Will the Law of Diminishing Returns Pit Automakers Against Uncle Sam?

The 2015 Bi-Fuel Chevy Impala may have arrived at a dealership near you last summer. Source: General Motors.

When the Obama Administration announced ambitious new targets for Corporate Average Fuel Economy, or CAFE, standards in 2011, automakers enthusiastically embraced the rules. Why? The initiative created certainty for the industry by introducing target "checkpoints" that served as transparent measuring sticks automakers could use to gauge internal progress. And considering that the first checkpoint arrived at 35.5 miles per gallon in 2015 (for 2016 models) -- a relatively manageable step up from the 25 mpg at the time -- and had the potential to spur research into next-generation technologies that might grow into competitive advantages, it was difficult to argue against Uncle Sam's wishes for more efficient vehicles.

Look no further than the present-day technology pipeline at General Motors comprised of hybrids, mass market electric vehicles, natural-gas powered autos, and fuel cell vehicles. Or how Ford Motor Company incorporated aluminum and carbon fiber into its F-150 and Mustang models, respectively, to improve the efficiency of its worst CAFE standard "offenders." And the list goes on.

But as the nation's vehicle fleet becomes more and more efficient as a whole in the coming years, it may not be too difficult for automakers to find fault with the original targets. While any competitive advantages achieved from boasting the most fuel efficient vehicle(s) wash away when all of your competitors have equally adept offerings, the biggest concern for Ford and General Motors might just be return on investment of their own R&D.

The "MPG Illusion"The U.S. Environmental Protection Agency might be tasked with regulating fuel efficiency ratings reported by automakers, but that hasn't stopped the agency from scrutinizing its own metrics. It admits that reporting fuel economy on the familiar "miles per gallon" basis might become misleading as vehicles become more and more efficient. In fact, it has dubbed the problem on the horizon the "MPG Illusion," which details the non-linear relationship in value delivered from increasing fuel economy in the form of gallons of gasoline saved.

In other words, there's a big difference in the amount of fuel saved by increasing fuel efficiency from 10 mpg to 15 mpg compared to increasing fuel efficiency from 40 mpg to 45 mpg. Have a look at the following chart that visualizes the relationship:

Image source:EPA.gov.

The "MPG Illusion" raises some very important questions that need to be openly discussed -- even if it challenges the assumptions made by an overwhelming majority of consumers that support fuel efficiency mandates.

For instance, what's the return on investment for costly and time-consuming R&D required from automakers? If it requires hundreds of millions or billions of dollars to commercialize new tools, processes, and fabrication methods (let alone the capital required to retool manufacturing facilities) to make fuel economy for a vehicle increase from 50 mpg to 54.5 mpg, and that only saves drivers 17 gallons of gasoline over 10,000 miles driven, then why should General Motors or Ford be forced to comply with the CAFE standards?

Consider the following table detailing engineering, research, and development costs for major automakers:

Source: SEC filings.

To be fair, research and development expenses are a relatively small contribution to the total expenses of an automaker and not all R&D costs are accumulated pursuing incremental fuel efficiency gains. Additionally, since alternative fuel vehicles can be used to meet compliance with ambitious CAFE standards -- and many automakers see tremendous growth potential in non-gasoline powered vehicles -- large R&D expenses will continue to be justified. The question is: How long does that last before automakers begin questioning fuel economy mandates?

What does it mean for investors?Luckily, the gap between the efficiency of cars on the road today and mandated targets is still relatively large, which makes fuel efficiency a competitive advantage for General Motors and Ford at the moment. However, it may get interesting when most, or all, automakers have a very fuel efficient fleet closer to the ultimate targets set by the CAFE standards.

That could have the added advantage of pushing automakers into alternative fuel vehicles -- something investors are seeing right now -- which will save substantial volumes of gasoline by default and have a large effect on a company's fleet average. But there will come a time in the near future where dollars invested to achieve fuel efficiency gains deliver questionable value.

The article Will the Law of Diminishing Returns Pit Automakers Against Uncle Sam? originally appeared on Fool.com.

Maxx Chatsko has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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