Volkswagen’s Clean Diesel Dilemma

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Martin Winterkorn, CEO of Volkswagen Group, had just received stunning news. The U.S. Environmental Protection Agency (EPA) and the California Air Resource Board (ARB) had notified Volkswagen that they would begin investigating claims that some of the company’s diesel engine vehicles were violating emissions standards. His sources informed him that this revelation was based on a study conducted by an independent research firm in West Virginia.

Sitting in his office in Wolfsburg, Lower Saxony, Winterkorn began to reflect on the ramifications this could have on his company. Since becoming CEO in 2007, Winterkorn had tried to make Volkswagen a global leader in car production as well as sustainability and clean transportation. The company had invested billions of dollars in research and development to create best-in-class diesel engines for the highly competitive North American automobile market.

If these claims were true, what would Volkswagen’s next steps be? How could such violations be taking place in an organization of Volkswagen’s prestige and reliability? How would this affect its brand and sustainability strategy? What will this mean for company leadership and governance? How can the damage be repaired with employees, the government, and its customers? And, as the company tries to look beyond this scandal, it must wonder whether it would have any cascading effects throughout the German economy and the auto sector? And more directly, what does this mean for the future market for diesel-powered vehicles?

The Volkswagen Group

Along with the Autobahn, the Volkswagen, or the people’s car, was to be one of the linchpins for Adolf Hitler’s “motorization” of Germany.2 In 1934, Hitler commissioned automotive designer Ferdinand Porsche to create a car that could be affordable on a worker’s wage as well as seat a family of five. The result was the

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creation of the Type 1, a vehicle with a sleek design, rear engine,3 and the aerodynamic beetle-shape still known today.4

In 1938, Volkswagenwerk built a factory in Wolfsburg, Lower Saxony, with the capacity to produce 500,000 cars a year.5 However, with the outbreak of World War II, the factory was reconfigured to produce multi-purpose military vehicles. Following the war, in 1945, the factory was transferred to the British Military Government and placed under the control of Major Ivan Hirst to oversee its dismantling. However, Major Hirst, seeing the potential of the Type 1, convinced the British military to place an order for 20,000 vehicles.6 In that moment, the Volkswagen plant and Type 1 became essential to Germany’s economic revival and post-war reconstruction.

In 1949 the British Military Government handed the company over to the State of Lower Saxony in the form of a trust.7 Under the guidance of its first director, Heinrich Nordhoff, Volkswagen saw massive improvements to its production capability and quickly gained 50% of the German automobile export business.8 Through sales to much of Europe and South America, Volkswagen became the top exporter and earner of foreign currency for the German economy during the 1950s.9 However, success in the U.S. would prove elusive, as most Americans preferred bigger, roomier cars and harbored resentment toward German- made products.

That all began to change in the 1960s, thanks to evolving consumer preferences and an advertising campaign that used simple design and clever, tongue-in-cheek copy to make an emotional connection with the consumer.10 The ads sparked the incredible popularity Volkswagen enjoyed throughout the ‘60s and early ‘70s. In 1968, Volkswagen would go on to control 5% of the American new car market.11 By 1972, the Volkswagen Beetle broke the world car production record with over 15 million units.12

Throughout the ‘80s, Volkswagen saw a decline in U.S. sales in the face of increased competition from well-manufactured and more fuel-efficient Japanese cars.13 Unable to keep up, the company became overstaffed and inefficient, with a diminished reputation for quality, by the early 1990s.14

Turnaround

“Over the short-term, we urgently need more efficiency and higher profit.”15

— Martin Winterkorn CEO, Volkswagen Group

In 1993, Ferdinand Piëch, grandson of Ferdinand Porsche, took over as chief executive with the singular goal of making Volkswagen the largest carmaker by volume by 2018.16 By then the company had lost $1.1 billion.17 Piëch began overhauling the company’s strategy and culture, fired many executives, and established himself as a leader who managed through fear and brutality.18 The tactics worked, and by the time the New Beetle arrived on the market in 1999, VW had become the world’s third-largest carmaker with $3.6 billion in profits before taxes.19

In 2002, Piëch stepped aside as CEO and became chairman of the Board of Management, while maintaining tight control over the company’s operations. The desire to grow VW into the No. 1 carmaker led to Piëch’s firing of two consecutive CEOs within five years, due to failures to gain market share. In 2007, Piëch promoted his protégé Martin Winterkorn to the chief executive position. Winterkorn was known for setting aggressive standards and firing executives for failure to meet sales targets.

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Winterkorn demanded perfection. He would visit factories and personally inspect the vehicles, sometimes getting on his hands and knees. If he discovered a flaw, Winterkorn would publicly chastise the employees responsible on the spot. As one executive described, “There was always a distance, a fear and respect.… If he would come and visit or you had to go to him, your pulse would go up.… If you presented bad news, those were the moments that it could become quite unpleasant and loud and quite demeaning.”20

Corporate Governance

Winterkorn’s management style went largely unchecked primarily due to VW’s unusual corporate structure.21 Company operations were led by a nine-member Board of Management, which included senior leaders from various VW groups and regions. Winterkorn served as CEO of Volkswagen AG and chairman of the Board of Management.22 Oversight of the management team was provided by a 20-member supervisory board.23 The supervisory board retained the power to hire and fire the CEO and was the approval authority for corporate decisions.24

VW’s supervisory board structure was unique due to its history of involvement with the local government after World War II. Nine of the 20 seats were given to labor representatives and two were allocated to Lower Saxony politicians, whose primary concern was securing continued employment for local workers.25 Another five seats were controlled by members of the Porsche and Piëch families.26 As long as VW kept growing, with wages rising, the board was happy to allow Winterkorn a relatively free hand27 in the operations of VW. Over time, VW would develop a corporate culture that centralized decision-making with Winterkorn and highly discouraged the open discussion of problems.28

Sustainability at Volkswagen

“The Volkswagen Group is well on the way to establishing itself long term as the world’s most sustainable automaker.”29

— Martin Winterkorn CEO, Volkswagen Group

In 2006, VW began laying the foundation for what would become its modern corporate social responsibility (CSR) structure (see Exhibit 1).30 It established a CSR and sustainability coordination office, which was primarily responsible for strategic direction and optimization of CSR and sustainability management across the Volkswagen Group.31 In 2010, it created a parallel office, the CSR and Sustainability Steering Group, a representative body made up of managers from across the Volkswagen business.32

The steering group was tasked with convening four times a year in order to determine strategic sustainability goals and sign off on sustainability reports.33 The steering group was also responsible for briefing the Board of Management twice a year on topics relating to sustainability and CSR.34 The Board of Management, the nine-member governing body of Volkswagen, included Winterkorn as its chairman and retained ultimate authority for all environmental matters affecting the company.35

In 2010, VW began publishing new sustainability reports, which outlined VW’s CSR successes within supply chain management, logistics, production, human capital, corporate governance, and development of new technology. The following year, the company began its “Think Blue. Factory” environmental campaign,36 which sought to reduce the company’s waste, energy, and water impact by 25% in 2018.37 Around the same time, VW was awarded LEED Silver for its main office in Herndon, Virginia, and spent over $1 billion to install an energy-efficient production line in its Chattanooga, Tennessee, manufacturing plant.38

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Exhibit 1 Volkswagen’s Corporate Social Responsibility Structure

O T H E R G R O U P S T E E R I N G

G R O U P S

VO L K S WA G E N G R O U P B OA R D (S U S TA I N A B I L I T Y B OA R D)

G R O U P C S R & S U S TA I N A B I L I T Y S T E E R I N G G R O U P C S R & S U S TA I N A B I L I T Y O F F I C E

R E G I O N S

B R A N D S

S u s t a i n a b i l i t y B o a r d & St e e r i n g G r o u p M A N AG E M E N T

Source: Volkswagen AG. “Sustainability Report 2014.” Accessed 9 Dec. 2015. <http://sustainabilityreport2014.volkswagenag.com/sites/default/files/pdf/en/Volkswagen_ SustainabilityReport_2014.pdf>.

By 2013, Volkswagen was ranked first in its sector on the Dow Jones Sustainability Index with a score of 89 out of 100.39 Highlighting this achievement, Winterkorn stated in the 2014 Sustainability Report, “our business is no longer just about the technical aspects like horsepower and torque. We have learned that sustainability, environmental protection, and social responsibility can be powerful value drivers.”40

Competition and Sustainability within the Global Automotive Industry

The global car and automotive manufacturing business was a mature, $2.5-trillion industry.41 It was a highly competitive market, with high barriers to entry.42 The largest four automakers — Toyota, VW, General Motors, and Ford — made up one-third of market share.43 Additionally, the industry was extremely capital intensive, with over 70% of expenses allocated to the procurement of raw materials and commodities, such as steel.44 Typical profit margins were around 5%.45

Volkswagen operated 119 production facilities in 20 European countries and 11 others in America, Asia, and Africa.46 It sold passenger cars under the Audi, Bentley, Bugatti, Lamborghini, Porsche, SEAT, Skoda, and Volkswagen marques; motorcycles under the Ducati brand; and commercial vehicles under the MAN, Scania, and Volkswagen marques.47 In the U.S. market VW sold hatchbacks, sedans, SUVs, and crossovers.

As the No. 2 global automobile company by volume, behind Toyota, Volkswagen sold vehicles in 153 countries48 and controlled 11.1% of the global automotive market share.49 However, VW commanded only 1.9% of the market in the U.S., making it number 12 behind BMW and Mercedes-Benz.50

Toyota

The Toyota Motor Corporation was founded in 1937 by Kiichiro Toyoda in Japan. Toyota produced vehicles under five brands — Toyota, Hino, Lexus, Ranz, and Scion. It also held stakes in Daihatsu, Isuzu, and Tesla and had joint ventures in China, India, and the Czech Republic.51

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Since its foundation, Toyota had strived for sustainable development through the production of quality motor vehicles that contributed to a better society.52 As the market leader worldwide since 2012, with global and U.S. market shares of 11.6%53 and 14.5%54 respectively, Toyota continued to strive for ambitious environmental targets such as eliminating gasoline cars by 2050.55 Toyota planned to radically reduce emissions by focusing on developing hybrids in every auto category in addition to fuel cell vehicles. As part of its environmental vision, Toyota pledged to “reduce carbon dioxide emissions from production lines during manufacturing in 2030 to one-third of 2001 levels.”56

General Motors

Founded in 1908,57 General Motors (GM) was an American multinational corporation with headquarters in Detroit, Michigan. GM produced vehicles for 120 countries58 and was the third largest global automobile company with an 8.2% market share.59 Domestically, GM was the No. 1 producer, commanding 17.7% of the U.S. market.60 GM, its subsidiaries, and joint venture entities sold vehicles under the Chevrolet, Cadillac, Baojun, Buick, GMC, Holden, Jiefang, Opel, Vauxhall, and Wuling brands.

GM had made many efforts toward responsible manufacturing practices. None of the company’s U.S. plants were powered by coal.61 GM used 105 megawatts of renewables to power its manufacturing operations with plans to increase that amount by about 20% by 2020.62 It had also increased the number of landfill- free operations to 122 sites worldwide with manufacturing sites recycling or reusing 84% of the waste they generated.63 In terms of lowering CO2 emissions, GM planned to have 500,000 vehicles on the road in the U.S. with some form of electrification by 2017.64

Ford

Founded by Henry Ford in 1903,65 the Ford Motor Company was an American multinational automaker with headquarters in Dearborn, Michigan. The company sold automobiles in North America, South America, Europe, Asia, and Africa.66 Its core brands included Ford and Lincoln.67 Ford was the fourth largest automobile manufacturer worldwide and tied for second in the U.S. with market shares of 7.6%68 and 14.5% respectively.69 Among its most acclaimed products was the F-150 pickup truck, which had been the best-selling vehicle of any kind in America for 33 years.70 The F-150 was redesigned and rebuilt with recyclable seat fabrics and a mix of high-strength steel and aluminum alloy that cut the vehicle’s weight by nearly 700 pounds, while improving its speed and braking ability as well as increasing towing capacity to 1,100 pounds.71

As a result, Ford managed to create what it called “the most sustainable truck ever to roll off a Ford assembly line,”72 decreasing greenhouse gas emissions, reducing life-cycle waste and improving fuel efficiency all in one stroke. Additionally, from 2010-2014, Ford reduced CO2 emissions from vehicle manufacturing by 22%73 and had set a 30% reduction goal by 2025.74 Recognizing that the automotive landscape was changing and moving away from diesel- and gasoline-powered engines, Ford had been developing and deploying a portfolio of alternatively powered passenger cars to include hybrid electric, battery electric, plug-in hybrids, biofuel, and hydrogen fuel cell vehicles.75

BMW

Bayerische Motoren Werke or Bavarian Motor Works (BMW) was a German luxury automobile and motorcycle manufacturing company founded in 1916 with headquarters in Munich, Bavaria. With BMW, MINI, and Rolls-Royce,76 the company possessed three of the strongest premium brands in the car industry. In 2014, BMW’s global market share was 4.2%.77 Though not one of the world’s top five auto manufacturers in volume, BMW was certainly a rival in technological development.

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BMW had committed to reducing its European fleet emissions by 2020 to half the levels recorded in 1995.78 Additionally, BMW had begun producing more hybrid and electric cars with its i3 and i8 models. These efforts earned BMW the rank of industry group leader for the Dow Jones Sustainability Index 2014-2015.79

In the diesel engine market, BMW and Daimler competed with VW through the utilization of BlueTec diesel engines. However, in terms of volume sales, VW was the clear leader in this market segment. BMW’s 2013 European diesel auto sales were an estimated 696,00080,81 compared to VW’s 2 million.82,83 In the U.S., VW sold 80,441 diesel passenger cars in 2014 compared to BMW’s 13,296.84

Amid this competitive landscape, Winterkorn set ambitious sales targets for VW. “We want to be the volume number one but also we want to have 8% in operating profit,” Winterkorn once famously said.85 To become the No. 1 automaker by volume sales, VW would have to unseat Toyota (see Exhibit 2). The key to achieving this goal was to capture more market share in the U.S., which was dominated by GM, Toyota, and Ford. In order to grow in the U.S., VW would have to produce cars that could appeal to American preferences as well as meet some of the most stringent emissions standards in the world.

Exhibit 2 Global Market Shares of the Largest Automobile OEMs as of August 30, 2014

Market share

11.6%

11.1%

8.2%

7.6%

5.9%

5.3%

5.1%

4.2%

Toyota Motor Corp

Volkswagen AG

General Motors Co

Ford Motor Co

Honda Motor Co Ltd

Fiat SpA

Nissan Motor Co Ltd

Daimler AG

BMW (Bayerische Motoren Werke AG)

SAIC Motor Corp Ltd

0% 2% 4% 6% 8% 10% 12% 14%

Source: Statistica. “Global Market Share of World`s Largest Automobile OEMs as of August 30, 2014.” Accessed 31 Jan. 2016. <http://www.statista.com.proxy.lib.umich.edu/ statistics/316786/global-market-share-of-the-leading-automakers/>.

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U.S. Emissions Regulatory Environment

During the 20th century a number of environmental events within the U.S. led to a public awakening to the hazards of environmental pollution. One event, known as the Donora Death Fog, is credited with being the catalyst for the American clean-air movement. For four days at the end of October 1948, smog from a U.S. Steel plant in Pennsylvania was caught in a temperature inversion, trapping sulfuric acid, nitrogen oxide, and fluoride over the town of Donora. The smog caused the deaths of 20 people and left another 600 with serious illnesses.86 Over the next two decades, environmentalists would push the government to take a more active role in protecting the environment, ultimately leading to the passage of the Clean Air Act (CAA) in 1963 and the creation of the EPA in 1970.87

The Clean Air Act and the Environmental Protection Agency

The CAA set the legislative framework for national air quality standards and pollution control efforts, specifically defining the regulations pertaining to air emissions from motor vehicles (see Appendix A).88 The EPA functioned as the centralized enforcement and certification authority, ensuring compliance with the CAA or legislation passed through congressional action. The EPA implemented environmental legislation by writing regulations89 and ensuring compliance by taking civil or criminal actions against violators. 90

The EPA subjected cars to three layers of testing: automaker self-certification, random testing on the production line, and testing of in-use vehicles.91 The first stage, self-certification, required car companies to carry out their own emissions testing and submit their results to the EPA. The EPA then randomly tested around 15% of cars on the company’s production line, under standard laboratory conditions, to confirm the reported results and issue certifications for sale within the U.S.

For the third test, the EPA could choose to subject a small percentage of after-market vehicles to in-use testing.92 This process involved the EPA contacting random car owners and asking them to volunteer their vehicles for testing on actual road conditions. This process was limited to around 3-4% of new car models.93

The California Air Resources Board (ARB)

Historically, California had set the pace for emissions regulations nationwide and globally. Collectively, 34 million residents owned about 25 million cars and drove more than most other Americans.94 Motor vehicles were California’s number one cause of air pollution.95 In 1967, Governor-elect Ronald Reagan established the California Air Resources Board (ARB) in an effort to “promote and protect public health, welfare and ecological resources through the effective and efficient reduction of air pollutants.”96

The ARB was the nation’s most progressive air quality regulation agency. Under the Federal Air Quality Act of 1967, California was allowed to “set and enforce its own emissions standards…based on [its] unique need for more stringent controls.”97 Automakers were required to meet the ARB’s emissions standards in order to receive certification for sales in California.98

U.S. Emission Standards for Light Duty (Passenger) Vehicles

Since the mid-1990s, the EPA had set tiered standards for tailpipe emissions of nitrogen oxides (NOx). Beginning in 1994, Tier 1 NOx emission for diesel cars was restricted to 1.25 grams per mile. Beginning in 2004, the EPA began enforcing stricter Tier 2 regulations, which limited emissions of NOx to 0.07 grams per mile (see Exhibit 3).99 Based on how a vehicle performed, it was assigned a Bin ranking of 1-8, with 8 being the dirtiest.100

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Volkswagen’s Clean Diesel Dilemma

Volkswagen’s Clean Diesel Dilemma

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