A mucky business

HERBIE, a Volkswagen Beetle with a mind of its own in a series of Disney films launched in the 1960s, had its share of misadventures. But things had a way of ending up happily for both the car and its passengers. The German carmaker’s more recent attempts to give its cars the gift of thought have things headed in an altogether grimmer direction. Its use of hidden software to deceive American regulators measuring emissions from diesel-engined cars has plunged VW into crisis. And as the scandal provokes further investigations it seems likely to throw into question a wider range of claims about emissions and fuel efficiency. It could thus be a blow to much of the industry—one that might be large enough to reshape it.

The damage to VW, the world’s biggest carmaker, is cataclysmic. The company’s shares have collapsed by a third since its chicanery surfaced (see chart 1). It faces billions of dollars in fines and other financial penalties. Lawsuits will be flying their way to its headquarters in Wolfsburg. Its strategy for the crucial American market is ruined; its reputation is in tatters. Its boss, Martin Winterkorn—who in 2009, when the misleading “defeat” software made its first appearance, was also directly responsible for the company’s R&D—resigned on September 23rd.

The company’s home country is in shock. Germany’s environment minister, Barbara Hendricks, spoke for many when she declared herself “more than astonished”—though the Greens, an opposition party, say that in its response to a parliamentary question earlier this year the government admitted that it knew manipulating emissions data was technically possible. Mixed in with this is some embarrassment that, as with the scandals over FIFA and the World Cup, it is falling to America to enforce rules that Europeans have been breaking.

There is also a certain apprehension. Sigmar Gabriel, the vice-chancellor and economics minister, said on September 21st that he hoped the export brand of Germany as a whole would not be tarnished. Germany’s economic strength rests in large part on the idea that anything stamped “Made in Germany” will offer a high level of reliability, trustworthiness and engineering prowess. Much of that reputation rests on the broad shoulders and sturdy tyres of the car industry, which directly or indirectly employs one in seven of the country’s workers; and with a stable of marques that includes Porsche and Audi, VW is that industry’s leader. Industrialists fret that consumers worldwide could exact reputational Sippenhaft—collective punishment, but literally “kin liability”—on all German engineering.

As well as being a threat to Germany’s export earnings, the scandal also menaces the brainchild of one of its most eminent engineers, Rudolf Diesel—at least as far as its future in cars is concerned. Diesel engines use fuel more efficiently than engines with spark plugs, and better efficiency reduces both drivers’ expenses and carbon-dioxide emissions. Those advantages have endeared diesel engines to thrifty Europeans with green governments; none too popular elsewhere in the world, they power half of Europe’s cars (see chart 2).

Unfortunately, the benefits come with costs. Diesel cars’ efficiency comes from burning their fuel at a higher temperature, and that means they turn more of the nitrogen in the air they use for burning into various oxides of nitrogen, collectively known as NOx. This does not have global climate effects on the same scale as those of carbon dioxide, which is the most important long-lived greenhouse gas. But it has far worse local effects, generating smogs and damaging plants and lungs. To make matters worse, the catalytic technologies used to deal with the NOx emitted by petrol engines are not well suited for use with diesels, requiring engine makers to deploy more complex and expensive alternatives. That is not a big problem for large engines like those of trucks and ships. But it is for small engines like those of cars.

In America NOx standards are more demanding than they are in Europe. Mazda and Honda, both accomplished producers of diesel engines, have had trouble complying with them. It now appears that VW, which has put a lot of effort into persuading Americans that diesels can be clean and green, would also have failed to comply if it had not cheated. The campaign to convince Americans of the merits of diesel may thus well be at an end. And if it turns out that under real-life conditions many diesels also break Europe’s less stringent NOx standards then the future of diesel cars worldwide will be bleak.

Nothing seems right

The scandal broke on September 18th, when America’s Environmental Protection Agency (EPA) revealed that several diesel-engined VWs and Audis had software which switched NOx-controlling technology on only when faced with the highly predictable sort of demands seen under test conditions. The NOx-emission limit for a fleet of cars is 0.07 grams per mile (0.04g/km); under normal conditions the cars were 40 times over the limit. The EPA ordered VW to recall around half a million cars in America to fix the software. On September 22nd the company admitted that in 11m vehicles worldwide there was a “noticeable deviation” between the NOx emissions seen in official testing and those found in real-world use.

On the basis of 482,000 cars sold and a maximum fine of $37,500 per vehicle under the Clean Air Act, the Department of Justice could in theory fine VW $18 billion. In practice the punishment may be a lot less severe. General Motors, which for years ignored problems with ignition switches that directly claimed 124 lives, was fined just $900m earlier in September. In 2014 Toyota paid $1.2 billion when it settled a criminal investigation into its handling of unintended acceleration problems that led to 8.1m recalls.

But fines are not the only losses involved. Class-action lawsuits from aggrieved motorists will arrive at the speed of a turbocharged Porsche. On September 22nd VW announced a €6.5 billion ($7.3 billion) provision to cover the costs of the scandal but that is likely to prove too little. By that stage the company’s value had fallen €26 billion.

The financial damage could go further. Hidden within the German firm is a big finance operation that makes loans to car buyers and dealers and also takes deposits, acting as a bank. Its assets have more than doubled in the past decade and make up 44% of the firm’s total. And it may be vulnerable to a run. In previous crises “captive-finance” arms of industrial firms have proven fragile. After the Deepwater Horizon disaster BP’s oil-derivative trading arm was cut off from long-term contracts by some counterparties. General Motors’ former finance arm, GMAC, had to be bailed out in 2009.

With €164 billion of assets in June, VW’s finance operation is as big as GMAC was six years ago, and it appears to be more dependent on short-term debts and deposits to fund itself. Together, VW’s car and finance businesses had €67 billion of bonds, deposits and debt classified as “current” in June. This means—roughly speaking—that lenders can demand repayment of that sum over the next 12 months. The group also has a big book of derivatives which it uses to hedge currency and interest-rate risk and which represented over €200 billion of notional exposure at the end of 2014. It is impossible to know if these derivatives pose a further risk, but if counterparties begin to think VW could be done for they might try to wind down their exposure to the car firm or demand higher margin payments from it.

If depositors, lenders and counterparties were to refuse to roll over funds to VW, the company could hang on for a bit. It has €33 billion of cash and marketable securities on hand, as well as unused bank lines and the cashflow from the car business. The German government would lean on German banks to prop up their tarnished national champion, 20% of which is owned by the state of Lower Saxony. So far the cost of insuring VW’s debt has risen, but not to distressed levels. Still, unless the company convinces the world that it can contain the cost of its dishonesty, it could yet face a debt and liquidity crisis.

Doubts about NOx emissions from VW’s four-cylinder TDI series of diesels (which can also be found in Seats and Skodas) first surfaced after testing by the International Council on Clean Transportation, a small NGO, two years ago. The tests—intended, ironically, to demonstrate the engines’ cleanliness—revealed that the cars’ emissions far exceeded what the company had previously stated. The ICCT brought the results to the attention of the California Air Resources Board (CARB), which badgered VW into a voluntary recall to fix what the company insisted were “technical issues”. When the recall failed to resolve things VW offered excuse after excuse before eventually confessing—it was still dithering when the EPA, with which CARB had shared its results, finally acted.

The image breaks down

Why did VW take the risk of cheating, given the devastation that has followed? There seem to be three parts to the explanation. The first is an overwhelming desire for size. The company has been obsessed with surpassing Toyota and becoming the world’s biggest car company, despite making little money from its most high-volume products (cars carrying the VW badge make up 60% of sales but the profit margin on them is just 2%). This required that the company increase its small share of the American market—the largest after China (see chart 3). Making more of the SUVs that Americans covet was one obvious strategy. Getting them keen on the fuel-efficient diesel engines that VW sells elsewhere was another. In a modest way it was succeeding; though diesels account for only 1% of the American market for cars, last year VW had half of that slim slice.

Though these cars were substandard when it came to NOx, they didn’t have to be. According to a British professor who specialises in the subject, “you can solve any emissions problem if you throw enough engineering and money at it”. As VW spends more on R&D than any other company on the planet—€13.1 billion in 2014—it is very well positioned for such throwing. But here the second part of the explanation comes into play: fixes to the NOx problem come with trade-offs. Exhaust-gas recirculation, one of the technologies VW uses, reduces both fuel efficiency and power, which drivers tend not to like. Reports indicate that this recirculation was something the software turned off when regulators were not looking. Selective catalytic reduction, used in some newer cars, reacts NOx with ammonia, reducing the eventual level of pollution by a great deal. But designing, installing and operating these systems all add to a car’s cost. Easier not to fix the problem, if you think you can get away with it.

Apparently some people at VW thought they could get away with it. And this leads to the third bit of the explanation: a large part of their reason for believing this would have been that carmakers, particularly European ones, are used to getting away with a great deal in such matters.Their trickery is an open secret within the industry; new scrutiny in the aftermath of the NOx revelations seems likely to make it an open scandal to the world at large. This may be why VW’s competitors, too, are seeing their share prices fall. Its crimes may be particular, but it is far from the only carmaker producing vehicles that fall far below the performance that regulators require of them.

The European Union (EU) is not as demanding in the matter of NOx as the Americans are. It concentrates more on fuel efficiency and carbon-dioxide emissions, where its standards are the highest in the world. The problem is that these tough limits bear little resemblance to what cars emit when on the road. According to Transport & Environment (T&E), a green pressure group, the gulf between stated fuel-economy figures (and by extension carbon-dioxide emissions) and those achieved by an average driver has grown to 40% in recent years (see chart 4)

It is possible that some companies are using software trickery to cheat on Europe’s tests on fuel efficiency. But as Nick Molden of Emission Analytics, a consulting firm in Britain, argues, the European testing regime is so out of date and open to abuse that carmakers do not have to bother with such subtlety. The companies test their own vehicles under the auspices of independent testing organisations certified by national governments. But these organisations are commercial enterprises that compete for business. Although obliged to put the vehicles through standard activity cycles both in a laboratory and on a test track—neither of which is remotely realistic—they are aware that their ability to “optimise” the test procedures is a way to win clients. In practice this means doing everything possible to make the test cars perform far better than the versions punters drive off the forecourt.

The cars that are tested have generally been modified to be as frugal as possible. Things that add weight, such as sound systems, are left out. Drag is reduced by removing wing mirrors and taping up cracks between panels. Special lubricants make the engines run more smoothly. Low-resistance tyres are overinflated with special mixtures of gas. Alternators are disconnected, which gives more power to the wheels but guarantees a flat battery in the end. The cars may be run in too high a gear, and conducting tests at the highest allowed ambient temperature—another efficiency booster—is commonplace.

Stable for days

Worst of all, though, is that once this charade has produced a claim as to the car’s efficiency, no one checks whether it is true or not. In America, too, carmakers are responsible for their own tests. But there the EPA goes on to acquire vehicles at random for testing at a later date, to see if the cars on sale to the public live up to the claims. If the numbers do not match up substantial fines can follow. In 2014 Hyundai-Kia was fined $300m for misstating fuel-economy figures. Europe has no such system for punishing those who transgress. As a result more than half Europe’s claimed gains in efficiency since 2008 have been “purely theoretical”, says T&E. And the industry as a whole has developed a gaming attitude to tests and regulations that it should take seriously. As Drew Kodjak of the ICCT observes, VW’s activities in America are part of a pattern of behaviour that the “European system created”.

A new level of scrutiny will change things. It may turn out that other manufacturers are using similar software to cheat on either NOx or carbon-dioxide tests. The NOx emissions from new diesel cars in Europe are on average five times higher on the road than in tests; some cars run at ten times the limit, according to T&E. But even if they are not, a wider understanding of the bogus way in which the system runs seems sure to provoke action, and weaken the power of the industry to keep the system lax. Carmakers have been lobbying against the EU’s plans to introduce more realistic cycles into their tests by 2017, saying it can’t be done until 2020. Their pleading is unlikely now to help; the changes may not just arrive in 2017 but also be more exacting than previously planned.

This all takes place against a background of increasingly strict controls on carbon emissions. Europe’s carbon-dioxide goal of an average of 95g/km across all a carmaker’s models by 2021 is already demanding. It will be even harder to achieve if it has to be reached honestly. The same goes for more stringent fuel-economy standards that are coming soon in other markets such as China, America and Japan.

The industry had built a continuing shift to diesel into its assumptions about how it would meet these requirements. But if diesels cannot deliver low NOx emissions while maintaining high fuel efficiency and staying affordable, that assumption will have to be jettisoned—quite possibly taking with it the whole idea of diesel engines for mass-market cars. They are difficult and expensive to develop, and there is already a backlash against them in Europe, where they are blamed for high particulates as well as NOx; both Paris and London have talked of banning them.

If diesels cannot deliver then carmakers will need to turn heavily towards hybrids and very efficient small petrol engines. All this at a time when, according to Mary Barra, boss of GM, carmaking already faces more change in five to ten years than in the previous half-century. On top of meeting environmental targets and pioneering new hybrid and all-electric drivetrains carmakers need to spend a lot on using the internet to make their machines smarter and preparing them for the advent of autonomous driving. The investment required will be monumental, and some will surely be unable to bear it.

Meanwhile cut-throat competitiveness is only going to get more intense as non-carmakers with deep pockets, such as Google and Apple (see article), eye up the industry. One answer is consolidation to tackle overcapacity. Big mergers have generally proved disastrous in the industry—but then so have attempts to become number one by other means. It was a devotion to size above all things that led to Toyota’s devastating outbreak of quality defects in the late 2000s, and the same ambition has played its role in the downfall of VW. If the gathering emissions scandal has any virtue it may lie in forcing a reshaping that the industry badly needs.