model S saloon, the I-Pace. Audi’s Q6 e-tron will arrive later in 2018 and Porsche’s Mission E will not arrive until 2019. Volkwagen’s and Daimler’s EVs are based on established internal combustion engine (ICE) vehicles and sell only in small quantities. In 2017 VW sold under 13,000 of its most popular all-electric model in Europe and Mercedes just over 5,000. BMW has done better with its “i” sub-brand, established in 2011. Global sales of the i3, a neat if pricey saloon, exceeded 31,000 in 2017 but sales have never matched the firm’s expectations.

Tardy arrival has significant costs. Suppliers are not in place to support an entirely new industry. German expertise in making chemicals and electronics could have been deployed to produce a battery industry to feed a thriving electric-car market. “We have no one in Germany who really understands batteries, and we lack the value chain; we are very, very late”, laments Ferdinand Dudenhöffer, of the Centre for Automotive Research, in Essen.

Further delays in switching to rapid development of electric cars would prove more costly for everyone, executives say. “The longer you wait, the more jobs you lose”, says Mr Dudenhöffer. Many are at stake. The IFO offers a startling estimate that 426,000 jobs among the main carmakers, plus another 130,000 jobs among suppliers, depend directly on making parts for ICE vehicles.

In theory, German carmakers have the skills and cash to respond quickly, by building high-quality hybrid, plug-in or all-electric cars. And they have ambitious plans to catch up. VW says up to 25% of its cars sold in 2025 will be electrified. But they will not come cheap. EVs are pricier to make than cars powered by an ICE. Daimler, which also says that up to 25% of its cars will be electrified by the same date, admits the shift will hit profits hard. Most carmakers are looking to spread the cost. Geely, a Chinese carmaker, announced on February 23rd that it had taken a 9.7% stake in Daimler, partly, it is thought, to forge an alliance to share the costs of developing EVs.

Ultimately, self-driving machines

Another problem is how to defend the carefully nurtured brands themselves from disruption. The reputation was built on superior engineering, ICEs and driving pleasure. Premium cars sell for more because they are on the cutting edge of developments in motoring. Antilock brakes, turbocharged (diesel) engines and a host of other whizzy extras all showed up first on German cars. In return carmakers can charge more and rake in fatter profits than their mass-market counterparts (margins average around 10% compared with 5% or below in the mass market).

Yet desirable brands and mechanical brilliance may be much less use as carmaking is turned upside down. EVs, mobility services and autonomous vehicles are likely to be increasing sources of profits. Electric motors are largely standardised and may not command the same premium. German cars, engineered to please their discerning drivers, are unlikely to carry the same kudos when vehicles drive themselves. BMW, which advertised its cars as “The Ultimate Driving Machine” may have to rethink its marketing.

German manufacturers, naturally, argue that there is plenty of scope for premium brands as the landscape transforms. The engine, after all, is a small part of a package that includes those plush interiors, smooth suspension and superior design, they note. That is because by using clever electronics, car manufacturers can tweak the performance of electric engines to give a premium experience, they say. To be on the safe side, BMW is even manufacturing its own electric engines. Passengers will still pay extra for a better driving experience even if they are no longer at the wheel, they contend.

Like all carmakers, Daimler, VW and BMW are trying to reinvent themselves as “mobility providers”. They have pilot projects for services including sharing ones such as Daimler’s car2go and BMW’s DriveNow. In late 2016 VW created MOIA, a separate division dedicated to new mobility, including an investment in Gett, a ride-hailing firm, and plans for carpooling and shuttle services. It says MOIA will “generate a substantial share” of revenues by 2025. Yet it offers no details on how.

Yet even if demand for fancy vehicles is still there, the business model is highly uncertain. The convention of making money chiefly from selling cars (the industry also profits from after-sales services) will have to be augmented and perhaps eventually replaced by new sources of income. As car drivers switch from ownership to services, revenues from sales will fall. It is unclear how long it will take for robotaxis and shared services to hit car ownership but some forecasts suggest that private sales will fall dramatically once these emerge.

Neither is it clear what carmakers reckon those models will be. As Dieter Zetsche, boss of Daimler, admits, he cannot say where the big returns will come in the future. “Maybe robotaxis and a sharing model…maybe something else”. He adds that for short journeys no one will much care about what brand of vehicle they are in. That leaves luxury robotaxis used on longer journeys, perhaps by wealthier commuters who are happy to pay more for added luxury and status.

Even if the road to future profits is hard to make out, at least the Germans are more advanced in some areas than many competitors. Daimler, for example, is widely acknowledged as a technological leader in developing autonomous cars. All three have teamed up to buy HERE, a mapping company of the sort that is vital for self-driving. The Germans do have the luxury of “deep pockets, deep thinking and time”, notes Max Warburton of Bernstein, a bank. It may be that the last hold-outs who drive themselves are the rich and indulgent. If so, conventional luxury cars will still have some customers. But that could be an ever dwindling niche. The onus is on carmakers to prove they can successfully reinvent themselves—and continue to keep the German economy in the fast lane.