CAFE Standards' Diminishing Value May Hurt Auto Sales

Corporate Average Fuel Economy (CAFE) standards appear to create diminishing returns on fuel savings. Will this reduce consumer incentives to upgrade cars?

Jul 21, 2014 at 1:57PM

The U.S. Energy Information Administration recently reported that improving fuel economy standards for vehicles actually produce diminishing returns in fuel savings. The report states that small improvements in fuel economy in less efficient vehicles produce incrementally greater value than large improvements in more efficient vehicles.

Eia Annual Fuel Consumption

Source: U.S.Energy Information Administration, Annual Energy Outlook 2014
Note: Calculations in graphic assume a fuel price of $3.50 per gallon and annual travel of 12,000 miles per vehicle.

The report states:

Fuel costs, which depend on vehicle fuel economy, miles driven, and fuel price, are an important factor in vehicle purchasing decisions. However, fuel economy improvement exhibits diminishing returns in fuel savings. For example, switching from a 10-mile-per-gallon (mpg) vehicle to a 15-mpg vehicle saves more fuel and results in greater fuel cost savings than switching from a 25-mpg vehicle to a 75-mpg vehicle. The fuel and cost savings of improving fuel economy from 12 mpg to 15 mpg are the same as increasing from 30 mpg to 60 mpg. 

This makes sense as switching from a 10 miles-per-gallon (mpg) vehicle to a 15-mpg is a 50% improvement while switching from a 30-mpg vehicle to a 35-mpg vehicle produces only a 16% improvement for the same 5-mpg difference. Factor in the limitation of driving an average of 12,000 miles per year and there is little consumer incentive to improve vehicle mileage performance beyond the current standards of about 36-mpg for a midsize car per the EIA Annual Energy Outlook 2014 report. In fact, past the year 2025 the projected improvements in vehicle miles per gallon are so small as to be purely speculative.

Alternative fuels offer little economic value
The EIA report focuses mainly on gasoline vehicles, but it does speculate on other vehicle fuels resulting in some interesting conclusions:

Vehicles that use fuels other than gasoline, such as diesel or electricity, will have different fuel savings and fuel cost. Diesel vehicles often have higher fuel economy than standard gasoline vehicles, but they also must use diesel fuel, which is more expensive than gasoline. Plug-in electric vehicles, which achieve high fuel efficiency and take advantage of relatively inexpensive electricity (compared to gasoline), can accrue significant fuel cost savings, albeit at higher incremental vehicle cost.

Furthermore:

Diminishing returns to improved fuel economy make standard gasoline vehicles a highly fuel-efficient competitor relative to other vehicle fuel types such as diesels, hybrids, and plug-in vehicles, especially given the relatively higher vehicle prices projected for these other vehicle types.

In other words, at higher vehicle mileage ratings gasoline is economically highly competitive with diesel and other alternative fuels. While gasoline may be slightly less efficient than diesel and some alternatives, that economic loss to the consumer is offset by gasoline's lower relative cost to other fuels and/or vehicle costs.

The takeaway for investors
There are two key conclusions from this report for the long-term investor:

  • Gasoline is not going away. As an economically highly competitive fuel, gasoline will continue to be the dominant vehicle fuel. But improving mileage standards may reduce overall gasoline consumption. As gasoline gains in economic competitiveness, the alternatives will likely be squeezed of market share.
  • CAFE standards will increase the price of vehicles while producing diminishing economic return to the consumer. Consumers may shift their long-term buying habits by delaying future purchases of higher mileage vehicles to replace current acceptable mileage vehicles; by purchasing heavier-duty vehicles as their CAFE imposed mileage standards improve; and by reducing their purchases of alternative fuel vehicles, resulting in a reduced market share for these vehicles.

These impacts will have broad long-term economic effects across a number of industries, most notably the auto manufacturing industry. Broad model manufacturers like American icons General Motors (NYSE:GM), Ford Motors (NYSE:F), and Fiat Chrysler (NASDAQOTH: FIATY) all build gasoline-fueled cars that must meet CAFE standards. In addition they offer (or plan to offer) alternative fuel cars, most notably electric hybrids, compressed natural gas (CNG), and diesel.

But if the EIA analysis is accurate then their alternative fuel vehicles may have a dim future. Reuters reports that GM's Chevy Volt is a big money loser for the company, and Car and Driver reports that electric vehicles (EV) in general are not selling as planned, and wonders if they ever will. Even CNG fueled vehicles face problems such as low consumer demand, higher vehicle pricing, range anxiety and infrastructure build-out.   

Foreign auto manufacturers are in no better shape as they have the same fueling issues. HybridCars reports that manufacturers like Toyota (NYSE:TM) with the most successful of the alternatives in the hybrid Prius family (at 66% of hybrid market share), posted lower Prius sales from 2012 to 2013. Most of the other manufacturers and their models posted reductions as well. Nissan (NASDAQOTH: NSANY) and Tesla (NASDAQ:TSLA) sales gains were notable exceptions in the pure EV plug-in category, but overall plug-in numbers are still small compared to gasoline cars, constituting a mere .6% of overall sales.

Foolish conclusion
Gasoline is not going away. In fact, the latest EIA analysis indicates the gasoline is actually increasing in economic competitiveness. From a consumer perspective, this will likely represent the most economical fuel in future car purchases and continue to be the dominant fuel of the auto market.

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Jonathan Cook has no position in any stocks mentioned. The Motley Fool recommends Ford, General Motors, and Tesla Motors. The Motley Fool owns shares of Ford and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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