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In my article last week I posited that electric cars are shifting the locus of competition in the automotive industry from cost to innovation:
“The auto industry is experiencing a once-in-a-century paradigm shift that will require companies that spent decades building their competencies in cost efficiency and supply chain management to reorient themselves around technological innovation, lest they be overthrown by Tesla or any of the other EV startups that have debuted in the last couple of years.”
That appears to answer the question in the title of this article. In an ideal world, the answer is that straightforward: in-house and innovate. But this is the real world with realities that add nuances worth exploring in a standalone article.
Let’s begin with the realities:
Battery technology is “pushed” innovation. Failure to innovate, i.e. reduce emissions, is punished by regulators and (on a relative basis) by consumers but is not conversely rewarded by customers with incremental revenue/profit. This makes cost an important consideration in contrast to the “pulled” innovation we often see in tech. It costs Apple more to make airpods versus earpods, but consumers are willing to pay even more for them such that Apple ends up making an incremental profit. Automakers can’t pass along the cost of innovation, forcing them to either accept lower profits or take cost out somewhere else.
Automakers are balancing a transition from a legacy business. With the exception of Tesla, automakers have billions invested in plants and equipment that build gas cars. The combustion engine, with its many parts, is the most labor intensive part of the car. Retooling those plants and negotiating with labor unions takes time and money and there will be cost disynergies from running smaller volumes on separate supply chains. Furthermore, OEMs are transitioning from a profitable product towards a product that currently relies on subsidies and regulation to sell. Until recently, that was a delicate subject to broach with investors, which gave rise to the final reality….
The OEMs are starting from behind. The old guard OEMs are built on cost efficiency and supply chains. In-housing battery technology not only requires significant capex investment but requires convincing in-demand battery engineers that they would rather work for a company perceived as the disruptee than for the disruptor. GE’s 2015 “What’s The Matter With Owen” ad campaign, featuring a young programmer trying to explain to disbelieving peers that he’s accepted an offer to work at an old economy company, sums up the cultural challenge facing these dinosaurs.
Given these constraints (let’s call them cost, legacy and culture), does it still make sense to try to innovate?
The answer is, it depends. OEMs need to make a judgement on three factors: battery demand, battery supply, and battery innovation. Where in the spectrum of innovation versus cost efficiency an OEM chooses to position itself comes down to its expectations for two inflection points: BEV adoption and battery innovation.
In the above graph, battery demand serves as a proxy for electric car adoption. To paraphrase Ernest Hemingway, change happens in two ways: gradually, then suddenly. At some point we will reach a tipping point for electric cars that will inflect battery demand. The second inflection point is battery innovation, or when we start to see diminishing returns on battery improvement. This can be absolute – a ceiling on energy density and charge rate that cannot be crossed – or relative – a consumer might value an extra 50 miles of range on a vehicle with a 600-mile range less than they would on a vehicle with a 200-mile range. Once we pass the innovation inflection point, batteries will become increasingly commoditized and the locus of competition will return to cost. The time between the inflection in demand and the inflection in innovation is the period to compete on innovation. The final line on the graph is battery supply. This is the most knowable variable and the least elastic one, since it takes 3 years to bring a plant fully online and OEMs sign 3-5 year supply contracts with battery manufacturers.
What’s key on this graph is the timing of the two inflections points. The two influence each other:
BEV adoption is highly unlikely to inflect until the utility of a battery car (a nebulous combination of cost, function and consumer preference) is at least equal to a gas car. It’s not impossible – regulators could ban gas car sales – but it’s unlikely. So an OEM’s focus should ultimately be on the top half of the chart and answering two questions: when will the battery car’s utility surpass a gas car’s utility and when innovation will inflect.
Admittedly, this is a simplified view of things, but it allows us to draw two conclusions:
An OEM who believes that BEV demand will inflect sooner is more likely to invest in supply, anticipating excess battery demand
An OEM who believes that innovation will inflect later is more likely to invest in innovation, anticipating the window of competing on innovation is wide enough to win or lose market share
Up until this point I’ve talked about investing in production and innovation somewhat interchangeably. They’re closely related, but an OEM can invest in production – via a joint venture or a consortium – without investing in (proprietary) innovation.
Depending on the conclusion an OEM makes, there are five options with varying trade-offs on capital and innovation to choose from:
In-house production. OEMs could choose to maximize innovation by developing their own proprietary technology. This is what Tesla is transitioning towards – the company still relies on batteries developed jointly with Panasonic. By doing this, an OEM can have a competitive edge in battery technology, maximize their cost efficiencies and secure their supply. On the other hand, it’s a highly capital-intensive approach with concentrated risk. It’s most feasible for pure electric OEMs like Tesla that have established competencies in technology and can grow their battery production alongside their fleet.
Outsource to traditional suppliers. On the other end of the spectrum is outsourcing to traditional suppliers like CATL or LG Chem. It’s the least capital-intensive option and the least differentiated, with innovation only possible at the periphery via battery management software and platform design. It’s also the least flexible option. An OEM who signs a battery supply agreement anticipating a plug-in hybrid strategy (which uses less batteries) will find itself dangerously constrained if BEV adoption inflects earlier than it expects, leaving it without the battery supply to support a pure BEV strategy.
Partner on platforms. In this option the batteries are outsourced and automakers partner up to use a common platform that improves cost synergies. This can be a dedicated electric platform like Volkswagen’s MEB or GM’s Ultium platform (more innovative, less scalable) or it can be a flexible platform that accommodates all-electric, hybrid or gas cars (less innovative, more scalable).
License from competitors. This is technically an option. It involves licensing EV software, powertrain and batteries, usually from the industry leader. It’s scalable, lower-risk exposure to innovation at the cost of supporting the competition’s lead over you. For this reason, the approach has never gained traction. Toyota tried to license its hybrid design with few takers; this tweet from Elon Musk suggests Tesla’s licensing efforts have likewise been received with crickets.
Spread your bets. Large OEMs face a particular challenge trying to scale up in-house production, but their size allows them to diversify their innovation risk. In the near-term they rely on outsourced batteries, but minority investments in startups, joint ventures with suppliers and consortiums secure supply and gives them optionality on innovation, albeit at a higher price than internally developed technology.
Up until this point the discussion has been largely conceptual. This wasn’t really my intention, but I think it will provide a useful context for understanding the different OEM strategies, which I plan to explore in part two, and possibly that of other industries facing disruption from sustainability.
I’ll end this article and preface the next on this cliffhanger: evaluating these strategies is a luxury that OEMs can no longer afford.