Can Volkswagen Move Beyond Its Diesel Emissions Scandal? by [email protected]

Eric Orts and John Paul MacDuffie on the Volkswagen Settlement

A settlement reached on April 21 between German car maker Volkswagen and U.S. regulators and car owners over alleged violations of the clean-air rules is just the beginning of a process of redemption for the company. First, the automaker has to manage what could be a lengthy and complex process of repairs and recalls of the vehicles covered by the agreement. Over the longer term, it has to rebuild consumer trust and perhaps reset its original goal of becoming the world’s biggest automaker and temper its growth ambitions in the U.S., while overhauling internal processes to prevent future lapses, say Wharton experts.

Under the terms of the agreement reached with the U.S. Environmental Protection Agency (EPA), the California Air Resources Board and a group of Volkswagen vehicle owners, the automaker would repair or buy back some 482,000 vehicles that do not meet emissions standards. The agreement covers Volkswagen and Audi sedans, hatchbacks and wagons powered by two-liter, four-cylinder diesel engines the company sold in the U.S. beginning in 2008, covering the model years from 2009 through 2015.

U.S. District Judge Charles Breyer said in a San Francisco court that the deal includes “substantial compensation” for people who bought Volkswagen cars that were fitted with so-called defeat devices, or software used to cheat emissions tests. That allowed the vehicles to meet emissions standards in test conditions, but while on the road, they spewed up to 40 times the permitted amounts of nitrogen oxide into the atmosphere. Based on an EPA notice last September, Volkswagen faced penalties and fees totaling $18 billion for violations of the Clean Air Act.

Volkswagen – Sense of Betrayal

“People like me have been hurt in a way that is not easy to calibrate or calculate the damages, when you thought you were buying something helpful to the planet and it ends up that you were doing the opposite,” said Eric Orts, Wharton professor legal studies and business ethics and director of the school’s Initiative for Global Environmental Leadership. Orts is also the owner of a diesel Volkswagen car, and is currently co-editing a book titled The Moral Responsibility of Firms, to be published by Oxford University Press.

“Volkswagen may try to steer attention away from engines to electronics and connected cars and some of the safety features of autonomous driving.” John Paul MacDuffie

Volkswagen will survive the current crisis because it is a large company and the U.S. happens to be one of its smallest markets, according to Wharton management professor John Paul MacDuffie. The company has a stronger presence in countries like China and Brazil where the regulatory requirements are less stringent than in the U.S., he said. It is strong also in Europe, which has favored diesel cars for years with subsidies. “What is going to help [Volkswagen] survive is that it is almost [as if] they are too big to fail, too global and diverse in markets,” he added.

Orts and MacDuffie discussed the likely outcomes from Volkswagen’s settlement with the EPA on the [email protected] show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Orts, who describes himself as a “deep green consumer,” said individuals like him would have to settle for a buyback or trade-offs in some performance if Volkswagen is unable to repair the vehicle. But larger issues bedevil the company, he points out. “How is Volkswagen going to win back loyalty? What happened internally in the company? Who was responsible? How high up did it go? Are they really going to be able to fix that problem and communicate effectively to the public that they are going to be a green car company now, or is that impossible at this point?”

MacDuffie agreed with Orts on the repercussions on consumer sentiments of faking test results. “The green consumer feels betrayed,” he said, adding that other consumers may ask themselves if they could trust this company after such “blatant deception.” He felt such consumers would switch to other car makers if they have options. “The dishonest or corrupt image might hurt them as well as the anti-environmental [image].”

Largest-ever Recall

The terms of the settlement, which are still being negotiated, have not been made public. The settlement could cost Volkswagen up to $10 billion, according to a Bloomberg report that cited a person familiar with the discussions. Judge Breyer has set June 21 as the deadline for the various parties to the settlement to submit their proposals, and that would be followed by a public comment period before a final decision is announced.

“It could really be cheaper if companies could watch themselves and regulate themselves and do the right thing without the big government over your head.” –Eric Orts

Orts noted that the Volkswagen recall would be the largest ever in the auto industry. Both he and MacDuffie predicted more trouble ahead after the report of an ongoing internal investigation into the company’s affairs is made public, including potential criminal prosecutions and class action lawsuits.

MacDuffie said he expected a split between the vehicles that are repaired and those that are bought back, depending on the age of the vehicle. The earliest-made or oldest cars in the vehicles covered may be hardest to repair, and the more recent cars may be closer to compliance and therefore easier to bring into compliance, he explained. Another split could occur between consumers who are environmentally conscious and want the cars fixed, and others who bought the car for its “peppy performance” and high gas mileage who wouldn’t care about getting those fixes, he added.

“The biggest unknown is [around what could] happen in Europe,” said MacDuffie. He pointed out that while the scandal surfaced in the U.S., Volkswagen has sold only a half a million of the cars with diesel engines compared to 11 million worldwide. He noted that even if the financial impact per vehicle is lower in Europe and other markets, Volkswagen could face a much bigger overall price tag for repairs and recalls.

Diesel’s Road Ahead

Will the Volkswagen scandal sound the closing bells for the diesel-powered car market in the U.S., as some people predict? MacDuffie pointed to the factors that could give fuel to that theory. It would be hard to convince car users to buy diesel vehicles because of issues with fuel costs and vehicle performance, the lesser availability of diesel compared to gasoline, and “the taint of the scandal,” he said. That scenario in the U.S. is far different than in Europe, where diesel reigns supreme. In France, for example, diesel-powered vehicles account for some 60% of sales, he pointed out.

Volkswagen’s ambitions to grow big and fast in the U.S. created the conditions for the current crisis, according to MacDuffie. “Part of the reason for the scandal was that Volkswagen set ambitious goals to be the biggest auto company, and to reach [those goals, it] had to grow a lot in the U.S., which was [its] smallest market and biggest opportunity,” he said. “[Volkswagen] thought they could conquer the U.S. with clean diesel.”

“You have yet another lesson of how expensive it is when you make a big legal or ethical mistake.” –Eric Orts

Now that Volkswagen’s dreams of capturing market shares in the U.S. with diesel-powered vehicles are all but shattered, the company will have to rethink its growth strategy, said MacDuffie. It could attempt to revive its goals with gasoline vehicles, where it still commands positive reviews, or perhaps get there with electric vehicles, he added.

Strategy Recast

“Volkswagen may try to steer attention away from engines to electronics and connected cars (cars with Internet access) and some of the safety features of autonomous driving,” said MacDuffie, adding that it has a reputation as an advanced engineering company. “The Germans are considered the toughest consumers in terms of reading all the technical stats and making their decisions based on who has the best new features,” he said. “If [Volkswagen] can tap some of that geeky interest, in particularly the IT-based features and some of new safety features, that could be an easier pivot for them….”

Meanwhile, would Volkswagen have learned the right lessons from the latest episode? Orts said the book he is editing on the moral responsibility of firms covers precisely that issue. The book looks at incentive structures at companies to see how such scandals could be prevented and how new standards could be created within them to ensure that, he added. “As [MacDuffie] said, they had the pressure within the company to hit financial targets and increase sales in the U.S. How do you encourage companies, when they are competing so hard against each another, to also follow the rules, to not cut corners and to not look the other way when you see there is pressure on engineers to cut the corners on hitting emissions targets?”

Orts believed that Volkswagen will learn useful lessons from the scandal. “You have yet another lesson of how expensive it is when you make a big legal or ethical mistake — $18 billion (the potential maximum fine) is not a small number, and it is avoidable,” he said. “It could really be cheaper if companies could watch themselves and regulate themselves and do the right thing without the big government over your head. When you have an event like this, looks like maybe we do need big government some times to look at big companies. That model will get reinforced. You do need watchdogs to ensure that the rules are being followed.”

Volkswagen CEO Martin Winterkorn