BMW, maker of the self-styled “Ultimate Driving Machine”, is developing an electric car, a battery-powered city runabout that could be available in 2012.

An electric “zero emissions” model would help BMW, better known for its sports saloons and weighty four-by-fours, to bring the average carbon dioxide output of its range closer to the 130g/km limit proposed by the European commission.

BMW also believes that private transport in cities may be moving into a new phase. A task force known as Project I (the “I” stands for innovation) is studying the optimum means for individual mobility in the huge cities of the future and has identified the plug-in electric car as a favourite candidate.

Norbert Reithofer, BMW chief executive, revealed the existence of Project I and the electric car prototype last week when he presented the group’s annual results.

BMW is the last of the three big German premium car brands to publish its full 2007 results. Daimler, maker of Mercedes-Benz cars, and Audi, a division of the Volkswagen Group, did so during the previous fortnight. There is intense competition between these three brands, all of which had record sales last year.

But the spectre of carbon-dioxide regulations, higher road taxes, and penalties such as the forthcoming £25aday London congestion charge for larger vehicles with powerful engines and high fuel consumption, makes the future uncertain for the cars of choice of the upwardly mobile. Between them, Audi, BMW and Mercedes sold 3.8m cars worldwide last year. BMW has doubled its sales since 2000 and is the leader in terms of volume, with 1.5m BMWs, Minis and Rolls-Royces sold last year, but it makes the lowest return on revenue.

The motor industry has notoriously low margins but the successful manufacturers of more expensive and prestigious cars consistently show respectable profits. As Reithofer said: “We develop only premium products and therefore must deliver an above-average rate of return.”

Finance director Michael Ganal explained that when exceptional factors like the settlement of an exchangeable bond in Rolls-Royce plc shares were put aside, BMW’s pretax profit of 6.4% equalled that of the previous year. Analysts are more impressed by Daimler’s 2007 return of 9.1% and Audi’s 8.7%.

They suggest that BMW’s plan for cost-cutting and improved productivity, its so-called Strategy Number One, which calls for €6 billion (£4.7 billion) savings by 2012, is too little and too late. But Reithofer insists that BMW is right on target, that the recently announced voluntary redundancy programme for 3,100 employees in Germany is part of the efficiency drive, and that, by 2012, the company will grow to produce 1.8m cars a year and an 8%-10% profit margin.

The battery-powered model may be part of that expansion. It will be a small city car, with new-generation lithiumion batteries (bigger versions of those used in laptop computers and mobile phones), charged by plugging into the mains. It is unlikely to be cheap (the state-of-the-art Think electric car from Norway costs more than £15,000) but will provide the comfort and features of bigger cars and have the same safety provisions.

BMW will make a decision on whether to put its electric car into production before the end of the year. It also has to decide whether it should carry a BMW or Mini badge or have a new name. Creating a new brand, as Mercedes has done with Smart, is the more risky option but BMW is keen to preserve the sporty characteristics that have served it so well over the years and an electric car may not match that image.

Ian Robertson, the former Rover and Rolls-Royce executive who has just been appointed sales and marketing chief for the BMW Group – and is the first British member of the company’s board of directors – points to the success of Mini as a separate brand. Mini is now so well established that it does not need the halo of BMW. Robertson wonders how many Mini customers know or care who makes it.

A new brand would provide the opportunity to emphasise the electric car’s green credentials. “2007 was the year when the environmental message hit home,” said Reithofer. BMW’s Efficient Dynamics programme – a series of fuel-saving (and therefore emissions-lowering) measures – has been applied to the majority of the BMW and Mini ranges and it now has 26 models achieving less than 140g/km carbon dioxide. BMW has decreased the carbon-dioxide output of its cars by 25% over the past 10 years.

But it remains clear that it can’t reach an average of 130g/km and neither can Mercedes. Audi is cushioned by being aggregated with the other brands in the Volkswagen Group that have smaller and more economical cars.

Reithofer is adamant that emissions have to be reduced in equal measure by small and large cars. He thanked the German government for taking a firm stance on the carbon-dioxide issue within the EU and defending the interests of BMW and Mercedes.

The reputation of German cars was established by these marques and could be damaged if the high carbon-dioxide rating of the most prestigious models was emphasised and penalised.

At present this is an EU issue and in the short and medium term Audi, BMW and Mercedes see most of their growth coming from emerging markets, notably Russia, China and India.

Audi leads the premium-car sector in central and eastern Europe and in China but doesn’t do so well in America, where BMW is the most successful European car company. Therein lies another problem. “The persistent weakness of the dollar affects us more strongly than competitors that sell fewer cars in America,” Reithofer said with some feeling.

BMW’s answer is to make more cars there and source more materials and components in the dollar zone. It has just announced an investment of $750m (£378m) to build a second assembly hall and expand the paint shop at its plant in Spartanburg, South Carolina. As well as making the big X5 and X6 four-by-fours, it will also build the next generation X3 model. Mercedes has a factory in Tuscaloosa, Alabama, that makes its ML and GL four-wheel drive vehicles. Audi may join with parent Volkswagen in its proposed new American plant.

Even if they get a reprieve in the EU regulations, the premium brands know that the drive to reduce carbon-dioxide emissions in the name of global warming isn’t going away. America could be next with tight fuel-consumption regulations, requiring some of the same moves and technology that have already been introduced in Europe.

Starting in 2009, Audi, BMW and Mercedes will offer petrol-electric hybrid four-by-fours - following the trend set by their only substantial rival, Toyota’s Lexus. The next step will be hybrid power for the biggest saloons, the Mercedes S400 and a version of the new BMW 7-series that will appear later this year. Somewhat surprisingly, BMW and Mercedes are sharing the electrical elements of these hybrid models.

Longer term, Mercedes is confident of a production-ready and realistically-priced zero-emissions fuel-cell car for 2015, but that will require the infrastructure to provide its hydrogen fuel. BMW already has a test fleet of hydrogen-fuelled 7-series saloons but uses the hydrogen gas in a conventional combustion engine; it thinks that the fuel cell is better in the minor role of an on-board battery charger.

Safe under the umbrella of the Volkswagen Group, Audi has less need for a carbon-dioxide-free model but is preparing a new small car, the A1, for launch in 2010 and a version of that could have hybrid drive. Audi’s last attempt at a fuel-sipping baby car, the lightweight aluminium-bodied A2, was a commercial failure.

Of the three German grandees, BMW is the most enthusiastic about a pure electric car. But if this looks like a promising new market sector, then its rivals are not going to ignore it. As Reithofer was announcing in Munich that it was evaluating a battery-powered model, at a conference in Geneva, Mercedes revealed that it is working on an electric Smart ForTwo.