Altius AM: Volkswagen AG: What happened and what’s next?

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October 12, 2015
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October 13, 2015

“The Volkswagen emissions scandal is testing the nerves of global credit markets. Car companies make up a huge part of the global credit market: in Europe, car companies make up almost 10 percent of the major corporate bond index, which doesn’t include financials, and VW on its own accounts for 30 percent of the sector”, said Mr Bill Bovingdon, Chief Investment Officer with Altius Asset Management

So what did happen, and what’s likely to happen next?

On 18 September 2015, Volkswagen received a notice of violation of the Clean Air Act from the US Environmental Protection Agency. This followed investigations by the European-US International Council on Clean Transportation (ICCT), a not for profit environmental organisation which had been trying to confirm that Volkswagen diesel vehicle emissions conformed to the required regulations.

The event: what happened?

In testing Volkswagen car emissions on the road, the ICCT could not replicate the results generated by Volkswagen diesel vehicles  in the laboratory. The ICCT measured said vehicles emitting 10 to 40 times the US legal limit of pollutants and notified the US Environmental Protection Agency (EPA).

The EPA and the California Air Resources Board (CARB) opened investigations into Volkswagen diesel vehicles in May 2014. CARB tests confirmed that nitrous oxide emissions violated California as well as US laws during real-world tests, even though they passed in the laboratory.  The agency shared those findings with Volkswagen and the EPA on 8 July 2015. 

Note the ICCT worked with West Virginia University’s Center for Alternative Fuels, Engines and Emissions, and tests were carried out on Volkswagen’s Jetta (exceeded the US nitrous oxide emissions standard by 15 to 35 times) and Passat (exceeded by 5 to 20 times), and also the BMW X5 (which passed).

Volkswagen admitted they had used ‘defeat device’ software in some 11 million diesel vehicles between 2009 and 2015, which detected when a vehicle was undergoing emission testing. Note software modifications in a testing environment are permitted in some cases but must be disclosed to the EPA. Regulators know engine management systems need to be switched to a different mode when cars are being tested to get accurate measurements. The issue is not the deployment of ‘defeat devices’, but the settings they switch to when activated. According to agency documents , Volkswagen did not tell the EPA about the existence of the software until the agency said they would not authorise sales of 2016 models.

Will they survive?

Volkswagen has of its own admittance committed malfeasance. 

Although painful, the cost of repair is within the financial capacity of the business, although could see a rating downgrade. Any such downgrade will reflect the direct financial consequence of Volkswagen’s behaviour, but perhaps more significantly reflect the much weakened reputation of the company as well as the loss of credibility of the company’s governance framework.

In mid-2015, Volkswagen for the first time became the largest seller of automobiles in the world, edging out Toyota.  With the exception of sale commitments already made, it would appear unlikely these volumes will be achieved again in the near term. Expect sales volumes to reflect this loss of faith in Volkswagen, which will also see considerably lower re-sale and residual values for existing vehicles. 

It will likely be some time before Volkswagen returns to historic pricing levels. Outstanding questions remain around whether other manufacturers may have also cheated on (US) emission tests. There is some media noise around BMW also not achieving test standards in ad hoc road tests, but research so far indicates little basis to these reports.

The effect: consequences so far


On 20 September, Volkswagen issued a media release admitting to their manipulation and stating they would fully co-operate.  Subsequently, Chief Executive Officer Martin Winterkorn addressed the public saying he is ‘endlessly sorry’. 

Four days after Volkswagen’s behaviour was made public, CEO Winterkorn stated he had no prior knowledge of these events but offered his resignation to the Board, which accepted it. His replacement, former Porsche unit chief Matthias Mueller, was announced on 25 September.

CEO since 2009, Mr Winterkorn was known for his attention to detail in a business with very centralised decision-making. One of Mr Winterkorn’s key objectives was to boost sales in the US, a region in which Volkswagen is yet to enjoy significant presence. 

Volkswagen is setting aside at least €6.5bn to meet potential recall costs.   However, the EPA estimates potential maximum fines of US$18bn  (482,000 vehicles in the US with a maximum allowable fine of US$37,500  per vehicle). Further, the company has halted sales of its 2015 and 2016 ‘clean’ diesel vehicles in the US. 

Rating agency reaction

On 23 September, Fitch placed Volkswagen’s A rating on Credit Watch Negative acknowledging the sheer scale of the uncertainty ahead, notwithstanding the strong financial position of the company. 

On 24 September, Moody’s placed Volkswagen’s A2 rating on Negative outlook, noting ‘investigation into Volkswagen’s alleged breach of US environmental laws, as well as the process by which that breach occurred, poses risks on the group’s reputation and future earnings’. Moody’s considers Volkswagen has sufficient financial strength to cover provisions of €6.5bn, although financial flexibility will be severely constrained at an A2 rating.  At 30 June 2015, Volkswagen had adjusted free cash flow of €6.1bn for the preceding 12 months and its automotive division had net liquidity of €21.5bn.

On 24 September, Standard & Poor’s placed Volkswagen’s A rating on Credit Watch Negative.


A slew of investigations are being launched by environmental regulators as well as consumer protection groups, along with multiple class actions.

Regulators from Germany, France, South Korea and Italy have stated they will scrutinize Volkswagen vehicles in their country, with France calling for an investigation to be carried out by the European Union. There is also potential for lawsuits as well as criminal charges for executives.

Bloomberg has reported that the FBI in Detroit is handling a US criminal investigation of Volkswagen.

New York is part of a multistate group investigation. Connecticut is investigating separately. 

Tennessee plans to hold hearings over whether the scandal could imperil the US$900m in incentives directed toward Volkswagen’s lone US plant in Chattanooga, with the state’s senator calling for a Senate Finance Committee hearing.

The German government opened its own probe on 15 September. 

Environment Canada also started an investigation, promising unspecified ‘enforcement action’ if the carmaker had cheated in Canada.

Bafin, the German financial regulator, ‘as a matter of routine’ will review the notice of violation from the EPA and market behaviour therein (e.g. insider trading and/or market manipulation).

Prosecutors from the US Justice Department’s Environment and Natural Resources Division will look for evidence of knowing fraud by Volkswagen employees. Given the company has admitted to using ‘defeat devices’ it seems likely we will see a corporate criminal plea by Volkswagen, a criminal fine assessed by the Justice Department, and criminal charges against individuals. 

South Korea is also set to investigate emissions standards on diesel versions of VW’s Jetta, Golf, and Audi’s A3 sedan in October, which will involve about 4,000 to 5,000 vehicles that have been imported to Korea since 2014. The country’s environment ministry did, however, indicate there are no plans at the moment to expand the investigation to other makers or models but ‘will continue to closely monitor the situation’.

Some of the most recognisable private plaintiff law firms in the US have already filed or are assembling lawsuits seeking compensatory and punitive damages for car owners whose vehicles are worth significantly less today than they were last week. Yet another category of suits will seek compensation for shareholders. 

Bloomberg estimates that assuming emissions average 25 times legal limits of 0.05 grams of nitrous oxide per mile, then 482,500 ‘modified’ vehicles equates to about 12 million compliant vehicles.  However, note that in 2011 the EPA estimated a total of 15 million tonnes of nitrous oxide was emitted, such that Volkswagen’s non-compliant emissions equate to less than 0.1 percent of this total.

Closer to home, on 9 October 2015 Volkswagen Australia announced a recall of 91,000 affected vehicles.  Law firm Maurice Blackburn is gathering interest for a class action, and reports state thousands of people have already signed up.

Some risks

The ultimate risk for Volkswagen is the reputational damage and economic cost of this event.

•                Timeframe until fines and damages can be reasonably estimated

•                Recall and obsolescence costs

•                Regulatory fines

•                Civil litigation – current owners have been sold cars that do not perform as they were sold. Once recalled and replaced, consumers will be left with a car that doesn’t perform as they were told it would at initial sale and will potentially use much more fuel in order to remain compliant

•                Legal costs – Volkswagen has appointed US firm Kirkland & Ellis LLP, which also represented BP in the criminal investigation of the 2010 Deepwater oil spill

•                Re-establishment of consumer trust (time taken and extent of repair)

•                Governance credibility (real and perceived)

•                Credit rating stabilisation in light of potentially protracted financial settlement

•                Operational/reputational impact – sales volumes, prices and residual values

•                Management distraction

The future: what next?

Does this signal the peak for diesel engines?

Germany has no plans to review its policy toward diesel technology, with the Environment Ministry saying ‘what matters is that the diesel engine complies with what it promises’ and the Deputy Economy Minister saying ‘it’s not the emission limits that are at fault but adherence to the limits as defined by the law’. 

In the mid-1990s, European governments converted car fleets from gasoline to diesel via generous use of tax preferences. Diesel vehicles now account for more than half of the European Union market.

The motivation was that, although diesel contains more carbon than gasoline, diesel engines burn less fuel: net, switching to diesel ought to give you lower emissions of greenhouse gases. However, the penalty is higher emissions of other pollutants including particulates and nitrous oxide. Curbing those emissions requires expensive modifications to exhaust systems. To facilitate the switch to diesel, the European Union made its emission standards for these other pollutants less stringent for diesel engines than for gasoline engines as the priority at the time was to cut greenhouse gases. 

However, the switch to diesel probably didn’t cut greenhouse gases as cheaper diesel fuel, owing to preferential taxes, encouraged people to drive more. Further, emissions of greenhouse gases higher up the fuel-supply chain are greater from diesel than gasoline. Treating diesel fuel to lower sulphur content adds additional carbon penalty. So it appears the clean-diesel strategy lowered carbon emissions much less than hoped, and at a very significant cost.

Why did VW do this?

Although diesel cars are more fuel efficient, the stricter US emission standards have meant only more recent innovations have enabled diesel engines to meet stringent nitrous oxide standards, facilitated through lower-sulphur fuels and advanced engines. Analysts suggest that reducing nitrous oxide emissions degrades performance with engines running hotter, wearing out more quickly and with lower mileage. In other words, Volkswagen wasn’t able to profitably produce diesel cars with a saleable mix of performance, fuel economy and low pollution. 

How was it so easy for Volkswagen to evade US rules? Were regulators partly to blame?

History of emission test cheating

In the 1970s some cars were found to be rigged with ‘defeat devices’ that turned off the emission systems when the air conditioning was turned on. Others had sensors that activated pollution controls only at the temperature regulators used during emission testing. 

In 1973, the US EPA accused Volkswagen of installing ‘defeat devices’ in cars to be sold in the 1974 model year. Volkswagen then admitted it had sold 1973 model year cars with the devices, which consisted of temperature-sensing switches that cut out pollution controls at low temperatures. The EPA suspected Volkswagen sold 25,000 ‘modified’ vehicles, ending with the company paying a US$120,000 fine without admitting any wrongdoing.

In 1995, General Motors agreed to pay a fine of US$45m after being accused of circumventing pollution controls on 470,000 Cadillac luxury sedans. The cars’ 4.9-litre V-8 engines were tuned to turn off pollution controls when the air conditioning ran. The government alleged the engines installed in the 1991 through 1995 model years released 100,000 tonnes of excess carbon monoxide into the atmosphere, but General Motors disagreed, saying it was paying the fine as part of a conciliatory approach to dispose of enforcement cases more quickly. In addition to paying US$25m in recall costs, the company paid a US$11m fine and agreed to spend US$9m in ‘corporate community service’.

In 1998, 95 percent of the US heavy diesel truck market, including Volvo, Mack, Renault and Caterpillar, were programming their diesel trucks to emit fewer pollutants in laboratory tests than they did on the road. In order to settle the case these companies agreed to spend more than US$1bn, including US$83m in civil penalties, and to undertake projects to offset the excess emissions already made as well as modify these engines to lower emissions.

Comparison with recent US automotive safety cases

In 2014, General Motors agreed to pay US$0.9bn to resolve a Federal criminal investigation of ignition-switch flaws linked to at least 124 deaths and the recall of 2.6 million cars.  So far, no individuals have been criminally charged but prosecutors have said the probe is continuing. The fault was reportedly known to General Motors for at least a decade prior to the recall.

Also in 2014, Toyota reached a US$1.2bn settlement with the Justice Department, the largest-ever US criminal penalty for a car company, concerning cars that allegedly accelerated spontaneously to which nearly 400 wrongful death and personal injury lawsuits arose.

Is European emission testing different from US testing?

Under European requirements, all cars must complete a standard emissions test, which, unlike in the US, is independently witnessed by a government-appointed independent agency.

In the US, the official tests are carried out by the manufacturer and not witnessed by an independent third party. The results are submitted to the US EPA which decides whether to accept them or test the vehicle itself.

The emissions limits set in the US tests are different from those in the EU. The conditions of the test in the US—the driving cycle—are also different to those in the EU.

Starting with model year 2017 vehicles, European regulators will require automakers to test passenger cars on the road in addition to laboratory tests.