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VW’s Deepwater Horizon?

Last week one of the biggest environmental scandals since the Deepwater Horizon disaster made its way to somewhere near the bottom of page 11 of most major newspapers. VW admitted to systematically cheating on emissions tests of its Diesel vehicles. This might sound snoozy, until you read up on the details.

vw-headquarters1
Photo courtesy of http://www.inautonews.com/labor-leader-says-vw-ag-can-do-without-a-chairman-for-a-while

Vehicles across the US must satisfy emissions standards for criteria air pollutants (e.g., NOx, SOx, CO2). California, of course, has the most stringent of these standards and enforces them for new and used vehicles. If you have an older car, you need to go get your car smog checked every few years to make sure your clunker is still clean enough to be allowed on California roads. It is for this reason that until recently the share of Diesel cars in California was extremely low, since almost no vehicles satisfied these stringent standards. In come the “clean Diesels”, pushed mainly by German manufacturers of normal people (e.g., VW) and luxury (e.g., Mercedes and BMW) vehicles. Diesel was finally salon worthy! Look! It’s fuel efficient and clean! Many of my Birkenstock-wearing, dog-owning, El Capitan-summiting colleagues and graduate students ran out and traded in their Prii for the VW TDI wagon. So much space! So much torque! So much fuel efficiency! So much clean! Well, it turns out what sounded too good to be true was.

In a Lance Armstrongian feat of deception, VW has now admitted to having installed a piece of software called a “defeat device” that turns on the full suite of pollution control gadgets when cars are being smog tested. As soon as you leave the testing station and head out for your Yosemite adventure with Fluffy barking in the back, your car emits 10-40 times (!!!!!!!!!!!) the amount of NOx you just reported on your smog check card. Just to put this in perspective – this is like that 215 calorie Snickers bar having 2150-8600 calories instead. The EPA will almost certainly sue VW. The penalties involved here are significant. The EPA can ask for $37,500 per incident, which amounts to roughly $18 billion in fines. Plus there will likely be criminal charges filed against VW executives. Further, depending on whether these vehicles will continue to be sold in the US after everything is said and done, this is a disaster for VW as they rely heavily on the high fuel efficiency ratings of Diesels to satisfy CAFE.

In my eyes there are two interesting economic points to be made here. The first, maybe more headline worthy, is trying to determine the optimal fine in order to deter other manufacturers from engaging in such behavior. An economist would argue that what we have here is the classic case of an externality. By selling the dirtier vehicles, VW exposed kids, adults and dogs to massive quantities of local air pollutants. VW is responsible and should be liable for this. Hence VW should correct this market failure by paying the full external costs it caused. This calculation would involve estimating the economic damages from this additional air pollution and passing the bill on to VW. My back of the envelope calculation suggests that for the NOx portion this is about $232 per vehicle over three years (far from $37,500).

But, there is a large law and economics literature on determining the fines to achieve the optimal and efficient amount of deterrence. The problem with just passing on the external damages is that VW was not going to be caught with certainty. If the executives thought there was a 1% chance of getting caught, it might have been more worthwhile to cheat than if they thought that they were going to get caught with certainty. In this case, the penalty should be approximated by the external costs divided by the probability of getting caught. This, of course, would be significantly larger than the external costs alone. Getting the external costs right is hard to do (e.g., you need more pollutants and the damages vary across space), but can be done with standard tools in the talented economists’ empirical toolkit.

The broader question is how did this happen? This is not one student cheating on an intermediate microeconomics exam and thinking (s)he would get away with it. This is the world’s largest car manufacturer intentionally deceiving the federal and state governments by gaming their enforcement strategy. While some cynic might remark that folks will always cheat when there’s a dollar to be made, I think we can rethink how we design regulations by building in evaluation from the get go.

Michael Greenstone, who spends his summers two doors down the hall, has thought a lot about this recently. In the US, we pass many of our major regulations based on ex ante cost benefit analyses. Testifying on Capitol Hill, he recently made two suggestions that would significantly improve things. First, he argues that we should institutionalize the ex post review of economically significant rules “in a public way so that these reviews are automatic in nature”. He also argues that rules already in effect should start being reviewed using retrospective analysis. The relevant agencies should commit to changing or abandoning rules based on these evaluations, or possibly create new rules based on these evaluations.

The big issue here is of course, who should review these policies? He argues in favor of the creation of a regulatory analysis division within the Congressional Budget Office. This division would conduct the regularly scheduled reviews and conduct reviews at the request of lawmakers. I would go one step further and argue that these reviews should not only be staffed with government employees, but require the review and participation by independent academics. There is precedent for this model.

The certainty of independent review of policies and enforcement strategies significantly drives up the probability of detection, which would diminish the expected profits from cheating. By firms large and small. Plus, we are spending scarce public funds on environmental regulation. We should spend it on what works. And we need to figure out what that is.

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Maximilian Auffhammer View All

Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.

29 thoughts on “VW’s Deepwater Horizon? Leave a comment

  1. It will be interesting to see how high the penalties will be in the end. This letter http://www3.epa.gov/otaq/cert/documents/vw-nov-caa-09-18-15.pdf is very interesting. First, VW apparently denied for almost a year that they did this, after being confronted with these anomalies. Only once EPA threatened to not allow 2016 model years in the US did they admit their scheme. That whole behavior to me doesn’t sound like “full cooperation”, which I assume could have been a mitigating factor in setting penalties.

    Also, that document mentions civil penalties for persons who violate the relevant CAA sections of up to $3750 for each violation. I’m not a lawyer, but if that means what I think, this could get pricey for some of the people involved…

    Finally, this would probably be a good time to reread Becker’s Crime and Punishment paper. While it seems pretty clear that his idea there really doesn’t work for ordinary crimes committed by actors with bounded rationality, it might be more applicable for this kind of corporate crime.

  2. In addition to punishment for breaking air pollution standards VW needs to be held accountable for the costs that this discovery will impose on owners of clean diesel automobiles. These people will incur higher fuel costs, assuming that the re-tuning of the engine to minimize pollutants will decrease fuel mileage. Secondly, their cars are will be worth less on the resale market. Current clean diesel owners should be compensated in both areas.

    • This will be taken care through the class action lawsuits. At least one is already rolling. I would be ‘happy’ to be refunded my purchase price.

  3. “The problem with just passing on the external damages is that VW was not going to be caught with certainty. If the executives thought there was a 1% chance of getting caught, it might have been more worthwhile to cheat than if they thought that they were going to get caught with certainty.”

    Great post, Max. Couldn’t you just make the fine arbitrarily large though, since in equilibrium VW should never have to pay it?

  4. Hi Max,

    It is not clear to me why you believe a new unit within CBO would have any impact on the regulated community’s perception of change in risk of cheat detection? What is it about the detection of VW’s cheating – – that leads you to believe a new unit within CBO could increase the probability of detection of similar or other types of regulatory cheating?

  5. Interesting post. I am glad someone is raising a fuss over the VW diesel admissions. But I am a bit confused: do we need a separate regulatory agency in order to implement ex post review of significant regulations? Here, I am thinking of the trade-off between gains from specialization and benefits of independence/separation.

    Many significant regulations, including those violated by VW in their diesel program, are technically challenging, requiring regulators with fairly specialized knowledge and skill sets. It is not clear that a separate could (at least cost effectively) maintain a staff whose collective expertise span the necessary areas. This would seem to suggest that the agency originally mandated to implement the regulation could/should also carry out the ex post review.

    But, separation has its advantages. If one fears that regulatory agencies are prone to being captured by the “regulated” industries, a third party agency might provide the desired independence. Also, there may be scope economies that offset the lost scale economies; for example, it might be easier to implement ex post review as a general consistent policy if it were handled by a separate agency rather than by each regulatory agency.

    Not sure which way the scale tips on this one.

  6. The death of one person would very quickly change your ‘back of the envelop’ $232!!
    There are at least two components to the onsequences and penalty: the consumers who bought/ leased these cars, and society that ‘suffered’ the externalities. The cap cost on my leased Jetta TDI was about $4k more than the equivalent gas Jetta. I took the car in for service twice [maybe three times] for checking the ‘diesel-lkie’ smell in the cabin. They changed a couple of filters!!
    The penalty using the cost/ probability approach would be about $2k [the lease component] + excess cost of diesel [about $100] + cost of service trips [4 hrs x 300] =3.3/0.01 = 330k.

    As you point out, penalties must be significantly greater than the amount in question. I will accept $33k payoff [and opt out of the inevitable class action lawsuits]

  7. “I would go one step further and argue that these reviews should not only be staffed with government employees, but require the review and participation by independent academics. There is precedent for this model.”

    Excellent! Shall we title the bill “The Full Employment of Economists Act”? :p

    • [tongue fully in cheek] “The Full Employment of Economists Act”.
      Lawyers have enough of those provisions in numerous laws. Bankruptcy. FCPA. etc

      • Just as a point of information. When we academics serve on government panels we don’t get paid. Or maybe I am serving on the wrong panels.

  8. “By selling the dirtier vehicles, VW exposed kids, adults and dogs to massive quantities of local air pollutants.”

    This is hyperbole. It looks to me that there are perhaps 50,000 or so registered VW AG diesels in California on a registered base of 21 million passenger vehicles, that’s plus or minus one in every 500 cars.

    I had no idea I should be so terrified when a Passat TDI rolls by, but now I know better. And so does my dog.

    • I have had a Jetta TDI since Spet 2013. On three occasions I have smelled diesel in the car while driving – at slow speeds with minimal wind outside … what was happening I think is that the exhaust was making it in. They change the ‘filter’ each time — maybe finally cut out the defeat switch. The car passed Calif smog test with ‘flying colors’ about 2 months ago.

  9. Isn’t part of the problem that big corporations expect that they’ll be let off with a smack on the wrist when they take shortcuts that have expensive consequences. They spend lots of money to purchase politicians as insurance against this – which is why Alaska never got properly compensated for the Valdez, and the gulf will never be restored to the state it was before by BP.

    In this case there was a known risk, and arguably VW should pay the full penalty – if the result is that VW is put out of business, then I think that is a penalty worth paying, a penalty that would deter companies that take a calculated risk of not getting caught. We could argue that this would have a negative impact on the economy, but that is doubtful, people will still buy cars, and VW’s factory’s showrooms etc would get bought by its competitors. After all if we apply 3-strikes to felons, shouldn’t 480,000 strikes count for something ?

    • “Corporations are people too” – so a ‘crime’ for which an individual may be jailed a corporation should also be ‘jailed’, i.e. business operations be suspended. If that means the corporation ceases to exist so be it. Read about the peanut farmer who was just sentenced to a 28 year term in jail [for intentionally shipping salmonella ‘contaminated’ peanut product]. IF only an INDIVIDUAL is held responsible the person should be sentenced.

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