If a product costs thirty times as much as the benefit it brings, and in addition, is capable of releasing a highly toxic chemical, one would not expect that product to be successful. If use of that product is mandated by government regulation, it might succeed in the marketplace despite its shortcomings. The product in question is the refrigerant R1234yf, made by a joint venture of DuPont (NYSE:DD) and Honeywell (NYSE:HON), and the prospective customers are auto makers selling in Europe, including Volkswagen (OTCPK:VLKAF), PSA Peugeot (OTCPK:PEUGF), Ford (NYSE:F), General Motors (NYSE:GM), Renault (OTC:RNSDF), Fiat (FIADF.PK), Toyota (NYSE:TM), Daimler (OTCPK:DDAIF), and BMW (OTCPK:BAMXF). Will we see a transfer of wealth amounting to hundreds of millions of dollars from these car makers and European car buyers to DD and HON or will the latter two companies have to reduce their earnings expectations?
The root of the problem is the well-intentioned European Union directive 2006/40/EC, which provides that cars to be sold in the European Union, in order to obtain the necessary type approval, must not use fluorinated refrigerants with a global warming potential larger than 150. Global warming potential (GWP) is a figure expressing a substance's power as an atmospheric greenhouse gas compared to carbon dioxide-for example, a substance with a GWP of 10 would be ten times as a powerful a greenhouse gas as carbon dioxide. The refrigerant currently in use, R134a, has a GWP of 1,430. America does not have the European mandate, but there are credits against a car maker's fleet emissions available for the use of refrigerants with lower GWP. Among the alphabet soup of possible refrigerants, the leading candidate until last year was R1234yf, which is reasonably close in properties to R134a, but has a GWP of only 4. Alternative technologies such as using carbon dioxide, known as R744 in that context, are feasible, but not ready for market introduction and would likely lead to both higher cost and higher fuel consumption; the latter characteristic causes an obvious tension with the goal of reducing greenhouse gas emissions.
The use of R1234yf, anticipated as it was until the end of last year, would be a substantial cash cow for DD and HON. While the old R134a is a commodity going for under $10/lb., HON holds substantial intellectual property rights in R1234yf that despite some patent trouble will likely keep competitors out of the marketplace for the time being and allow HON and DD to charge a monopoly premium that increases the price about tenfold vs. R134a. Marginal manufacturing costs are anybody's guess; the process of making R1234yf is substantially more complicated than for R134a, but it appears reasonable to assume that a large chunk of that price will have to go to fixed cost for the HON/DD joint venture's new plant in China and economic rents for the two companies.
This positive story for DD and HON became doubtful last year, just as the new manufacturing plant went online, as Daimler recalled its new 2013 SL in order to replace the expensive new refrigerant with the tried and true R134a and announced that it would not use R1234yf in any new cars. The reason for this move was that in Daimler's testing R1234yf proved inflammable under the conditions found in engine compartments; this is a particular problem because one of R1234yf's combustion products is the highly toxic and caustic gas hydrofluoric acid, which is aggressive enough to destroy even glass and can easily penetrate skin. The media reaction labeling R1234yf the "killer refrigerant" following this might have been exaggerated-igniting the new refrigerant is possible, but difficult-but even if the danger turned out to be not that great, the public relations damage is done. European buyers might be rather hesitant to purchase a car equipped with R1234yf for the foreseeable time, and DuPont's attempt to present the refrigerant as safe seems unlikely to regain the public's trust.
The question now is whether political pressure will still force car makers to use the unloved, expensive, and possibly dangerous refrigerant. They certainly would do so if that was the only way to get new car models approved for sale in the European Union, but are likely to resist rather fiercely. Green politics is powerful in Europe: Daimler's very own home state of Baden-Württemberg has a prime minister from the Green party, and the prohibition against most light bulbs in the EU is in force despite its unpopularity. Does that mean that green will be more important that safe?
A possible answer to that question lies in the following chart showing the price history of greenhouse gas emissions certificates in the European emissions allowance trading scheme:
In short, the price for greenhouse gas emissions has fallen off a cliff, reflecting, depending on one's point of view, either that emissions reductions in Europe are ahead of schedule or that European politicians aren't actually serious about reducing greenhouse gas emissions very much. Either one should bode well for car makers and badly for DD and HON.
Automotive refrigerants are not actually part of the EU emissions trading scheme, but to see how the political process might play out, let's pretend that they were. The climate does not care from what source greenhouse gases are emitted-they unfold their activities over the course of decades or centuries after being mixed with the atmosphere. For the sensible goal of reducing greenhouse gas emissions, it is immaterial from which source we reduce them. That is the entire point of a cap and trade system. Now if automotive refrigerants were included in this emissions trading scheme and if we assume full release of the refrigerant into the atmosphere with no recycling (even though recycling actually does take place and is mandated) it would take an allowance for 700 kg of carbon dioxide emissions to offset the global warming potential of a one-pound charge of refrigerant in a smaller auto air conditioning system. This would currently cost all of €3! If one takes the emissions trading system seriously at all, for €3 one could have the same reduction in greenhouse gas emissions that can be obtained by spending more than €100 to redesign, build, and charge an air conditioning system for R1234yf. Conversely, for the same price spent on converting the air conditioning system, one could have thirty times the reduction in greenhouse gases, and all without using a combustible refrigerant that releases poison gas when burned. That's all there is to say about the merits of the EU regulation and of DD's and HON's product.
But how will this play out in practice? Car makers seem to be in a good position to renegotiate the EU directive. They can demonstrate the directive's absurdity, and they can offer a greater greenhouse gas reduction to politicians by offering to purchase emissions allowances offsetting a larger amount of greenhouse gases than actually corresponds to the refrigerant charges in their air conditioning systems, which would also contribute to the goal of supporting the price of emissions certificates. They also have the benefit of being local and being able to enlist the support of unions whereas DD and HON are American companies and their production plant is in China. And they have the most powerful argument of all on their side: "Save the children (from hydrofluoric acid)!"
If these thoughts hold true, DD and HON might well be forced to reduce their expectations for the money to be made from R1234yf. By how much? As a back-of-the-envelope calculation, let's take 10 million new cars per year equipped with a metric pound of refrigerant each, giving a volume of 5,000 tons of refrigerant. If we assume a profit impact of $30 per kilogram R1234yf sold, we would have a loss of $150MM per year. This would correspond to a reduction in earnings of 2-3% for both HON and DD for years to come. About the only way for R1234yf to become a useful product would be a rise in the price of European carbon allowances to at least €80, which is very unlikely, plus clarity about the safety issues.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Promanthan LLC provides consulting services with respect to offsetting automotive refrigerant emissions with emissions certificates. I and Promanthan LLC hold certain intellectual property rights with respect to offsetting automotive refrigerant emissions with emissions certificates.