No time like the present – the automotive sector is going to be the first real world test of the industrial strategy.

A flurry of worry….

Over the last week or so a number of stories have emerged about concerns over the risks to existing and future foreign investment in the UK automotive sector by companies from Germany, Japan and the USA. This potential vulnerability may appear surprising at first pass as the UK automotive industry has enjoyed a strong resurgence in recent years. Car production is at levels last seen in 2000, around 800,000 people are employed in the sector and it accounts for around 12% of UK exports. Why could future investment be at risk?

…because trading arrangements are a concern…

Trading arrangements are critical to the automotive industry because of the integrated nature of supply chains across borders. Modern automotive manufacturing relies on just-in-time techniques and specialisation in production. As a result, parts and finished goods have to be able to move seamlessly across borders at speed. Any delay risks causing shut downs in production, so lean are inventory levels - this is why the West Midlands accounts for the highest share of trade through the Channel Tunnel, reliability and speed are critical. The importance of cross-border supply is especially pronounced in the UK because we have offshored more of our production than any of our developed country peers. Hence, efficient trade is crucial for the ongoing performance of the UK automotive sector.

While discussion of the costs of higher import prices and restrictions on future trade agreements from membership of the EU’s customs union was a prominent feature of the EU referendum campaign, there was much less discussion of its role as a facilitator of trade. For manufacturers, the ability to move goods without tariff and non-tariff barriers across the EU underpins their operations, and hence a way forward on the future movement of goods at reasonable cost and in a manner which guarantees timely delivery is crucial.

Some commentators seem relaxed about the ability of technology to address concerns over customs processes issues, but it is not clear if manufacturers  share this optimism. Lyons and Halligan note that current delays at French Customs for non-EU goods are six minutes and therefore predict that there is little to worry about from leaving the EU Customs Union. EY estimate there are around 76 million customs declarations in the EU currently and this could increase to 300 million in a worst case scenario. Clearly there is a real risk of significantly increased customs clearance and processing costs, and this may be weighing on the minds of manufacturers who operate supply chains on which delays of even six minutes are potentially significant.

…especially with a changing market…

The automotive market is also in the midst of a period of rapid change. The move to scale up production of electric cars, the rush to create autonomous vehicles, and continuing innovation in vehicle connectivity all threaten to disrupt the traditional sector model. This change is creating opportunities for UK based producers: market share and growth are both potentially up for grabs as existing relationships and market positions change. It is generally easier to grow in dynamic markets. The UK Government recognised the opportunities in the industrial strategy green paper, identifying key elements of the future value chain such as batteries, for focus.

However, change also creates risk and uncertainty. Manufacturers will need to invest in new facilities and technology, re-train existing workers, hire new ones and spend extensively on research and development. This creates potential problems for companies operating in the UK. The UK has a strong domestic automotive production and research base, but lags behind in automation in the economy generally. Research by Goldman Sachs suggests the UK has about half the number of robots to manufacturing employees as Germany, and less than a quarter of the level found in the USA and Sweden.

The UK is therefore not as well positioned for rapid industry change as the headline statistics might suggest, and it is possible that Brexit may mean further deterioration in the UK's competitive position. The potential issues with future trading relations were discussed above, but additional challenges could come from:

• Restrictions on migration - it is possible that researchers will be harder to attract to the UK and if UK trade with the EU is more restricted than today, it would surely not be too surprising if foreign owned manufacturers chose to locate their innovation activities outside of the UK to guarantee access to the required knowledge.
• Lack of ability to shape the future regulatory environment. Driverless cars and electric vehicles will require new standards and regulations. The EU is likely to be a key player in this process, given the size of its car market, the European ownership of key players and the EU institutional structure. By leaving the EU, the UK will be giving up a chance to influence the future regulatory environment.

…so lack of control and influence becomes a major concern…

The UK car industry is a success story, but one based on significant foreign direct investment. All of the major car producers in the UK are owned by foreign parents. Automotive has attracted the highest number of FDI projects into the UK over the last five years, according to EY’s European Investment Monitor (EIM), accounting for over 20% of the total volume of projects attracted in UK manufacturing facilities.

The increased uncertainty about the sector’s future does appear to be being driven at least in part by concerns over how non-UK owners faced by industry change, who by definition have options to locate production in other markets, might react to changes in the UK’s relationship with the European Union post-Brexit.

While the UK led Europe in attracting automotive FDI, with 15% of all European projects between 2011 and 2015 according to EY research, UK automotive businesses only made 20 investments in other European countries, compared to 232 by Germany, 143 by North American companies and 94 by Japanese corporates in the same period. The UK is hugely dependent on foreign investors in this sector compared to our peers, we have little international leverage and the majority of investors in the UK have choices in other European markets where they have existing investments.

…which means it is time to make the industrial strategy a reality.

The automotive sector is an important part of the UK economy, and the change in the sector means that there is potential for UK based manufacturers to continue to grow their position in the sector. However, the sector in the UK does face a number of challenges to respond to dramatic industry change with relatively low levels of automation in UK manufacturing generally, and the additional complexity and uncertainty due to Brexit posing as it does potential risks to trade, skills, research and political influence.

A potentially vulnerable market position is made worse by the fact that decisions about future UK investment will typically be made outside of the UK by owners likely to face pressure to invest in their home markets. This should come as no surprise to the UK Government. The good news is that the potential of the automotive sector is recognised, the industrial strategy green paper made this clear. The challenge now is to turn rhetoric into reality.

The first priority is for the Government to explain how customs processes will work after Brexit. Without a workable model, investment by goods manufacturers will surely fall. The need is for a clear description of future plans and how technology, investment in people, and trade policy will minimise any disruption.

Manufacturers are keen to engage with the Government, suggesting a priority should be to rebuild UK supply chains so creating critical mass in the sector to stimulate investment, and reducing any negative impact of tariffs and non-tariff barriers. Investment in research and development, a commitment to drive skills development, incentives to support investment in capital equipment, and the successful delivery of improved infrastructure, can form the basis of an effective response. Once again, there is a need for a clear plan as quickly as possible.

Finally, the UK will have to find a way to be able to influence regulatory and standards development in the automotive industry. Outside of the EU, the challenge is how to command influence from a relatively small market compared to North America, the EU, and China, this is likely to be the hardest issue to resolve.

As the automotive sector drives direct economic activity in the North, Midlands, and Wales, and indirect activity across the country, making a success in this industry will go some way to helping the Government meet its objective of building an economy that works for everyone. The challenge is that, as recent news demonstrates, events are accelerating and decisions are likely to be made before the detail of the future EU-UK relationship is known. The industrial strategy needs to become real action much faster than currently envisaged.

@MarkGregoryEY

markgregoryeconomics.ey.com

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