Why There’s No Quick Fix for Volkswagen’s Emissions Crisis

The crisis underway at Volkswagen over EPA allegations — and now company admissions — that the firm cheated on emissions tests for its popular TDI diesel engine line has already cost the company’s stock more than a third in value — or some $26 billion — and has caused some to question the company’s viability. It has also now cost the company its CEO: Today, Martin Winterkorn announced his resignation.

And the meter is still running.

The EPA says penalties could run up to $18 billion, and that would be in addition to individual and class action lawsuits on the way from formerly loyal customers who thought they were buying an environmentally progressive vehicle but now find it is pumping out pollutants far higher than advertised.

The big stock price hit followed reports that some 11 million cars worldwide are affected – not just the nearly half million Volkswagen and Audi cars sold in the U.S. since 2009 with a so-called emissions test “defeat device” as first reported. The device is actually a software fix that tricks emissions tests into picking up deceptive readings. Actual emissions released on the road can be up to 40 times the levels found under the tampered testing conditions for the Volkswagen TDI diesel engines, news reports noted.

Now that the U.S. Justice Department is conducting a criminal probe to follow up the EPA charges, questions are being raised about the future of Volkswagen and of diesel-powered cars in the United States, potential peripheral damage to the image of German automakers more generally, and the health and environmental harms caused by the false readings.

The latest black eye for automakers comes on the heels of General Motors’ ongoing controversy. The company recently agreed to spend $575 million to end a shareholder suit connected to flawed ignition switches that led to the death of 15 people and serious injuries to an unspecified number of others. GM also paid $900 million to resolve a federal criminal investigation and faces billions more costs in potential liability from consumers claiming they were placed in harm’s way after the company learned of the problem but took no initial action.

Wharton management professor John Paul MacDuffie noted that any damage to the health of the public or the environment from VW’s issue cannot be known immediately, but there could be plenty of fallout for hopes of making diesel-powered cars a viable, environmentally sound alternative in the U.S. The disclosures will of course damage VW’s reputation, though it is too early to say how much.

With so much focus on air quality and climate change, “to have such a big, prominent automaker [caught] is a pretty big deal,” MacDuffie added. And it was not easy to catch them. VW “spent years denying it” and it took a “dogged” effort from a small university lab to piece it together. It is “hard to imagine a rogue engineer” being responsible. “That does not mean the CEO knew, but he oversees R&D.”

Wharton professor of legal studies and business ethics Eric W. Orts, who is also director of the Wharton/Penn Initiative for Global Environmental Leadership, noted that it is likely several parts of the firm participated in the deception – from programmers to executives – which makes it difficult to precisely locate blame. The question the case will shine light on, he said, is: “How do you pin responsibility on individuals and the firm” in a way that changes this kind of behavior in the future?

With so much focus on air quality and climate change, “to have such a big, prominent automaker [caught] is a pretty big deal.” –John Paul MacDuffie

According to Cary Coglianese, a Penn law professor and director of the law school’s Penn Program on Regulation, the case will highlight the “widening gulf” between the private sector’s increasingly sophisticated technological capabilities and the government’s ability to keep pace in that arena. “We need to close the gap so that the government can effectively regulate.” (Both Coglianese and Orts shared their views on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. Listen to the podcast at the top of this page.)

The Cost to Volkswagen

Could the controversy grow large enough to bring the company down? “I can’t see it taking down the company in any sense,” MacDuffie said. While the damage to the company’s U.S. market could be huge, “VW is not so strong in U.S.” Worldwide, its presence is stronger: The company recently surpassed Toyota as the world’s largest automaker – temporarily, it would appear — and has a massive global portfolio of models and markets. “They were first in China with a joint venture. They have been strong for years in Brazil, Mexico and all over South and Central America,” setting down stakes before most other companies, MacDuffie noted. “They have many brands and strong brand portfolios, from Audi to SEAT in Spain…. They have been clever about platform engineering, and get a lot of different models to fill these many different segments from a small number of platforms” very efficiently. “None of those competitive strengths are going to disappear.”

Volkswagen has set aside more than $7 billion for costs arising from the crisis. Coglianese said that under the Clean Air Act, the company faces fines of up to $37,000 per vehicle, which would be well in excess of the $7 billion the company has set aside. That would be on top of facing class action suits in the U.S., general litigation over fraud, and the Justice department’s investigations into alleged corporate crime and fraud, in addition to other actions in Europe, he noted.

According to Coglianese, prosecutions of individuals are highly likely in the Volkswagen case. “It is even more likely in this case because a system-wide decision was made,” he said. “It’s hard to imagine that whoever made [the decision] didn’t deliberately intend to deceive. Here we have what seems to be at some level a centralized deceit, and that is going to be very hard to withstand individual prosecution.”

Aligning Incentives with Responsibility

MacDuffie thinks that instead, if the crisis turns out to be the direct responsibility of corporate executives versus a rogue engineer, then “they might be replaced with the next person vowing to make sure it never happens again.”

Fixing moral and legal responsibility on individuals within a firm in such cases is critical, according to Orts. He noted that incentive structures for employees lower down in the organization’s hierarchy could be a factor in such frauds. He also questioned the wisdom of prosecuting, say, a programmer who may not have come up with the idea to tamper with the software so as to show lower emissions in tests.

Orts called for incentives within organizations in general that encourage employees to follow the law. “There have to be some basic rules of the game,” he said. “Fraud and deceiving governments for basic environmental standards have just got to be off the table within the firms. And when that becomes found out, there has to be a way to provide incentives to hold those who did the wrong thing responsible. Our current system is not set up well for that. We don’t hold the right people responsible, so it is going to repeat.”

Regulatory Gaps

According to Coglianese, the Volkswagen case is also worrisome because it went on for many years undetected by the EPA. “[It came] to the attention of the regulators by the handiwork of a nonprofit organization that commissioned its own study of this,” he said.

Coglianese said that although he doesn’t want to let Volkswagen or its managers and leaders off the hook, one fundamental question is about responsibility of the government. “We need to realize that we are entering a world of big data, machine learning, [etc.], and this is a machine learning fraud,” he said. “As the public and as a society, we need to think about investing in the capacity of government regulators. If there is going to be level playing field … then government has to be able to detect these very sophisticated frauds.”

“How do you pin responsibility on individuals and the firm” in a way that changes this kind of behavior in the future? –Eric Orts

Coglianese also bemoaned “a culture that disparages government and government capacity,” and shrinking budgets of government agencies. He also felt that the technical capacity of government officials is inadequate, especially in a world of the Internet of Things and big data. “That gap is growing as government resources shrink and the resources of the private sector are growing,” he said.

The Diesel Preoccupation

As a backdrop to the whole issue, MacDuffie pointed out that Europe generally has had auto and tax regulation rules favoring diesel — “so that diesel was always cheaper than gasoline in Europe” — while the opposite is true in the U.S. What’s more, the U.S. is the only major market where VW’s diesel car sales are soft.

“I can imagine … the mindset of the engineers,” said MacDuffie. The so-called “clean” diesel high-tech engine is a “source of tremendous technical advance.” When Toyota first introduced the Prius, “a lot of Europeans I talked with could see no chance of it becoming popular.” They thought their diesel engine had equal mileage and better performance characteristics and avoided the inefficiency of “having two drive trains (gasoline and electric).”

Today, those engineers may have seen the U.S. Clean Air Act as a stumbling block to their “clean” diesel technology. Europe is highly conscious of pollutants and climate change, and has stringent regulations on them overall. But U.S. regulations are very “tough on NOx (nitrogen oxides), which is what diesel emits in higher quantities, so they might feel the only thing keeping them from proving the superiority of this technology are these American regulations, which are ‘anti-diesel.’ I could see that having some effect: Because all of Europe is on a different standard that allows more NOx,” the engineers may not agree with the American standards, rather seeing them as a means of “trying to keep diesel out.”

‘Wait and See’

Could this significantly damage the German auto brand overall? According to MacDuffie, “A lot depends on what they find when they test the other makers of diesel, which are mostly German…. If they turn out to be clean, the contrast effect will probably help them” or certainly not cause damage. “But if they are found to have done any version of the same thing then absolutely [it could damage German automakers]…. We must wait and see.”

The reputation hit would also be substantial. Coglianese noted that the company has marketed the vehicles as environmentally sensitive. “Although Europe has a less stringent in use emissions testing regime than in the U.S., the consumer marketplace [in Europe] values the environmental performance of vehicles — even greater than the American market does.”

Regarding crisis management, MacDuffie pointed to the way Toyota appears to have mishandled its latest embarrassment of problems with Takata airbags, which led to the recall of nearly 3 million cars. American officials had difficulty getting a clear story from Toyota executives, and they even had to fly to Japan to interview them. Toyota had “no clear spokesman in the U.S. to represent top management.” There were senior American executives, but they were not the top brass.

“It’s hard to imagine that whoever made [the decision] didn’t deliberately intend to deceive.” –Cary Coglianese

One Congressman even tried to pass legislation requiring large foreign companies to have an American CEO so there was someone they could get hold of, MacDuffie said. The legislation didn’t go forward, but it showed the level of frustration U.S officials felt.

In light of Toyota’s difficulties, it would be “very helpful” for Volkswagen “to get some very effective communicator from their senior executive team to be in the U.S. and show responsiveness…. In terms of American public opinion, it helps to have a sense that somebody is here and that the company is taking [the issue seriously enough] to send a top executive.”

MacDuffie noted that because diesel engines comprise a small part of the U.S. fleet (about 1%, and VW is a fraction of that), at first glance it would appear that the health consequences of the emissions scandal would not be high. “But when you hear that with the controls turned off it was almost 40 times the level of pollutants as when the controls are turned on … that is a huge multiple. If it were only four times as much, it would not be getting this kind of attention…. You would almost have to multiply the impact of their diesel vehicles by 40 to say what their real impact was.”

Creating Deterrents

Will the Volkswagen case create a sufficient deterrent for others in its industry? Coglianese noted that Volkswagen is dealing with the crisis “almost by the playbook for crisis management by admitting that there was a mistake, coming forward and cooperating.” Yet, it is also true that the company had an opportunity to do that earlier. “It depends on what hit Volkswagen ultimately takes. That [would be] a deterrent for other companies.”

Orts noted that typically, in the case of banks involved in financial scandals, they engage in crisis management and see their stock prices dip. “But at the end of the day, if business continues as usual and no one has to take responsibility for a very large problem, then you set up incentives for it to be repeated in future,” he said. “We need to think about how we reform both businesses and the legal structure to try to get those incentives better aligned.”

The Volkswagen case strengthens the case for effective regulation, said Coglianese. “If Volkswagen plays by the book and is able to recover, and the brand value is retained, [then] the market hasn’t disciplined this process,” he added. “That is why we need regulation — because of market failures.” He noted that emissions standards like the EPA’s are examples of performance-based approaches to regulation which are being advocated worldwide and in several fields. Even President Barack Obama has encouraged federal agencies to pursue performance-based approaches to regulation, he said.  And yet, Coglianese said, the Volkswagen case makes plain that performance-based regulation is no panacea and depends vitally on careful monitoring of firms’ compliance.