Demand for Electric Vehicles Accelerates

Editor's note: This article first appeared in the Q4 2021 issue of Morningstar magazine. Click here to subscribe.

By 2030, electric vehicles and hybrids will make up two thirds of autos sold globally. So forecasts Seth Goldstein in a recent Morningstar Elective Vehicle Observer. The market consensus questions whether rapid growth in the EV market is sustainable without subsidies. Goldstein, chair of Morningstar Research Services' electric vehicle committee, contends that it is, noting that by 2025, entry-level EVs should be cheaper than cars with internal combustion engines.

I spoke with Goldstein about the EV outlook and related investment opportunities throughout the supply chain. Our discussion reflects performance and valuations as of Sept. 30.

Laura Lallos: How does your forecast for EV adoption differ from consensus?

Goldstein: My forecast is for EVs to grow from about 3% of new autos sold globally today to 30% by 2030. Consensus is only at 21%. It will be different region by region: I think Europe is going to be leading the world in EV adoption, at 50% of sales. China will be second, at 35%. And the United States will be in line with the global average, at around 30%.

Lallos: How has the pandemic affected the EV market—is the impact different than on autos in general?

Goldstein: It's been entirely different. In fact, EV sales grew in 2020 and are expected to grow again this year, even as we saw auto sales decline 15% globally last year. Due to chip shortages and supply chain delays, we're not going to see quite the V-shaped rebound this year. It might be a more gradual, multiyear recovery.

For electric vehicles, the growth was driven by government incentives in the very near term. In Europe and China, COVID-19 stimulus packages also included incentives for consumers that would drive greater EV adoption. Many countries in Europe started giving incentives, tax rebates, and subsidies directly to the consumer. China had subsidies in place already that were set to expire in 2020, but they extended that by two years. Governments were trying to stimulate the economy but also help boost EV sales.

Lallos: A recent United Nations report put climate change in the headlines again. Do you anticipate further regulatory response as a result?

Goldstein: It's certainly possible. The European Union is developing their next auto fuel emissions standards. While it's already the strictest in the world, there's a possibility of an outright ban of combustion engines in the future for the entire EU. I wouldn't expect that to be off the table right now.

China has strict emissions regulations that are likely to get stricter. China has also required automakers to make a certain percentage of new-energy vehicles, which includes EVs, plug-in hybrids, and fuel cells. This percentage increases every year. Right now, it’s only set through 2023, but I wouldn’t be surprised if they continue to set a higher and higher portion each year after 2023.

The U.S. is up in the air based on whether the Democrats retain control of Congress in the midterms and maintain the White House in 2024. There is a sort of push/pull based on which party is in power: The Republicans tend to want to roll back regulations, while the Democrats tend to want to make regulations stricter.

But either way, I don’t view U.S. regulations as driving EV adoption. It’s Europe and China that have created the need for global automakers to invest in developing profitable electric vehicles. Then, because they’ve already made those research and development investments, they’re going to start selling the same products in the U.S. as well.

Lallos: Illinois recently passed a climate bill that incentivizes consumers to buy electric vehicles. Do you foresee such legislation from other states?

Goldstein: I would not be surprised if more states wanted to follow Illinois' example, much the same way as when France rolled out subsidies, Germany quickly followed suit. But by 2025, I think the EV will be cheap enough on its own that you won't need subsidies in most parts of the world. The cost barrier most likely will no longer exist. Subsidies are good right now for the consumer who's interested in an EV but doesn't want to pay more for it. They're certainly needed in the near term to help get more consumers crossing that purchase threshold. But longer term, I don't really see subsidies as a driving factor.

Lallos: The idea that cost parity will alleviate dependence on subsidies is one of the things that differentiates your forecast from the consensus. What about your take on charging infrastructure?

Goldstein: Even if you take cost out of the equation, consumers are still very hesitant to buy an electric vehicle because of what we call road-trip anxiety, even though more than 95% of the time, we're just staying in town: commuting to work, going to the grocery store, going out to eat dinner. An EV range would be fine for daily normal city life.

But consumers fear that they won’t be able to use an EV on a road trip. The fear of not being able to find places to charge is the number-one reason consumers hesitate to buy an EV, even more important than having to pay more for it. That is really a big barrier to entry. That’s why we’ve seen a big push by governments to build chargers along highways and in cities to give people confidence. In my mind, while subsidies are great near-term drivers, the biggest long-term driver of EV adoption is governments building more charging infrastructure. That’s what’s going to alleviate road-trip anxiety. We think that enough chargers will be in place in China, the EU, and the U.S. to support the EV fleet and boost adoption.

Lallos: What role does hybrid technology have in this transition?

Goldstein: Hybrids will be cheaper for the consumer truck market. The average consumer drives 12,000 miles a year. That's not really enough to make up the extra purchase price of buying an EV, but it will be enough for hybrids due to the fuel savings versus the internal combustion engine. That's where we see hybrid trucks and SUVs reaching cost parity on the total cost of ownership. And that's where we see higher hybrid adoption for regions like the U.S. and China, where the majority of auto sales are light trucks.

With hybrids, you don’t have any functional concerns, either. People don’t have to worry about range and finding places to charge. That may boost hybrid sales for some of the more skeptical EV consumers out there.

Lallos: What about EV adoption outside the consumer auto market?

Goldstein: Motorcycles are used largely in major cities throughout Asia and Europe for the daily commute, where you don't have to worry about range. You can usually charge these bikes either at home with just a regular electric plug, because they don't have that big of a battery, or you can charge them pretty quickly at a public charger. These are more expensive up front, but you'll save on lower maintenance and fuel costs over five years. Given the fact that they are cheaper today on total cost of ownership, I think that as more bikes hit the market, the consumer will say this is a good decision.

Similarly, when we look at city vehicles—mainly buses and commercial delivery vehicles, like United Parcel Service UPS and FedEx FDX vans—the business case is there to save money by going electric right now. These vehicles tend to drive on fixed routes. They don’t drive that many miles in a day, and they can return to the garage and charge overnight. The functional limitations that hold back consumers just aren’t in place, and the cost-saving argument is there. As battery costs continue to fall, that argument only gets stronger. That’s why we forecast higher adoption in those vehicles.

Lallos: When investors think about how to participate in this emerging trend, they start with the automakers themselves. Putting aside the question of valuation, who are the industry leaders?

Goldstein: We have to start with Tesla TSLA. Obviously, it's one of the first automakers you think of when you think of an electric vehicle, and they have the best technology today. But a lot of the traditional automakers have been investing heavily in EVs for years and are starting to produce some really cool vehicles. Volkswagen VWAPY, General Motors GM, and BMW BMWYY are three companies I'd highlight that have gone all in on EVs for a number of years now and are likely to be some of the first traditional automakers to make EVs a profitable business venture.

Lallos: Are any of those names worth looking at from a valuation standpoint?

Goldstein: We see Tesla as slightly overvalued, but GM and BMW are at 4 stars, and Volkswagen preferred shares are at 5 stars. The market may be fearing the damage from the chip shortage right now. That's temporarily depressing valuations of traditional automakers, which can be a good opportunity to buy these higher-quality automakers at a discount.

Lallos: How important is regulation to these automakers' efforts at this point?

Goldstein: Thinking of where regulation will evolve over the next 10, 20, 30 years creates an impetus to invest in the development of a profitable zero-emission electric vehicle today. The fuel cell technology isn't quite there. That leaves battery electric vehicles as the way to get there from a consumer auto standpoint.

These early adopters are a little ahead of the curve versus some of the other traditional automakers. But right now, all traditional automakers are investing heavily in the development of EVs. It’s a survival mechanism. Some of these major automakers might not be around or might not be around in the same capacity that they are today in 10 or 20 years if they don’t invest in electric vehicles today.

Lallos: What other industries should investors look at?

Goldstein: We tend to like industries throughout the EV supply chain more than the actual automakers themselves. At the most upstream end of the EV supply chain is lithium, which is one of our favorite ways to play EV adoption. All EVs need batteries, and all EV batteries need to have lithium. It doesn't matter what the battery chemistry is or what the automaker or the brand is. You're basically investing that there will be more EVs on the road tomorrow than there are today. Our top pick here is SQM SQM.

Another industry that will benefit just from more EVs being on the road is semiconductors. The electric vehicle needs a lot more semiconductors than a traditional internal combustion engine does, so there’s an opportunity for automotive-focused semiconductor makers to generate higher revenue and grow profits accordingly. NXP Semiconductors NXPI, Infineon Technologies IFNNY, and STMicroelectronics STM are names that we believe stand out here, though perhaps not valuationwise today. These are companies that continue to invest heavily in developing their automotive semiconductors.

Lallos: Automakers lost a lot of their chip supply when they canceled orders early in the pandemic and other buyers moved in. Does that create an opportunity for smaller semiconductor companies?

Goldstein: It should create opportunities for anyone who wants to invest to serve the auto market. Autos are still only 10% or so of the semiconductor market today, much smaller than, say, computers or phones and other electronics. But chipmakers are seeing growing demand from the auto sector, and you're likely to see some capacity expansion and potentially some chipmakers that have served the auto market as more of an afterthought start to get more serious about it.

We also like specialty chemical companies that sell to the automotive industry. These companies not only sell to automakers, but also to battery makers and to technology component makers, including semiconductor producers. As more batteries are needed, and as more semiconductors are needed, companies like DuPont DD or Eastman Chemical EMN or Celanese CE can sell more content per vehicle by selling to basically the entire auto supply chain.

I also look at traditional auto suppliers that are investing heavily in electric vehicle powertrains. Look at BorgWarner BWA. They’re known for their industry-leading internal combustion powertrain, but they also have some of the best electric vehicle motors and powertrains out there. They’ve invested heavily to position themselves as being able to win no matter how fast or slow the transition to EVs and hybrids occurs.

Lallos: You've noted that some companies in the utilities sector stand to benefit from EV adoption.

Goldstein: There's an opportunity to build charging infrastructure, especially for regulated utilities. State regulators that want to address climate change and set pro-EV policies can allow utilities in their state to build more charging infrastructure. For a regulated utility, growing capital spending is a way to grow profits. For utilities like Edison International EIX, which operates in California under a very pro-EV state environment, this is a great new source of profit growth.

Look to the state utilities that are operating in pro-EV states and jurisdictions. There are three main levers states can pull. There’s the subsidy for the consumer. There’s regulation of what automakers can and cannot sell. And then there’s building charging infrastructure to support the EV market once it’s there and alleviate consumer fears. As more states want to boost EV sales, I think they’ll take the subsidy approach and then combine that on the back end with funding charging infrastructure.

Lallos: What do you believe will ultimately be the main driver of EV adoption?

Goldstein: Consumer demand. A big difference between us and consensus is that consensus focuses too much on regulations over the near term. While we do think regulations are important over the next couple of years, we think eventually the EV will be able to stand on its own, reaching cost and functional parity with internal combustion engines. When this happens, the bigger long-term driver will be consumer demand. Consumers will look to an EV as just another car they might want to buy and will consider it without any of the hesitations that exist today.

Laura Lallos is managing editor of Morningstar magazine.