The U.S. Court of Appeals for the District of Columbia Circuit ruled yesterday that the U.S. Environmental Protection Agency (EPA) should not have enabled Navistar to pay non-conformance penalties (NCPs)  on diesel enginesit produced that did not comply with clean-air standards. The NCPs allowed Navistar to sell diesel engines that had emissions levels above 0.20 grams of NOx.

What and how great an impact the ruling will have on Navistar remains to be seen. While the manufacturer urgently needs to complete EPA certification of its engines, it also must now await the issuance of a final rule on NCPs by EPA. It remains to be seen how Navistar will fare going forward—including whether its current predicament makes it an attractive takeover target by another truck maker.

The ruling favors the competitors of Navistar that have been selling EPA-compliant engines. That’s because Navistar will now no longer be able to pay NCPs to sell its non-compliant engines and because the OEM has said that it will soon use up its banked emission “credits” (from earlier compliant engine sales) that can be “traded” to allow the sale of non-compliant engines.

Noting that the ruling resulted from a lawsuit filed by “certain Navistar competitors against the EPA,” Navistar said in a statement that it is “impacted by the decision” and that it disagrees with the ruling and will ask for a rehearing.

“Navistar will work with EPA to fully understand the ruling and its impact on the use of NCPs until a final rule is implemented,” the truck and engine builder stated. “At the same time, we will continue to cooperate with the EPA on the final NCP rule and will continue to work with the EPA on our 0.20g NOx certification.

“Navistar continues to make and ship engines and our customers will continue to receive the products they ordered with EPA-certified engines,” the OEM added.

Up to this point, via both trading emission credits and paying NCPs, Navistar has been able to continue selling diesel engines that do not comply with EPA emission regulations. Navistar has continued to attempt to meet those rules using cooled exhaust-gas recirculation (EGR) whereas their competitors have all deployed a combination of EGR and selective catalytic reduction (SCR) technology to successfully meet the EPA requirements.

Navistar had contended that if EPA did not let it pay NCPs, it would have to end production of its Class 8 engines and trucks.

EPA responded to Navistar’s concern with an “interim rule” that required the manufacturer to pay up to $1,900 per non-compliant engine while the EPA considered a final rule on this matter-- which it has yet to issue. 

The EPA interim rule triggered a lawsuit by Navistar competitors Cummins Inc.; Daimler Trucks North America and its subsidiary Detroit Diesel; and by sister OEMs Mack Trucks and Volvo Trucks North America. Those OEMs told the court that EPA should have conducted a public-comment process before issuing its interim rule and the court ruling came down on the side of the petitioning manufacturers.

“In January 2012, EPA promulgated an interim final rule (IFR) to permit manufacturers of heavy-duty diesel engines to pay nonconformance penalties (NCPs) in exchange for the right to sell noncompliant engines,” stated Circuit Judge Janice Rogers Brown in her opinion field for the court.

“EPA took this action without providing formal notice or an opportunity for comment, invoking the ‘good cause’ exception provided in the Administrative Procedure Act (APA),” Judge Brown continued. “Because we find that none of the statutory criteria for ‘good cause’ are satisfied, we vacate the IFR.”

Judge Brown noted that the EPA interim rule “does not stave off any imminent threat to the environment or safety or national security.  It does not remedy any real emergency at all, save the 'emergency' facing Navistar's bottom line…. Simply put, [Navistar] bet on finding a way to make exhaust gas recirculation a feasible and compliant technology before its finite supply of credits ran out. Navistar’s day of reckoning is fast approaching: its supply of credits is dwindling and its engines remain noncompliant.”

Now that the court has spoken—and loudly-- what can Navistar do to hope to stave off its predicted “day of reckoning”?

The manufacturer is now caught between not yet having its engines EPA-certified and no longer being able to pay NCPs as well as facing the exhaustion of its emission credits. On top of that, Navistar has no inkling what a final rule on this issue by EPA may involve or how soon it will come out. And that final rule can only be issued subject to the circuit court’s review.

However, in Navistar’s favor is the possibility that the EPA final rule could permit it to again pay NCPs.

A Dow Jones Newswiresreport on the ruling quoted Jefferies & Co. analyst Stephen Volkmann as remarking that “…EPA could issue a final ruling in the coming weeks, and although this could also be challenged in court, it would take time during which Navistar could be allowed to continue producing engines."

Also offering something of a positive take on the situation, a Barrington Research stock report posted today observed that for Navistar the year 2012 “will likely continue to be a messy period due to uncertainty and delay in the transition to EPA compliance. However, EPA compliance should soon get resolved.”

Indeed, Barrington said that its investment thesis is unchanged due to Navistar’s second-quarter earnings release and the “negative” court ruling. The investment firm said that Navistar’s “low valuation and prospects as an acquisition target should support the stock at the current levels. We believe that the EPA final ruling will allow Navistar to continue paying NCPs and that the 13L [engine] 2010 EPA certification should happen soon [for Navistar].”

While Barrington went on to say that the EPA “overhang” will continue to impact the company’s profitability and market share” thus “ creating uncertainty about Navistar’s chances for long-term success,” it also pointed out that “potential synergistic truck buyers like VW or Fiat might go for a takeover to gain a larger share in the North American truck market.”