Image source: Volkswagen

Volkswagen (VWAGY 1.06%) is in the midst of a scandal caused by its decision to cheat on emissions tests. The scandal has cut the German auto giant's market cap by about a quarter and forced the company to set aside billions to deal with the consequences. But what is the scandal really about? And will it really cost Volkswagen billions of dollars to address?

As I write this almost three months after the initial revelations, it's still not clear if we know the whole story. But here's what we do know.

How and why did Volkswagen cheat on emissions tests?
Here's the background: Modern cars with diesel engines include some advanced technology to keep the exhaust clean. Generally speaking, diesel cars get better fuel economy than gasoline-powered equivalents, but diesel exhaust contains more pollutants. The new "clean diesel" technology reduces the level of pollutants to legal levels before the exhaust gases are emitted by the car.

For auto engineers, emissions controls pose a challenge: They can inhibit the performance of the engine. That can hurt power output, fuel economy, or both. Engineers have long since learned how to work around that with gasoline engines, but diesels have posed a more complex challenge.

VW's German rivals, Daimler and BMW, came up with technical solutions that (apparently) have allowed their diesel engines to meet emissions requirement while still delivering good performance and fuel economy. But the systems are expensive. That's fine if you're selling luxury cars, but it's not fine if you're selling mass-market VWs.

Simply put, it appears that VW engineers couldn't figure out how to clean up their diesels in a cost-effective way without hurting performance and fuel economy. So they came up with a "workaround": The car's software disables the emissions controls during normal driving. They're only turned on when the car detects that a government emissions test is under way.

The upshot is that the diesel-powered VWs equipped with the software get impressive fuel economy and are fun to drive. But in normal driving, they emit far more pollutants than allowed under U.S. and European laws.

VW has admitted that the software in question was used in all of the company's four-cylinder diesel models starting with the 2009 model year. That's about 11 million vehicles in all, about 482,000 of which are in the United States.

Why is this such a big deal?
The pollutants in question are oxides of nitrogen, which cause smog. That's a big deal under the U.S. Clean Air Act. Smog is a health hazard and is linked to a number of respiratory diseases. 

Under the Clean Air Act, VW's software is considered an illegal "defeat device." That's a civil violation, not a criminal one. But it's an expensive one: The U.S. Environmental Protection Agency (EPA) can hit VW with a fine of up to $37,500 per car. Theoretically, VW could be on the hook for over $18 billion in fines, though it's likely to be far less.

There's also potential criminal exposure. Violating the Clean Air Act isn't a crime, but conspiring to do it might well be. Unlike some other scandals involving automakers, where the problems were caused by negligence or errors, VW (or at least, some people within VW) clearly intended to break the law. The U.S. Justice Department has opened an investigation, and criminal charges are possible in other countries as well.

How much will this cost?
We don't know yet. But the costs will start mounting soon on several different fronts.

  • The cost to recall and fix all of the affected vehicles. This might run as high as several billion dollars, as it's possible that the U.S. or California regulators will force VW to buy back some of the affected cars.
  • The cost of any fines or criminal settlements, in the U.S., Europe, or elsewhere. Again, this is likely to run into the billions, though it's way too early to even estimate a dollar amount. 
  • The costs of litigation. In the U.S., VW is being sued by owners of the affected cars, by dealers, and by several state attorneys general under state consumer-fraud statues.

When will we know more?
There are a couple of key dates coming up:

VW has retained outside counsel to conduct an extensive investigation into what happened and who is responsible. The company is expected to release an interim report on that investigation on Thursday, Dec. 10.

Separately, VW has submitted its plan to recall and repair the affected vehicles in the U.S. to the EPA and the California Air Resources Board. The details of the plan aren't public yet. The regulators have until Dec. 21 to review the proposal and respond. It's likely that we'll hear much more about VW's plans on that date.