Volkswagen, Penalties of Proportion or Precedent?

Introduction of the Scandal, Technical Background

The Volkswagen diesel scandal is the largest the company has ever faced, both in terms of potential liability as well as damage to the brand’s reputation and marketing strategy. It is also unique among the rash of recent automotive industry controversies in terms of the sheer scale of penalties sought.

Those penalties count among the highest in history to date, as the U.S. Department of Justice (DOJ) is seeking $48 billion for the company’s violation of environmental laws by installing a “defeat device” to circumvent U.S. Environmental Protection Agency (EPA) emissions rules.

The initial study on which the DOJ bases its case, “In-Use Emissions Testing of Light-Duty Diesel Vehicles in the United States,” tested three vehicles; two were equipped with an emissions testing system known as an “urea-based selective catalytic reduction” (SCR) and one with a “leanNOx trap” (LNT). All vehicles were “broken- in” having accumulated 3,000 to 4,000 miles but less than 15,000, and were not showing any fault codes or anomalies. They were tested over five routes, categorized by three predominant driving conditions: highway, urban/ suburban, and rural-up/downhill driving.

The report found that “real-world emissions” exceeded EPA standards by a factor of 15 to 35 for the LNT-equipped vehicle, and by a factor of 5 to 20 for the first, yet at or below the standard for the second urea-SCR fitted vehicle. The second urea-SCR equipped vehicle (which on average performed at or below the EPA standard) exceeded that benchmark only during rural-up/downhill operating conditions, by a factor of around 10. The study goes on to state, “Generally, distance-specific NOx emissions were observed to be highest for rural up/downhill and lowest for high-speed highway driving conditions with relatively flat terrain.”

Emissions for the two highest-emitting test vehicles were found to be below the standards only during dynamometer testing, the controlled test performed by the EPA and the California Air Resources Board (CARB), which is how VW initially passed emissions tests. In September 2015, Volkswagen admitted to using defeat devices to cheat the system and overcome the discrepancy between the real- world results and the controlled test results.

Consequences of the Scandal

In addition to the massive government penalties, the automaker will likely face payments to owners seeking damages due to lost resale value (including the possibility of buying back older models that cannot be easily retrofitted) as well as costs associated with whatever emissions fix is required.

Kenneth Feinberg, (who previously headed compensation funds for the 9/11 attacks, BP’s Deepwater Horizon spill, and GM’s ignition switch scandal) is in charge of VW’s claims fund. Feinberg said in an interview with German newspaper Allgemeine Sonntagszeitung, “It is a purely business transaction, less emotional. I see that from emails I get from vehicle owners, who say things like: ‘Mr. Feinberg, I know I haven’t lost a relative, I just want to be treated fairly.’ They are all quite reasonable.” Feinberg indicated that Volkswagen had given him full authority to set compensation levels, and expected an overwhelming majority to accept a deal. He also said he was unlikely to meet his goal of setting up the claims fund within 60 to 90 days, stating, “My hands are tied as long as VW and the authorities have not overcome their differences.” Those problems are likely to continue for some time, as CARB has rejected Volkswagen’s first proposed recall plan.

The impact on Volkswagen’s identity and strategy will be as massive as that on its finances. The company has staked its reputation in the marketplace for years as a purveyor of “clean diesels,” trumpeting their cost and range of advantages over hybrids and electric cars. This strategy may have to be completely rethought, as the public image of diesel engines, always a hard sell in the U.S. market, may be tarnished for years. There is also a possibility that the company will be forced to sell off one or more of the 13 brands currently under the VW Group umbrella, in order to meet the financial burden of the fallout from the scandal.

Volkswagen’s product portfolio includes luxury brands like Audi and Porsche, budget vehicles like Skoda and SEAT, truck manufacturers MAN and Scania, and ultra-luxury/ performance brands Lamborghini, Bentley, and Bugatti. “VW has several brands that fall into the ‘nice to have’ category. Bugatti, Lamborghini, Ducati too – they’re not core to the company in terms of making money,” said Stefan Bratzel, director of the Center of Automotive Management at the University of Applied Sciences in Bergisch Gladbach, Germany.

There are a myriad of unintended consequences that will come from the diesel saga, aside from the staggering direct costs. Individual Volkswagen investors as well as any larger mutual or pension funds which hold shares in the company will be hit hard; as will the otherwise strong German economy in general, as Volkswagen is Europe’s largest carmaker and one of Germany’s biggest employers. VW directly employs 270,000 people, and thousands more work for one of its associated brands or for the company’s suppliers. The German automotive sector as a whole (two percent of the country’s workforce) employs 775,000 workers and the sector exported $225 billion worth of inventory in 2014 (one-fifth of total German exports).

“All of a sudden, Volkswagen has become a bigger downside risk for the German economy than the Greek debt crisis,” ING chief economist Carsten Brzeski told Reuters. “If Volkswagen’s sales were to plunge in North America in the coming months, this would not only have an impact on the company, but on the German economy as a whole.” In addition, Volkswagen announced that they would be postponing their 2015 financial statements due to uncertainty regarding the costs of the scandal.

All of this will likely be a boon to sellers of electric cars and other alternative fuels, as the scandal has besmirched the reputation of diesels as a “green” alternative to gas. Tesla Motors CEO Elon Musk stated, “What Volkswagen is really showing is that we’ve reached the limit of what’s possible with diesel and gasoline. And so the time has come to move to a new generation of technology.”

In addition, regulators will likely scrutinize manufacturers selling diesel cars more closely than before. German environmental group Deutsche Umwelthilfe has alleged that a bevy of European carmakers are exceeding EU diesel standards, and the latest to feel its ire is Fiat. Spokesman Axel Friedrich (who is also a co-founder of the group which commissioned the original Volkswagen emissions study) said, “The extreme overruns of NOx emissions that have meanwhile been detected with an Opel Zafira, a Renault Espace, a Mercedes C-Class and now a Fiat SUV are technically not plausible and point towards defeat devices.”

A Benchmark Scandal, with Benchmark Penalties

Beyond the impact on Volkswagen’s reputation, another major aspect of the scandal is the sheer scale of the penalties sought by the DOJ. The $48 billion levied against Volkswagen would be the largest penalty for automobile company wrongdoing, by far. General Motors paid $900 million to the government as part of a deferred prosecution deal for its ignition switch default that killed well over 100 people. Toyota paid $1.2 billion for its “unintended acceleration” controversy, and the National Highway Traffic Safety Administration eventually determined many of those incidents to be a result of user error. Takata, meanwhile, paid $70 million for airbags that exploded, sending shrapnel into the cabin (and will have to pay $130 million more if they violate the terms of their deal).

It is obvious that people died in the three smaller cases of manufacturer malfeasance, while the Volkswagen punishment has largely been interpreted as due to violations of environmental laws as well as misleading the public.

However, there may be health repercussions due to the emissions. According to a study published in Environmental Research Letters, “59 (95% CI: 10 to 150) early deaths will be caused by 2008–2015 excess emissions, with a monetized cost of ~$450m.” The study also estimates that not recalling the offending vehicles in 2016 will result in “140 early deaths from 2016,” with a monetized cost of $910 million. “However, assuming that vehicles are recalled at a constant rate from the start of 2016 and all devices replaced by the end of 2016, the total cost of future mortality impacts could be reduced by 93% to $61m. This is equal to 62% of the total projected costs from 2008 to 2040.” Volkswagen is under a stop-sale order for vehicles on dealer lots, and while concrete figures on this next point are not available, it is reasonable to assume that a large number of owners traded or sold their vehicles as the scandal broke (to avoid a precipitous depreciation curve) and that the number of potentially linked deaths and their associated costs will be more in line with the study’s adjusted estimate.

Conclusions, Moving Forward

This entire situation will have a substantial impact on a range of stakeholders. The eventual judgments against Volkswagen will have significant bearing on two important questions: 1. Whether environmental violations (and the potentially linked early deaths) are considered to be more “severe” than direct deaths due to a defective product; 2. Whether this is a case of manufacturer bad behavior, or a more systemic problem with the expectations of emissions tests and the way those tests are performed.

The former issue will be one largely resolved by the extent of the eventual judgment against the company. While the potential penalties sought by the DOJ are astronomical, they are still just that: potential.

In reference to the latter, the rash of manufacturers implicated in smaller-scale diesel scandals points to a systemic problem. Renault is another manufacturer currently dealing with a controversy of its own, as authorities in Europe (Renault does not sell cars in the U.S.) have alleged that some of the company’s cars exceed emissions standards in real world driving, though they have not accused the company of Volkswagen-scale malfeasance.

Renault CEO Carlos Ghosn defended his company, saying that all Renault vehicles “followed the norms.” He added, “you can say that anyone is cheating… test any other car you will find this kind of things.”

The International Council on Clean Transportation sponsored the West Virginia University (WVU) emissions study that ultimately condemned Volkswagen in the U.S. as a result of findings by previous studies, including the European Commission’s Joint Research Centre, which found vehicles that emitted 4-7 times higher than European standards. The WVU study “concluded that the introduction of tighter emissions limits for the purpose of vehicle/engine certification has not necessarily translated into effective on-road NOx reductions of the same magnitude.”

Regardless of the outcome of these aspects of the scandal for Volkswagen specifically, and automakers in general, it is certain that the consumers are severely affected. These are different effects than the fear of an unsafe product brought on by the Toyota, GM, and Takata scandals; this is a largely economic hit for owners coupled with a loss of faith in a company and in a previously lauded alternative to gas-powered engines.

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