Why the VW Diesel Scandal Happened

Do you remember where you were when you first heard about Watergate? (OK, maybe you weren’t born yet.) How about Chris Christie's "Bridgegate" in New Jersey? How about Congressman Anthony Weiner sexting pictures of his ... Anyway, the point is obvious, "What were they thinking?"

The same applies to TDIGate, a mushrooming crisis that is hugely affecting the sprawling Volkswagen conglomerate. How could VW have thought it could possibly get away with such a gigantic fraud, involving 11 million VW Group cars worldwide (and 500,000 in the U.S.)? And why did the company think it was necessary? Here’s my take.

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A few weeks ago, I saw CEO Martin Winterkorn, having survived a bloody internal battle, riding high as he introduced a new and exciting (and proudly electrified) product line. Just months before, he’d been happy to learn that VW had overtaken Toyota as the largest automaker in the world, with more than 5 million cars sold worldwide.

Winterkorn didn't have long to bask in the company's success, because even as he took his bows in Frankfurt, he knew this scandal was brewing.

Like all VW executives, Winterkorn was obsessed with the companys failure to prosper in the key U.S. market. In fact, he almost lost his job in the spring in a dispute with former Chairman Ferdinand Piech, who accused Winterkorn of being responsible for the low U.S. numbers.

VW was holding on to a perhaps unrealistic sales goal (first articulated in 2007) of 800,000 cars annually in the U.S. by 2018. But despite some fairly strategic moves — building the Jetta in Mexico, launching a new SUV to come out of the gleaming, eco-friendly plant in Chattanooga — actual 2014 U.S. sales of 366,970 were not far off from what they'd been in 2011.

So what was the answer? For VW, a big part of it was diesels, and the company had a winner in the four-cylinder Golf (with 36 mpg combined, and 43 on the highway), Beetle TDI (34 combined, 41 on the highway) and Jetta TDIs (36 combined, 46 on the highway). Let's look at the numbers. Diesels are subsidized in Europe, and more than half the cars on the road are so powered. But the U.S. sales were pretty good, too — Audi and VW together have 39 percent of all U.S. diesel sales. And nearly a quarter of its new car sales are diesel, too.

So a strategy of convincing Americans to go TDI made sense, and VW went all-out with the marketing and the celebrity-laden ads. I went to a New York launch that featured Katy Perry. VW could have invested heavily in hybrids, like most other manufacturers, but it remained convinced that Americans would get the message on diesels (only 2 percent of the market now).

I've had many German engineers waving fingers in my face explaining why diesels are "greener" than hybrids or electric cars. VW, in fact, offers the all-electric e-Golf (a solid entry) and the Jetta Hybrid (with 48 mpg on the highway), but in discussions around the world it always steered the message back to the advantage of diesels.

So what happened, I'm convinced, is that VW — desperate to increase U.S. sales — decided it needed to make the Golf/Jetta/Beetle TDI offer even better by combining great fuel economy with scratch-your-head stellar emissions numbers. And it could keep the price low if the three cars (plus the Audi A3 diesel) seemingly achieved those goals without the urea injection system that brought the nitrogen oxide (NOx) numbers down on bigger cars, like the Tiguan and Passat.

Frankly, it can't be done, not with current technology, and that's why VW resorted to trickery it had already been fined once in the U.S. (back in 1973). It turns out there's a long history of automakers using these "defeat devices" to turn off pollution controls while the vehicle is on the highway (and back on during emissions testing). The relatively small fines and brief media black eyes are outweighed by the sales increases and good word-of-mouth.

I think this is what happened, but I still can't believe they’d do something so incredibly risky, so easily detected. This was the biggest automaker in the world, with an unimpeachable reputation! All the International Council on Clean Transportation (ICCT) had to do was test a TDI on the road, and then under standard test conditions, and they'd see big discrepancies.

What happened was this: ICCT proposed a study, funded at just $50,000, and farmed it out to an engineering team under Daniel Carder at West Virginia University (just five of them, including graduate students). "The testing we did kind of opened the can of worms," Carder told Reuters. "(We) saw huge discrepancies. There was one vehicle with 15 to 35 times the emissions levels and another vehicle with 10 to 20 times the emissions levels."

And with that, VW came crashing down. The stock, at $170 a share a month ago, now trades at $100. The company's market value declined $28 billion in one week. Because of a basis of a $50,000 study.

There are no easy-outs for VW here. This isn't a manufacturing defect; it's fraud. The EPA is demanding that the cars be fixed, but that will cut into their performance and fuel economy. Sales of new cars — stopped now — won't easily recover, and as used cars right now they're very dubious prospects.

The U.S. Public Interest Research Group thinks VW should compensate customers, paying TDI owners what their cars were worth before the scandal. According to the New York Times, buying back all 482,000 TDIs affected would cost the already beleaguered company $7.3 billion. VW has already set aside that amount, so maybe it will go that route — but even then consumer confidence will still be shaken.

Touring the Chattanooga factory site, seeing, state-of-the-art paint facilities and the acres of solar panels providing power (in lieu of a landfill gas scheme tried earlier), I definitely got the sense of a company leading on the environment. That's in tatters now.

Ironically, in Frankfurt, the VW Group's message was that it was finally willing to invest in an electric car strategy. The Audi e-tron quattro and the Porsche Mission E, both due by 2018, are both high-performance battery vehicles with huge Tesla-challenging range. Frankly, I was surprised no automaker, German, Japanese or American, hadn't tried this strategy earlier. Even now, it's a sound strategy for VW.

Tesla's Elon Musk is probably amused by all this. Indeed, he told reporters in Belgium after the scandal broke that the German automakers problems prove that "we've reached the limit of what’s possible with diesel and gasoline. The time has come to move to a new generation of technology." Dismissing Tesla (and electric cars in general), the standard line has been that we could get to the same place with improvements to internal combustion. Now that dog can't hunt.

VW's deception shows that hitting the fuel economy and emissions numbers with conventional technology may require faking it. As Fortune puts it, "We are entering an era of cataclysmic innovation that will force many automakers out of business and others to abandon their incremental tweaking of technologies like the diesel engine."

Here's Elon Musk in his Belgian press conference. Sorry about having to wade through the foreign languages, but Musk himself is in English, speaking his mind on the VW scandal:

https://www.youtube.com/watch?v=zQC_EYEiQ0I