What Are EV Regulatory Credits And Why Is Tesla Selling So Many Of Them?

Tesla Inc TSLA reported its fourth consecutive profitable quarter on Wednesday after the company generated 50 cents in GAAP EPS in the second quarter. Despite an earnings and revenue beat, Tesla shares fell 5% on Thursday, and regulatory credits may be to blame.

Tesla reported $6.04 billion in revenue in the second quarter. However, despite opening a new plant in China and launching the new Model Y, Tesla’s automotive sales were down 4% from a year ago.

Tesla also reported just $104 million in GAAP net income in the second quarter, but that profit includes $428 million in regulatory credit sales.

What Are Regulatory Credits? Environmental emissions programs around the world, such as the Zero Emissions Vehicle (ZEV) program in California, give out credits to automakers that produce and sell electric vehicles. In addition to California, there are at least 13 other U.S. states that have similar programs in place. If an automaker doesn’t have enough credits by the end of the year, it could face punishment from state regulators.

Since Tesla produces nothing but EVs, the company racks up way more credits than it needs to meet the minimum regulatory requirements, so it turns around and sells the excess credits to other automakers so that they can avoid penalties.

For example, Fiat Chrysler Automobiles NV FCAU has reportedly committed to buying $1.27 billion in credits from Tesla to comply with new European environmental regulations that go into effect in 2021.

See Also: ARK Invest Analyst Discusses Tesla's Path To $15,000 Share Price

Why Does It Matter? Since Tesla receives these regulatory credits for free, they're able to sell them at 100% profit margins, which boosts the company’s overall margins. Tesla’s regulatory credit sales revenue in the second quarter was up nearly 200% from a year ago.

Tesla is seemingly relying heavily on these credits to turn a profit, according to GLJ Research analyst Gordon Johnson.

“In fact, given TSLA is guiding 2020 credit sales of $1.2bn vs. the current consensus EBIT estimate of $1.2bn, TSLA is effectively guiding to zero profits from actually selling cars, again, in 2020,” Johnson wrote in a note.

To make matters worse, Johnson and other analysts say demand for these credits is unsustainable in the long-term as automakers around the world roll out their own EV models in coming years. Without this 100%-margin revenue boost, Johnson estimates Tesla’s actual automotive gross margin was just 18.7% in the second quarter, its lowest level in a year.

Benzinga’s Take: Tesla certainly isn’t doing anything wrong in profiting off of its excess regulatory credits, but investors can bet their bottom dollar other auto companies like Fiat Chrysler are doing everything they can to wean themselves off of buying credits and boosting Tesla’s numbers as soon as possible.

A big part of Tesla’s 500% gain in the past year has been proving a sustainably profitable business model, but it’s unlikely that regulatory credit sales will be part of that equation in the long-term.