The end of August marked the end of an annual trading window in China: For the past two months, carmakers have been trading their "New Energy Vehicle" credits in the dark. Leading electric vehicle companies like Tesla and BYD were making hundreds of millions, thanks to a three-year-old quasi-carbon market set up to boost the EV industry's growth.
While the United States just started injecting billions of dollars into its EV industry, China is already ahead of the game, with a "dual-credit" policy that Beijing adapted in 2017 from California state law. Over three years into its existence, the "dual-credit" policy, which punishes the production of fossil fuel cars and rewards the production of EVs, has become one of the most successful policies globally in incentivizing EV production. Some Chinese companies are even selling EVs below cost, as long as the revenue from selling carbon credits can make up for the shortfall.
As China gradually phases out its direct subsidy program and moves to a market-based regulation scheme, this carbon credit market is powering China's ascension in the global automobile industry.
The ever-rising price to purchase a NEV credit
Announced in 2017, the "dual-credit" policy has a somewhat complicated design. There's a Corporate Average Fuel Consumption (CAFC) credit, where carmakers gain credits for reducing the average fuel consumption to below a certain level and lose credits for failing to achieve it. There's also a New Energy Vehicle (NEV) credit, where carmakers receive positive credits for each EV produced and negative credits for not producing a specified percentage of EVs in a year.
The criteria were designed so that most traditional carmakers would have a negative total of CAFC credits at the end of the year. To avoid a penalty in the form of a next-year production cap, carmakers had to either make EVs of their own or purchase NEV credits from other companies.
In April, China's Ministry of Industry and Information Technology released the annual credit totals for all automobile companies operating in China, a sort of annual report card for corporate performance. Most prominent firms, like the joint ventures between Volkswagen, General Motors and their Chinese partners, accumulated hundreds of thousands of negative credits. But Tesla, Chinese company BYD and other EV makers amassed a big surplus of NEV credits that they can now sell for profit.
Every year for a few designated months in the summer, these companies are supposed to trade their credits with one other directly. There's no public trading platform, so each participant has to negotiate a price based on their own deal-making abilities. That has motivated most of them to stay silent about the price and the volume of the transactions. "A company may be selling its credits to different companies at different prices. If the prices are made public, the market will be in chaos. So all deals are kept secret," said Tian Yongqiu, an independent auto industry analyst.
But from media reports and numbers released by the government, it's clear that the average price of a NEV credit has changed drastically over the years. It went from about $50 in 2019 to $180 in 2020. While results aren't out yet for 2021, analysts said it had reached nearly $500. Some even speculate that the price could reach $900 per credit next year.
Part of that increase is baked into the design, as the criteria for getting positive credits get harder incrementally every year. "The point of changing the policy every year is to force the price of NEV credits to rise," Zhang Xiang, auto industry analyst at the North China University of Technology, told Protocol. "If credits are too inexpensive, the traditional carmakers won't be incentivized to produce their own EVs."
Before this year, producing an EV typically could earn the company between two and eight credits. That means one EV can equate to thousands of dollars of extra profit in a given year, collectively adding up to a major revenue stream for EV companies.
From the outside, people can only get a hint of how much EV companies are making from selling NEV credits. Tesla disclosed in its 2020 financials that it made $1.6 billion by selling regulatory credits — in China, the United States and Europe combined. (It did not break out its China numbers.) In April, Reuters reported that Tesla has reached a deal with a Volkswagen JV in China to sell NEV credits at $460 each.
NIO, the Chinese hit EV brand recently engulfed in an autopilot-related controversy, earned $18 million in Q4 2020 through selling NEV credits, executives said on an earnings call. Equity analysts from Shenwan Hongyuan wrote that BYD, the Chinese company with the most NEV credits, is on pace to earn at least $200 million from selling credits this year.
There's no reason to believe companies are hoarding their credits for future deals, analyst Tian Yongqiu said. The rules currently dictate that any NEV credit that's left after the trading window will be discounted by half going into the next year.
The larger picture
The effect of China's EV incentive policy is significant. Today, EVs make up over 10% of all automobiles sold in China, while that number is just 2.5% in the United States. This has given China an unprecedented opportunity to assert itself into a market traditionally dominated by the West.
"[China] had no chance to gain traction with traditional cars," Felipe Munoz, senior analyst at market research firm JATO Dynamics, told Protocol, calling EVs "a different story." In this industry, "both the Chinese and the Westerners are equally positioned, and that gives China an advantage."
Particularly, it gave Chinese companies an edge in the affordable end of the market. "Today, China is years ahead the rest of the world in terms of affordable EVs. This can lead them to conquer the emerging markets, as they are the only choice for the population there," said Munoz.
Some side effects
Of course, the policy has its unintended consequences. One common criticism of the "dual-credit" policy is its unsatisfactory impact on fossil fuel-powered cars. The parallel system was supposed to also incentivize carmakers to improve their gasoline engines' efficiency, but because the NEV credits are so much easier to get than CAFC credits, most carmakers haven't bothered to improve their traditional engine models. The fluctuation in NEV credits' price is also a problem, as it could encourage hoarding and speculation.
It also breeds a market where small EVs are designed just for the purpose of gaining NEV credits. Because the credit criterion for EVs is only centered around the driving range — for example, any car with a maximum range of 300km (about 186 miles) is converted into 2.08 credits — companies aren't incentivized to produce EVs that really meet the needs of car buyers rather than cars that can drive long and earn lots of NEV credits.
When Wuling Hongguang EV, China's viral tiny EV, was introduced last year, company executives were clear that the motivation was to generate enough NEV credits so the parent company, a joint venture between General Motors and China's SAIC, could relieve the pressure of having too many negative credits.
"A tiny car and a massive car are no different when it comes to how many credits they contribute [to the company]." Zhu Jun, deputy director of SAIC's passenger car technology center, said in a conference in Nov 2020. Wuling Hongguang's Mini EV, which costs only about $5,000, "would greatly help the company meet its need for credit under the current policy. Otherwise, [we] would have to spend a lot of money purchasing credits."
Successful as it is, the "dual-credit" policy still has a long way to go from an environmental perspective. "The current dual-credit policy only covers passenger vehicles. However, China's medium and heavy-duty commercial vehicles account for 46.9% of road transport greenhouse gas emissions," Chen Zhinan, climate policy fellow at the California-China Climate Institute, told Protocol. Incorporating commercial vehicles into the current system will be an important task going forward.
Replacing gasoline cars with EVs also doesn't necessarily benefit the environment when electricity production in China remains so dependent on burning coal. That might be how this separate, quasi-carbon market of NEV credits can eventually connect to the larger carbon market China started building this year. "In the long term, China could consider assigning credits based on life-cycle emissions instead of on-road emissions only," said Chen.