UNIVERSITY DARDEN VIRGINIA Business Publishing UV7245 Rev. Oct. 30, 2018 The Volkswagen Emissions Scandal In October 2015, Mathias Müller became CEO of Volkswagen (VW), the 78-year-old economic jewel of Germany. His predecessor, Martin Winterkorn, who had led VW for eight years, had resigned suddenly in the midst of one of the biggest scandals to ever hit VW and the auto industry. In September, VW had admitted to United States regulators that it had deliberately installed "defeat devices" in many of its diesel cars, which cnabled the cars to cheat on federal and state emissions tests, making them able to pass the tests and hit ambitious mileage and performance targets while actually emitting up to 40 times more hazardous gases into the atmosphere than legally allowed. The discovery had prompted the US Environmental Protection Agency (EPA) to halt final certification of VW's 2016 diesel models, and VW itself had halted sales of its 2015 models. As fallout from the defeat devices developed, VW posted its first quarterly loss in more than 15 years, and its stock plummeted. Winterkorn and several other top executives were replaced, and VW abandoned its goal of becoming the world's largest automaker. In addition to significant financial implications, VW was rapidly losing its prized reputation as a trustworthy company capable of outstanding engineering feats. Volkswagen Background: The Power of German Engineering1 In 1937, VW was founded in Germany under the Nazi regime by the labor unions with the help of Ferdinand Porsche, the inventor of the Beetle (the people's car). Tasked with making a car that was affordable for all consumers, WW's flagship car, the compact and iconic Beetle, first rolled off the manufacturing floor in 1945, and by 1949, half of all passenger cars produced in West Germany were built by VW. The company began exporting cars in the late 1940s, and by 1955, the company had sold over one million Beetles worldwide. The Beetle would eventually surpass Ford's Model T as the highest-selling model ever built, reaching sales of more than 15 million by 1972. When sales of the Beetle began to decline in the late 1970s, VW branched into other models, including the Passat, Jetta, Golf, and Polo. The VW brand eventually folded into a broader public holding company, Volkswagen AG, which by 2014 owned 12 subsidiaries, including VW passenger cars, Audi, Porsche, and Bentley Page 2 UV7245 vehicles, a 5% growth over 2013, and reached its goal of taking over the title of "world's largest auto manufacturer" from Toyota. Sales revenue in 2014 was EUR202 billion, with an operating profit of EUR12 billion (Exhibit 2).2 The shareholders of Volkswagen AG were largely made up of descendants of Porsche (50% ownership), but VW also had significant ownership from the German state of Lower Saxony (20% ownership) and Qatar's sovereign wealth fund (17% ownership), as well as independent shareholders who made up 10% ownership. Per German corporate law, Volkswagen AG had a 20-member supervisory board responsible for corporate governance, rather than a board of directors. As required by law, 50% of the scats were allocated to VW's labor force (union representatives and employees that are elected representatives of the union), leaving the other 10 seats to be divvied up among the shareholders. As of 2015, only one of these seats was held by an outsider (Annika Falkengren, the CEO of a Swedish bank); the other nine were as follows: five to members of the Porsche and Piech (relatives of the Porsche) families, two to Lower Saxony, and two to Qatar.“ At a time when Europe was continuing to recover from the global financial crisis, VW was one of the most significant engines in the German economy. In May 2015, it was listed by Forbes as the largest public company in Germany by revenue, surpassing its nearest competitor, Daimler, by almost USD 100 billion. It was also one of Germany's largest employers. Wolfsburg, Germany, the town in Lower Saxony where Vw was headquartered, owed its existence to the company. it was created out of farmland to be the original site for manufacturing the VW Beetle. By the mid-2000s, the company owned the town's professional soccer team, its major hotels, and even an automotive theme park that attracted millions of visitors per year.? The company's stated values included “customer focus, superior performance, creating value, renewability, respect, responsibility, and sustainability": These values were intended to guide decisions made by employees throughout the company and were accompanied by a 25-page Code of Conduct on which every employee was trained after joining VW. This Code of Conduct was written in 2009 and systematically rolled out to employees across the globe in 2010. It addressed topics such as management culture and collaboration, anticorruption, and fair competition, and it was intended to be a "guidepost that combines the essential basic principles of our activities and supports our employees in mastering the legal and ethical challenges in their daily work." In addition, all VW employees received compliance training: 185,000 were trained on compliance in 2014.10 Page 3 UV7245 Throughout its history, VW had been widely admired for its innovation in design and engineering. It was one of the first companies to introduce the three-way catalytic converter, prompting it to boast on its website that it was a “pioneer of low-emission monitoring."! The company experienced its first brush with US emissions standards in the 1970s, however, when the EPA caught it installing defeat devices that would allow it to cheat on newly enacted emissions standards. At the time, it paid a USD120,000 fine. 12 VW had also been known for its quirky advertising highlighting its unique products and top-notch engineering. The company made advertising history with its "Think Small" campaign in the United States in the 1950s, which encouraged Americans to consider smaller vehicles like the Beetle. In recent years, it stressed its virtue through advertisements proclaiming "the power of German engineering," with commercials featuring engineers sprouting angel wings. At a time when most major US automakers were still struggling to recover from the global financial crisis and both Toyota and General Motors were reeling from major safety recalls, VW was perceived as reliable, successful, and innovative. In his 2014 annual letter to shareholders, CEO Martin Winterkorn wrote: "We stand for strength, reliability, and long-term success—even under less favorable conditions."13 "The power of German engineering" was more than just a marketing tagline for VW; it was a motto, a way of doing business, and a symbol of national pride. Germany had become a country that prided itself on its world-class engineering and precision manufacturing. In part due to the country's engineering prowess, the automobile industry had become a powerhouse in Germany, and VW had become the leader in that industry. This dominance in manufacturing helped Germany weather the 2008 global financial crisis and kept unemployment low. Germany was able to boost employment and its economy largely through its ability to export products; automobiles made up a full one-fifth of this market. The strength of VW and much of the German economy depended on the growth of its engineering exports, making German engineering more than a just a point of national pride—it was an economic necessity.15 WW Leadership and Strategy 2018 Winterkorn, who took over as CEO in 2007, was focused on leading VW through its Strategy 2018, an ambitious plan to position the company as a global and environmental leader. The overarching goal of the strategy was to transform VW into the world's largest automaker. Said Winterkorn, “Our pursuit of innovation and perfection and our responsible approach will help to make us the world's largest automaker by 2018—both economically and ecologically." Strategy 2018 had four primary goals: (1) to sell 10 million+ vehicles per year (thus making VW the world's largest automaker); (2) to become the world leader in customer satisfaction and Page 4 UV7245 quality; (3) to achieve an 8% return on sales; and (4) to be the most attractive employer in the automotive industry.16 Throughout Winterkorn's tenure, VW made steady progress on each of these goals. Under the leadership of Winterkorn and his mentor, VW Chairman Ferdinand Piech (a grandson of VW founder Porsche and himself VW CEO from 1993 until 2002), VW became a tightly controlled, highly centralized company. Its corporate culture was one of command-and-control, with leadership setting aggressive goals and senior executives involved in even relatively minor decisions."7 The company gained a reputation for being hard-charging and brutally competitive, and former employees described an environment in which subordinates were fearful of ever admitting failure or contradicting their superiors. Both Piech and Winterkorn came from engineering backgrounds and kept a close eye on product development. Piëch, who recruited Winterkorn to Audi in 1981 and became his mentor for more than 25 years, would boast that he elicited superior performance by terrifying his engineers. "Is It was well known that VW executives and engineers would be "shaking in their boots prior to presentations before Piöch, knowing that if he was displeased, they might be fired instantly."!! By the time he became CEO in 2007, Winterkorn was considered a cold, distant figure... known for obsessive attention to detail.”20 Unlike other contemporary auto industry CEOs who were experts in financial management and turnarounds, Winterkorn was considered a "classic car guy."21 He was known for carrying a gauge with him at all times to measure flaws in vehicles as they came off the production line and for publicly disparaging subordinates. Said an industry analyst, “He doesn't like bad news. Before anyone reports to him, they make sure they have good news."22 Winterkorn was relentless in his pursuit of becoming the world's largest automaker. Speaking at the opening of VW's new factory in Chattanooga, Tennessee, in 2011, he promised that "by 2018, we want to take our group to the very top of the global car industry. "23 Although VW was growing, these promises were still considered ambitious, especially in the United States, a market that VW had previously neglected and where it held a reputation for selling expensive and undesirable cars.24 In order to meet Winterkorn's goals, the US market would be a critical component to success. The company would need to sell 1 million vehicles (800,000 Volkswagens and 200,000 Audis) annually, tripling its 2007 sales.25 Page 5 UV7245 Achieving Ambitious Goals While Meeting Regulations26 In the mid-2000s, when Winterkorn began his tenure as CEO and announced VW's goal of becoming the world's largest automaker within the next decade, the auto industry in the United States and around the world was facing significant engineering challenges. Persistently high prices at the gas pump and toughening mileage standards put pressure on automakers to design more fuel-efficient vehicles, while growing concerns about climate change spurred increasingly stringent emissions regulations. In order to drive sales, automakers needed to find ways to optimize fuel efficiency and emissions while still designing the high-performing vehicles that Americans had become accustomed to driving. The market for hybrid-electric cars, notably Toyota's Prius, was growing rapidly.27 Rather than compete with Toyota and other automakers in the hybrid market, VW had opted for a strategy of diesel, viewing it as a huge growth opportunity within the US car market and a viable eco-friendly alternative. While diesel made up almost half of new car sales in Europe, it held just 5% of the US auto market in 2007,28 and Winterkorn believed it was an opportune time to expand diesel sales in the United States. Diesel offered a cheaper, more powerful alternative to hybrid vehicles, promising high fuel efficiency without sacrificing powerful performance. But before it could market fuel-efficient diesel in the United States, VW had to overcome one major roadblock: diesel cars generated significantly more nitrogen oxide (NOx) than gasoline- powered engines, making it difficult for them to clear the stringent American emissions standards without sacrificing fuel efficiency or performance. In order to sell its cars in the US market, a critical part of the company's goal of becoming the world's largest car manufacturer, VW would have to engineer a way to strip its cars of these pollutants to meet US regulations Exhibit 3). In 2005, Wolfgang Bernhard, VW's head of brand, was in charge of designing the next-generation diesel engine for consumer cars that would provide both fuel efficiency and meet low US emission standards. Bernhard chose a strategy seen as controversial within the VW management team. Rather than develop an in- house solution, he instead adopted a competitor's technology, a Daimler invention called BlueTec. BlueTec used a substance called urea-essentially cat urine-to neutralize NOx. It required that VW install an extra pump and tank of urea in each vehicle, at a cost of EUR300 per vehicle. But just two years later, in 2007, boardroom battles within VW led to the appointment of Winterkorn as CEO, who promptly ousted Bernhard and cancelled the BlueTec deal. VW leadership stressed that BlueTec was too expensive, took up too much space in small cars, would hamper fuel efficiency, and that VW did not need to partner with an archrival to achieve its engineering goals. VW engineers were suddenly on their own to find a way to meet stringent US emissions standards on diesel without sacrificing mileage or performance, and they needed to find it quickly. As it struggled to come up with a solution, the company was forced to delay for six months the release of the new diesel Jetta that was to be at the center of its new marketing push. Whatever solution was devised, software was likely to be at the center of it. Modern cars contained approximately 100 million lines of software code that controlled everything from basic operations to media to safety. Software could also help a car control the amount of pollutants it emitted, by monitoring carbon
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