Case 14 The Volkswagen Diesel Emissions Scandal: An Expensive Corporate Ethics Debacle

AUTHOR BIOGRAPHY

Frank L. Winfrey, PhD is the Clark N. and Mary Perkins Barton Professor of Management at Lyon College in Batesville, Arkansas. Dr. Winfrey earned his PhD at the College of Business Administration at the University of South Carolina, his MBA from the University of Alabama in Birmingham, and his BA from the University of North Carolina at Chapel Hill. His research interests include corporate governance, competitive advantage, and executive compensation.

Overview

This case examines the Volkswagen (VW) nitrogen oxide emissions scandal and its aftermath for the company and key members of its executive management. In the spring of 2017, the scandal was on track to be the most expensive corporate ethics debacle in history, with a cost to the corporation in excess of $25 billion in the United States alone. In an attempt to market the next big thing?"clean diesel"?VW and its engineering partners crossed over the line between legal and illegal emissions testing.

A "VERY, VERY, VERY SERIOUS" CASE

On Friday, March 11, 2017, Volkswagen General Counsel Manfred Dss entered an unprecedented corporate guilty plea in the criminal case involving the firm's conspiracy to defraud the United States. The Volkswagen Group had been charged with three criminal counts: committing wire fraud and violating the Clean Air Act, obstruction of justice, and import violations. U.S. District Court Judge Sean Cox declared this to be a "very, very, very serious" case.¹On April 21, 2017, Judge Cox announced a $2.8 billion federal fine and $1.45 billion penalty, bringing the total in fines, penalties, and other legal settlements to over $25 billion.²

With the guilty plea and federal fine, Volkswagen began to bring formal closure to an emissions-cheating scandal dating back to 1999³and later discovered under the auspices of a not-for-profit research organization, and to legally respond to U.S. government charges initially filed in September 2015.⁴

The scandal first broke in March 2014 when the Washington, D.C.-based International Council on Clean Transportation (ICCT) received the results of a study it had commissioned in 2012 to prove that diesel cars in the American market were much less polluting than those in Europe.⁵John German, an ICCT senior fellow and former U.S. Environmental Protection Agency official, suspected that the answer was simply compliance to stricter regulations because the U.S. standards on nitrogen oxide emissions (NO_X) for diesel vehicles were far tougher than the European standards. Specifically, the U.S. standard was 31 milligrams per kilometer versus the European Union (EU) standard of 80 milligrams per kilometer.⁶

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The $50,000 ICCT study grant assigned researchers at the Center for Alternative Fuels, Engines and Emission (CAFEE) at West Virginia University to measure gaseous emissions from diesel vehicles certified to US-EPA Tier2-Bin5 and CARB LEV-II ULEV (California) regulatory standards, but to do so during typical real-world conditions using onboard instrumentation.⁷Ironically, the CAFEE researchers found that the three diesels it tested under real-world driving conditions were, in fact, producing much higher levels of gaseous NO_Xemissions than U.S. standards allowed?up to 40 times as much NO_Xemissions. During the testing, the West Virginia University researchers kept recalibrating their portable, onboard equipment, thinking it might be malfunctioning because the same diesel cars were consistently passing their laboratory-based emissions tests.⁸

After receiving the ICCT study report, the California Air Resources Board (CARB) and the Environmental Protection Agency (EPA) continued testing the VW diesel cars under increasingly more sophisticated laboratory conditions.⁹After the release of the CAFEE report, VW made statements to U.S. regulators claiming that the discrepancies between the emissions findings in the laboratory and the emissions findings on the road were "innocent mechanical and technological problems" or an unspecified "technical glitch."

In December 2014, VW issued a voluntary recall covering half a million of the vehicles. After the recalled vehicles failed to alter additional testing results, the CARB researchers intensified their diagnostic system efforts. Ultimately, the CARB researchers were able to circumvent the diesel vehicles' defeat device software in the laboratory, thus confirming suspicion of possible fraud.¹⁰

ORIGIN OF THE DEFEAT DEVICE

In 1999, engineers at Volkswagen's Audi unit had developed software technology to make its diesel vehicles run more quietly. The Audi engineers named the software the "acoustic function." According to documents submitted in support of a plaintiff lawsuit filed by Lieff Cabraser Heimann & Bernstein LLP in federal court, a meeting was held on May 28, 2014, between Martin Winterkorn, Volkswagen's chief executive officer (CEO), and Volkmar Denner, the CEO of Robert Bosch GmbH, to discuss Volkswagen's "acoustic function."¹¹The Volkswagen Group had long been supplied with Bosch-created engine control devices, so it is likely that the emissions defeat device may have been a natural extension of the technology of the Audi acoustic function software. Software in a modern automobile is astonishingly complex, requiring up to 100 million lines of code. Theoretically, it was unlikely that engineers could have simply slipped the emissions-defeating algorithm into the system without the knowledge of upper management.¹²On September 3, 2015, Volkswagen admitted to the U.S. EPA that it had installed software algorithms that allowed the engine control system to detect in-laboratory emissions testing conditions.¹³

On February 1, 2017, Robert Bosch GmbH, the world's largest automobile supplier, agreed to settle a U.S. civil claim that it had assisted in the creation of the defeat device software for Volkswagen.¹⁴However, Bosch claimed its settlement did not mean that it accepted any of the charges against the company and asserted that how its "components are calibrated and integrated into complete vehicle systems is the responsibility of each automaker."¹⁵

ISSUES WITH DIESEL EXHAUST AND EMISSIONS

Diesel vehicles achieve more torque and better mileage, emit lower levels of carbon oxide gases, and hold their long-term value better than gasoline combustion vehicles do. The efficiency of diesel vehicles is the result of burning their fuel at a higher temperature, meaning more nitrogen is released to the atmosphere as NO_X.¹⁶With diesels, because of the fundamentals of their combustion process, carbon oxides are not an issue. Total hydrocarbons are only an issue in a cold start. Soot is generally not a problem because contemporary diesel cars have diesel particulate filters. Thus, NO_Xbecame the remaining concern.¹⁷NO_Xemissions are associated with premature death, bronchitis, asthma, other respiratory problems, and cardiovascular illnesses. Additionally, NO_Xemissions are a precursor to ground-level ozone. However, CAFEE researcher Dr. Arvind Thiruvengadam notes that NO_Xtypically lingers in the atmosphere for some time, having photochemical effects that only eventually create ozone.¹⁸

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The portion of diesel emissions catalyst systems that deal with NO_Xuse variations of either a selective catalyst reduction (SCR) method or an oxidation reaction method.¹⁹Heavy-duty trucks use the costly and bulky SCR method. SCR involves squirting an aqueous urea solution into the engine's exhaust chamber, where it reacts with NO_Xto produce emissions of only nitrogen, CO₂, and water.²⁰SCR systems work best when the diesel engines are running in a temperature range of 200 to 250 degrees Celsius, rather than from a "cold" start.²¹SCR was impractical for the Volkswagen passenger vehicles because of the enormous tank required to meet a VW internally mandated interval of 16,000 kilometers between fluid refills. Further, designing, installing, and operating SCR systems significantly adds to a vehicle's cost. Lean-NO_Xis an oxidation reaction method in which NO_Xaccumulates onto a catalyst surface, so it is limited in the amount of NO_Xit can absorb and needs its surface frequently regenerated.²²

LOOPHOLES IN LABORATORY-BASED EMISSIONS TESTING

The measurement and testing of vehicle exhaust emissions is not exactly a citadel of ethical fortitude. In the European Union, automobile makers test their vehicles emissions by contracting with independent testing organizations certified by individual national governments. Competition among these testing organizations frequently results in their optimization of test procedures to achieve favorable outcomes for their clients. To begin with, cars that are tested have been modified to be as lean as is possible?anything that adds weight to the vehicles is left out: sound systems, air conditioning systems, and so forth. On the outside body of the vehicles, wind drag is reduced by removing side mirrors and taping all cracks between body panels. Low-resistance tires are overinflated and filled with special mixtures of light gases. Under the hood, special lubricants combined with the highest allowed ambient temperature are used to enhance the smooth running of the engine, and alternators are temporarily disconnected to provide more power to the wheels. Additionally, the cars may be tested while set in a high gear mode.²³Given such conditions, it should not surprise researchers or regulators that laboratory conditions might significantly vary from real-world testing and measurement.

Laboratory testing is, however, conducted under standardized conditions so that all vehicles are consistently examined under identical simulated sequences. Running vehicles are put in a locked position while their wheels turn on a chassis dynamometer with instrumentation attached to the exhaust systems. Unfortunately, such testing provides identifiable indicators of its presence, such as constant drive train speeds, lack of steering mechanism movement, and constant ambient climatic conditions, wind and barometric pressure. If stationary testing parameters were determined by the software defeat device, the engine control system would switch on the catalytic converters as well as the valves controlling exhaust gas recirculation systems to reduce emitted pollutants.

An additional factor in emissions testing, measurement, and certification is that manufacturers are required only to meet corporate average standards so as to allow for flexibility from one particular model to another. Some models may be certified above the air quality goals while other models may be certified below the air quality goals. Regulators chose the fleet average method because it enabled use of cost-effective emissions reduction technologies.²⁴

ICCT'S REAL-WORLD TESTING PROTOCOL

When the researchers at CAFEE set out to measure the exhaust emissions during typical driving conditions, they conducted testing on three light-duty diesel automobiles using portable emissions systems (PEMS) instrumentation. There were two vehicles with lean-NO_Xtrap technology and one vehicle with an aqueous-urea-based selective catalytic reduction system.²⁵

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The test plan encompassed a wide variety of topological, road, traffic, and ambient conditions in three urban areas in California: San Diego, Los Angeles, and San Francisco. Additionally, the automobile with the SCR system was tested on a long-distance highway conditions during a 4,000 kilometer round-trip between Los Angeles, California, and Seattle, Washington.²⁶To contrast the real-world road conditions, two of the vehicles underwent chassis dynamometer testing over standardized test cycles at the CARB vehicle certification facility in El Monte, California.²⁷

"CLEAN DIESEL" AT VOLKSWAGEN

Volkswagen Group Chairman Ferdinand Pich had long held the ambition of creating the world's leading vehicle group. He was aware that this necessitated a much greater penetration in the crowded U.S. vehicle market where Volkswagen was a perennial also-ran brand. So Pich and VW CEO Pischetsrieder aggressively attempted to expand VW's share in the United States by offering vehicles with the next big thing, "Clean Diesel." Diesel cars in the U.S. market suffered from an image of being slow, clunky, and dirty.²⁸VW's Clean Diesel, in contrast, promised surprising performance at modest prices without any traditional dirty diesel emissions. VW had licensed SCR technology from DaimlerChrysler but then decided not to use it in its key 1.6-liter and 2-liter (EA 198)²⁹engine cars, perhaps because it was estimated to cost about ?1,000 per car (about $800 at 2005 exchange rates).³⁰

VW decided instead to use its own turbo-injection (TDI) engines, which Pich had pushed in the 1980s when he headed Audi.³¹VW also decided to equip each of the TDI engines with lean-NO_Xtraps. However, the engineers were unable to make the expensively engineered diesel engines meet strict emissions standards given their budget and timelines.³²Confronted with messages from VW executives that the engineers were solely responsible for making the car engines meet the standards, they feared for their jobs.³³

One former Volkswagen worker observed that Volkswagen executives should have recognized that there were problems because the software engineering team was doing double the amount of work to program the engine to run one way on the road and another way under test conditions (writing two million lines of code). The hardware was also suspect because the catalyst was not as big as would have been expected and lasted longer than it should have been able to do.³⁴

In April 2008, Volkswagen launched its 2009 VW Jetta diesel cars, followed by VW diesel Golfs, and Audi A3 diesels. All three models were equipped with the defeat device. Volkswagen later admitted to the EPA that all Volkswagen 2-liter model years since 2009 contained the illegal software and that all Volkswagen, Audi, and Porsche 3-liter model years since 2014 contained the illegal software.³⁵

CORPORATE GOVERNANCE IN THE FEDERAL REPUBLIC OF GERMANY

The economic system in the Federal Republic of Germany is based on the idea of codetermination, where shareholders and employees should have the ability to influence company policy.³⁶The intent is to balance the drive for market economy profits with societally acceptable means of generating them.³⁷This results in intense collaboration among employers, works counselors, and the trade unions at companies.

A unique feature of German corporate governance is its dual-board structure. German stock corporations have both a management board, the Vorstand, and a supervisory board, the Aufsichtsrat. Operating at the workplace level, the management board is responsible for the firm's strategy, planning, business development, risk situation, risk management, and compliance, with the objective of the sustainable creation of value. The management board is required to comprehensively and regularly inform in writing the supervisory board of any deviations in performance formulated in corporate plans and targets. Operating at the enterprise level, the supervisory board appoints, supervises, and advises the members of the management board in matters of fundamental importance to the corporation (seeFigure 1).³⁸

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FIGURE 1VOLKSWAGEN GROUP GOVERNANCE

Supervisory Board Management Board Composition: Composition: 10 Shareholder Close Commercial Vehicles Representatives Cooperation Human Resources and 10 Worker representatives Organization, China, VW Group Chairman, Volkswagen Group Committees: Chairman VW Passenger Cars, Governance Executive, Nominating, Reports to Finance and Controlling, Mediation, Audit, Integrity and Legal Affairs, Special Committee on Diesel Engines Appoints, Advises Chairman Audi AG Oversees, Approves Management Board, Procurement Duties: Duties: Reviews and Approves Operational Decision Making Financial Statements Prepares Financial Statements Ratifies Reports to Ratifies Reports to Annual Shareholders' Meeting Apportions Net Income Elects Shareholder Representatives to Supervisory Board Evaluates Acts of the Supervisory Board Evaluates Acts of the Management Board Certifies External Auditors