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November 15, 2006
Merrill Lynch and World Resources Institute Issue Second Auto Sector Climate Change Report
    by Bill Baue

The report again balances stock picking and investment analysis with in-depth discussion of regulatory and market developments in response to global warming and energy security concerns.

Last week Merrill Lynch (ticker: MER) and the World Resources Institute (WRI) issued their second joint auto sector report in the Energy Security and Climate Change series, this time subtitled Alternatives for the Clean Car Evolution. As with the first, the report harnesses the strengths of both organizations. Fred Wellington and Britt Childs of WRI's Capital Markets Research team provide a comprehensive, in-depth overview of recent regulatory and market developments. Merrill analysts John Murphy and Pamela Yi in the US and Thomas Besson and Stephen Reitman in the UK offer perceptive investment insights and recommend specific stock plays in the auto sector in light of energy security and climate concerns.

Two of the stock picks from last year's report remain: BorgWarner (BWA) for products offering higher fuel efficiency and/or lower emissions, and Magna International (MGA) for its high-pressure hydroforming business that helps create lighter vehicles with higher fuel economy. France-based Valeo (VLEEF) is a "direct play on fuel economy" according to the report, which highlights two products: a system that silently stops and restarts the engine in traffic or at red lights to save fuel, and a cam-less engine that reduces fuel use and emissions 20 percent.

The report's handling of biofuels blends WRI's and Merrill's strengths best. One table lists US Congressional bills related to biofuels, most of which address flexible fuel vehicles (FFVs) that run on petroleum gasoline as well as bio-based fuels.

"Broadly speaking, these policies are either aimed at developing the supply of biofuels available for transport use (so called 'supply-side push') or are focused on encouraging the production of vehicles that can accept multiple fuels, i.e. FFVs (so called 'demand side pull')," the report states. "This dual approach to regulation creates something of a 'chicken and egg' dilemma around biofuel policy."

"Encouraging the production of FFVs does not necessarily get you the energy savings or reduced emissions unless the new fuel is used--and that fuel is still available in only limited quantities," it continues. "Conversely, increased production of biofuels does not become economic unless there is adequate consumer demand for alternative fuels from users of FFVs or biofuel vehicles."

The report also notes another dilemma. Federal biofuel regulation favors E85, which blends 85 percent ethanol with 15 percent gasoline to significantly reduce greenhouse gas (GHG) emissions but requires new delivery infrastructure (E85 corrodes current systems) and FFVs. State regulation, listed in another table, favors E10, a lower percentage blend with reduced--but more immediate--environmental benefits, as it can be delivered via current infrastructure and burn in standard automobiles.

While this regulatory uncertainty makes it difficult to predict whether E85 or E10 will predominate, investors can benefit either way by investing in biofuel producers. Yet another table, contributed by Merrill Lynch oil sector analysts, lists direct biofuel plays, including US-based Pacific Ethanol (PEIX), Verasun Energy (VSE), and Aventine Renewable Energy (AVR), and Europe-based Abengoa (ABG.MC) and Biopetrol (B2I.DE).

The seemingly capricious regulatory scene is compounded by fickle consumer markets, making it difficult to predict which technology for reducing fuel consumption and emissions will become the standard--fuel cells, hybrids, biofuel, or diesel.

"Although many global automakers often highlight specific powertrain strategies, most are exploring a number of options as the ultimate winner is unclear," the report states. "Most [original equipment manufacturers] point to fuel cells as the holy grail of powertrain technology, but considering the timing to introduction (10+ years), it is a dubious solution, and another technology could emerge."

"In the interim the alternatives being explored are increased diesel penetration, increased ethanol and biofuel use, and the popular hybrid," the report continues.

To explain the responses of the "Big Six" auto companies--GM (GM), Ford (F), DaimlerChrysler (DCX), Toyota (TM), Honda (HMC), and Nissan (NSANY)--the report uses a table to encapsulate their strategies and one-page discussions in the body of the report. The report also discusses responses by European companies--such as BMW (BMW), VW (VOW), and Renault (RNO)--that focus on the region's traditional commitment to diesel.

Both investors and lay readers will find the first section of the report indispensable reading for understanding how climate change and energy security are converging to drive the regulatory and policy scene, especially as it relates to auto companies. One of the most significant developments to watch is whether the US Supreme Court allows carbon dioxide (CO2--the primary GHG) to be classified as a pollutant under the Clean Air Act in its decision on the Massachusetts v. EPA case, expected in June 2007.

State-level developments to watch are focused in California, where the California Air Resources Board approved the Pavley law in 2004 requiring passenger vehicles to reduce emissions 30 percent. Two auto industry organizations filed a federal lawsuit against the Pavley law, contending that the federal government regulates fuel economy, not states. Adding fuel to the fire, two months ago California Attorney General Bill Lockyer filed a lawsuit against the Big Six holding them liable for the environmental damages caused by their products' GHG emissions.

"While it remains unclear how California Air Resources Board (CARB) will specifically implement the various GHG requirements that that have been signed into law, what is clear is that these requirements are, in fact, law," the report states. "Lawsuits or not, the auto industry will likely be impacted by this regulatory trend."

In the end, the charts and tables eclipse the textual discussion in illustrating the dilemma posed by climate change. One WRI chart shows that transport sector CO2 emissions from the US are almost double that of the second largest regional emitter, the European Union. Another WRI chart traces almost a third of US GHG emissions to the transport sector, with 83 percent of these emissions pegged to road transport. No wonder why the report focuses on the auto sector!


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