Energy & Resources

The next ‘overcapacity’ sector

Investor Francois Perrin warns China’s electric car battery boom could bust

BYD

Perrin says BYD’s new electric battery plant in Kengzi is state of the art

Shenzhen, on a Friday morning, a couple of weeks ago. We are visiting BYD’s new electric vehicle battery production plant, the largest EV battery plant in China. With 10GWh of designed production capacity and Rmb6 billion ($897 million) of investment, the Kengzi plant can supply battery packs to more than 400,000 passenger electric vehicles annually.

The three storey cubicle building looks like any other factory in the Pearl River Delta. We go through the entrance and are asked politely to cover the cameras of our mobile phones with tape. Moving to the first floor, we discover a state-of-the-art production line and suddenly we feel alone.

Two technicians sitting in the middle of the floor in front of a computer are managing an army of robots. Equipment has been produced internally by BYD with Japanese, Korean and German components; the robots have been supplied by ABB.

No direct human intervention on the production chain, state-of-the-art technology, fully automated production flow, high quality output: this plant strongly reflects the ambitions of the Chinese government and its most advanced domestic champions in the new energy vehicle and automation spaces.

But will such investments in advanced batteries follow a similar course to what we saw with solar panels? Unfortunately, I think so, though the BYD factory may be advanced enough to weather future price falls in a way that other Chinese battery makers will struggle to match.

China is on track to become the largest electric vehicle market in the world thanks to generous subsidies schemes

The new energy vehicle (NEV) industry is indeed one of the key seven strategic industries retained by the government and reaffirmed in Beijing’s 13th Five-Year Plan. Five millions NEVs on the road are targeted by 2020.

NEV sales are on a healthy and steady growth trend. With a record of 176,627 plug-in passenger cars sold in 2015, China became the world’s best-selling plug-in electric car market that year, with 34.2% of global sales. As of December 2015, China was also the world’s largest electric bus market, and by 2020, the country is expected to account for more than 50% of global electric bus sales.

The strength of the market since 2014 can mainly be attributed to very generous subsidy schemes offered by central and local governments. Until recently, a buyer of an Rmb1.2 million electric bus received almost Rmb500,000 from the central government and a similar amount from the local government. On top of free licence plates, customers for passenger NEVs are enjoying on average a rebate of Rmb60,000, equivalent to one third of the selling price.

Lessons to be learned from other clean technologies

The development of the NEV industry displays uncanny similarities to what I have witnessed before in China. Specifically the government throws its support behind a technology; vast amounts of capital pours in; as does competition from local governments to host factories; huge overcapacity quickly builds up; and finally prices plummet and funds invested are written down. The upside for consumers is that what was once an expensive technology becomes more affordable and its use more widespread.

What I see happening now: China is doing precisely this with electric battery manufacturing.

DRAM, LED or photovoltaic technologies went through similar boom and bust experiences. In 2009, China had only 300MW of solar panel capacity installed domestically. In 2015, thanks to accommodative policies, China was not only producing 80% of solar panels worldwide, it had also overtaken Germany as the largest country in terms of photovoltaic capacity installed. Over that period, the cost of production of a solar panel was cut by a factor of ten, moving from $4/W in 2009 to $0.4/W today. This led to a massive consolidation of the industry and more rational investment decisions in terms of future capacity expansions.

Is the NEV industry in China immune to such pressure?

China’s EV battery shipment volume reached 7.5GWh in the first quarter of this year, up 454% year-on-year versus only 83% growth in EV volume. The discrepancy between these growth rates mainly comes from a change in the product mix – the new EVs coming to market require a higher battery load per vehicle. The launch of an investigation into subsidy fraud may also play a role (some small manufacturers initially sold EVs without the EV battery packs to cash in the subsidies and they now have to cover this shortfall).

The top five vendors accounted for 59% of the total EV battery market in China in 2015; and the market will remain fragmented. Currently, China has more than 150 EV battery manufacturers all ramping up new capacity due to the supply shortage experienced in 2015 and a comfortable median gross margin at 24%, according to Nomura.

In that process, EV battery production capacity could reach 50GWh by the end of 2016 with the bulk of the new capacity to reach the market in the second half of the year. With an estimated demand in the range of 25GWh this year, the midstream part of the NEV value chain will face massive oversupply. EV battery prices have already fallen by 65% since 2010, and 35% just in 2015, reaching $350 per kWh. Bernstein Research estimates that production cost will continue to decline at over 10% a year to below $200/kWh by 2020.

How many of the 150 EV battery makers will survive the overcapacity wave? Due to unconditional government support, most of these players should still be there five years down the road but only a few will offer attractive returns for investors.

In addition to massive cost decline, EV batteries will continue to improve their energy density, lifetime, efficiency and depth of discharge. Lithium iron phosphate (LFP) battery producers – representing almost two thirds of the shipments in 2015 – will be impacted the most. Nickel manganese cobalt (NMC) technology has clear advantages versus LFP technology. NMC batteries can store and release more energy and can be recharged more frequently without degradation than LFP batteries. NMC should become the long-term choice for the Chinese industry.

What to look out for?

Historically, China has focused on LFP technology – but the tightening in January of NEV subsidy policies is a clear signal by Beijing of a shift in emphasis. With the imposition of a partial ban on access to the China market for foreign battery producers, China is buying time for its domestic firms to catch up with Japanese (Panasonic) and South Korean competitors (Samsung SDI, LG Chem) on NMC technology. Its domestic champions, among others BYD, have already started to focus their research and development efforts and production capacities on NMC.

Although in the short term local EV battery equipment makers could be the major beneficiaries of the NMC capacity expansion, small players focusing on LFP EV battery production may have to write off their investments earlier than expected. Samsung SDI announced during its first quarter 2016 results that it was provisioning a substantial amount for asset impairment due to the obsolescence of a five-year-old plant in the face of a larger-than-expected decline of battery prices and innovation required.

If EV battery makers are going to face a tough time, where do we see more value being created by the green vehicle revolution? Companies benefiting from operational leverage due to rising volumes should be considered. Downstream charging station businesses displaying very high levels of return on invested capital, and upstream scarce raw materials, stand out in that framework. For instance, cobalt prices have remained at a low point in the first half of this year. The migration of LFP to NMC technology may change the global cobalt supply and demand dynamic. Some Chinese companies have seen the opportunity and recently secured access to the largest cobalt reserves in the world.

The strategic ambitions of China in electric vehicles are intact; the marathon has just been transformed into a long distance sprint.

Francois Perrin is a portfolio manager with East Capital. He has been investing in clean technologies in China for 10 years. He is also a regular reader of WiC.


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