BRUSSELS (Reuters) -- Volkswagen Group's cheating on emissions tests has soured the European car industry's heavy bet on diesel, with Renault, PSA/Peugeot-Citroen and Fiat Chrysler potentially facing bigger long-term setbacks than the company that sparked the crisis.
In the face of that perceived injustice, tensions are mounting behind the united facade that European automakers present to regulators, some of their representatives say.
VW's use of a banned "defeat device" has drawn scrutiny of more widely practiced test manipulation which, although legal, has allowed real-world nitrogen oxide (NOx) emissions to surge to more than seven times their European limits.
A renewed push to close EU test loopholes promises to add billions of euros to diesel engine costs already at the limit of mass-market viability, hitting small-car brands hardest while shifting demand to hybrids, where the Europeans are several years behind Japanese competitors.
"This VW tidal wave will accelerate the shift," said a senior executive at a French supplier of diesel emissions technology. "Some carmakers aren't ready for this."
In the near term, VW will continue to suffer the worst repercussions of its test-rigging, exposed by U.S. authorities on Sept. 18. The carmaker may raise new capital, a company source told Reuters on Thursday, if the costs of recalling millions of vehicles, fines and lawsuits far exceed the 6.5 billion euros ($7.3 billion) it has set aside.
But when the diesel soot eventually settles, smaller victims may turn out to be more critically injured.
The blackening of diesel, whose superior fuel-economy has been crucial to meeting ever-tougher carbon emissions rules, may force carmakers to spend billions fixing their NOx problem, and billions more to bring forward rechargeable hybrids.
The average CO2 limit for European carmakers' fleets will fall from 130 grams per km to 95 grams in 2021 -- a goal carmakers say cannot be met if diesel sales fall significantly.
The industry now faces a hefty bill just to "commercialize technology that may have a limited long-term future," Morgan Stanley analyst Adam Jonas said. "On top of this, they have the burden of developing alternative powertrains at the same time."
Goldman Sachs believes a regulatory crackdown could add 300 euros per engine to diesel costs that are already some 1,300 euros above their gasoline equivalents, as carmakers race to bring real NOx emissions closer to their much lower test-bench scores.
That threatens the very existence of small diesel cars, which currently account for about 60 percent of European sales by PSA and Renault, and 40 percent of Fiat's. Premium and larger models -- a bigger part of VW's sales -- can more easily absorb the extra outlay and still turn a profit.
All four carmakers declined to comment on the longer-term impact of the emissions scandal.
In a letter to EU policymakers this week, the industry's main Brussels lobby group insisted that significant progress on NOx was impossible before 2019.
Behind the scenes, however, divisions have emerged over plans for tougher real-world tests, with Peugeot and Renault aggrieved to be sharing public blame for German foot-dragging.
"There is now unanimous backing for the tests among mid-market carmakers, but not with the Germans," a French industry source said. "The sense of injustice is real."
Even before the scandal, new Euro 6 engine standards were set to add as much as 600 euros per car in costs from which customers see no obvious benefit, Renault-Nissan CEO Carlos Ghosn told Reuters in an interview last week. "No consumer is willing to pay (the extra) 500-600 euros," he said.
The conundrum reflects the magnitude of diesel's rise since 1990, when it powered 14 percent of European cars. Helped by tax breaks, it now claims more than half of the market.
But the fuel had already lost some ground after the World Health Organisation declared it cancer-causing in 2013, prompting London and Paris to announce restrictions. NOx and particulates are blamed for many thousands of deaths each year.
"We expect research and development investments to increase further as manufacturers face new and more stringent rules," said Emmanuel Bulle, a director at credit ratings agency Fitch.
Abrupt changes to engine programs, which often take two decades to pay off, may "lead to material investment writedowns", he added in a note.
That is particularly sobering for Paris-based PSA, which depends on Europe for 60 percent of its global sales.
Carlos Tavares, who took the helm after a brush with bankruptcy last year, has said PSA must show it can survive alone if only to strengthen its hand in likely consolidation.
Without a partner, PSA would struggle to meet sudden new investment demands to upgrade its diesels and rush plug-ins to market. Its current hybrids are large, costly and diesel-powered, with rechargeable petrol-electrics not due before 2019.
Like the 1973 oil price shock, which upended the global auto market and gave fuel-efficient Japanese models a U.S. foothold, the diesel scandal may benefit Toyota and Honda , world leaders in affordable plug-in hybrids.
Soon after Ghosn's 1999 arrival from parent Renault, Nissan shelved its hybrid plans to focus on battery-only cars -- so far a mass-market flop -- and is now the only major Japanese carmaker without its own rechargeable hybrids. A revived program will launch plug-ins around 2018.
"Renault may have made a strategic error in betting entirely on electric vehicles over hybrids and its exposure to diesel is the highest of any global manufacturer," Exane BNP Paribas analyst Stuart Pearson said.
"Longer term, on the other side of this mess, VW has the stronger price point and margins to pay for plug-ins," said Pearson, who expects European hybrid sales to pick up swiftly from their current 2.2 share of the market and overtake a declining diesel in the next decade.
The diesel fallout also challenges Fiat Chrysler, which has no plans for mass-market hybrids. CEO Sergio Marchionne regularly jokes about selling battery-powered Fiat 500s at a loss to satisfy California regulators.
Along with Renault and GM's Opel, Fiat relies heavily on Lean NOx Trap (LNT) technology whose real-world emissions are a larger multiple of legal limits, and harder to fix, than the Selective Catalytic Reduction (SCR) exhausts prevalent in Peugeots. VW models are more evenly split between the two.
While financial claims against the disgraced German giant will complicate immediate investment decisions, its Audi premium division and sheer overall scale bring advantages in the scramble for electrification.
The group, which is about to launch a third rechargeable hybrid for its core VW brand, will spend 11.9 billion euros on development this year, according to Exane, or 65 percent more than Fiat, Renault and Peugeot combined.
That is enough to persuade small VW shareholder Achim Hellmann, a self-employed marketing advisor from Hamburg, to take the long view on a stock down 43 percent since the scandal broke.
"The scandal is terrible for the brand but I believe in their stance on future technologies," said Hellmann, 54. "VW spends more on R&D than any other firm in Europe. Why should I sell?"