Ukraine war redrawing Europe's auto supply chain map

Early this month, Volkswagen Group's value brand Skoda said it had started producing its own wire harnesses in its plant in Mlada Boleslav, Czech Republic.

Automakers decades ago began outsourcing labor-intensive commodity jobs, such as wire harness assembly and seat sewing. And prior to February of this year, when Russia launched its war on Ukraine, the idea that an automaker would choose to bring such a supply chain job back in-house would have been unthinkable.

But Europe is now a map of change as automakers look at the future of their supply chains.

The Czech Republic in eastern Europe had gained status as one of the region's low-cost countries to build vehicles. But it is not cheap enough to build wire harnesses cost effectively, which is why Ukraine — with far lower labor rates — became a manufacturing hot spot.

However, the Ukraine war has given a supply chain shock to the European auto industry. Automakers and suppliers are wondering just how safe various production sites will be in the coming years. The Volkswagen Group was particularly hard hit by the disruption to wire harness supplier Leoni's plants there. One of the immediate fallouts was a delay in the launch of the VW ID5 electric coupe crossover.

Political worries are just one factor in how the industry is rethinking sourcing strategies. Manufacturers are still reeling from the global shortage of semiconductors, and from the disruption of COVID-19 lockdowns in China, which impacted shipping of parts and materials. And looming over all of this is new pressure on automakers to realign their powertrain, manufacturing and purchasing plans to comply with tightening European Union regulations that will sharply curtail CO2 emissions.

In response, automakers are looking anew at previous purchasing decisions, questioning the industry's vaunted just-in-time supplier model and looking to bring critical components closer to home — or even in-house.

"We are going through a period of de-globalization," said David Bailey, professor of business economics at the U.K.-based Birmingham Business School.

"Carmakers in recent years have focused more and more on fewer and fewer Tier 1 suppliers. The Tier 1s built very long supply chains that crossed borders many times," Bailey said. And while those global chains were occasionally broken by natural disasters, such as the devastating 2011 Japanese tsunami or the Thai floods the same year, their cost-effectiveness outweighed such temporary problems, and the largely opaque chains were allowed to flourish.

But then the calendar rolled over to 2020.

"The combination of the pandemic, the war, political issues such as Brexit, etc., etc., has had a big impact. It bit the OEMs on the bum," Bailey said.

The idea of "local assembly" has given the industry the illusion of homegrown production in recent years. But the reality is much different.

Finished vehicles transported out of the factory gate are "85 percent bolt-on parts," Stellantis CEO Carlos Tavares reminded the audience at the company's strategy day held in March. But while bulky items, such as an instrument panel, are often sourced from nearby supplier parks, the chain for their individual parts still extends well beyond the country, or even the region, leaving automakers vulnerable to global shocks.

"Regionalization — build where you sell, source where you build — was never possible because it had never been designed like that," Jim Rowan, the new CEO of Volvo Cars, told an audience last month at the Financial Times Future of the Car summit. He gave the example of Taiwan as the "epicenter" of semiconductors — thousands of miles upstream from any "local" factory producing components that require semiconductors.

But car companies such as Volvo are now looking to make "source local" a reality.

"I think that is a direction of travel," Rowan said of the new emphasis. It won't be possible for all parts, he warned. And it will necessitate letting go of the purest interpretation of just-in-time manufacturing, in which parts arrive at the plant only as they're needed for assembly.

"People will need to augment that with higher inventory levels so that they can become a little bit more resilient," Rowan said. "The just-in-time mindset is likely to change."

One important new motivation for localization has been the European region's scarce capacity for manufacturing the batteries used in electric vehicles.

European governments and car companies alike have been investing heavily to boost battery production to recapture some of that end value from Asia. Examples include Volvo's joint venture plant with Swedish battery maker Northvolt, VW Group's partnership with both Northvolt and Chinese maker Gotion, Stellantis' and Mercedes' investment in the French battery company ACC, and Renault's stake in cell maker Verkor.

Each of those automakers uses batteries from Asian suppliers, most commonly South Korea's LG Chem.

Yanking back the sourcing to Europe is seen as vital to protect jobs threatened by the gradual ending of internal combustion engine production in Europe, which has been given a deadline after the European Parliament voted this month to eliminate CO2 tailpipe emissions by 2035.

With a few exceptions, car companies and suppliers reacted angrily to that deadline, saying that it will effectively ban internal combustion engines instead of allowing for some less drastic solutions that might still emit CO2 at the tailpipe but capture it elsewhere, such as the use of biofuels.

"The only region implementing a ban on technology is the EU," Sigrid de Vries, outgoing head of European supplier association CLEPA, said in a reaction statement. "With this vote, we risk a considerable relocation of the automotive industry."

The most vocal lobbyist was the Italian automotive supplier association ANFIA. Association head Paolo Scudieri estimated the shift to electric would eradicate around 40,000 jobs in his country, while creating only 6,000.

"It is as if they were asking us Italians to cancel the Renaissance from our history," he said.

In response, European automakers are racing to replace those jobs by bringing in-house production of electric drivetrain components they might have previously outsourced.

"The idea over the last two years was to really get back control of the value chain at Renault," Luca de Meo, CEO at Renault, said at the Financial Times event in May. De Meo boasted that the French company was "probably the second most integrated EV manufacturer after Tesla," having in-sourced production of components such as electric motors, which it builds at its plant in Cleon, France.

Mercedes, meanwhile, will build electric motors at its diesel plant in Berlin.

"We forecast a steady shift toward electric drive insourcing in the coming decade," said Demian Flowers, automotive financial analyst with S&P Global Mobility.

Legislation is also forcing more localization. The messy divorce of the U.K. from the European Union affected the auto industry on both sides of the English Channel because of a Brexit trade agreement that stipulated minimum levels of local content in vehicles shipped between the two. If the total amount of EU or U.K.-sourced parts doesn't reach 55 percent of value from 2027, tariffs are to be imposed.

Given the huge value of the battery in EVs, such as the materials that make up the cathode, automakers will have to ensure that much more of the lithium, nickel or cobalt is at least refined in Europe, if not mined.

Then there's the European Union Battery Directive ruling, designed to reduce the CO2 in battery production. That ruling again forces automakers to inspect the value chain and, ideally, localize it.

From July 2027, batteries in vehicles sold in the EU must "comply with carbon footprint thresholds," according to legislation. The exact thresholds haven't been agreed to yet. But Mercedes pointed out in its 2021 company report that the production of an all-electric vehicle generates about twice as much CO2 as producing a conventional combustion-engine vehicle — "primarily due to the lithium-ion batteries."

As automakers look for new ways to cut CO2 from their entire manufacturing process, it is certain to affect supply chain decisions.

"Every electric car sold increases the importance of the upstream supply chain for the climate footprint," BMW CEO Oliver Zipse said in a speech at the company's annual general meeting last month. For its Neue Klasse (New Class)-platform electric cars, BMW is "taking CO2 emissions and the percentage of secondary [recycled] material into account as criteria for selecting suppliers," he said.

That strategy might generate higher wage costs, but it gives an advantage to local suppliers, given the high levels of renewable energy generated by some European countries.

"The whole Northvolt setup [in Sweden] is done in a very, very sustainable way using predominately hydroelectricity," Volvo's Rowan said.

Not everyone is convinced that supply chains will move from global to local. Global trade has been too beneficial and too entrenched after the last 30 years to change, Mercedes-Benz CEO Ola Källenius argued at the Financial Times event.

"To move away from that is not the right thing," he counseled. "Sourcing will become more sophisticated, maybe a little bit more complex, but to believe that the overall economic system will go into some kind of a re-regionalization — well, I think it would be the wrong goal."