Tesla’s Lucrative ZEV Credits May Not Be Sustainable

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While Tesla (NASDAQ: TSLA) has been a beneficiary of a fair amount of indirect government incentives at both the federal and state levels, the Zero Emission Vehicle credits (ZEVs) are perhaps the most overlooked perks garnered by the company.  In this note, we take a look at what these credits mean for the company and whether it’s sustainable in the long-run.

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The Credit Has Provided A Boost To Tesla’s Earnings In The Past

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California, and nine other U.S. states that have adopted its ZEV regime, require automakers that sell internal combustion engine-based vehicles to earn a certain number of ZEV credits every year by selling zero-emission vehicles. The credit requirement is typically determined by the number of vehicles that the manufacturer sells in the state. If an automaker doesn’t produce enough electric cars to meet its quota, it can choose to buy credits from other manufacturers who do or pay a $5,000 fine for each credit it is short. This has proved positive for manufacturers such as Tesla, who produce only battery-powered vehicles, leaving them with ZEV credits that they can sell to other manufacturers. For instance, in California, Tesla earns four credits for each Model S vehicle that it sells. Although the revenues from the sales of these credits are quite volatile (see chart below), they are very lucrative, as Tesla essentially incurs no direct costs to earn them. For instance, during Q3’16 revenues from the sale of ZEV credits stood at $139 million, helping Tesla post a small profit instead of a sizable loss. Tesla has likely sold more than $700 million in credits so far, helping the company mitigate the extent of its overall losses.

Rising Supply, Regulatory Risks Can Hurt ZEV Credit Revenues

While each ZEV credit should theoretically be worth about $5,000 (the fine for non-compliance), their market value is typically far less. For instance, over the first half of the year Tesla sold around $100 million in ZEV credits.  If we assume that the company sold about 16k cars in states that offer ZEV credits over the period (about one third of the company’s 47k cars delivered), revenue from ZEV credits per vehicle sold stood at about $6,250. Assuming 4 credits per Tesla, this would amount to under $1,600 per credit. Moreover, with electric vehicles gaining traction, there is a possibility that the number of credits available in the market will start to outstrip the number of credits required by manufacturers, causing prices to decline. Tesla’s own mass-market Model 3 could itself boost the supply of ZEV credits, with the company targeting a run-rate of 500k vehicles next year.

There are also some regulatory concerns that could hurt Tesla’s ZEV credit revenues. For one, the Trump administration has deemphasized climate-related issues, and there is a possibility that it could push states to roll back their ZEV credit programs (though that would be difficult to enforce), as it essentially makes non-electric car buyers bear the burden of electric car subsidies. There is a possibility that modifications could be made to the plan as well. For instance, under the current system, EV manufacturers are awarded credits based on the range of their vehicles. This methodology favors Tesla over other electric vehicles such as the Nissan Leaf, which has a lower range, despite the fact that both vehicles have zero emissions.

That said, we believe Tesla should be less reliant on such credits and subsidies going forward. Declining battery costs and manufacturing efficiencies are helping the company cut costs and improve margins from its core operations.  For instance, the company expects gross margins of about 25% on its new Model 3 sedan. The thicker margins, coupled with the larger volumes, should help Tesla move towards operating profitability in the near term.

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