case study is Case 14 from Collins: The VW Diesel Emissions Scandal
Write a 2-3 page paper on a short case study or selected topics that were explained in the chapter. Each assignment should be at least 2 pages long (font size 12, double-spaced). You must use scholarly sources: the textbook is required plus at least two (2) additional scholarly sources to support your answer. Be sure to cite and reference according to APA format.
The Volkswagen Diesel Emissions Scandal: An Expensive Corporate Ethics Debacle
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.
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 Döss 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.1 On 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 19993 and 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.5 John 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 (NOX) 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
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.7 Ironically, the CAFEE researchers found that the three diesels it tested under real-world driving conditions were, in fact, producing much higher levels of gaseous NOX emissions than U.S. standards allowed—up to 40 times as much NOX emissions. 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.9 After 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.”11 The 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.12 On 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.14 However, 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 NOX.16 With 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, NOX became the remaining concern.17 NOX emissions are associated with premature death, bronchitis, asthma, other respiratory problems, and cardiovascular illnesses. Additionally, NOX emissions are a precursor to ground-level ozone. However, CAFEE researcher Dr. Arvind Thiruvengadam notes that NOX typically lingers in the atmosphere for some time, having photochemical effects that only eventually create ozone.18
The portion of diesel emissions catalyst systems that deal with NOX use variations of either a selective catalyst reduction (SCR) method or an oxidation reaction method.19 Heavy-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 NOX to produce emissions of only nitrogen, CO2, and water.20 SCR 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.21 SCR 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-NOX is an oxidation reaction method in which NOX accumulates onto a catalyst surface, so it is limited in the amount of NOX it 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.23 Given 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-NOX trap technology and one vehicle with an aqueous-urea-based selective catalytic reduction system.25
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.26 To 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 Piëch 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 Piëch 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.28 VW’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)29 engine 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 Piëch had pushed in the 1980s when he headed Audi.31 VW also decided to equip each of the TDI engines with lean-NOX traps. However, the engineers were unable to make the expensively engineered diesel engines meet strict emissions standards given their budget and timelines.32 Confronted 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.36 The intent is to balance the drive for market economy profits with societally acceptable means of generating them.37 This 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 (see Figure 1).38
FIGURE 1 VOLKSWAGEN GROUP GOVERNANCE
Source: ”Corporate Governance in Germany” by Prof. Dr. Theodor Baums, Universitat Osnabruk; “Corporate Governance Practces in Germany and the United States,” by Amanda Rinehardt, Kevin MacFerrin, Allison Stephens, Rachael Duffield, and Neel Patel in the Drake Management Review, Vol. 3 Issue 1, October 2013, Figure 1.1; IMF Working Paper WP/08/179 “Germany’s Corporate Governance Reforms: Has the system become flexible enough?” by Jurgen Odenius.
VW’s 20-person supervisory board differs from that of other German carmakers in a very important respect: the firm’s home state of Lower Saxony controls two seats on board. The two representatives from Lower Saxony share a common goal with the legally mandated 10 representatives from the VW workforce: protecting jobs at one of Lower Saxony’s biggest employers. To that end, they are willing to give the VW CEO wide latitude.39
The “VW Law”—“Gesetz über die Überführung der Anteilsrechte an der Volkswagenwerk Gesellschaft mit beschränkter Haftung in private Hand”— enacted as federal law in Germany in July 1960 was designed to shield VW from takeover attempts to protect jobs in the northern German state of Lower Saxony where five of six VW manufacturing plants are located.40 Following a 2007 decision by the Luxembourg-based European Union Court of Justice (EUCJ), Germany amended the law.41 However, the amended law retained the provision preserving VW workers’ rights to veto plant construction or relocation. The law also continued the original law’s Section 4 provision requiring an 80 percent majority plus one share board vote for important decisions. This effectively continued Lower Saxony’s influence because the state holds 20.75 percent of VW’s shares.42 The amended law was subsequently upheld by the court.43
LEADERSHIP AT VOLKSWAGEN: FERDINAND PIëCH AND MARTIN WINTERKORN
Ferdinand Piëch started his career as an engineer at Porsche. In 1972, Piëch moved to Audi, the VW luxury brand, where he rose through the ranks. When he became the CEO in 1993 of Audi’s parent company, VW, Piëch instituted a sustained product and quality turnaround.44 At Audi, Piëch developed his reputation for utter ruthlessness with subordinates.45 However, he succeeded in restoring the brand to profitability without eliminating jobs, which earned him the loyalty of the workforce.46 Piëch stepped down as the CEO of the VW brand in 2002 to accept appointment as the Volkswagen Group supervisory board chairman. As CEO of Volkswagen brand, and later as the chairman of the Volkswagen Group supervisory board, Piëch’s “icy stare, impatience, and perfection drove fear into the hearts of underperforming managers.”47
On March 6, 2002, Bernd Pischetsrieder succeeded Piëch as the CEO of Volkswagen AG. Before moving to the Volkswagen Group in 2002, he had risen through the engineering ranks at BMW to become the firm’s CEO. Pischetsrieder recruited Wolfgang Bernhard from Mercedes to head the VW brand and turn it around because he was recognized as a skillful cost-cutter. Pischetsrieder and Bernhard attempted to use the outcome of the works council bribery scandal to cut costs and reform problematic labor practices at the Volkswagen works, such as its 28.8-hour, 4-day workweek.48
VW union representatives resented the attempts by Pischetsrieder and Bernhard to streamline the VW work’s bloated processes and practices. As chairman of the Volkswagen supervisory board, Ferdinand Piëch had in the past undermined management board decisions by seeking the endorsement of the works council representatives to establish positions on important issues, and then afterward presenting a fait accompli to the shareholder representatives. In November 2006, Piëch again aligned himself with the labor representatives on the supervisory board, which voted to replace Pischetsrieder as VW CEO with Martin Winterkorn, a 25-year Piëch protégé from Audi.
Winterkorn worked in a variety of production and quality roles before becoming the CEO at Volkswagen and was known to be methodical and precise. Although Winterkorn was not from the Porsche-Piëch lineage, as CEO he behaved like the firm’s owners by working long hours and insisting that he have his own way over even tiny design details.49 He stated, “I have always been driven by ambition to solve every problem I face, whether as a scientist, engineer, or entrepreneur.”50
Shortly after being named CEO, Winterkorn had outlined ambitious goals for Volkswagen in his “Strategy 2018.”51 The ambitious plan was to become the world’s number one auto maker, “not just in units, but in profitability, innovation, customer satisfaction, everything.”52
Piëch and his protégé Winterkorn transformed VW into a global conglomerate encompassing 12 vehicle brands with 600,000 employees. The two were described as two alpha males, tough as iron, and fastidious.
On April 10, 2015, Piëch, the VW chairman, made a phone call to the news magazine Spiegel Online and spoke about the VW CEO in an uncharacteristically negative tone, stating, “I’m distancing myself from Winterkorn.” When Winterkorn learned of Piëch’s comment, he repeatedly asked, “What’s with that? I can’t even believe it.”53
Piëch’s action gravely concerned members of the VW supervisory board’s executive committee. A special meeting of the executive committee was held at the Braunschweig-Wolfsburg airport to confront Piëch. After the meeting, Piëch and his wife Ursula abruptly resigned from the VW supervisory board. Piëch communicated to Matthias Müller, who had replaced Wendelin Wiedenking as the CEO of Porsche, that he (Müller) would be appointed the new chairman of VW’s supervisory board. But instead it was Hans Dieter Pötsch, the VW chief financial officer, who was nominated to become the chairman. In November 2015, Pötsch was ratified as the chairman at an extraordinary general shareholders’ meeting.54 Pötsch had a long, close association with both the Porsche and Piëch families. In addition to his new VW supervisory board role, he continued as the chief executive officer of Porsche Automobil Holding SE.55
THE “FAILURE IS NOT AN OPTION” CULTURE
Several former VW executives and industry observers described the management under Winterkorn as unchecked authoritarianism fostering a climate of fear. Several former Volkswagen Group managers stated, “Few executives dared to approach Winterkorn” and that there “was always a distance, a fear, and a respect.” One of the former executives also told Reuters, “If you presented bad news, those were the moments that it could become quite unpleasant and loud and demeaning.” Professor Ferdinand Dudenhuffer, an expert on the German automobile industry at the University of Duisburg-Essen, was quoted as stating, “All you hear when you speak to people is that there is a special pressure at VW.”56 Another observer characterized the culture as “North Korea (minus the labor camps).”57
A 2015 Fortune magazine article described the corporate culture at Volkswagen as “ruthless” and “overweening,” with a “high-octane mix of ambition and arrogance—and micromanagement—all set against a volatile backdrop of epic family power plays, liaisons, and blood feuds. It’s a culture that mandated success at all costs.”58
One industry analyst observed that the management style at Volkswagen was top-down, imposing rigid goals and punishing middle-level and lower-level employees if they were unable to meet expectations. The analyst further noted that the top-down approach was applied so “unremittingly” at Volkswagen “that this was the likeliest explanation for why its engineers were willing to commit crimes . . . to save their jobs.” The analyst quoted one person who had worked with Volkswagen colleagues as having said the company was “fueled by intimidation at every level, which creates a borderline, or sometimes over the borderline, unethical culture.”59
Philippa Foster Black, a director at the UK-based Institute of Business Ethics, observed, “The real focus should be on establishing a proper enterprise-wide ethical culture reinforced by principles and led by its executives.” She came to the conclusion, “The recent revelations of corporate misbehavior at organizations like Volkswagen . . . have shown that management knew and connived in the wrongdoing, and there was a culture whereby people who knew and spoke up were either ignored or decided not to say anything.”60 Sir Gerry Grimstone, chairman of the UK-based Standard Life, has faulted Volkswagen’s boards for not acting on risk information, asking, “Do you really think there weren’t people who knew that was going on?”61
An alternative explanation for the emissions cheating evolution was first identified by sociologist Diane Vaughn in a 1986 book about the Challenger space shuttle disaster. Vaughn described a cultural drift phenomenon in organizations where under certain circumstances behavior normally classified as “not okay” is gradually reclassified as “okay.”62 Repeated over time, such behavior becomes routine in an organization. She named the phenomenon the “normalization of deviance.” Under such circumstances, individuals slowly, but progressively, generate rationales that incrementally exacerbate the original deviance.
Rather than a vast emissions-fixing conspiracy at Volkswagen Group, initiated by its engineers and subsequently concealed by its executives, perhaps there had been a manifestation of the normalization pattern. Put under the stress of a goal with a strict timetable, the engineers might have rationalized that inserting the software emissions-cheating algorithm as merely a slight improvement derived from what had happened previously.63
EXECUTIVES: WHAT DID THEY KNOW, AND WHEN?
Volkswagen hired the U.S.-based law firm Jones Day to perform an internal investigation of the emissions scandal. The preliminary results of the investigation exonerated members of VW’s management board of any direct knowledge of the cheating, “according to the current state of knowledge, a group of persons—whose identity is still being determined—at levels below the Group’s Board of Management in the powertrain development division, decided to modify the engine management software.”64 The Jones Day investigators were told by a company whistleblower, “It wasn’t acceptable to admit anything is impossible . . . no one had the courage to admit failure.”65
Following a 16-month criminal investigation by the U.S. Federal Bureau of Investigation (FBI), on January 11, 2017, a U.S. grand jury indicted six executives of Volkswagen AG. The executives were each charged with one count of conspiring to defraud the United States, committing wire fraud, and of violating the Clean Air Act by lying to regulators and the public.
The erstwhile chairman, Ferdinand Piëch—who had been forced to resign from the chairmanship in April 2015—testified to prosecutors in Braunschweig, Germany, that senior executives and directors were aware of the company’s emissions cheating months before it was disclosed by the U.S. EPA.66 Piëch’s testimony directly conflicted with statements by former CEO Martin Winterkorn and the Volkswagen Group’s supervisory board, who separately claimed that they knew nothing of the emissions cheating until it was disclosed in September 2015. However, Winterkorn also testified before a German parliamentary committee in January 2017 that he had discussed the diesel emissions issue (but apparently not any cheating) with Piëch in February or March of 2015. Winterkorn testified, “For me, the issue was resolved with the recall.”67
CONSUMER RECALLS AND BUYBACK
In addition to having to pay the monetary and criminal penalties imposed by U.S. courts, Volkswagen took steps to repair its breach of trust with consumers. An array of recalls and free repairs were offered to dealers and owners of Volkswagen, Audi, and Porsche diesel vehicles, depending on the model and year.68
Although Volkswagen took the position that its emissions testing manipulation was not in violation with laws in the European Union,69 recall programs did extend beyond the United States. By April 2017, settlements and recalls were under way or proposed in Canada, China, Singapore, and elsewhere.70 Consumer Reports estimated that “as many as 11 million vehicles worldwide” might ultimately be affected.71
Critical Thinking Questions
1. Discuss the role of research organizations such as the Center for Alternative Fuels, Engines and Emission (CAFEE) in monitoring corporate ethics. Why should governments provide funding for such organizations? Should private industry also contribute?
2. What key elements of corporate culture led to the Volkswagen emissions scandal? If you were a high-level executive, what would you do to exert a positive ethical influence on your company’s culture?
3. Was the German corporate governance system of dual boards, a management board and a supervisory board, part of the systemic reason the scandal developed over a decade?
4. Ironically, many reporters and industry analysts have suggested that the VW emissions scandal has “killed” any future for diesel engines as substitutes for gasoline engines. Even VW has announced plans to pursue advanced electrical vehicles. How likely is it that advanced electrical vehicles will supplant combustion engine vehicles in the near future?