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Copyright 2016. No quotation or citation without attribution.UCSD - GPS CASE 16 - 12Analysis of the Volkswagen ScandalPossible Solutions for RecoveryBy: Angie ZhouSchool of Global Policy and Strategy, UC at San DiegoPrepared for Professor Peter GourevitchCourse on Corporate Social ResponsibilityWinter 2016

Copyright 2016. No quotation or citation without attribution.Analysis of the Volkswagen Scandal Possible Solutions for RecoveryThe Volkswagen scandal is a notorious example of how corporations can shape theethical and political issues of the environment. The Volkswagen Group that is headquartered inWolfsburg, Germany owns Bently, Bugatti, Lamborhini, Audi, Porsche, SEAT, and Škoda.Volkswagen’s presence as a global company made this a significant event not because of thelegal and financial repercussions that occurred from different countries, but because of thelasting damage on society and the environment that cannot be fully perceived. Volkswagenpreviously had a goal of becoming the world’s largest automaker by 2018, but the scandal causedthe company to lose one third of the company’s market cap.1 In an attempt to compensate for theemissions violations, Volkswagen ordered a voluntary recall, issued a public apology, and theCEO along with other directors of the firm resigned. The company is also facing lawsuits andcriminal charges and the future of the company looks grim. In order to analyze how such a globalcompany could commit fraud for so long on such a big scale, it is beneficial to view this case asa problem of regulatory capture involving information asymmetry, issues with oversight, andprivate governance. This analysis attempts to examine the problems of social concern presentedby the behavior of Volkswagen in the international economy and provide some recommendationsto increase the system of accountability within the global auto industry.Action Forcing EventThe action forcing event to this whole story began with a group of scientists at WestVirginia University who were testing diesel cars on the road. The International Council on CleanTransportation, a nonprofit, tried to provide independent research to environmental regulation1Clifford Atiyeh, Everything You Need to Know About the VW Diesel Emissions Scandal, (Carand Driver, 2016). Accessed March 16, 2016 -know-about-the-vw-diesel-emissions-scandal/

Copyright 2016. No quotation or citation without attribution.government agencies. It hired West Virginia University to perform standard emissions tests ondiesel cars. Volkswagen had been promoting their diesel cars to be one of the motsenvironmentally friendly and fuel efficient vehicles on the market, which generated some of thehighest sales. However, research assistant professor Arvind Thiruvengadam noticed dramaticallydifferent results from Volkswagen’s claim of low emissions. The team kept repeating the studyin order to confirm their findings. Thiruvengadam stated, “And then, I mean, we did so muchtesting that we couldn’t repeatedly be doing the same mistake again and again.”22Sonari Glinton, How a Little Lab in West Virigina Caught Volkswagen’s Big Cheat (NPR,2015). Accessed March 16, 2016 in-westvirginia-caught-volkswagens-big-cheat

Copyright 2016. No quotation or citation without attribution.The International Council on Clean Transportation (ICCT) suspected that Volkswagenhad installed a defeat device. This is a programmer writing code that tells the computer it is onthe official test cycle and allows for changes in how the emissions control system.3 In essence,diesel engines have a trade-off between power, fuel efficiency, and clean emissions and thevehicle can only choose two out of three. However, the device can only do so much. Somebodywithin the company must have deliberately performed the validations incorrectly. The ICTTsummed up the data on 15 vehicles from three different sources, then turned its findings to theEnvironmental Protection Agency (EPA) and the California Air Resources board. On September18, 2015, the EPA publicly announced that Volkswagen had violated the Clean Air Act byillegally installing software into diesel cars to cheat emissions tests that emitted toxic gases up toa staggering 40 times above permitted levels.43Glinton, Volkswagen’s Big CheatClive Coleman, VW Could Face Long Legal Nightmare (BBC, 2015). Accessed March 16,2016 http://www.bbc.com/news/business-343522434

Copyright 2016. No quotation or citation without attribution.RepercussionsVolkswagen soon became the target of regulatory investigations in multiple countries.Prosecutors from the United States, South Korea, France, Italy, Canada, Germany, and the UKtried to find out how many people knew of the deceit that occurred within the corporation.5 OneGerman newspaper even labeled this scandal as the “most expensive act of stupidity in thehistory of the car industry.”6 As news of the scandal began to leak, Volkswagen’s stock priceimmediately began to fall. Volkswagen admitted that 11 million cars worldwide had been fittedwith the defeat device. Then on November 2, 2015, the EPA also found the same defeat deviceson additional Volkswagen, Audi, and even Porsche models.7However, the biggest tragedy of this entire scandal is the release of enormous amounts ofnitrogen oxide into the atmosphere. NOx gases cause smog, acid rain, and the formation of theground level ozone which are associated with adverse health effects such as inflammation of theairways and respiratory problems including asthma, bronchitis, emphysema, etc.8 High levels ofNOx also cause damage to vegetation including reduced growth.9 The EU also published aninventory report in 2011 that stated the majority of NOx emissions comes from the road transportsector at 40%.10 It is important to realize that the environmental damage of this scandal will havea far more lasting and immeasurable impact on the ecosystem.5Coleman, NightmareColeman, Nightmare7Coleman, Nightmare8Jack Ewing, Volkswagen Says 11 Million Cars Worldwide Are Affected in Diesel Deception(The New York Times, 2015). Accessed March 16, nal/volkswagen-diesel-car-scandal.html9Nitrogen Oxide Pollution10Nitrogen Oxide Pollution6

Copyright 2016. No quotation or citation without attribution.As a step towards remedying the situation, Volkswagen vowed to set aside 6.5 billioneuros (about 7.3 billion) to use towards fixing the cars to comply with pollution standards.11This may seem like a big sum but in reality, it is equivalent to only half a year of Volkswagen’sprofits. The company is currently facing a 3.3 billion euro lawsuit and could face possiblecriminal prosecutions.12 In the US, the company is facing a fine of up to 30,000 per car which isa total amount of approximately 18 billion.13 Within a day of the news release, Volkswagen’sshare prices fell by a third and dropped over 20% to a four-year low.14 It is also important to notethat the European market accounts for 40% of the company’s profits while the United States onlyaccount for 6% of unit sales.15 This means that issues in the European market are much morepressing on Volkswagen’s agenda. However, standards for diesels in Europe are not as strictlytested and enforced as the United States.11Ewing, Diesel DeceptionEwing, Diesel Deception13Exposure of the Volkswagen Scandal: The Full Story Explained (Amazon Digital ServicesLLC, 2016), 22.14Ewing, Diesel Deception15Ewing, Diesel Deception12

Copyright 2016. No quotation or citation without attribution.Aside from public apologies, Volkswagen announced a voluntary recall of all thevehicles with TDI engines. The CEO Martin Winterkorn immediately resigned andVolkswagen’s top US executive also stepped down.16 Heinz-Jakob Neusser (the head of branddevelopment), Ulrich Hackenberg (Audi research and development head), and Wolfgang Hatz(Porsche research and development head) were also suspended.17 The Volkswagen head office inWolfsburg and other offices were raided for investigation purposes.18 It is impossible to fathomthat only a handful of people were involved in the master plan of the manipulation software.Perhaps the company made the wrong decisions and followed a wrong strategy, but this scandalwas way too big to be an accident. Firms have an obligation to be open and honest to owners andmanagers should be held accountable to stakeholders. However, this was more than just aproblem of simple deceit. This case involved more complex theories that deal with the theory ofregulatory capture.The Problem of Public InterestVolkswagen should be held accountable to their actions, but the bigger issue is how themanipulation software went undetected for so many years. If it were not for the existence ofNGOs such as the ICCT, this scandal may have never been uncovered and Volkswagen wouldhave proceeded to emit harmful gases above permitted levels. Environmental groups hadpreviously warned national car approval authorities and the European Commission that dieselcars emitted much less NOx in official laboratory tests than on the roads. Many also knew thatthis was due to tricks used by manufacturers, but regulators did not take urgent measures.16Volkwagen Faces 2.5bn Lawsuit From Investors (The Week, 2016). Accessed March 16,2016 -steps-down-with-immediate-effect17Julia Bradshaw and Jon Yeomans, VW Scandal: Porsche Boss Named New Volkswagen ChiefExecutive- As it Happened (The Telegraph, 2015)18Exposure, 18.

Copyright 2016. No quotation or citation without attribution.According to the International Center for Financial Regulation (ICFR), regulatory captureis a form of corruption that occurs when an agency that's supposed to act in the public interest,instead chooses to advance the commercial or political concerns of special interest groups or theindustry or sector it is charged with regulating. 19 One month after the release of the scandal tothe public, the officials of the EU member states gathered in Brussels and came to discuss therepercussions, but failed to push alternative testing methods such as testing auto emissions on theroad which would have defeated the manipulation software.20 The representative from Spainurged for proposals to overhaul the testing system to be watered down in order to prevent thedestruction of highly qualified jobs and prevent a negative influence on the Spanish economy.21Of course the British, French, Italian, and German representatives also took a similar stance andin the end and the EU commissioner feared the talks would collapse so he urged everybody toback the watered-down deal.22 The European car industry is too close to the government and thegovernment has been reluctant to take any steps that risk the stability of a sector that employs12.1 million people or 7% of the EU’s manufacturing employment. 23 Many fear that ifVolkwagen walks away with a slap on the wrist, this will act as an incentive for future firms todo the same.The European car industry is an example of regulatory capture because it is oftenparticular to “revolving doors” that exist between the regulatory agencies and the firms theyregulate. Regulators often find their best career opportunities within the firms that they regulate19Stefano Pagliari, Making Good Financial Regulation: Towards a Policy Response toRegulatory Capture (Governor House Publishing, 2012).20Jim Brunsden and Christian Oliver, Volkswagen Emissions Scandal: Noxious Omissions(Financial Times, 2016). Accessed March 16, 2016 39b6f2164.html21Brunsden and Oliver, Noxious Omissions22Brunsden and Oliver, Noxious Omissions23Brunsden and Oliver, Noxious Omissions

Copyright 2016. No quotation or citation without attribution.and the reverse trend is also true. The traditional concept of regulatory capture focused onmaterial incentives between regulators and different stakeholders, but today, it can also be usedto investigate how policies may favor a narrow set of special interests. The problem is that anagent in the regulatory body will do one thing but the interest of the agent is different. The agentwill always have slack and this means he is able to go off and do something that’s fundamentallydifferent from the principal. The principal can also only enforce things they observe which iswhy there is always slack. If the principal sits and observes the agents, then they lose the point ofhiring agents. The European Commission decided to choose economic incentives overremedying environmental policy.In order to overcome agency problems, it may be helpful to focus on contract design thatspecify the roles of the agent and create penalty or rewards for their behavior. For example, if theEuropean Commission or EPA can consider making even more detailed outlines. Another optionis screening and selection mechanisms to reduce information asymmetry. This is also a goodoption because it can be done ex ante and is less costly. If Volkswagen had hired trust workers inthe first place, then this scandal may have not occurred. Of course, it is difficult to tell whowould be trustworthy or not before they are placed in a position of power. This is why it ishelpful to increase monitoring and reporting requirements. Since these can only be performed expost, they are often costly and inefficient. Another downside is that they can also be manipulatedby agents. Monitoring takes the form of police patrols which may be carried out through randomaudits of the company. Fire alarms by third parties may be a feasible option, but this method willalso be detrimental to the company’s image. Finally, institutional checks such as checks andbalances can be implemented. As professional norms and standards become more clear, it will bemore costly for agents to deviate from expected professional behavior.

Copyright 2016. No quotation or citation without attribution.The main policy failure was failure to incorporate new information and to combat this,new mechanisms to create transparency in the organization must be implemented. The problemwith private governance is that the decisions affect the quality of life and opportunities of thelarger public so it requires more than just self-governance or self-regulation. Volkwagen as afirm should have tried harder to adhere to environmental regulations because of true accountingcost. It is cheaper for firms to follow regulations now rather than later but future costs cannot beshown on a balance sheet. Managers are only paid for what can be shown on a balance sheet andthey don’t get paid for what the company brings in 100 years from now. New structures need tobe implemented so that consumers have the confidence that other firms will not repeat it.The Volkswagen case is also an an example of how business dominates policymaking.Politics shape corporate governance by setting rules that companies are bound by and financialincentives often play a large role in shaping political preferences.24 Shareholder ideology saysthat managers have the obligation to maximize the rate of return and they are often the ones whohave to face conflicts of interest whether it is from sources of income or conflicts of interest fromseparate shareholders or public/social goals.25 Owners, managers, and workers are responsiblefor getting the laws and regulations they want to the public arena to obtain their preferredcorporate governance outcome.26 If corporate governance reporting standards are high, then itwill be more difficult for companies to commit fraud in the future.27Possible SolutionsThe Volkswagen Group is now faced with a problem of establishing credibility to its24Peter Gourevitch and James Shinn, Political Power and Corporate Control: The New GlobalPolitics of Corporate Governance (Princeton University Press, 2005)25Peter Gourevitch, What Do Corporations Owe Citizens, (Springer Science, 2007)26Gourevitch and Shinn, Political Power and Corporate Control, 1-1427Gourevitch and Shinn, Political Power and Corporate Control, 57-94

Copyright 2016. No quotation or citation without attribution.consumers and stakeholders. There are no set guidelines on what to do when a company’sreputation is damaged. However, three possible solutions include having Volkswagen restartunder a new name, join an independent verification agency, and/or set up a bond. Volkswagenshould implement as many measures as possible to restore credibility to its company. The worstcase scenario would be a lack of action that may spark a consumer boycott. This would lead to adecrease in sales and the eventual collapse of this company.Re-brandingIn the last 60 years, Volkswagen has become a global brand and it is the biggest carcompany in the world. While some believe that the scandal will be forgotten soon, otherVolkswagen directors have discussed the possibility of restarting the company under a new name.If the company restarts under a new name, this may improve brand image to have a company thatis smaller and more efficient than the current Volkswagen Group. Re-branding will make iteasier for the company to speed up efficiency programs and potentially save the company.Rebranding can be expensive and risky, but it may reduce the negative publicity that was causedby the scandal. It is important that the rebranding not only focuses on exterior changes, but alsochanges in other aspects of the company.The Volkswagen group is headed by the group chief executive Matthias Mueller. Themanagement board includes 9 bosses led by Herbert Diess, the Volkswagen car chief.28 Themanagement board oversees the supervisory board which is composed of 20 members, includingkey investors, led by Berthold Huber, interim chairman.29 Most shockingly, Martin Wintercorn islikely to receive two years pay and a pension of more than 22 million.30 This is the same man28Bradshaw and Yeomans, VW ScandalBradshaw and Yeomans, VW Scandal30Bradshaw and Yeomans, VW Scandal29

Copyright 2016. No quotation or citation without attribution.who first tried to cover up the scandal by claiming the company did not lie but faced a “technicalproblem.” 31 Bernd Osterloh, the Chairman of the General and Groups Works Council ofVolkswagen AG, has suggested a new CEO who has a deep knowledge of technology needs tobe appointed. He stated, “We need changes in our corporate culture. For the future we need aclimate in which problems are not concealed, but rather are openly communicated tomanagement.”32 A new CEO will bring a new lease of life into the organization and lead to achange in business strategy, competitive position, and business environment. A change in thegovernance process such as shareholder process, open election of directors, and wide inclusionof membership may also prove to be beneficial to the new company.If Volkswagen chooses to rebrand, it should try to develop a company that is more greenand has better corporate social responsibility practices. Studies show that “greenwashing,” whena company tries to portray itself as more environmentally minded than it actually is, has becomeincreasingly prevalent in recent years.33 The reputation of a company has become an increasinglybigger factor when it comes to consumer decisions. The new company should try to work withorganizations such as the Federal Trade Commission to focus on sustainability work andcollaborate with suppliers, universities, and other scientific institutions to embed its corporatesocial responsibility practices in every sector of the new company. For example, in order tocompensate for the previous emissions, employees could change the way they travel or businesstrips could be replaced with internet conferences.The new company should focus on reducing energy consumption, reducing carbon31Atiyeh, Everything You Need to KnowBradshaw and Yeomans, VW Scandal33David Gelles, Social Responsibility That Rubs Right Off (The New York Times, 2015).Accessed March 16, 2016 ? r 032

Copyright 2016. No quotation or citation without attribution.emissions, saving water, and reducing waste. The new company should also design ex postevaluations to test the efficiency of new programs. The new company may also engage with localcommunities or NGOs to show the public that they care about society and sustainability. After all,NGOs are powerful vigilantes best suited to hunt down new information. They are often the oneswho go out to scream and yell to get the public’s attention about sustainability issues. Anupdated website illustrating all of their practices and an annual report would greatly improve thecompany’s image. Clear financial statements are necessary to show the public where the moneycomes from and goes within the company. It would be helpful to use social marketing as part ofan overall strategy to increase transparency within the company.Joining an Independent Verification AgencyWhile Volkswagen has its own internal team that examines vehicle emissions, thecompany should also partner up with other independent verification agencies to rebuildconsumer trust. Some agencies that the company could consider partnering up with include theWorld Business Council for Sustainable Development (WCSBD), Fair Labor Association (FLA),Federal Trade Commission (FTC), and the Landfill Methane Outreach Program (LMOP). TheWCSBD is “a CEO-led organization of forward-thinking companies that galvanizes the globalbusiness community to create a sustainable future for business, society and the environment.”34The WCSBD already works with a global network of over 65 independent national andregional business councils and partner organizations and their executive committee meets threetimes a year to tackle the latest sustainable development issues. The FLA has their ownWorkplace Code of Conduct and a sustainable compliance methodology that gauges normalworking conditions and uncovers root causes of problems so issues are fixed in a lasting way.34Overview: Business Solutions for a Sustainable World (WBCSD). Accessed March 16, 2016http://www.wbcsd.org/home.aspx

Copyright 2016. No quotation or citation without attribution.The FTC is an independent agency of the US government that focuses on consumer protectionand addressing deception practices. The LMOP is a voluntary assistance program that aims toreduce methane emissions from landfills by using landfill gas as a renewable energy resource tofuel power plants, manufacturing facilities, vehicles, homes, etc.35If Volkswagen decides to partner with independent groups, then not only will it rebuildconsumer trust, but gain recognitions and rewards from NGOS that rank and test companiesbased on corporate social responsibility practices. For example, the Dow Jones SustainabilityIndices is the longest-running global sustainability benchmark worldwide and has become a keyreference point in sustainability investing because they conduct analysis on corporate economic,environmental, and social performance.36 The index is updated annually and this is better thanthe Institut der Wirtschaftsprüfer, a non-profit company based in Germany that focuses oncarrying out quality assurance procedures, but only publishes reports for the German public. IfVolkswagen joins more prestigious international organizations, this will give them strongercredibility.Posting a BondOne final method to regain consumer trust is for Volkswagen to post a bond that assuresthe public nothing like this will happen again. A bond is an indicator of credibility. PerhapsVolkswagen can state that if any fraud happens again within the company, they will pay a bondout to the European Commissions automotive industry. This will motivate the EuropeanCommissions regulators to be stricter and thorough with their audits. The money can also beused towards the research and development of green vehicles, decarbonization of conventional35Landfill Methane Outreach Program (EPA). Accessed March 16, 2016https://www3.epa.gov/lmop/36The First Decade: 1999-2009" (Dow Jones Indexes, 2009) Accessed March 16, 2016

Copyright 2016. No quotation or citation without attribution.engines, safety, and informational technology infrastructure. The bond needs to be set at a reallyhigh amount so that consumers will know that Volkswagen truly regrets cheating emissionsstandards. Volkswagen is a big company with a lot of assets and well-known brands. In order tofinance this bond, Volkswagen should sell one of their brands.Out of the current companies that Volkswagen owns, it may be wisest to sell their bigtruck manufacturing company MAN SE. MAN SE generates approximately 14.68 billionrevenue and its subsidiaries include MAN Truck & Bus, MAN Diesel & Turbo, MAN LatinAmerica, Neoplan, Renk, Sinotruk (Hong Kong), and ÖAF.37 Money acquired from this sale canbe used towards posting the bond. The money could also be used to pay out claimers andgovernments. Of course, Volkswagen will most likely try to solve this problem without sellingany brand. Volkswagen has become a fairly lucrative brand the past few years and it would bebest to compensate claims and governments from its own resources, but the company also needsto spend money on innovation. Volkswagen has to invest in new technologies to create better,more efficient engines and environmentally friendly cars. This is why the most feasible optionmay be to sell one of their brands and dedicate their resources on research and development.Today, oil demand continues to rise and air pollution becomes an increasingly pressingproblem. Volkswagen should sell one of its companies to focus on creating cleaner hybrid andelectric vehicles. They should work with policymakers to encourage the expansion of the electricvehicle industry and consumer acceptance. Maybe the money from selling a company can gotowards offering lower prices on their new electric vehicles since one of the biggest barriers ofexpansion is that electric vehicles are still much more expensive than gasoline fueled vehicles.37Annual Report 2010 (MAN Group, 2011). Accessed March 16, ://www.man.eu/MANDownloadgalleries/All/3Investor Relations/Geschaeftsbericht/2010/gb 2010 online e s.pdf

Copyright 2016. No quotation or citation without attribution.Governments around the world continue to raise fuel prices to push consumers towards highermileage vehicles and hopefully electric vehicles. If Volkswagen can capitalize on this market,then it has a hope of regaining its leading position in the global auto industry.RecommendationAt the moment, Volkswagen should dedicate all efforts and resources into re-establishingcredibility with the company. Volkswagen may choose to re-brand, although this option is fairlyunlikely. It can also join independent verification agencies, which is more feasible and fairlyeasy to accomplish. Finally, the costliest option would be to sell one of its brands and post abond. This is the most expensive option and probably a method of last resort, however it wouldalso restore the most faith in the Volkswagen brand.A combination of the second and third option would be the best recommendation. Asconsumers slowly regain trust in the brand, then sales will most likely gradually increase.Consumers are currently debating on purchasing the cheap Volkswagen stock because manyhave faith that the company will take the necessary steps towards mediating the scandal. It isdoubtful that the stock prices will return to previous levels anytime soon, but if Volkswagenshows consumers that it regrets deceiving consumers and is dedicated towards better corporatesocial responsibility practices, then perhaps it can regain its status in the global auto industry.Bibliography Annual Report 2010 (MAN Group, 2011). Accessed March 16, ://www.man.eu/MANDownloadgalleries/All/3Investor Relations/Geschaeftsbericht/2010/gb 2010 online e s.pdfClifford Atiyeh, Everything You Need to Know About the VW Diesel Emissions Scandal,(Car and Driver, 2016). Accessed March 16, 2016

Copyright 2016. No quotation or citation without attribution. o-know-about-the-vw-dieselemissions-scandal/Clive Coleman, VW Could Face Long Legal Nightmare (BBC, 2015). Accessed March16, 2016 http://www.bbc.com/news/business-34352243David Gelles, Social Responsibility That Rubs Right Off (The New York Times, 2015).Accessed March 16, 2016 ? r 0Exposure of the Volkswagen Scandal: The Full Story Explained (Amazon DigitalServices LLC, 2016), 22.Jack Ewing, Volkswagen Says 11 Million Cars Worldwide Are Affected in DieselDeception (The New York Times, 2015). Accessed March 16, nal/volkswagen-diesel-carscandal.htmlJim Brunsden and Christian Oliver, Volkswagen Emissions Scandal: Noxious Omissions(Financial Times, 2016). Accessed March 16, 2016 39b6f2164.htmlJulia Bradshaw and Jon Yeomans, VW Scandal: Porsche Boss Named New VolkswagenChief Executive- As it Happened (The Telegraph, 2015)Landfill Methane Outreach Program (EPA). Accessed March 16, 2016https://www3.epa.gov/lmop/Overview: Business Solutions for a Sustainable World (WBCSD). Accessed March 16,2016 http://www.wbcsd.org/home.aspxPeter Gourevitch and James Shinn, Political Power and Corporate Control: The NewGlobal Politics of Corporate Governance (Princeton University Press, 2005)Peter Gourevitch, What Do Corporations Owe Citizens, (Springer Science, 2007)Sonari Glinton, How a Little Lab in West Virigina Caught Volkswagen’s Big Cheat (NPR,2015). Accessed March 16, 2016 www.npr.org/2015/09/24/443053672/how-

Analysis of the Volkswagen Scandal Possible Solutions for Recovery The Volkswagen scandal is a notorious example of how corporations can shape the ethical and political issues of the environment. The Volkswagen Group that is headquartered in Wolfsburg, Germany owns Ben