Tesla’s astonishing valuation points to an all-electric future. Toyota shows how electrification is making the internal combustion engine ever more appealing. Who will prevail?

Introduction

Tesla has recently overtaken Toyota to become the world’s most valuable automaker. And the rally did not stop there. Following an incredible 600% gain, shown on a quarterly basis below, Tesla is now worth twice as much as Toyota.

When considering standard financial metrics, this valuation looks downright crazy. Tesla has not shown significant revenue growth for two years, and revenues remain an order of magnitude smaller than that of Toyota (aside from the Covid-19 drop in the most recent quarter).

Tesla has now achieved four consecutive quarters of profitable operations, aided by over a billion USD in regulatory credit sales (the profit/credit ratio is 0.46). Without regulatory credits, automotive gross margins remain steady at about 18%, which is low considering Tesla is a premium brand that skips the middleman (dealerships).

No, Tesla’s astonishing valuation is linked to market expectations of wild future profits. Given that 85% of Tesla’s revenue comes from its automotive business, much of this rally relies on two assumptions:

1. Battery electric vehicles (BEV) will see massive and sustained growth.
2. Tesla will strongly outperform the BEV competition.

This article presents a critical evaluation of the first point by contrasting the fundamental value propositions of BEVs against that of hybrids and plug-in hybrids (PHEV) championed by Toyota. The second point has little to do with fundamentals and is not within the scope of this article.

The Tesla Effect

Tesla’s meteoric rise is a result of the incredible speed at which they boosted the attractiveness of BEVs. Innovation certainly played a major role, but arguably the biggest factor is the bravado of Elon Musk and his management team. Basically, Tesla established a virtuous cycle in which they developed desirable cars and an appealing vision that attracted many dedicated fans willing to pay big money to be beta-testers for Tesla products.

This large pool of paying test subjects allowed Tesla to quickly roll out products with significant defects and fix the issues based on user feedback. Large pre-order deposits for the Model 3 and ongoing sales of the pure-profit $8000 “full self-driving” option (that is nowhere near the level 5 autonomy its name suggests) are additional benefits of this strategy.

As a result, Tesla greatly accelerated the development of BEVs in terms of performance, efficiency, battery cost reduction, and charging technology. Meanwhile, traditional automakers were advancing conventional internal combustion engine (ICE) and hybrid technology at the usual incremental rate.

Thanks to this dynamic, I believe that BEVs have already overtaken ICEs and hybrids in the race to their ultimate potential. In terms of performance and efficiency, BEVs have little left to gain. Battery costs have considerable room to fall, but absolute annual cost reductions are slowing and will have trouble compensating for subsidy phase-outs. In many markets, the low-hanging fruit of fast-charging has also already been picked.

On the other hand, ICEs have plenty of potential remaining to piggyback on electric drive advances towards substantial efficiency and performance gains. In fact, hybridization allows ICEs to derive similarly large benefits from further battery cost reductions and performance improvements as BEVs.

To support this claim, let us take a closer look at the latest offerings from the world’s two largest automakers (in terms of market cap).

Model Y vs. RAV4

Back in 2017, I wrote an article about the technological potential of hybrids. Since then, Toyota has dutifully delivered on two of my expectations from that article:

1. Hybrids will become better to drive than conventional ICE options.
2. Hybrid systems will be implemented as electric all-wheel drive (AWD).

The RAV4 offers a good example of these benefits. Relative to the AWD RAV4, the electric AWD hybrid offers 8% more power (with even better low-end performance due to instant torque from electric motors) and 33% better fuel economy for only $1000 (3.7%) higher sticker price.

Recently, the RAV4 Prime PHEV has taken another big step forward. In this model, Toyota has capitalized on the larger battery pack by greatly boosting the power of the electric motors. The result is a 0–60 mph time of 5.7 seconds, which is very close to that of the long-range Tesla Model Y.

In terms of real-world fuel economy, the Model Y achieves about 90.7 MPG (225 miles from the 75 kWh battery pack, accounting for 90% charging efficiency), whereas the RAV4 prime achieves 39.1 MPG in hybrid mode and about 90 MPG in electric mode.

Since the RAV4 Prime and the Tesla Model Y achieve similar performance, we can fairly compare their fuel costs. For conventional city driving, the 40 miles of all-electric range will be sufficient for almost all daily trips, giving the RAV4 Prime identical fuel costs to the Model Y. When it comes to longer trips, where the Model Y must rely on fast charging (currently 0.28 $/kWh), fuel costs will be more than twice as much as with the RAV4 when oil costs $50/barrel, as shown below.

Thus, performance in the city will be essentially identical, whereas the RAV4 will be much cheaper on road trips (in addition to the convenience and freedom afforded by 567 miles of gasoline range that can be topped up anywhere in only a couple of minutes). 

This means that, for fundamental competitiveness, BEVs will have to ensure that a 4x larger battery pack is considerably less expensive than the added ICE in the PHEV. This is a tough ask, given the considerable room left to run before reaching the fundamental potential of hybrid powertrains.

The Future of Hybrid Drivetrains

Toyota has now started rolling out the hybrid benefits of superior performance and cheap all-wheel drive, but there are many improvements yet to be realized. Here is a list of my top five expectations:

1. Larger battery capacity in conventional hybrids, facilitating a large increase in the power of electric motors and a substantial downsizing of the ICE to reduce cost and improve driving dynamics.
2. Standardized use of increasingly intelligent systems to optimize hybrid drivetrain energy management to cut fuel consumption by about 20%.
3. Greatly simplified ICE transmissions that contain only a few higher gear ratios, relying on the electric motor for all low-speed driving
4. Large gains in ICE efficiency and environmental performance via advanced compression ignition technology. Implementation of such complex engines will be much simpler in hybrid systems that allow the ICE to operate predominantly under steady conditions.
5. The gradual introduction of waste-heat recovery systems.

Following these gains, a hybrid will have similar or better (due to lower weight) driving characteristics to a BEV, and similar or lower costs than a conventional gasoline vehicle. In addition, I expect that technologically mature BEVs will only be about 50% more efficient than technologically mature hybrids, making hybrids cheaper to fuel in almost all circumstances.

But there are several additional factors that drive so many smart people to predict the imminent demise of the ICE. Let us now take a critical look at the four most important ones.

The Million-Mile Battery

There has been much excitement about Tesla’s million-mile battery, although this was not mentioned at the recent battery day. However, this development is much more interesting for PHEVs than BEVs.

Very few people will drive their cars anywhere close to a million miles, but, when placed in a PHEV with a 5x smaller battery, such technology will allow for 200000 miles of all-electric driving, which is more reasonable. In addition, the much smaller battery of the PHEV will also greatly reduce potential challenges with battery materials as electric drive scales up.

If the need ever arises, million-mile hybrids will soon emerge. As hybrid technology improves, the load on the engine will grow smaller, allowing for optimal steady-state operation under almost all driving conditions. The superior reliability and lower depreciation of hybrid cars is already demonstrating the long-term benefits of the synergy offered by hybrid drivetrains.

Driverless Taxis

One application where a million-mile BEV makes sense is autonomous taxis. However, there are several issues with this scenario. First, the technical challenge of safely and efficiently operating a large fleet of fully driverless taxis in a generalized urban environment is huge. After first writing about this in 2016, I remain of the opinion that full autonomy will take considerably longer than proponents suggest, and that benefits will be minimal before almost all vehicles on the road are fully autonomous.

Second, even when we finally reach full autonomy for all vehicles, the benefits of driverless taxis are questionable. A recent study found that driverless taxis will have trouble competing with privately owned cars. This study came to a similar conclusion, also highlighting the importance of cleaning costs in driverless taxis and the fact that customers will have to be monitored by video to ensure they behave appropriately. In urban centers, public transport remains cheaper.

Third, when considering the timescales required for achieving full autonomy in all vehicles, I think the biggest competition will come from virtual mobility and small electric vehicles that will thrive in cities increasingly designed for people instead of cars. Even without accounting for the large quality of life benefits of living in an environment with minimal cars and maximal green spaces, the economic benefits of these options are enormous. Hence, I believe that car traffic will increasingly shift to highways, where the ICE will benefit most.

Grid Services

One option for effectively using a privately owned BEV with a million-mile battery is to supply grid services by charging when electricity is cheap and discharging when electricity is expensive. However, executing this strategy in a way that never inconveniences drivers will be very difficult, especially when balancing fluctuating wind and solar power.

Solar power features attractive daily regularity for integration with BEVs, but the problem is that cars will need to be charged in daytime, interfering with use patterns, requiring many costly public chargers, and demanding expensive grid upgrades to handle increased peak system load. Stationary batteries installed at carefully optimized locations to minimize transmission and distribution grid capacity may well be more economical than BEVs for this purpose (and will certainly be much more practical).

BEVs fit very well with a baseload (e.g., nuclear) power system where highly convenient and predictable grid-friendly charging can happen every night. However, this gives minimal opportunities for discharging, meaning that PHEVs will be a better use of million-mile batteries in such a scenario.

CO₂ Emissions

Climate change impacts of BEVs depend heavily on the CO₂ intensity of grid electricity. The figure below gives the equivalent efficiency that the RAV4 needs to have to match the emissions of the Model Y. The top of the blue band is the current RAV4 efficiency, and the bottom is the expected long-term efficiency.

Clearly, hybrids will have similar or lower emissions to BEVs in the largest developing car markets for many years into the future (e.g., China’s CO₂ emissions intensity is about 840 kg/MWh). Higher biofuel blend ratios and hybrid efficiency gains mean that BEVs will require considerably cleaner electricity to match hybrid CO₂ emissions over the coming years.

In regions blessed with cheap and clean electricity, PHEV market share will increase relative to regular hybrids. These PHEVs can drive mostly on electrical power and still use gasoline for longer trips.

But even if we assume the Model Y from the fuel cost comparison presented earlier is charged with zero-carbon electricity, the CO₂ price will have to reach 250 $/ton before the RAV4 fuel costs exceed the cost of charging the Model Y with 0.28 $/kWh electricity from fast chargers. Many low-carbon fuel options (e.g., biofuels, hydrogen, ammonia) will enter the market long before such CO₂ prices are reached.

Conclusion

Following this analysis, I remain convinced that Toyota is on a sound strategic path with its balanced hybrid and PHEV strategy. Pure BEVs have an important role to play in the future transportation system, and Toyota will do well to include a few BEV models in their line-up, but the total BEV dominance suggested by Tesla’s valuation seems unlikely.

With the RAV4 Hybrid and RAV4 Prime, Toyota has finally managed to bring the electric drive performance benefits to its hybrid offerings. We can expect this development to proliferate through the rest of Toyota’s line-up, upgrading their brand image from just being reliable and efficient, to being fun as well. I’m looking forward to seeing how quickly they manage to implement the other hybrid drivetrain advances discussed in this article.