Will the EPA's New Fuel Economy Guidelines Crush Automakers in 2016?

The 2013 and 2014 Ford C-Max Hybrid had its fuel economy ratings adjusted downward after the car hit the market. Image source: Ryan Finnie / Flickr.

I bought my first car in 2013. I did my homework, decided what features mattered to me, and finally threw down the largest check I've ever written on a brand-spanking-new Mazda 3Gi hatchback. Buying that particular car assured I wouldn't win any drag races, but I was more interested in the fuel economy ratings: 39 mpg on the highway and 28 mpg in the city.

Problem is, even if I drive "perfectly" on long road trips, I'm lucky to max out at 34 mpg between fill-ups, which amounts to a difference of 60 miles per tank! You might have a similar experience and be asking the same question: "What gives?" Well, we're not alone.

The U.S. Environmental Protection Agency has asked that same question after an increased rate of "gotchas!" in the last two years. After finding major discrepancies between reported and real-world fuel economy, the agency forced Ford (F 0.66%) to knockdown the advertised fuel economy for its ultra-efficient C-Max Hybrid, and handed Kia and Hyundai fines totaling $300 million for infractions across their model lineups. The hefty fines served as a wake-up call to automakers, but the EPA is now introducing more permanent changes to guidelines governing the new vehicle testing that ultimately determines the fuel economy reported to consumers.

While the move could protect consumers purchasing new vehicles, it could also expose automakers that haven't fully complied with the guidelines in previous years in an attempt to keep up with ambitious Corporate Average Fuel Economy standards. In other words, this could get interesting -- or scary -- for investors.

What's happening to testing guidelines?
For the first time in over 10 years, the EPA is updating guidelines automakers use to determine vehicle fuel economy -- this will land for model-year 2017 vehicles, or those that go on sale in 2016. As it turns out, the agency is learning from recent infractions. One of the big complaints from Kia and Hyundai was that testing guidelines were too vague, which created the opportunity for discrepancies (in this case, sizable discrepancies) in reported fuel economy and real-world fuel economy. Well, be careful what you wish for.

The biggest guideline changes cover how test vehicles are prepared for testing. Starting next year, vehicles must be warmed up for 30 minutes and have roughly 4,000 miles. Both changes are aimed at better reflecting real-world conditions for data generated from the "coast down" test, which measures aerodynamic drag and tire rolling resistance as a vehicle slows from 70 mph (now lowered to 50 mph). These metrics are ultimately used to determine fuel economy.

In the near future, the EPA might also close the loophole that allowed Ford to initially report a combined fuel economy rating of 47 mpg for its C-Max Hybrid before lowering it to 43 mpg. The Blue Oval didn't actually do anything wrong, since current guidelines allow automakers to slap tested fuel economy from one vehicle onto another if both are the same size and have the same engine and powertrain.

An example window sticker for a gasoline vehicle. Image source: FuelEconomy.gov.

It's important to note that there's a difference between regulatory guidelines and rules. The former are technically voluntary, meaning infractions can only be exposed through audits, while the latter can take several years to propose, introduce, and enforce. Thus, the EPA decided not to draft a new rule because it wanted a more immediate solution and believes random audits will be sufficient to enforce the guideline changes.

Why does this matter for investors?
The guideline changes are really just clarifications on how the EPA expects the tests to be conducted, since previous rules didn't explicitly spell out expectations. In other words, if automakers complied with the tests before, then there shouldn't be any reason to worry. But while the EPA maintains most automakers do in fact follow the guidelines, the agency only knows if these companies are in compliance if it has randomly selected a vehicle for an audit.

These stricter guidelines, while still voluntary, could expose automakers that don't share the same attention to detail. For instance, let's say a model-year 2016 vehicle was rated at a combined fuel economy of 33 mpg, but the model-year 2017 version reports 29 mpg. This could force the EPA to conduct a not-so-random audit and potentially discover some not-so-encouraging results. That could lead to bad press, lost vehicle sales, big fines, and punished stock prices in a worst-case scenario. 

Unfortunately, investors have no way of knowing if an automaker they own will be affected. Of course, it's difficult to imagine that any automaker has managed to fool the EPA for years in a selfish attempt to give the appearance that it was on its way to meeting ambitious CAFE standards. So while the new guidelines could expose out-of-compliance vehicles and automakers, I don't think investors should brace for a worst-case scenario.