Tesla: Profitable? It depends on the climate.
Climate change regulation in California has a significant impact on Tesla’s profitability.
Last week Tesla announced its second-ever quarterly profit. Analysts were stunned by the results . Tesla has historically been largely unprofitable because it reinvests its cash into R&D and manufacturing, but it managed to squeeze out a small $22 million in profit this Q3 2016 .
This profit, however, would have been impossible without climate change regulations.
In 1990 California adopted the Zero Emission Vehicle (ZEV) regulation, which is still in effect today. Managed by the California Air Resources Board (CARB), the regulation aims to hasten the development of non-polluting vehicles in order to mitigate the effects of climate change. Automakers are required to sell a certain number of ZEVs each year, in proportion to their overall sales. 
Each automaker is required to maintain a certain number of ZEV credits and can only receive these credits when selling non-polluting vehicles. Automakers lacking credits can purchase credits from competitors, like Tesla, who hold more ZEV credits than required by the regulation. Automakers holding insufficient credits are fined.
Tesla sold $139 million of ZEV credits this past quarter.
Taking into account Tesla’s $22 million profit and $139 million ZEV credit revenue, it’s easy to see that Tesla would not have been profitable without ZEV credits – it would have faced a Q3 loss of $117 million. Tesla’s automobile-related revenues are not yet profitable, and its reliance on ZEV credit revenue is crucial in the near-term.
In Q4, however, Tesla is projecting negligible revenue from ZEV credits. This is because there are so many excess ZEVs flooding the market. Tesla CEO Elon Musk is therefore pushing CARB to significantly raise ZEV standards:
“The California Air Resources Board is being incredibly weak in its application of ZEV credits,” Musk said on the company’s earnings call Wednesday, referring to the state’s zero-emission vehicle program. “The standards are pathetically low. They need to be increased. There’s massive lobbying by the big car companies to prevent CARB from increasing the ZEV credit mandate, which they absolutely damn well should. It’s a crying shame that they haven’t. And as a result, you can barely sell the ZEV credits for pennies on the dollar.” 
Musk’s comments are no surprise – Tesla would bring in far more revenue from ZEV credits if CARB raised standards. But even though Musk is biased, we should not disregard his suggestion.
Right now, with so many available ZEV credits – largely caused by Tesla’s rapid success –automakers can fulfil their regulatory requirements with as little as 6 percent of their sales consisting of ZEVs. California was hoping for this figure to reach 15.4 percent by 2025, but there is little incentive with ZEV credits so inexpensive. 
California needs to raise these standards as soon as possible. The ZEV regulation is designed to force automakers to manufacture a larger percentage of non-polluting vehicles each year, but this only works if automakers produce the bare minimum. Tesla has decided to go above and beyond, producing hundreds of thousands of electric vehicles and flooding the market with cheap credits. This removes the incentive for competitors to produce more ZEVs; they can instead purchase credits for pennies on the dollar.
CARB should also not limit the number of credits per company (this is a commonly suggested solution). Tesla should be rewarded for going above and beyond, and competitors need to be incentivized to catch up fast.
Ultimately, Tesla needs to break its reliance on ZEV credits for profitability. Its Q3 profit is just a fluke – without ZEV regulation, Tesla would have not been profitable. Musk is currently on the right path. While pushing CARB to raise standards, he is also pushing Tesla to reach profitability without the assistance of ZEVs. Musk is actually predicting a Q4 profit without ZEV credit revenues!
 Higgins, Tim. “Tesla Generates a Profit.” Wall Street Journal. October 26, 2016.
 Musk, Elon. “Tesla Third Quarter 2016 Update.” Tesla. October 26, 2016.
 California Air Resources Board. “Zero Emission Vehicle (ZEV) Program.” California Environmental Protection Agency. October 16, 2016.
 Hull, Dana and Lippert, John. “Musk Tears Into California Board Over Emission Credits Rules.” Bloomberg. August 4, 2016.
 Lippert, John. “California Ponders Changes to Fuel Rules as Tesla Cries Foul.” Bloomberg. July 7, 2016.
All images from Tesla.com
Student comments on Tesla: Profitable? It depends on the climate.
While I completely agree that Tesla needs to break their reliance on ZEV credits as a source or revenue, I question Musk’s motives in pushing for more stringent regulation. Is Musk’s statement: “There’s massive lobbying by the big car companies to prevent CARB from increasing the ZEV credit mandate, which they absolutely damn well should. It’s a crying shame that they haven’t. And as a result, you can barely sell the ZEV credits for pennies on the dollar.” he makes it seem that it is a crying shame because he cannot make as much of a profit. Is Musk really concerned about the effects of climate change or about turning another profit?
I too was struck by that quote, but for different reasons. I wonder about the effectiveness of Musk’s statement here when trying to incite action on the part of the regulator. As the author points out, the scheme is failing to achieve the change in behavior that the regulator set out to, given the glut of credits. The regulator is also in the midst of a review of the regulations (https://www.arb.ca.gov/msprog/consumer_info/advanced_clean_cars/consumer_acc_mtr.htm). Given how important this scheme is to Tesla’s profitability, and therefore the amount it can reinvest in R&D in the near term, working collaboratively with the regulator to try and influence the scheme’s review might be an approach worth considering for Tesla.
Do you think that Tesla’s shareholders are concerned about the prospect of near-term profitability? While I imagine that profitability is a nice thing to have, I would argue that Tesla’s shareholders own their shares based on their views of Tesla’s growth potential in the medium-term. In that context, ZEV revenues are helpful cash flows, but I do not believe that they are critical to Tesla’s economic model going forward.
Interesting analysis. It seems that you are highly supportive of Tesla, but quite punishing toward the other major OEMs. While I agree Tesla is the clear leader in the automotive clean energy arena, I don’t think the progress of the other OEMs should be overlooked. For example, per the below article, it seems that almost every OEM has some sort of eco-friendly vehicle, including notable cars such as the Ford Fusion and Toyota Prius
At the end of the day, for all of the OEMs, including Tesla, consumer demand will likely determine the success of these vehicles, not regulations. Unfortunately for hybrid vehicles, with gas prices at extremely low levels, it seems that much of the steam has been taken out of the electric vehicle movement.
Zach — this is awesome! Thank you for bringing Musk into the conversation. I want to address Anthony’s comment in relation to your great post:
I am somewhere in between your extreme view of the results of low gas prices and the greatness of Tesla. Design-wise and in terms of “visionary-ness”, I’d say Tesla is the clear leader; it’s not hard to be with Musk at the helm. Especially for consumers who tend to buy the gas guzzlers in terms of very high performing cars, Tesla is really one of the only options on the market. One potential competitor is the BMW i8 (http://www.bmwusa.com/vehicles/bmwi/i8.html), but it’s MSPR is almost twofold a basic Tesla model S. But adoption will be difficult until they figure out the solar panel/charging problem: plug-in charging only gets us so far. And Tesla is pushing to solve this problem with a partnership with SolarCity (http://cen.acs.org/articles/94/i44/Tesla-launch-solar-roofs.html). Agreed with Zach re increasing ZEV standards as a way to increase the pie size and incentivize the industry to get moving, but I think a large part of Tesla’s success and profitability will come when the solar panel/charging issue is solved in a way that’s functional on a mass level.
Regarding the first comment questioning whether Musk is truly in the game to solve climate change or looking for profits – I think he is genuinely seeking to solve the challenge, he is just also very pragmatic about what needs to happen (e.g., lobbying for regulatory support, shifts in his own corporate strategy) for his actions to affect society more broadly than just what his company can achieve. He successfully democratized the residential solar market with SolarCity, the installer/finance business he started (and also a business that takes advantage of tax credits) — because when his financing model proved successful, a lot of copycats jumped in, helping stimulating improvements along the value chain.
Intriguing post! Thanks for sharing your thoughts. I had no idea how “low-quality” Tesla’s 3Q earnings were perceived to be; the headlines pointed mainly to the company finally turning a profit.
This dynamic around the ZEV credits is an interesting one. A lot of people insist that, instead of command-and-control regulation, leveraging market mechanisms can effectively financially incentivize companies to operate in an environmentally-friendly manner. But, this case with Tesla and the ZEVs indicates that it’s not a perfect tool and requires input from stakeholders, including impacted corporations and the regulators themselves, in order to optimize the incentive structures.
I absolutely think that Musk is taking advantage of the financial incentives being presented to him by the California state government in order to turn a profit when he can. And I’m not sure that there is anything wrong with that, unless it evolves into a sort of mission-critical reliance on revenue from ZEVs as non-core operations to stay afloat and avoid insolvency. Overall, long-term investors in Tesla are probably less focused on the quarter-to-quarter earnings as they are the growth and transformative potential of Tesla – particularly once it fully integrates SolarCity and maximizes those synergies.
I found this article to be incredibly interesting. I had no idea ZEV credits even existed. However, it’s incredibly frustrating that the current ZEV credit market is flooded due to lack of standards. I spent a good deal of time thinking about an alternative for Musk besides lobbying for increased standards, but no reasonable answers present themselves. Perhaps CARB can issue a flat bonus to manufacturers and the manufacturer receives the proportion of its bonus that equals the proportion of total vehicles produced that are ZEV’s. So if the bonus is $100 and 50% of Manufacturer X’s cars produced this year are ZEV, so Manufacturer X gets $50. Obviously it is a fine line between prodding innovation and placing an excessive burden on auto manufacturers (especially American manufacturers given the issues of 2008 that are still being dealt with), but Musk should absolutely be rewarded in some way by being so far ahead of the curve.
Wow, did not know about this side of their “business model” at all. However, I do not think that Elon Musk is relying on this revenue to turn a profit. While ZEV revenues will definitely be a welcome upside for a company with operating losses, Musk does eventually aim to make Tesla profitable through car sales and prove to the auto industry that the future of cars has arrived.
This is a great insight on Tesla business model. I didn’t realize that Tesla rely so much on ZEV to be profitable. On a separate note, I wonder if Musk push on raising ZEV standard is the right option for the world. I assume that Tesla objective is to help be part of creating a world with better environment (and make money). Raising ZEV standard significantly might cause more companies to stop their ZEV program completely than improve their ZEV program. If this were to be true then Tesla is going to lobby CARB into doing something that has the negative net effect to the environment. This, of course, depend on the magnitude of “significantly improve ZEV standard”.
Wow, great article Zach. Really interesting. A few thoughts I had come up: first, is the production and sale of ZEV credits to other OEMs in fact a viable business model for Tesla? Obviously no, but I think more that question, is maybe, could it ever be a viable business model? One thought as a result could be fore Tesla to focus on this as a core product strategy, and pivot to designing their EV’s as ultra low cost, high volume, and likely low quality, just to fit this role. Although I don’t know the economics behind the ZEV’s, or Tesla’s inherent vehicle cost structure, there is (possibly) a minimum cost per car which this strategy could become attractive. Certainly counter to anything Tesla would ever want to do based on their company values and Musk’s beliefs; however, an interesting thought to discuss.
Greta article Zach. Great to understand the ZEV and how many large automakers are exploiting the low standards set by the state. I completely agree that ZEV targets should be increased and TESLA must be rewarded for the excess energy efficient, green cars it produces. But also TESLA must now start looking at driving its business towards profitability. It looks quite unsustainable to be fueling the growth for future innovations with any solid financial performance.
Interesting article — however, I find Elon Musk to be extremely hypocritical in his quote mentioned above. Tesla is lobbying CARB to increase the ZEV standards for the same reason the other major automotive OEMs are lobbying to decrease it — because it is in its financial best interest to do so. It seems to me that he’s trying to paint these companies as “wrong” or “evil” just because they happen to be on the opposite side of his ZEV equation, when in reality they are all publicly traded, for-profit companies that are trying to do one thing: maximize profits and shareholder value. You can argue Elon Musk is targeting some higher good and actually believes in his cause, but that doesn’t negate the primarily financial incentives behind his words and actions.
The one thing I’d add to this article is the consumer demand piece. In the past, other OEMs besides Tesla have invested heavily in electric vehicle technology, only to find that the demand for these vehicles simply wasn’t enough to sustain or justify these investments. Therefore, I believe regulation and standards shouldn’t be set in a vacuum to encourage what behavior you think should happen versus what is actually happening. Requiring OEMs to invest in the production of vehicles that few people want to buy will only decrease the capital available to invest in other areas of automotive innovation. While Musk is betting that the electric vehicle demand trend will reverse in the future, it’s necessary to balance the demands of now versus later to ensure companies are in a position to accelerate product development innovations in the future, not decline.
Great article Zach. Although I agree on Musk’s approach to push for increased environmental standards, I think this is a particularly risky strategy. Instead, Mr. Musk should put more of the company’s focus on improved product performance and cost cutting. As Anthony mentioned in his comment above, cheap oil prices have minimized consumer demand for energy efficient vehicles.
Furthermore, in the current political environment I believe that a bigger push for environmental standards will continue to be a second hand issue which is not truly in the minds of congress.
A strategy that Mr. Musk should consider is to invest in a massive “car emissions” awareness campaign which would get consumers in the conversation and thus cause national attention. Mr. Musk should seek to influence environmental standards by directly placing a spotlight on the issue and asking the government for action.
Great article Zach. Do you think ZEV credits create misleading financial data for investors when evaluating Tesla’s performance? Is it common knowledge in the investor community that Tesla’s profits are largely due to sales of ZEV credits? I personally think that the credits are great incentives to encourage companies to produce more zero emission vehicles, but I also see an opportunity for the system to be manipulated. If Tesla is selling credits at a cheaper rate than the market value, then isn’t that a manipulation of the system, which will not lead to more zero emission cars being sold?
Is Tesla really being rewarded for going above and beyond or is this Elon’s plan to have a monopoly over the zero emission vehicle industry? If Elon can convince the car manufactures to not invest in zero emission cars, but instead purchase his credits, doesn’t Elon’s action create an environment that hinders the competitiveness of the zero emissions cars industry? Therefore, I think CARB should limit the number of credits per company and CARB should set regulations on a minimum value for which the credits can be sold.
My first reaction to this post is to be highly impressed by the foresight of California`s legislators. it is truly remarkable that California introduced ZEV credit regulations back in 1990, when carbon emission was not yet a highly debated issue. That said, I completely agree with your recommendation to increase the bar, and have California leading the way once again, to guarantee that automakers who are already producing energy-efficient cars, such as Tesla, are able to benefit from offering such superior performances. It is critical to ensure that a more fair incentive system is put in place to reward the car-makers that are truly making the difference, thereby attracting other car-makers to invest in this space
This is a very ironic circumstance that Tesla is in. By simply trying to build low emissions vehicles and better the climate, Tesla has actually opened the door for old competitors to drag their feet in doing the same. The net result actually slows the transition to zero emission vehicles in the auto industry. I find it to be strange that regulators would allow automakers to simply buy ZEV credits when they have not satisfied their development requirement. I think Tesla is simply running smart business in this regard, but it is actually critical that regulators find better ways to align incentives of automakers and their own. As it stands, automakers are effectively getting away with simply buying credits, which does not really incentivize them to build greener vehicles.
Great article, tech rep! One curve ball to the situation at Tesla could also be further regulation of the broader energy industry, which is all the more important given it’s recent merger with Solar City. One of the big constraints in adopting the broader battery technology outside of car use is the regulation of the electric grid by major players which don’t allow consumers to substantially add supply to the grid. A change in this dynamic, could substantially increase the revenues that Tesla generates not just from cars but more broadly from the Solar City business and either push it to profitability or keep it lagging behind investor expectations. http://money.cnn.com/2016/11/01/technology/tesla-solar-city-merger/