An was to go with small diesels in

An
economic perspective of the ‘Dieselgate’ scandal involves much more than
nitrogen oxide, competitive pressure and corporate memos. It involves
questioning the very fabric of ethics and principals of the people running the
company and under whose watch such a scandal took place. It marks a huge dent
in the corporate governance of the companies worldwide and acts as an eye
opener for the people highlighting the importance of an external body to
oversee the implementation of governance and ethics in an organisation.

Around a decade ago, VK
wanted growth pretty badly. It was fighting Toyota and General Motors for the
number one position in the car market globally. The obvious place for it to
grow was the huge US market, where it had a very minimal market share. Due to the
tax incentives in Europe, VW had special expertise in making small diesel
engines. Also, these engines produced lesser carbon dioxide than petrol engines
and thus selling them was easier owing to the greenhouse gas rules. Given its
commercial footprint, technical strengths and the regulatory climate, the
economically optimal strategy for VW was to go with small diesels in the US.
There was one small problem. US rules about
nitrogen oxide emissions — where diesel is a worse offender than petrol — are
tougher than European ones. The technology that enables cars to meet them is
expensive, making it practically impossible to produce a mid-priced car that
passes muster.

While it
was no hidden fact that manufacturers attempted to ‘work around’ these tests,
what was astonishing about VW’s case was the scale and method of their
deception. The technology that VW used for cleansing Nitrous Oxide emissions involved
a trade-off with fuel mileage and performance. For this, the VW’s programmers and
engineers decided to mask it by introducing two distinct driving ‘modes’ into
the car’s software- a ‘best behaviour’
mode that complied with US regulatory emissions requirements, and another for
all other circumstances. The car systems were designed smart enough to detect
whether they were undergoing the highly predictable and fancy requirements of
the US Environmental Protection Agency (EPA)’s tests, and put themselves on
best behaviour accordingly. The deviation between the two modes was
significant. The cars emitted up to 40 times more Nitrous Oxide during normal
circumstances than under test conditions. About
500,000 vehicles were affected in the US, spanning the model years 2009-16. The
tactic was used in other markets as well, raising the total number of affected
vehicles to approximately 11 million worldwide.

Commentators
have said that a key motivator would have been the huge cost savings for VK to
take up such actions. VW’s competitors in selling diesel cars in the US market-
BMW and Mercedes developed a much more expensive technology known as urea
filtering for cleansing diesel fumes of particulates and Nitrous Oxide
specifically and conforming to the stringent emission requirements of the US
EPA. By choosing not to license this
technology from Mercedes, analysts estimate VW could have saved up to
$4.8bn worldwide.

The losses suffered by VW

Details of
their expected quantum emerged in late April from VW’s 2015 Annual Report and
the announcement of an agreement in principle regarding a settlement with
US authorities and class-action lawyers, under which VW reportedly agrees to repair or buy back the cars sold in
the US with the illegal software, and to pay additional compensation. In
addition, the US Department of Justice has opened a criminal investigation, and
civil, criminal and/or administrative actions have been commenced in many other
countries.

VW’s 2015
Annual Report announced provisions totalling €16.4 billion ($18.4 billion)
for the clean-up and legal costs, including €7.0 billion ($8.0 billion) dollars
for “legal risks” and a further €1 billion ($1.2 billion) for contingent
liabilities. VW also began a product recall in the EU of cars sold
with affected engines.

VW’s stock
price fell rapidly by 40% after this scandal came to light, although it
subsequently regained ground, now wavering at just under 20% down. This
suggests the market’s estimate of VW’s likely losses is similar to the firm’s
provisions, at around $18 billion.  As a result, it doesn’t seem that VW’s
case bucks the trend of purely environmental harms (as opposed to uncompensated
harms to customers) not triggering reputational losses.

The Management inaction

Any company
cheating its customers depends highly on expectations about the probability of
getting caught, and attitudes to risk. Consider first the (highly implausible)
idea that the decision to cheat was in fact deliberately taken by the VK
management, knowing well that the benefit would be around $5bn and the costs
approximately $18bn. This would have a positive expected return for VW provided
that the probability of getting caught was less than approximately 25%. Now consider
the much more plausible position of a CEO who has a whiff that something may be
amiss amongst junior engineers. He can either pursue an internal investigation,
which would alienate engineers and may reveal wrongdoing or he can do nothing
and continue by turning a blind eye to the issue. The real problem is that an
internal investigation would surely increase the likelihood that the firm will
get caught for any prior misconduct. If the CEO judges the initial probability
of getting caught to be low, it is easy to see that it may maximise expected
profits to turn a blind eye, rather than draw attention to a potential
catastrophe. The executives, being risk averse, failed to launch an internal
investigation into extensive emissions cheating by their engineers. They could
not comprehend the scale of costs that would come knocking in case of the
scandal coming to light and it can be clearly seen how they compromised on
their long term financial health by only considering the short-term gains and
in totality the company suffered a huge blow due to their actions.

In corporations
with diversified ownership, high-powered incentives are conventionally deployed
in the form of large performance-related variable pay as a means of encouraging
managers to be less risk averse with respect to business decision-making. The
‘performance’ criterion is normally defined in reference to the stock price,
and it is ‘high powered’ because it responds very swiftly to changes in the
criterion laid out. In such a scenario, complications are known to arise when
it comes to compliance with obligations imposed on the company for purposes
other than to maximise shareholder wealth – examples being Enron, or the banks
prior to the financial crisis of 2008 which also compromised on the spirit of
the obligations put in place by the regulators in order to maximise their short-term
gains.

The VW scandal
showcases how such high-powered incentives can be linked to compliance issues,
even in firms that are not known to have a culture of pursuing ‘shareholder
value’ as their primary objective. Like all large German firms, VW had a
two-tier management board structure. VW’s CEO, Martin Winterkorn, had a pay
package which was heavily tilted towards variable pay. In 2014, he took
home €16m ($18.3m), of which only €2m ($2.3m), or 12.5%, was fixed
compensation. The heavy tilting towards performance related pay was common
across members of VW’s Vorstand, or Management Board. While the executives’
variable pay was not linked directly to the company share price, it was tied
closely to a number of metrics including profits, revenue growth, customer
satisfaction, employee productivity and satisfaction. This is consistent with
the publicly-announced goal for VW since many years- “growth” i.e., To make
Volkswagen the largest car maker by sales in the entire world, which it
ironically achieved in the first half of 2015, only to lose again it in
the wake of the scandal and witness a dramatic fall.

Financial
incentives were not the only high-powered incentives acting upon senior VW
executives. There would also have been intense monitoring by the Aufsichtsrat,
or Supervisory Board. Unlike Anglo-American corporations’ boards, the members of
German supervisory boards are the representatives of major shareholders and their
labourers.VW’s Aufsichtsrat of 21 had 5 members appointed by the Porsche
family, the majority shareholder, 2 appointed by the Qatar Sovereign wealth
fund (which has a 17% stake), 2 appointed by the state of Lower Saxony (having
a 20% stake), 10 appointed by employees, trade unions, and middle management.
The other two comprised the Supervisory Board’s venerable former Chairman, and
a single independent. Growth was an ambition that unanimously appealed to both
stakeholder groups dominating the Aufsichtsrat- the controlling shareholders as
well as the employees.

Surprisingly,
the bias toward performance pay was shared by VW’s Aufsichtsrat. The Chair of
the Aufsichtsrat, until April 2015 Ferdinand Piëch, took home €1.5m in
2014, of which only €200,000 (13%) was fixed; this ratio was similar across the
entire Aufsichtsrat. The Aufsichtsrat’s variable pay is expressly linked by §17
of VW’s Satzung, or Articles of Association, to shareholder dividends.

Although
European executives are usually expected to earn lesser than their counterparts
in the US, it is worth noting that Winterkorn’s package was similar to the
total salary amount earned by Mark Fields, the CEO of Ford ($18.6m) and
more than that of Mary Barra, the CEO of GM ($16.2m), in the same financial
year. Financial incentives and close monitoring of performance is likely
additive in terms of their impact on executive behaviour. Thus the intensity of
the combined incentives might have been even stronger than those faced by a US
executive. In short, high-powered incentives can give rise to perverse
incentives in firms without dispersed share ownership, and where performance
targets are not defined solely by reference to the share price.

What also
emerges starkly from the VW affair is the importance of distinguishing between
agency costs and externalities in issues of corporate governance. Conflicts of
interest between managers and shareholders are an agency cost. But so too are
conflicts of interest between employees and shareholders. Harm caused to the
environment, or any other interest external to the corporation, however, is an
externality. Simply because a company’s structure is designed—as codetermination
does in Germany—to minimise agency costs between shareholders and
employees—does not necessarily imply that it will be less problematic in terms
of externalities. Corporate decisions that for instance harm the environment or
are ethically wrong but lead to corporate growth benefits both investors and
employees.

Lessons of corporate governance
from VW scandal

The VW
scandal has clearly put the spotlight on the appropriate use of high powered
incentives and the lessons that can be learnt by all companies in this regard.
The most startling implication however would be the need for effective personal
liability of individuals who either deliberately engage in misconduct, or those
who fail to ensure ethical practices by the entire organisation. The deterrents
for the former, which amounts to criminal liability, is already in place in
most jurisdictions, but suffers from serious issues of substantial proof
requirements. The latter, however, which would take the form of negligence
based liability, has a lot of potential to be further emboldened. A healthy
system of checks and balances to ensure the latter is effectively deterred
could go a long way in avoiding such disasters for organisations.

Another
possibility might be to contemplate public enforcement of directors’ duties
under these circumstances. This model is adopted in Australia, where ASIC has
power to enforce directors’ private law duties.

All
this presupposes some guidance as to what sort of actions such oversight should
involve. Here we move into the realm of ‘risk management’. The VW case has some
very interesting pointers about this too. The striking thing about the VW case
is how the actions of a small number of technical personnel can lead to harms
affecting 11 million vehicles. It also shows how eternal vigilance is the price
of long term successful growth devoid of any ethical misdemeanour and how even
a small negligence on part of those in charge can have serious repercussions
for a company in terms of irreparable damage to its reputation as well as the
huge mountain of financial burden stemming from such a scandal.