The Emissions Issue

IRREGULARITIES IN EMISSIONS

On September 18, 2015, the U.S. Environmental Protection Agency (EPA) publicly announced in a “Notice of Violation” that irregularities in relation to nitrogen oxide (NO_x) emissions had been discovered in emissions tests on certain vehicles with Volkswagen Group diesel engines. It has been alleged that we had used undisclosed engine management software installed in certain four-cylinder diesel engines used in certain 2009 to 2015 model year vehicles to circumvent NO_x emissions testing regulations in the United States of America in order to comply with certification requirements. The US environmental authority of California – the California Air Resources Board (CARB) – announced its own enforcement investigation in this context. Following these announcements by EPA and CARB, authorities in various other jurisdictions worldwide commenced their own investigations. Volkswagen publicly admitted to irregularities on September 22, 2015.

On November 2, 2015, the EPA issued another “Notice of Violation” alleging that irregularities had also been discovered in the software installed in vehicles with type V6 3.0 l diesel engines. CARB also issued a letter announcing its own enforcement investigation in this context.

In the course of the internal inquiries at Volkswagen, we also encountered evidence that irregularities in the determination of the CO₂ figures for vehicles’ type approvals in the EU28 countries could initially not be ruled out.

EXTENSIVE INVESTIGATIONS BY VOLKSWAGEN

Volkswagen’s reaction has been comprehensive and the Company is working intensively to clarify the irregularities. To this end, Volkswagen ordered both internal inquiries and external investigations. The external investigation is being conducted with the involvement of external lawyers in Germany and the USA. To facilitate the investigations in the course of clarifying the facts, the Group Board of Management established a cooperation program, which was in place for a limited time and was open to all employees covered by collective agreements.

The Supervisory Board of Volkswagen AG formed a special committee that coordinates all activities relating to the emissions issue for the Supervisory Board. Further information regarding the special committee on diesel engines can be found in the Report of the Supervisory Board. Volkswagen AG retained the US law firm Jones Day to conduct an independent and comprehensive external investigation of the diesel issue. Jones Day is updating the Company on the current results of its investigation on an ongoing basis. Furthermore, Volkswagen AG filed a criminal complaint in September 2015 with the responsible public prosecutor’s office in Braunschweig.

We are cooperating with all the responsible authorities to clarify these matters completely and transparently. Jones Day is supporting Volkswagen AG in its cooperation with the judicial authorities.

DIESEL ISSUE

Four-cylinder diesel engines

In its ad hoc release dated September 22, 2015, the Volkswagen Group announced that there were discrepancies in relation to NO_x emissions figures in vehicles with type EA 189 diesel engines. Around eleven million vehicles worldwide were affected. This is attributable to the engine management software. The vehicles remain technically safe and ready to drive.

AFFECTED FOUR-CYLINDER DIESEL ENGINES

Technical solutions have been prepared for the three European variants of the type EA 189 engine affected. These solutions have been approved in principle by the German Kraftfahrtbundesamt (German Federal Motor Transport Authority) for Volkswagen AG and AUDI AG. The Group brands SEAT and ŠKODA also received approvals in principle each from their respective type approval authorities – the Ministry of Industry in Spain and the Vehicle Certification Agency in the United Kingdom. We are now working expeditiously to implement the technical solutions in order to ensure that all legal requirements are met in the EU28 member states. The recall of the highest-volume variant – the 2.0 l TDI engine –already began in January 2016. The recall of the 1.2 l TDI is expected to commence at the end of the second quarter. A software update is being performed for these engine versions. The implementation phase for the recall of the 1.6 l TDI engine is scheduled for the third quarter, which will provide additional lead time necessary for certain hardware modification. In the 1.6 l TDI engines, a “flow transformer” will be fitted in front of the air mass sensor to improve the sensor’s measuring accuracy. Combined with updated software, this will optimize the amount of diesel injected. Based on current planning, implementation of measures will take at least the full 2016 calendar year to complete. Holders of affected vehicles will be notified by Volkswagen when their cars can have their software updated and, where appropriate, receive the modified hardware. Volkswagen guarantees that the solutions will be implemented free of charge.

In addition, Volkswagen AG has, until December 31, 2017, expressly waived citation of the statute of limitations with regard to any claims made in relation to the software installed in vehicles with engines of type EA 189 by vehicle customers outside the United States and Canada.

In some countries outside the EU – among others Switzerland, Australia and Turkey – national type approval is based on prior recognition of the EC/ECE type approval. We are also working closely with the authorities in these countries to coordinate the corresponding actions.

In North America, three variants of certain four-cylinder diesel engines are affected. Due to considerably stricter NO_x limits in the USA, it is a greater technical challenge to refit the vehicles so that all applicable emissions limits can be met. Volkswagen is currently in intensive discussions with the EPA and CARB concerning remedial measures. We will present the solution for North America as soon as it has been agreed with the responsible authorities. The respective US companies of the Volkswagen Group have withdrawn all affected new vehicles from sale in the USA and Canada.

Clarification regarding four-cylinder diesel engines advancing

Some 450 internal and external experts are involved in the work to clarify the issue, which is divided into two investigations. The Group Internal Audit function, which involved bringing together experts from various Group companies to form a task force, and focused – as instructed by the Supervisory Board and Board of Management – on reviewing relevant processes, reporting and control systems as well as the accompanying infrastructure. The Group Internal Audit function provided its findings to the external experts from Jones Day. The internationally renowned law firm has been appointed by Volkswagen AG to fully clarify the facts and responsibilities in a second investigation. Jones Day is receiving operational support from the auditing firm Deloitte.

The special investigation involves conducting briefings with employees and managers who have been identified by Jones Day as relevant sources of information in connection with the diesel issue. In addition, Jones Day is evaluating documents and data (such as e-mails) and conducting follow-up interviews based on the documents that are relevant for clarifying the facts. Relationships between the various areas under investigation will also be analyzed and the respective findings collected.

Based on the facts currently known by the Group Internal Audit function, in the past there were process deficiencies on the technical side in addition to misconduct on the part of individuals. This was true of the testing and certification processes for the engine control units, for example, which were unsuited to preventing the use of the software in question. The Group Internal Audit function proposed specific remedial measures to address the identified weaknesses, which focus on creating more clearly structured and systematic processes on the technical side. For example, the processes and structures used for approving the software for engine control units are being reorganized with more clearly defined and binding powers and responsibilities.

We have already resolved to make comprehensive changes to testing practices on the technical side as a key response to the Group Internal Audit function’s findings. Therefore, Volkswagen has decided that in the future emissions tests, in general, will be externally evaluated by independent third parties. Real-world random tests of vehicles’ emissions behavior on the road will also be introduced.

Furthermore, the internal control system has been optimized through a new set of regulations for the procedure in control unit software development, emission classification and escalation management.

While the Group Internal Audit function has already completed its analysis of the Company’s processes, the work being done by Jones Day will continue well into 2016. One reason for the different durations of the investigations is that the external investigators must screen very large volumes of data. By the end of December, over 100 terabytes of data had been secured and more than 1,500 electronic data storage devices from some 380 employees had been collected. Moreover, the external investigation is seeking to establish legal responsibility for what has occurred. This means that the findings not only need to be plausible and consistent with the evidence, but must also stand up in court.

Employees from the affected departments have been dismissed as a further direct consequence of the findings to date from the internal inquiries and external investigations.

The information that has been viewed so far has helped trace the origin and development of the diesel issue to a large extent. The starting point was the strategic decision to launch a large-scale promotion of diesel vehicles in the USA in 2005. To this end, a new diesel powertrain unit featuring high performance and cost-efficient production – the EA 189 type engine – was to be developed.

The US emissions limits for emissions of pollutants are strict. Under the strictest standard in the USA at the time, only 31 mg/km of NO_x were allowed to be emitted, about six times less than under the Euro 5 standard applicable in Europe at that time. When designing state-of-the-art diesel engines, technicians and engineers face the challenge that measures to reduce nitrogen oxides categorically have a knock-on effect on other parameters (e.g. CO₂).

In the ensuing period, in order to resolve this conflicting objective satisfactorily within the time frame and budget of the EA189 project, according to the current state of knowledge, a group of persons – whose identity is still being determined – at levels below the Group’s Management Board in the powertrain development division, decided to modify the engine management software. With this software modification, emissions values were generated in bench testing that differed substantially from those under real driving conditions.

As things stand, outside the group of persons mentioned above, the then and current Board of Management of Volkswagen AG had, at any rate, no knowledge of the use of unlawful engine management software at the time. Even after the International Council on Clean Transportation (ICCT) study was published in May 2014, the discrepancies were initially regarded – on the basis of the facts currently known regarding the members of the Board of Management responsible at that time – as a technical problem that did not basically differ from other everyday technical problems at an automotive company. In the exhaust measurements carried out in-house at Volkswagen in the subsequent months, the test set-ups on which the ICCT study was based were repeated and the unusually high NO_x emissions confirmed. CARB was informed of this result, and at the same time the offer was made to recalibrate the type EA 189 diesel engines as part of a service measure that was already planned in the USA. This measure was evaluated and adopted by the Ausschuss für Produktsicherheit (APS – product safety committee), which includes, among others, employees from the technical development, quality assurance, sales, production, logistics, procurement and legal departments, as part of the existing processes within the Volkswagen Group. The APS thus plays a central role in the internal control system at Volkswagen AG. There are currently no reliable findings to confirm that an unlawful software modification was reported by the APS as the cause of the discrepancies to the persons responsible for preparing the 2014 annual and consolidated financial statements. Instead, at the time that the annual and consolidated financial statements were being prepared, this group of people remained under the impression that the discrepancies could be eliminated with comparatively little effort as a part of a field measure. Based on what is currently known, the actual background of the discrepancies only became clear gradually to the members of the Board of Management dealing with the matter. It was only reliably recognized in the summer of 2015 that the cause of the discrepancies was a software modification, to be qualified as a so-called "defeat device" as defined by US environmental law. This culminated in the disclosure of the "defeat device" to the EPA/CARB on September 3, 2015. According to the assessment at that time of the members of the Board of Management dealing with the matter, the scope of the costs expected as a result by the Volkswagen Group (recall costs, retrofitting costs and financial penalties), was basically not dissimilar to that of previous cases in which other vehicle manufacturers were involved, and therefore appeared to be controllable overall with a view to the business activities of the Volkswagen Group. This appraisal by Volkswagen AG was based on the assessment of a law firm brought in in the USA for approval issues, according to which similar cases in the past were resolved amicably with the US authorities. Publication of a "Notice of Violation" by the EPA on September 18, 2015, which came as a surprise to the company, on the facts and possible financial consequences, then presented the situation in a completely different light.

Six-cylinder diesel engines

On November 2, 2015, the EPA announced that it had determined that engine management software installed in vehicles with V6 3.0 l TDI diesel engines contains “auxiliary emission control devices” (AECDs) which had not been disclosed adequately in the US type approval process. Also on November 2, and additionally on November 25, 2015, the CARB published allegations that legal requirements for NO_x emissions were circumvented through the use of engine management software under test conditions.

AFFECTED V6 TDI 3.0 L DIESEL ENGINES

After discussions with the EPA and CARB, Audi publicly announced on November 23, 2015 that it would revise the software parameters and resubmit them for approval in the USA. The technical solutions will be implemented as soon as they have been approved by the authorities. Around 113 thousand vehicles from the 2009 to 2016 model years of the Audi, Volkswagen Passenger Cars and Porsche brands are affected in the USA and Canada. The respective US companies of the Volkswagen Group have withdrawn all affected new vehicles from sale in the USA and Canada.

Clarification regarding six-cylinder diesel engines

Audi has confirmed that a total of three AECDs were not declared in the course of the US approval documentation.

To clarify this issue, Audi set up an internal task force, furnished committees with the necessary resources and launched a program of cooperation for employees covered by collective agreements. The law firm Jones Day is also conducting independent and comprehensive investigations into this matter.

The incumbent members of the Board of Management of AUDI AG have declared that prior to the notification by the US Environmental Protection Agency EPA in November 2015 they had no knowledge of matters concerning the V6 TDI 3.0 l engines that the authorities are now treating as infringements.

We are consistently seeking to realize organizational and procedural potential for improvement that has come to light as a result of the diesel issue.

On January 4, 2016, the U.S. Department of Justice (DOJ), on behalf of the EPA, filed a civil complaint against Volkswagen AG, AUDI AG and other companies of the Volkswagen Group. The claims asserted under civil law are founded on the alleged use of illegal (Defeat Device) software in violation of the American Clean Air Act. The complaint’s allegations relate to both the four-cylinder and the six-cylinder diesel engines, although technically Volkswagen AG Group-wide held internal development responsibility for the four-cylinder diesel engines within the Group, and AUDI AG for the V6 3.0 l TDI engines.

CO₂ issue

In the course of the internal inquiries at Volkswagen of all diesel engines, we additionally found that initially we could not rule out irregularities in determining the CO₂ figures for vehicle type approval in the EU28 member states. The CO₂ levels, and thus also the fuel consumption figures, appeared to have been set too low in the case of some vehicle models during the CO₂ certification process. On November 3, 2015, we informed the public that around 800,000 vehicles, primarily with diesel engines, could be affected. Our initial estimate put the economic risk at €2 billion.

Clarification of the CO₂ issue

The investigations conducted into the potentially illegal manipulation of CO₂ values did not bring about the adverse impact on earnings that we had expected. Just one month later, on December 9, 2015, we were able to publicly announce that clarification of the CO₂ issue had largely been completed. Following extensive internal reviews and measurement checks, we found slight discrepancies in only a very limited number of engine-transmission variants from the Volkswagen Passenger Cars brand. These variants are now being reviewed by a neutral technical service under the supervision of the authorities. The discrepancies between the stated figures and the values found during testing, on average, amount to a few grams of CO₂. No technical modifications to the vehicles are required and real-world consumption figures for customers are unchanged. The catalog figures will be adjusted for the affected variants in the course of normal processes.

IMPACT ON THE VOLKSWAGEN GROUP

Operating result for 2015

As a result of the irregularities in the software used in certain diesel engines, provisions totaling €16.2 billion were recognized and charged to operating result, primarily for pending technical modifications, for repurchases, and customer-related measures as well as legal risks.

The special items originally expected as a result of the CO₂ issue have not materialized.

We have therefore adjusted the Group’s earnings targets accordingly, and have revised investment planning and intensified the ongoing efficiency program.

Legal risks

Various legal risks are associated with the diesel issue. The provisions recognized for this matter in the amount of €7.0 billion are partially subject to substantial estimation risks given the complexity of the individual factors, the ongoing approval process with the authorities and the fact that the comprehensive, exhaustive investigations have not yet been completed. The legal risks include (detailed information on the legal risks can be found on chapter “Litigation”):

• Criminal and administrative proceedings all over the world (excluding the USA/Canada)
• Product-related lawsuits worldwide (excluding the USA/Canada)
• Lawsuits filed by investors worldwide (excluding the USA/Canada)
• Proceedings in the USA/Canada

Should these legal risks materialize, this could result in considerable financial charges.

Further risks from the emissions issue can be found in the Report on Risks and Opportunities.

Ratings and rankings

As a result of the emissions issue, Moody’s Investors Service downgraded Volkswagen AG’s short- and long-term ratings by one notch each from P–1 to P–2 and A2 to A3 in November 2015. The long-term ratings for Volkswagen Financial Services AG and Volkswagen Bank GmbH were downgraded from Aa3 to A1. The rating agency lowered the outlook for the companies from stable to negative.

In connection with the irregularities in the software used for certain diesel engines from the Volkswagen Group, in October 2015 Standard & Poor’s initially downgraded the short-term and long-term ratings for Volkswagen AG, Volkswagen Financial Services AG and Volkswagen Bank GmbH by one notch each, to A–2 and A– respectively.

In a further step in December 2015, also as a result of the emissions issue, Standard & Poor’s downgraded the long-term ratings for Volkswagen AG and Volkswagen Financial Services AG from A– to BBB+. The outlook for Volkswagen AG, Volkswagen Financial Services AG and Volkswagen Bank GmbH is negative.

Share price development

The emergence of the news about irregularities in the software used in certain diesel engines and the resulting public speculation about possible consequences to be expected led to a sharp fall in the prices of Volkswagen AG’s ordinary and preferred shares in mid-September 2015. After reaching the lowest closing price for the year at the beginning of the fourth quarter, Volkswagen shares recovered temporarily from their sharp declines. As a result of the news that, as part of the internal inquiries at Volkswagen of all diesel engines, we also encountered evidence that irregularities in the determination of the CO₂ figures for vehicles’ type approvals in the EU28 countries could initially not be ruled out, the prices of both classes of shares trended lower again. As the fourth quarter progressed, the provision of technical solutions for our customers in the EU28 countries to rectify the irregularities in NO_x emissions and the clarification of the CO₂ issue led to a rise in the share price amid significant fluctuations.

Personnel changes

The Chairman of the Board of Management of Volkswagen AG, Prof. Dr. Martin Winterkorn, took responsibility for the irregularities that had emerged in relation to diesel engines. He stepped down on September 25, 2015.

The Supervisory Board of Volkswagen AG appointed Matthias Müller as the new Chairman of the Board of Management of Volkswagen AG with effect from September 26, 2015.

Effective January 1, 2016, Christine Hohmann-Dennhardt took up a newly created responsibility as member of the Board of Management of Volkswagen AG for Integrity and Legal Affairs. This is a clear indication of the great importance we attach to these issues.

REALIGNMENT OF THE GROUP

In late October 2015, the Group Board of Management announced a five-point plan to realign the Group. The first and most important priority is to provide technical solutions for our customers and therefore to work closely with the authorities. The second priority is to pursue and complete the investigation independently and systematically. This will involve examining the facts and analyzing how they occurred, with the aim of ensuring that such mistakes cannot occur again. The third priority is to implement the new Group structure. The Volkswagen Group’s management will be more decentralized in future, with greater independence for brands and regions. This will mean better sharing of responsibility and will encourage entrepreneurial thinking and behavior. Our decisions and processes will become leaner, faster and more efficient. The Group Board of Management will focus on its core role: pursuing major Group-wide topics for the future and working on synergies, control and strategy. The fourth point involves a realignment of culture and management practices at Volkswagen. Establishing a new way of thinking takes time. We want our work to be defined by open and honest communication, a constructive approach to dealing with mistakes and greater courage and innovation. The fifth and final point is the Group’s new objectives. In 2008 the Volkswagen Group sent a strong signal with its Strategy 2018. The cornerstones remain unchanged: satisfied customers, motivated employees, excellent quality products and services, sustainable profitability and ecological responsibility. Additionally, the “Future Tracks” initiative (see also chapter “Corporate Social Responsibility and Sustainability”) has already laid the valuable groundwork for the realignment, enabling us to address the issues of the future such as e-mobility, the digital shift and new business models. We are developing our Strategy 2025 for the Volkswagen Group on this basis, with which we will determine our technological and strategic direction for the next ten years.

TO OUR STAKEHOLDERS

Volkswagen does not tolerate any infringements of rules or laws. The irregularities that occurred contradict everything Volkswagen stands for. The trust of our customers and the public is, and will remain, our most important asset. We are sincerely sorry that we have disappointed our stakeholders. We will do everything within our power to prevent incidents of these kinds from reoccurring and commit ourselves fully to winning back all of the trust.