The economics of the rental car industry give companies including Avis Budget Group and Enterprise Holdings multiple reasons to go slow on the adoption of electric vehicles. Just think of how much money they make every time a renter forgets to return a car with a full gas tank. But on Monday, the rental car companies received the biggest reason yet to move quicker to EVs as part of their fleets. The deal between Hertz and Tesla for 100,000 vehicles is a signal to the major car rental companies that a strategy for EVs is going to be needed, and maybe sooner than they had planned on it.

It was not a surprise to auto industry analyst John Healy of Northcoast Research that Hertz is the first among the small group of major rental car companies to place a big bet on EVs. After an era of industry consolidation, the three companies represent as much as 95% of the car rental agencies at an airport terminal: Enterprise owns Alamo and National; Hertz owns Dollar and Thrifty; Avis combined with Budget. But it’s only Hertz that has offered EVs in any significant way to date, and its focus was limited to the niche market of luxury renters using its premium services such as Ultimate Choice.

“There hasn’t been a lot going on in electric,” said Healy.

That “ultimate” vehicle category offered consumers access to high-end electric cars from Porsche and Tesla, among others, but the numbers were at the level of a “few hundred” in the fleet versus the 100,000 Teslas in the Hertz deal. “They were trying to make money renting cars, not meet this niche,” Healy said of the main competitors. Hertz saw the affluent renter combined with an EV “intrigue” factor as enough of a reason to experiment on the margins of the business, “but nothing more than that,” Healy said.

Enterprise and Avis Budget did not immediately respond to requests for comment.

If demand hasn’t been there yet to justify a major spend on an EV fleet, the Hertz deal may be the signal that the time has come. But there are big economic hurdles for the rental car industry to overcome that are related to hesitation about EVs to date.

As Hertz prepares to re-IPO after restructuring under private equity investors and with former Ford CEO Mark Fields in as interim-CEO, the Tesla headline gives it another way to differentiate itself in a consolidated rental car space. But ultimately EV fleets are an issue the major rental car companies are all going to need to work through as part of sustainability commitments and new economic thinking.

Dan Ives, analyst at Wedbush Securities who covers Tesla, said the rental car fleets were always viewed as “untouchable” because of the scale of their bulk purchases. “The fact that Hertz dove into the deep end of pool and is spending over $4 billion, that was never even on the radar for the likes of a Tesla,” he said. But now it represents a tipping point not only in EV interest from the market but the supply that Tesla can produce with its factory operations expanding around the world and, within the U.S., to Austin.

The rental car industry represents 1.5 million to 2 million cars per year, a significant part of new sales. 

“For Tesla that is 2 million cars that were never on the radar,” Ives said.

Tesla reached a $1 trillion market capitalization on Monday after the deal was announced.

“This announcement is a clear signal from Tesla that they can deliver a large volume of vehicles,” Jonathan Smoke, chief economist at Cox Automotive, wrote in an emailed statement to CNBC.

Size of EVs for rental has been an issue beyond the luxury market with the sedans too small for most renters’ preferences, but that is changing with the production of more crossover EVs and other hybrid vehicles. The crossover utility segment accounted for 50% of EV sales in the second quarter.

While the carbon footprint of the car rental industry has not been a primary focus of the U.S. government, the pressure is expected to increase in the future and there has been talk among those who follow the industry, Healy said, that President Biden wants the rental car companies to commit to electric vehicle fleets.

“The government push is yet to be determined but it’s probably not going away,” Healy said.

The car rental agencies have sustainability in their business models, such as Enterprise’s carbon offsets program and a longstanding research affiliation it has in the biofuels area. Enterprise has reported on Scope 1 and Scope 2 carbon emissions for years, but not the scope 3 emissions that occur at the tailpipes of its fleet cars. Avis Budget also offers carbon offsets, carbon footprint estimates for corporate clients and cites its acquisition of car-sharing company Zipcar as part of its sustainability initiatives. Avis Budget reports 21,000-plus hybrid vehicles in its fleet globally.

Shareholders advocates focused on ESG have pressed the issue with Avis and Hertz. Shareholders asked Avis to purchase 40,000 EVs. A Hertz shareholder climate resolution in 2020 included EVs as part of a broader discussion on climate change. “Hertz’ standard rental car business currently has only three hybrid electric vehicle options at select locations for consumer rentals, with no all-electric vehicles. While Hertz has taken steps to improve energy efficiency for its operational facilities, the impact of the company’s fleet remains insufficiently addressed,” shareholder advocacy group As You Sow wrote in the 2020 measure.

Driss Lembachar, manager of transportation and infrastructure at Morningstar’s Sustainalytics ESG risk evaluation business, said car rental companies are less exposed to car emissions than automakers, given that the ultimate responsibility for emissions and meeting fuel economy standards from a regulatory point of view mainly rests with car manufacturers. But the fuel efficiency and age of a car rental company’s fleet and its renewal (or lack thereof) is material to investors since these areas impact its attractiveness and customer satisfaction/retention levels.

Sales in the U.S. of zero emissions cars continue to rise, with more than 168,000 zero emission vehicles (battery, plug-in hybrid, and fuel cell electric vehicles) sold in the second quarter of 2021, a 33% increase and 122,000 units more than the same period in 2020, according to industry trade group Alliance for Automotive Innovation. It noted Q2 2021 sales represented 3.8% of the auto market, their highest percentage ever. The auto industry is investing $330 billion in electrification by 2025 and it forecasts more than 130 zero-emission vehicles and 30 hybrid-electric models will be available in the next five years.

The upfront expense for the rental car companies from EV adoption, not only in the purchase price of cars, but in the build out of the charging station infrastructure they would need, have been major reasons for moving slowly, and the current economics of the rental car business makes staying with gas-powered cars attractive. Rental companies make money every time a car is returned without a full tank of gas, and while that represents only about 5% of total revenue, according to Healy, it is high margin revenue. While business models can presumably be developed to charge for “topping off” an EV, there is no established practice for that today.

That is one of the unknowns the rental car agencies are going to experience in a steep learning curve for fleet management with EVs. The timing of EV charging has to be taken into account as part of moving cars in and out of agency lots, and there are basic questions they still can’t answer: how many charging stations will they need, and how many will have to be fast-charging. It takes two minutes if not less to put gas in the car, but it could take hours to charge a car and that time differential could be significant in meeting customer demand.

Analysis of older EVs in recent years as Tesla customer service received scrutiny showed that they can present a unique maintenance and servicing profile. Hans-Werner Kaas, Senior Partner at McKinsey and Company, told CNBC in 2019 that fixes for EVs may be less frequent overall, but more expensive, and equipment including ride control and tires may require more frequent service or replacement due to the higher curb weight and acceleration of electric vehicles.

There are potential economic advantages that EVs may offer rental car companies. They could potentially save money on maintenance and the residual value of the cars hold up better. But all of the unknowns associated with unit economics on EVs have taken precedence over any potential economic benefits.

“Their view was that there is not enough infrastructure and no salivating custom that wants it, so why change anything?” Healy said. “There view has been ‘we will wait and see, but now is not the time.”

For Hertz, in process of coming back to the public market with an IPO, the timing is good for a big announcement related to its positioning versus competitors.

The major car rental agencies have tended to follow each others’ moves in recent history whether it is marketing approach or how they charge customers for various services, and with the space consolidated among the major three players, there will be pressure on Avis Budget and Enterprise Holdings to make moves in the EV space. That could be with Tesla, though they might be getting in line for deliveries behind Hertz, or the major automakers, including GM and Ford, planning to produce a large number of EVs in the years ahead. Rental car agencies have historically focused fleet purchases on the U.S. automakers before adding units from overseas.

“I would think Avis and Enterprise need to respond with something,” Healy said. “This has been a been copycat business for the last 50 years and that won’t change.” 

Ives cited a saying about the car industry, that with bulk orders there is never just one. “I would be shocked if the other competitors of Hertz haven’t put in calls to Tesla,” Ives said.

With a changing consumer landscape and more interest in EVs, the rental car agencies will risk losing business if they move too slowly. Healy expects more consumers in the future will be willing to pay extra to try an EV. “If I can rent a Tesla for an extra $40 a day at Hertz … and Avis doesn’t have it, I might try. … There is a customer who will respond to this and on the margins, Hertz is in a better spot.”

For Tesla, the deal is a good way to introduce consumers who have never driven an electric vehicle before to the technology, especially as the sales prices of EVs relative to traditional cars come down to a level where there is more room for mass adoption.  

“Every consumer that gets into a rental car car could be a conversion to a buyer … it’s an extended test drive,” Ives said.

If the rental car industry remains hesitant, it isn’t because the companies lack the money to spend on EVs. “The industry has never been more profitable,” Healy said. Amid the chip shortages that have limited car production, fleet size is only up 15% against demand that is now back up to 80-85% of the pre-pandemic level, according to Healy. The value of the cars on their balance sheets also have been appreciating in contrast to the typical depreciation they would expect in used cars.

The coming quarterly results should show record profitability and in the current market of high demand and limited car supply, the rental car companies are able to charge as much as double what would have been normal pricing in the past. “If you need the minivan in Florida you are going to pay $100 rather than $75 a day,” Healy said.

There also isn’t much else out there for these companies to buy even as their balance sheets are strong with the industry controlled by the three main players, making more consolidation less likely.

Healy said more changes are occurring across the auto landscape and beginning to get the focus from the businesses ancillary to the carmakers. He covers the auction space and noted that Manheim, the largest auction house, recently said in an investor presentation that it will retrofit 53 auction locations with 127 EV stations for charging and the diagnostic work on battery condition it needs to perform to properly assess the value of an EV up for auction. “We starting to see some change among adjacent companies in the industry,” Healy said.