The VW Emissions Scandal: A Failure of ESG Investing?

Until five weeks ago, Volkswagen appeared to be reaching its well-publicized goal of becoming the world’s leading automaker, both economically and ecologically. Sales figures for the first half of 2015 showed VW edging past Toyota into the global lead. The Dow Jones Sustainability Index released in early September ranked VW number one among the world’s car companies, with full marks awarded for codes of conduct, compliance and anti-corruption as well as innovation management and climate strategy. On September 9, VW’s CEO basked in the award’s glow, proclaiming in a press release that “this distinction is a great success for the entire team. It confirms that the Volkswagen Group is well on the way to establishing itself long term as the world’s most sustainable automaker.” Many ESG-guided portfolios held full positions in VW shares.

On September 21, the wheels fell off. VW’s leaders admitted that the success was achieved while cheating on emissions tests. The stock plummeted. The CEO resigned. Recalls, fines and lost sales could run into the tens of billions of dollars. As with many other corporate crises, poor corporate governance appears to be at the root of the problem.

Not Quick and Easy
Investors have become increasingly interested in corporate sustainability in recent years, boosting the status of scorecards like the DJ Sustainability Index that are based on financially material Environmental, Social and Governance (ESG) factors. Just as many purchasers of VW “clean” diesel cars feel betrayed and outraged, those whose investment decision was influenced by perceived ESG suitability feel abused by VW management. Many such investors are also questioning the validity of sustainability ratings.

We believe the VW crisis exposes the shortcomings of a “skin deep” approach to ESG investing. The effort to reduce financial or other data to a simple score or rank has serious limitations. It reinforces a check-the-box mentality among corporate managers and investment analysts alike.  In our view, the most valuable insights are gained while assembling the facts. Along the way, one may discover pieces of information that when put together, reveal a more complete picture of a company’s ethical foundation. Over the course of many investigations, the experience gained in thoughtfully reviewing corporate behavior yields valuable perspective. The appearance of cozy board relationships, obscenely generous stock options or aggressive accounting triggers an uneasy sense of déjà vu.

VW had a formal code of conduct that might be considered exemplary. “We act responsibly for the benefit of our customers, shareholders and employees. We bear responsibility for continuous improvement of the environmental tolerability of our products and for the lowering of demands on natural resources while taking economic considerations into account.” On the surface, there was a lot to like. However, a bit of digging reveals a corporation with misguided incentives, including an unrelenting pursuit to be recognized as the biggest. There was also dysfunctional share ownership and a board structure that led to internal power struggles rather than appropriate oversight. For example, approximately one-fifth of the shares are owned by the state of Lower Saxony, and another significant stake is owned by the labor unions, known as the workers’ council. Both have representation on the board. Should we wonder why VW’s workforce (many of whom are in Lower Saxony) is larger than that of Toyota and GM combined? Few of us could smell the extra NOx produced by VW diesels, but there were risk factors evident to those willing to peer under the corporate hood.

To be clear, even the most rigorous ESG analysis is not meant to predict a specific event. However, substandard governance increases the odds of bad things happening. Upon discerning elements of poor governance, we think investors have three options; 1) stay away, 2) think there are improvements coming that the market doesn’t see, or 3) view the heightened risks as adequately reflected in the valuation, and see other positive catalysts that are especially compelling.

Could some good come of it?
A growing body of research points to the long-term materiality of ESG factors on investment performance. The hope is that as more and larger investors commit to ESG principles (by selling/avoiding offending shares or by agitating for change), bad actors will find themselves paying more for capital, and less able to fund businesses that undercut ESG standards. Conversely, capital will flow more cheaply to companies “doing the right thing.”

We take a utilitarian point of view, and examine ESG factors as part of our risk assessment. While we are constantly looking for good, we have learned that trying (not always successfully) to avoid bad is more critical to successful analysis.

We offer no prediction that governance will improve at VW (the promotion of insiders is unlikely to change the company culture). Elsewhere, we foresee improvements in governance that will come slowly but surely; investors will need to dig deeper and vote to hold management accountable. We also expect corporate boards, managers and employees to demand more from each other. This should ultimately reduce the risk of more large-scale financial and environmental frauds.