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Dieselgate:

What it means for the automotive industry

page 2 October 2015

Table of Content

1 FOREWORD ............................................................................................................................................ 3

2 VOLKSWAGEN’S DIESEL EMISSION SCANDAL ......................................................................................... 4

2.1 STATUS QUO ..................................................................................................................................................... 4 2.2 EMISSION LAWS IN THE US AND EUROPE ................................................................................................................ 6 2.3 TECHNICAL VIEW ............................................................................................................................................... 8 2.4 LEGAL VIEW .................................................................................................................................................... 11 2.5 VOLKSWAGEN VIEW ......................................................................................................................................... 12 2.6 POTENTIAL REMEDIAL ACTIONS ........................................................................................................................... 13

3 IMPLICATIONS FOR THE WIDER AUTOMOTIVE MARKET ...................................................................... 14

3.1 IMPACT ON VEHICLE MANUFACTURERS ................................................................................................................. 14 3.2 FUTURE OF DIESEL ............................................................................................................................................ 16 3.3 IMPACT ON NEW VEHICLE SALES .......................................................................................................................... 17 3.4 IMPACT ON USED VEHICLES SALES AND RESIDUAL VALUES ......................................................................................... 18

4 POTENTIAL IMPLICATIONS FOR VOLKSWAGEN .................................................................................... 20

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1 Foreword

This whitepaper was written at the end of September 2015, fewer than two weeks after the first headlines appeared about “Dieselgate” – the scandal that revealed Volkswagen had installed a “defeat device” on EA189 diesel engines fitted to around 11 million vehicles. Here, we evaluate the implications for the automotive industry based on the best information available at the time of writing, both from public sources and industry experts who have usually chosen to remain anonymous. While the focus of this paper is on Europe, the situation in the US is referenced where it is likely to have major repercussions for the European market.

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2 Volkswagen’s diesel emission scandal 2.1 Status quo

Volkswagen has now have admitted that engine management software in cars fitted with EA189 diesel engines was manipulated with a “defeat device” to cheat US emissions tests. The software determined when the car was being tested and adjusted engine characteristics for a so-called “dyno mode” to ensure that US EPA1 emission standards were met. In real world conditions, with the software operating normally, vehicles actually emitted substantially more nitrogen-oxide (NOx), a highly dangerous pollutant. The company’s initial internal evaluation has revealed that globally, 11 million vehicles built between 2009 and 2014 have been equipped with this engine type and software. Most of these were sold in Europe. Certain models and model years of these vehicles (such as Volkswagen’s Golf VI, Passat VII and Tiguan I) are equipped exclusively with type EA189 diesel engines. In Europe, this affects the vehicle generations compliant with Euro 5 but not the newer Euro 6 compliant ones (such as the Golf VII, Passat VIII and Touran II models). Broken down by brand, about 5 million Volkswagen brand cars, 2.1 million Audi brand cars (A1, A3, A4, A5, A6, TT, Q3 and Q5), 1.2 million Skoda and an, as yet, undisclosed number of SEAT brand cars are affected by the diesel emissions scandal. Additionally, about 1.8 million VW commercial vehicles carry the defeat device. About 2.8 million affected Volkswagen Euro 5 vehicles were sold in Germany alone, and 1.42 million Audi vehicles are affected in Western Europe, with 577,000 in Germany and almost 13,000 in the U.S. However, it may be worth bearing in mind that some reports question whether the manipulated software has actually been activated in all vehicles and therefore its effect on emissions during different type approval processes.

1 United States Environmental Protection Agency

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Tab. 1. Breakdown of registrations of vehicles with EA189 engine (source: IHS) What has been the manufacturer’s reaction so far? Volkswagen is occupied creating a plan for how it will fix vehicles containing the defeat device and said in a statement on 25 September: "We are working intensively on remedial measures in close coordination with the certification authorities. The vehicles are and remain technically safe and roadworthy." And what has been the reaction of the authorities? EU nations have stepped up scrutiny of diesel cars sold by the automaker. In Volkswagen’s home market Germany, where the bulk of the affected diesel cars are on the road, the transport agency (KBA) has set a 7 October deadline for Volkswagen to present a plan to bring diesel emissions into line with the law2. If Volkswagen fails to satisfy them, the KBA will withdraw type approval for the cars involved, which means they can no longer be sold or driven. A Volkswagen spokesman said: "It is in our strongest interest to provide clarification here as soon as possible. We will inform the KBA about what we are doing and the talks are occurring on the highest level." France has said it will carry out testing on its roads to establish whether vehicles are equipped with banned software of the kind used by Volkswagen. Italy will test 1,000 Volkswagen Group brand cars, its transport minister said.

2 Source: Frankfurter Allgemeine Zeitung, 27 September 2015

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Volkswagen’s Italian unit advised its dealers to stop selling affected cars which would quarantine a stock of around 40,000 vehicles3. In Belgium, Volkswagen's distributor, D'Ieteren Auto, said it has stopped the sale of affected vehicles. Their combined stock amounts to around 3,200 vehicles. The Swiss authorities have said they are suspending sales of Volkswagen diesel vehicles that could contain devices capable of cheating emissions tests, including Audi, Seat, Skoda and Volkswagen brand vehicles built between 2009 and 2014. They said this could affect 180,000 vehicles. The UK's Department for Transport is re-running vehicle tests and investigating the regulatory failure that allowed Volkswagen to use the defeat devices to conceal high emissions, it said in a statement on 25 September. Other countries that have either announced that they will start testing or asked for clarification from Volkswagen include Australia, Canada, India, New Zealand, South Africa and South Korea. Volkswagen said there had been no instructions from company headquarters in Germany to dealers to stop selling the affected cars, but sales units in individual countries had the right to take such decisions on their own.

2.2 Emission laws in the US and Europe

In the following paragraphs, this paper outlines the main emissions regulations in the US and Europe. In 1999, EPA issued new tailpipe emission standards called Tier 2. These set an average standard of 0.07 grams per mile for nitrogen oxides (NOx) for all classes of passenger vehicles beginning in 2004. This includes all light-duty trucks as well as the largest SUVs. For the heaviest light-duty trucks, the program provided a three-step approach to reducing emissions, starting with a maximum of 0.6 grams per mile (gpm), a more than 60% reduction from previous standards. Secondly, these vehicles were required to achieve an interim standard of 0.2 gpm to be phased-in between 2004 and 2007. Thirdly, in the final step, half of these vehicles were required to meet the 0.07 standard by 2008 and the other half by 20094.

3 Source: Corriera della Sera, 27 September 2015 4 Source: EPA's Program for Cleaner Vehicles and Cleaner Gasoline, Regulatory Announcement,

December 1999

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In April 2014, EPA issued their Tier 3 standards which will be effective as of 2017, reducing the combined NMOG+NOx limits to 62.8 mg/km (2017) and further down to 18.6 mg/km by 20255. Europe has followed a similar approach while allowing generally higher levels of emissions. Euro 6 will bring NOx levels down to US Tier 2 levels shortly before the US Tier 3 standards come into effect.

Tab. 2. Comparison of US and European emission standards for passenger cars6

5 Source: EPA: Control of Air Pollution from Motor Vehicles: Tier 3 Motor Vehicle Emission and Fuel

Standards; Final Rule, April 28, 2014 6 Source: TransportPolicy.net

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Emission limits for Passenger

Cars

U.S. Europe7 Tier 2 Tier 3 Euro 5 Euro 6 2004 2017 2009 9/2014

NOx 70mg/mi (=43.5mg/km)

180mg/km 80mg/km in NEDC testing cycle, RDE8 testing as of 2017

NMOG9 + NOx 2017: 101mg/mi (=62.8 mg/km) 2025: 30mg/mi (=18.6mg/km)

THC+NOx 230mg/km 170mg/km CO 4.2g/mi

(=2.6g/km) 1g/km (petrol) 0.5g/km (diesel)

1g/km (petrol) 0.5g/km (diesel)

Tab. 3. Comparison of US and European emission standards for passenger cars

2.3 Technical view The exhaust emissions standards for new cars, both in the US and Europe, have effectively required fitment of a range of new technologies. The first of these was the diesel particulate filter (DPF) in the exhaust of diesel cars when Tier 2 and Euro 5 standards came into force. In fact, many cars registered before 2009 had one fitted in anticipation of the change. With stronger emissions regulation, Lean NOx Trap (LNT), Selective Catalytic Reduction (SCR) and EGR (Exhaust gas recirculation) have become the most prevalent technologies for the control of NOx emissions from diesel passenger cars. LNTs predominate in combination with smaller engines. However, in the US, due to Tier 2 and Tier 3 legislation, a number of OEMs have been forced to reduce the use of LNT significantly and introduce SCR instead. In contrast, in Europe, many OEMs are still using LNT and will switch later to SCR systems when comparably rigid emission limits are introduced in the EU. For example, BMW equips all their diesel vehicles in US with LNT plus SCR but not on the European market. The US systems tend to perform better but are also more complex and expensive.

7 Source: Federal Environmental Agency Germany, 24 June 2013 8 Real-driving emission 9 Non-methane organic gases

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As with any filter, LNTs catalysts “trap” NOx. Through a process called regeneration, either active, passive or forced regeneration, the accumulated NOx is reduced to pure nitrogen (N2). LNTs enrich hydrocarbon (HC) in the exhaust gas upstream of the catalyst by injecting diesel fuel into the exhaust gas or by shifting the combustion to a mode in which more HCs are produced at engine outlet. NOx storage capacity is limited in LNTs and therefore this process has to be operated frequently. However, SCR catalysts have a higher NOx loading capacity. By injection of urea (called “AdBlue”) a chemical reaction with NOx can be triggered, which allows a complete regeneration of the SCR catalyst. It does not increase the fuel consumption but the urea has to be stored in a separate tank and injected into the exhaust gas via a separate pump and injection device. OEMs instruct drivers to visit a professional mechanic for refilling, usually within the regular service period. Both methods use load models which monitor the remaining capacity of the catalyst via oxygen, temperature and NOx sensors in the exhaust gas and which control the initiation and length of regeneration. Combined LNT/SCR systems exploit the NOx reduction opportunities in different optimized operation conditions and help to meet the challenging US emission standards – for example, by LNT being heated up quicker after start and hence quicker reducing NOx than SCR systems, which are usually located nearer to the tailpipe and need more heating energy to come to optimized operation points.

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Tab. 4. Overview of main technologies for the control of NOx emissions from Euro 6

passenger cars10;11

10 Source: ICCT, NOX Control Technologies for Euro 6 diesel passenger cars, September 2015 11 Source: ICCT, September 2015

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When engineering their powertrain, vehicle manufacturers typically have to deal with a number of trade-offs: • The higher an engine’s performance, the higher the requirements for exhaust

after-treatment in order to meet standards • The larger, the more complex the after-treatment (e.g. LNT + SCR, or larger

the filter), the more space is required and the higher the costs • The more regeneration cycles of the LNT are required to hit NOx standards,

the higher the fuel consumption and CO2 emissions • The more additives (urea, also marketed as AdBlue) are required to meet

NOx standards, the more often the vehicle has to be taken to a mechanic

2.4 Legal view Volkswagen has acknowledged that the defeat device is illegal. According to Germany’s Bild am Sonntag12, Robert Bosch warned Volkswagen in 2007 that it would be illegal to use engine management software in the production cars. Frankfurter Allgemeine Zeitung reported13 that Volkswagen was also warned by one of its own engineers in 2011 about illegal emissions testing practices, citing initial results of Volkswagen’s internal investigation. Volkswagen finds itself exposed to several legal challenges: • The EPA is expected to fine Volkswagen for the unlawful use of the defeat

device. Expert consensus now seems to be around US $7-8 billion although some initial estimates suggested up to US $18 billion.

• Fines at U.S. state level. • Consumer lawsuits and class actions are underway. There are already more

than 40 class actions pending in the US from consumers seeking compensation from Volkswagen. Depending on the type of remedial actions Volkswagen take, the prosecution case may become stronger. For example, if the technical fix involves reducing engine performance.

• Norway’s Economic Crime Unit has opened an investigation and Sweden’s National Anti-Corruption Unit is considering a probe.

• In South Korea, India and South Africa, government organisations have announced that they will test VW vehicles.14

12 Bild am Sonntag, 28 September 2015 13 Frankfurter Allgemeine Sonntagszeitung, 28 September 2015 14 The Telegraph, 30 September, 2015

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• It remains to be seen if government organisations in other geographies can and will follow the EPA’s course and try to fine Volkswagen. Generally, the legal situation is far less clear than in the US.

2.5 Volkswagen view

At this point, it is not yet clear why Volkswagen resorted to the defeat device in order to pass the Tier 2 standards in the US but the key hypotheses are: • Volkswagen has had the declared goal to become the global number one

vehicle manufacturer by 2018. Volkswagen of America’s market share had fallen short of expectations for a long time and Volkswagen had become increasingly desperate to finally make major inroads into the world’s second biggest passenger car market. Green diesel, driving performance and the quality of German engineering were identified as key pillars of the Volkswagen campaign.

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Tab. 5. Audi commercials in US, TV and print

• The production costs of Volkswagen group vehicles were higher than those

of competitors thus putting cost pressure on engineers. More recent evidence seems to suggest that Volkswagen engineers had actually developed a urea-based exhaust after treatment system by 2007 which eventually was not included in EA 189 due to the incremental costs of around 200-300 Euro it would have added.

2.6 Potential remedial actions

Volkswagen now has to ensure that the EA189 engine complies with emission standards. In light of a recall of around 500,000 vehicles in the US in December 201415, it seems unlikely that a software update to the ECU alone will solve the issue without causing a substantial deterioration in vehicles’ performance or driving up fuel consumption. The latter would increase the likelihood of class actions being successful and would in the long run further dent Volkswagen’s reputation. So, in all likelihood, Volkswagen will have to resort to physical changes, at least for some car lines. The interesting remaining question is whether all affected models will allow this sort of change – for example, whether there is enough space to introduce a larger DPF?

15 Source: The Guardian, 26 September 2015

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3 Implications for the wider automotive market 3.1 Impact on vehicle manufacturers

While Volkswagen is in the centre of the diesel test cheating furore, other OEMs have, for now, publically denied any wrongdoing. Although John German of ICCT – the initial US whistleblower - also tested a BMW X5 and published in the same report that it kept all legislative requirements in real world driving, this positive result did not prevent all German automotive stocks suffering noticeably since the Volkswagen problem surfaced.

Tab. 6. Share price movements of major OEMs and EuroStoxx 600 auto index May-Sep 2015 These stock price movements are likely driven by two concerns: • Other OEMs may also find themselves in the spotlight as research ramps up

further scrutiny of emission test results. • Pressure from regulators on OEMs to introduce emission-reducing

technologies faster could mount, thus increasing OEMs’ cost base. An accelerated introduction of more rigid testing cycles and/or tighter standards could mean that OEMs have to improve NOx emission within existing model lifecycles, potentially forcing them to introduce improved exhaust after-treatment equipment or even new engine generations. In a number of cases, this challenge will be more complex than anticipating this level of change in a new model generation.

Stocks of automotive suppliers with diesel activities such as Continental, Faurecia, etc. have also suffered, indicating widespread concerns about the future of diesel. In addition, the entire automotive industry has suffered from a credibility issue. While there has been, for some time, increasing evidence of a widening gap between real-life and type approval test emissions, the negative PR impact has

figures 2015 May 29 June 30 July 31 Aug 31 Sep 29% change May - Sept

% change Aug - Sept

STXE 600 Automobiles & Parts Index 634.9 € 610.2 € 581.8 € 526.0 € 464.8 € -27% -12%Volkswagen AG 219.5 € 207.6 € 184.5 € 166.7 € 105.0 € -52% -37%AUDI AG 752.0 € 785.0 € 838.0 € 800.0 € 670.0 € -11% -16%BMW AG 100.7 € 98.2 € 91.3 € 82.2 € 79.2 € -21% -4%Daimler AG 85.3 € 81.6 € 81.4 € 71.7 € 64.9 € -24% -10%Fiat Chrysler Automobiles N.V. 14.6 € 13.4 € 14.3 € 12.6 € 11.6 € -21% -8%Ford Motor Co. 14.0 € 13.0 € 13.8 € 12.1 € 12.2 € -13% 1%General Motors Co. 32.7 € 30.0 € 28.7 € 26.2 € 26.6 € -19% 1%Toyota Motor Corp. 62.0 € 59.8 € 60.3 € 52.9 € 51.9 € -16% -2%

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so far been negligible. However, ever since Dieselgate grabbed the headlines, research and lobby groups have tried to gain benefit from the current attention. For example a report from Transport & Environment (T&E), working closely with the European Commission, said that “its data did not prove other carmakers were using such devices…but that the gap between lab results and road performance for emissions had grown...to such extent that further investigation was needed to discover what carmakers were doing to mask CO2 emissions.” The widening gap affects many OEMs and carlines as the following chart shows. However, according to the European Automobile Manufacturers’ Association (ACEA), representing OEMs, there is no evidence that using such illegal software such as defat devices is an industry-wide issue.16

Tab. 7. Divergence between real-world and manufacturers’ type-approval CO2 emissions for

various real-world data sources, including average estimates for private cars, company cars, and all data sources17

16 Source: Reuters, 28 September 2015 17 Source: ICCT, “From laboratory to road”, Whitepaper September 2015

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Tab. 8. Gap between official car CO2 tests and real world emissions in 201418

3.2 Future of diesel

During the first days of the crisis, it was unclear whether other OEMs would be implicated. Consequently, some industry experts asked the question whether this scandal could ultimately lead to diesel disappearing in the short-to-medium term. Certainly, in the US it is unclear whether only Volkswagen’s diesel aspirations have been bruised although the BMW X5 proves that a technological solution compliant with US legislation is possible for a high-end segment vehicle. Nevertheless, the VW case has initiated a campaign which has the potential to jeopardise an entire technology in the U.S. market without an adequate discussion taking place about the pros and cons of the exhaust gas treatment technologies available. As far as Europe is concerned, diesel has a strong heritage, fuel price subsidies and CO2-based taxation regimes in some countries. These have contributed to a TCO advantage, in particular for consumers driving higher annual mileages.

18 Source: European Federation for Transport and Environment AISBL, based on ICCT data, September 2015

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The current discussion is currently masked by emotions rather than facts. An extension of the ICCT approach to other OEMs and vehicles may well reveal the legal compliance of the OEM certification practices and the current state of technology for vehicles running on American and European roads. European and US certification authorities failed to detect VW's illegal practice for a long time and should take this case as an impetus to extend their control activities and improve their detection performance in future. The question now is whether regulators will maintain their stance or gradually distance themselves from diesel. This will largely depend on whether public opinion changes due to “Dieselgate” and how successfully the strong diesel engine lobby operates. It is too early to say, but the risk that the tipping point has been reached has increased. If governments remove tax advantages for diesel, the business case for diesel suffers especially if costs for after-treatment rise. Needless to say, any impact on diesel popularity would be a blow to manufacturers’ efforts to meet the European 2021 emission target of 95g CO2 per km. They have heavily relied on diesel to help them reach the target. This is despite the fact that public discussions on the impact of diesel emissions on human health have been ongoing for years, culminating in the Mayor of Paris announcing radical plans to ban diesel cars from the French capital by 2020, driven by environmental concerns. Some governments in Europe, such as the Netherlands, have had taxation schemes in place for years that favour petrol and hybrid engines over diesel engines. This has had a negative effect on diesel popularity on new and used car markets and has already led to a decline in diesel residual values of 6% between 2010 and 2014, a trend likely to continue as the unfavourable scheme continues to be tightened. The next two sections scope out the impact of two potential scenarios, one called “Straw Fire” and one titled “Diesel Sell-Out”. Watching and analysing how the story finally plays out will keep large parts of the automotive industry busy during the next months, including ourselves.

3.3 Impact on new vehicle sales Scenario “Straw Fire” What we will read in the press in six months: Much reduced coverage. What happens: Volkswagen takes full accountability to provide the required degree of transparency and offers comprehensive solutions for its 11 million affected vehicles and customers. No major new revelations occur. Announcements are made that the real-life emissions test cycles will be brought forward and OEMs claim to welcome it. Buyers continue to have

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favourable opinions of the qualities and longevity of the diesel engine. Regulations in the main European markets remain unaffected by the scandal. No current diesel tax advantages - on fuel or on vehicles - are substantially cut or even removed. Implications for Europe: We should see only a marginally negative effect for diesel sales in Europe and markets rebound. Our current verdict on the likelihood: Medium-to-high

Scenario “Diesel Sell-Out” What we will read in the press in six months: Dieselgate reduces demand for diesel models for good. What happens: Dieselgate continues to produce new revelations and the press coverage remains substantial, not just covering Volkswagen. Regulatory bodies and governments feel the pressure to take a stricter stance on diesel fuel. Further cities announce plans for diesel bans or introduce congestion charges for diesel engines. Buyers’ opinions shift towards petrol engines. In combination with forthcoming cost challenges, OEMs abandon diesel (to concentrate their development efforts on petrol engines) and push forward adoption of alternative powertrain solutions. Implications for Europe: During the past six years, diesel market penetration has already dropped substantially in many markets (In Spain, France and Belgium from 70%+ to low 60% levels). In the UK, in Germany and in Italy, diesel engine penetration rose during the same period and is at around 50% presently (Italy is 55%). Should France and Spain hit the 50% diesel share in 2016, which would be substantially quicker than the trend suggests, this alone would result in a drop of diesel sales by more than 300.000 vehicles (passenger car registrations). Manufacturers will need to sell off some of their cars in stock at discounts, effectively reducing the overall price levels in the market. Some of the drop in demand for diesel will be compensated by petrol-fuelled vehicles but will unlikely fully compensate the volume loss. Our current verdict on the likelihood: Medium-to-low.

3.4 Impact on used vehicles sales and residual values Under the “Straw Fire” scenario we would expect no major impact on the number of expected used car sales. The slight and shorter-term decrease in supply of diesel vehicles on the new car market will positively affect price realisation on the used car market. We believe that under this scenario the traditionally more rational and price-sensitive used car buyer will be confronted with a reduced supply of attractive vehicles and thus willing to pay a small premium. As a consequence, diesel residual values may even slightly improve for a short period of time until supply/demand balance is restored.

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Under the “Diesel Sell-Off” scenario, we would expect a similar relative drop in demand for used vehicles as for new vehicles. The fall in demand on the used car market will be accompanied by a high supply of vehicles as registrations from 2010-2014/2015 will hit the used car market in 2015/2016. While it is too early to put a percentage value against the drop in residual value, one should note that Europe’s economic crisis of 2008/2009 resulted in RVs dropping around 14% across Europe on average across segments. RV losses had recovered by 70% by the end of 2011 but some segments lost 25% of residual value in few months. However, older vehicles, where used car buyers are even more price sensitive, would be less affected by the scenario.

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4 Potential implications for Volkswagen “Under my leadership, Volkswagen will do everything it can to develop and implement the most stringent compliance and governance standards in our industry. If we manage to achieve that then the Volkswagen Group with its innovative strength, its strong brands and above all its competent and highly motivated team has the opportunity to emerge from this crisis stronger than before.” Matthias Mueller, new CEO of Volkswagen Group 19 Given the importance of its brand, we believe that Volkswagen will aim to address the issue comprehensively, even if this means substantial costs. Analyst consensus seem to be that Volkswagen will need to raise capital if total costs for remedial actions and fines exceeded Euro 12 billion. At this point, Volkswagen has made provisions for Euro 6.7 billion. Subject to the size of the capital raised, Volkswagen would also have to issue ordinary shares at which point the Porsche/Piech families, the state of Lower Saxony or Qatar would have to step in. Irrespective, Volkswagen is expected to cut costs in all areas that are seen as non-strategic to soften the blow for its shareholders. The big unknown in this context is the reaction of consumers to Volkswagen’s current negative publicity. Have the affected brands been sufficiently damaged to depress sales volumes in the medium-to-long term on new and used car markets? We believe that it is premature to present firm conclusions at this point. A lot will depend on how well Volkswagen handles the recall of up to 11 million affected vehicles and whether new revelations hit the market during the next days and weeks. In the short term, there will definitely be a major impact as sales of affected vehicles have been suspended in most countries. Consequently, Volkswagen, importers, and franchised dealer networks will focus on alternative power sources such as petrol, alternative drive trains and potentially even larger diesel engines. For some customer groups, these alternatives will be of limited attractiveness (for example, fleets where diesel engines are mandatory per se or for drivers with high annual mileages due to TCO disadvantages. It is therefore safe to assume that Volkswagen will suffer volume losses. An OEM’s natural reaction will be to contain the negative impact by using incentives. This will have wider repercussions on the automotive community as the price competition intensifies. Increased discount levels on new cars typically have a negative impact on used vehicle prices within a matter of a few weeks.

19 Matthias Mueller, press release following his election as CEO Volkswagen group