An was to go with small diesels in

Aneconomic perspective of the ‘ Dieselgate’ scandal involves much more thannitrogen oxide, competitive pressure and corporate memos. It involvesquestioning the very fabric of ethics and principals of the people running thecompany and under whose watch such a scandal took place. It marks a huge dentin the corporate governance of the companies worldwide and acts as an eyeopener for the people highlighting the importance of an external body tooversee the implementation of governance and ethics in an organisation. Around a decade ago, VKwanted growth pretty badly. It was fighting Toyota and General Motors for thenumber one position in the car market globally.

The obvious place for it togrow was the huge US market, where it had a very minimal market share. Due to thetax incentives in Europe, VW had special expertise in making small dieselengines. Also, these engines produced lesser carbon dioxide than petrol enginesand thus selling them was easier owing to the greenhouse gas rules. Given itscommercial footprint, technical strengths and the regulatory climate, theeconomically optimal strategy for VW was to go with small diesels in the US.

There was one small problem. US rules aboutnitrogen oxide emissions — where diesel is a worse offender than petrol — aretougher than European ones. The technology that enables cars to meet them isexpensive, making it practically impossible to produce a mid-priced car thatpasses muster. While itwas no hidden fact that manufacturers attempted to ‘ work around’ these tests, what was astonishing about VW’s case was the scale and method of theirdeception. The technology that VW used for cleansing Nitrous Oxide emissions involveda trade-off with fuel mileage and performance. For this, the VW’s programmers andengineers decided to mask it by introducing two distinct driving ‘ modes’ intothe car’s software- a ‘ best behaviour’mode that complied with US regulatory emissions requirements, and another forall other circumstances. The car systems were designed smart enough to detectwhether they were undergoing the highly predictable and fancy requirements ofthe US Environmental Protection Agency (EPA)’s tests, and put themselves onbest behaviour accordingly.

The deviation between the two modes wassignificant. The cars emitted up to 40 times more Nitrous Oxide during normalcircumstances than under test conditions. About500, 000 vehicles were affected in the US, spanning the model years 2009-16. Thetactic was used in other markets as well, raising the total number of affectedvehicles to approximately 11 million worldwide.

Commentatorshave said that a key motivator would have been the huge cost savings for VK totake 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 ureafiltering for cleansing diesel fumes of particulates and Nitrous Oxidespecifically and conforming to the stringent emission requirements of the USEPA. By choosing not to license thistechnology from Mercedes, analysts estimate VW could have saved up to$4. 8bn worldwide. The losses suffered by VWDetails oftheir expected quantum emerged in late April from VW’s 2015 Annual Report andthe announcement of an agreement in principle regarding a settlement withUS authorities and class-action lawyers, under which VW reportedly agrees to repair or buy back the cars sold inthe US with the illegal software, and to pay additional compensation. Inaddition, the US Department of Justice has opened a criminal investigation, andcivil, criminal and/or administrative actions have been commenced in many othercountries. VW’s 2015Annual Report announced provisions totalling €16. 4 billion ($18.

4 billion)for the clean-up and legal costs, including €7. 0 billion ($8. 0 billion) dollarsfor “ legal risks” and a further €1 billion ($1. 2 billion) for contingentliabilities.

VW also began a product recall in the EU of cars soldwith affected engines. VW’s stockprice fell rapidly by 40% after this scandal came to light, although itsubsequently regained ground, now wavering at just under 20% down. Thissuggests the market’s estimate of VW’s likely losses is similar to the firm’sprovisions, at around $18 billion.  As a result, it doesn’t seem that VW’scase bucks the trend of purely environmental harms (as opposed to uncompensatedharms to customers) not triggering reputational losses. The Management inactionAny companycheating its customers depends highly on expectations about the probability ofgetting caught, and attitudes to risk. Consider first the (highly implausible)idea that the decision to cheat was in fact deliberately taken by the VKmanagement, knowing well that the benefit would be around $5bn and the costsapproximately $18bn. This would have a positive expected return for VW providedthat the probability of getting caught was less than approximately 25%.

Now considerthe much more plausible position of a CEO who has a whiff that something may beamiss amongst junior engineers. He can either pursue an internal investigation, which would alienate engineers and may reveal wrongdoing or he can do nothingand continue by turning a blind eye to the issue. The real problem is that aninternal investigation would surely increase the likelihood that the firm willget caught for any prior misconduct. If the CEO judges the initial probabilityof getting caught to be low, it is easy to see that it may maximise expectedprofits to turn a blind eye, rather than draw attention to a potentialcatastrophe. The executives, being risk averse, failed to launch an internalinvestigation into extensive emissions cheating by their engineers.

They couldnot comprehend the scale of costs that would come knocking in case of thescandal coming to light and it can be clearly seen how they compromised ontheir long term financial health by only considering the short-term gains andin totality the company suffered a huge blow due to their actions. In corporationswith diversified ownership, high-powered incentives are conventionally deployedin the form of large performance-related variable pay as a means of encouragingmanagers 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 thecriterion laid out. In such a scenario, complications are known to arise whenit comes to compliance with obligations imposed on the company for purposesother than to maximise shareholder wealth – examples being Enron, or the banksprior to the financial crisis of 2008 which also compromised on the spirit ofthe obligations put in place by the regulators in order to maximise their short-termgains. The VW scandalshowcases how such high-powered incentives can be linked to compliance issues, even in firms that are not known to have a culture of pursuing ‘ shareholdervalue’ as their primary objective. Like all large German firms, VW had atwo-tier management board structure. VW’s CEO, Martin Winterkorn, had a paypackage which was heavily tilted towards variable pay.

In 2014, he tookhome €16m ($18. 3m), of which only €2m ($2. 3m), or 12.

5%, was fixedcompensation. The heavy tilting towards performance related pay was commonacross members of VW’s Vorstand, or Management Board. While the executives’variable pay was not linked directly to the company share price, it was tiedclosely to a number of metrics including profits, revenue growth, customersatisfaction, employee productivity and satisfaction. This is consistent withthe publicly-announced goal for VW since many years- “ growth” i. e., To makeVolkswagen the largest car maker by sales in the entire world, which itironically achieved in the first half of 2015, only to lose again it inthe wake of the scandal and witness a dramatic fall.

Financialincentives were not the only high-powered incentives acting upon senior VWexecutives. There would also have been intense monitoring by the Aufsichtsrat, or Supervisory Board. Unlike Anglo-American corporations’ boards, the members ofGerman supervisory boards are the representatives of major shareholders and theirlabourers. VW’s Aufsichtsrat of 21 had 5 members appointed by the Porschefamily, the majority shareholder, 2 appointed by the Qatar Sovereign wealthfund (which has a 17% stake), 2 appointed by the state of Lower Saxony (havinga 20% stake), 10 appointed by employees, trade unions, and middle management. The other two comprised the Supervisory Board’s venerable former Chairman, anda single independent. Growth was an ambition that unanimously appealed to bothstakeholder groups dominating the Aufsichtsrat- the controlling shareholders aswell as the employees.

Surprisingly, the bias toward performance pay was shared by VW’s Aufsichtsrat. The Chair ofthe Aufsichtsrat, until April 2015 Ferdinand Piëch, took home €1. 5m in2014, of which only €200, 000 (13%) was fixed; this ratio was similar across theentire Aufsichtsrat. The Aufsichtsrat’s variable pay is expressly linked by §17of VW’s Satzung, or Articles of Association, to shareholder dividends. AlthoughEuropean executives are usually expected to earn lesser than their counterpartsin the US, it is worth noting that Winterkorn’s package was similar to thetotal salary amount earned by Mark Fields, the CEO of Ford ($18.

6m) andmore than that of Mary Barra, the CEO of GM ($16. 2m), in the same financialyear. Financial incentives and close monitoring of performance is likelyadditive in terms of their impact on executive behaviour. Thus the intensity ofthe combined incentives might have been even stronger than those faced by a USexecutive. In short, high-powered incentives can give rise to perverseincentives in firms without dispersed share ownership, and where performancetargets are not defined solely by reference to the share price. What alsoemerges starkly from the VW affair is the importance of distinguishing betweenagency costs and externalities in issues of corporate governance. Conflicts ofinterest between managers and shareholders are an agency cost.

But so too areconflicts of interest between employees and shareholders. Harm caused to theenvironment, or any other interest external to the corporation, however, is anexternality. Simply because a company’s structure is designed—as codeterminationdoes in Germany—to minimise agency costs between shareholders andemployees—does not necessarily imply that it will be less problematic in termsof externalities. Corporate decisions that for instance harm the environment orare ethically wrong but lead to corporate growth benefits both investors andemployees. Lessons of corporate governancefrom VW scandalThe VWscandal has clearly put the spotlight on the appropriate use of high poweredincentives and the lessons that can be learnt by all companies in this regard. The most startling implication however would be the need for effective personalliability of individuals who either deliberately engage in misconduct, or thosewho fail to ensure ethical practices by the entire organisation.

The deterrentsfor the former, which amounts to criminal liability, is already in place inmost jurisdictions, but suffers from serious issues of substantial proofrequirements. The latter, however, which would take the form of negligencebased liability, has a lot of potential to be further emboldened. A healthysystem of checks and balances to ensure the latter is effectively deterredcould go a long way in avoiding such disasters for organisations. Anotherpossibility might be to contemplate public enforcement of directors’ dutiesunder these circumstances. This model is adopted in Australia, where ASIC haspower to enforce directors’ private law duties. Allthis presupposes some guidance as to what sort of actions such oversight shouldinvolve. Here we move into the realm of ‘ risk management’.

The VW case has somevery interesting pointers about this too. The striking thing about the VW caseis how the actions of a small number of technical personnel can lead to harmsaffecting 11 million vehicles. It also shows how eternal vigilance is the priceof long term successful growth devoid of any ethical misdemeanour and how evena small negligence on part of those in charge can have serious repercussionsfor a company in terms of irreparable damage to its reputation as well as thehuge mountain of financial burden stemming from such a scandal.