Volkswagen Races to Put ‘Dieselgate’ in the Rear View

Eager to finally move past the scandal, the auto giant is making a bold bet on electric vehicles.
July 23, 2018, 10:30 AM UTC
Photograph by Frank Schinski—Ostkreuz for Fortune

On a hot summer afternoon in central Germany, the new CEO of one of the world’s largest automakers sinks into a white leather armchair, digs his shoes into the thick shag carpet under his feet, and grins. Herbert Diess, who took over as Volkswagen AG’s chief executive in April, has his tall frame folded inside a cherry-red chunk of metal that closely resembles a car—except for the fact that it’s missing a steering wheel, pedals, gears, or anything else you’d normally expect to find in an automobile. The slick contraption is a VW concept car called the I.D. Vizzion. It made its debut at the Geneva Motor Show in March.

The I.D. Vizzion is more than just an experiment, however, or a living room on wheels. Rather, says Diess, it offers a glimpse of our driverless near-future. And Diess is betting heavily on a strategy built on that vision—staking hundreds of millions of dollars on electric and autonomous technology. The CEO insists that getting the technology right will be key to the survival of his company.

“Look what happened when we went from horse-drawn carriages to cars, from chemical-based photography to digital photography,” says Diess, sitting in Volkswagen’s gargantuan factory headquarters in Wolfsburg, a sleepy company town of 125,000 people, some 140 miles west of Berlin. “There was huge disruption. Very few of the successful companies remained. Kodak did not make it, and they knew what was coming.”

Just a couple of months into his job, Diess, 59, has chosen to meet me inside Volkswagen’s secretive innovation center—a black velvet curtain hides one part of the room from view—in order to underscore his point: That only radical transformation can save the auto giant from being left behind by more nimble competitors. “It is now really important for us to change,” he says.

SHIFTING INTO A HIGHER GEAR: Workers assembling an e-Golf electric vehicle at a Volkswagen plant in Dresden, Germany. VW plans to phase out the e-Golf in favor of a new EV platform.Photograph by Frank Schinski for Fortune

Few businesses sit so squarely in the crosshairs of a tech upheaval as the auto industry, whose very existence has depended for more than 100 years on a single invention: the combustion engine. Today, the industry overall sells about 80 million cars a year. Last year, a full 10.8 million of those came from the Volkswagen Group, more than the 10.4 million sold by Toyota, which had held the top-selling spot for years. Volkswagen’s 12 brands include Porsche, Skoda, Audi, and VW itself, the biggest brand of all. Last year, Volkswagen’s total revenues were a record $260 billion. That was enough to place the company at No. 7 on this year’s Fortune Global 500 list—one spot behind Toyota.

And yet, while millions of us will probably be filling our tanks with fuel for years to come, carmakers are facing a major shakeout as the world begins a long-term shift to electric vehicles and as carbon-emissions targets in many countries slowly upend old driving habits. A boom in ride-sharing could also drastically reshape cities and car ownership within a decade.

Amid this transformation, the U.S., whose passion for cars virtually dictated the industry’s strategy for decades, is seeing its market dominance fade. More important now is China—Volkswagen’s biggest market—which buys about one-quarter of all the world’s new cars and which is racing full speed into producing mass-market electric vehicles. “Change,” says Diess, “is imminent.”

Turbulence on this scale would be daunting for any business. But at Volks-wagen, it’s happening while the company is still reeling from its mammoth diesel-cheating scandal, which some execs describe as its biggest trauma since Adolf Hitler launched the Wolfsburg factory as a prized Nazi project exactly 80 years ago.

“Dieselgate,” as the scandal is known, exploded in September 2015, when the U.S. Environmental Protection Agency revealed that Volkswagen had engaged in carbon-emissions testing fraud in about 600,000 diesel-powered vehicles; that number has since risen to millions. Over a period of more than five years, engineers in Wolfsburg had installed “defeat devices” in vehicles—software that masked the level of nitrogen oxides the engines were emitting. The real emissions rates were revealed to be up to 40 times above the legal U.S. limit, according to MIT scientists, who estimate that the toxic compound in the tricked-out engines could cause about 1,200 early deaths in Europe and about 60 more in the U.S.

Nearly three years on, Volkswagen has so far paid almost $30 billion in legal settlements and recalled or refitted more than 11 million vehicles—and the fallout is still far from over. “To my dismay we sometimes still find functions in older software that we did not know was there,” says Volkswagen’s chief technology officer Ulrich Eichhorn. In addition, Volkswagen is embroiled in dozens of prosecutions and lawsuits across Europe and the U.S. that are likely to linger for a long while yet; the latest annual report, in March, listed dozens of ongoing legal challenges. “It will take years,” Diess says. How many? “I cannot say.”

To show how the company is moving forward, Volkswagen invited Fortune to spend several days in late June in its sprawling Wolfsburg headquarters, offering a rare, deep look inside the company at a pivotal moment in its 80-year history.

YEARS OF DAS AUTO: A Volkswagen getting a test-drive on a track across the river from the 80-year-old Wolfsburg facility.Photograph by Frank Schinski for Fortune

The giant factory complex, roughly the area of the principality of Mon-aco or the Atlanta airport, produces 8 million cars a year, from a set of austere-looking redbrick buildings that date back to when the -Nazis ran the operation in the 1930s and 1940s. The factory’s World War II bomb shelter sits directly underneath the state-of-the-art, robot-controlled assembly line and has been turned into a memorial to the 20,000 or so forced laborers and concentration-camp inmates who worked in the factory, watched over by the Gestapo. Coincidentally, the week Fortune visited Wolfsburg, the town celebrated its 80th birthday, marking Hitler’s inauguration of the Volkswagen factory in 1938. Today, Volkswagen apprentices take three-day trips to the Auschwitz concentration camp as part of their training.

Volkswagen says it’s eager to talk about the future rather than rehash the scandal. But ignoring Dieselgate has proved impossible. Two weeks before Fortune’s visit to Wolfsburg, German prosecutors had levied a billion-euro penalty (about $1.17 billion) against Volks-wagen for Dieselgate, one of the country’s biggest-ever industrial fines—and a blow against one of Germany’s most iconic companies. Days later, police stormed Audi CEO Rupert Stadler’s home and arrested him for alleged involvement in the scheme. Among the documents police seized was Volkswagen’s internal report on Dieselgate, which it had commissioned Jones Day lawyers in Munich to compile and which the company has refused to release publicly; in early July, it lost a legal challenge to keep the report confidential.

VW’s sprawling Wolfsburg headquarters is roughly the area of the principality of Mon-aco or the Atlanta airport and produces 8 million cars a year.Photograph by Frank Schinski for Fortune
Photograph by Frank Schinski for Fortune

Dieselgate overshadowed almost every conversation I had in Wolfsburg, as executives pored over its details, described their shock and embarrassment, and outlined their plans to exit the crisis and remake Volkswagen.

“This is the worst industrial scandal in Germany since World War II,” says Hiltrud Werner, who joined the company last year to take charge of integrity and legal affairs and is the sole woman on Volkswagen’s board of management. “This will stay with the history of this company forever,” she adds. “It has a magnitude that we have not seen before.”

The financial cost has been mammoth as well: The $30 billion paid out so far—a figure that is sure to rise further—equals “the money we make in three good years, and we don’t always have good years,” says technology chief Eichhorn. “I am ashamed that my company did this.”

For all the soul-searching in Wolfsburg, however, one question remains: Now that the company is rushing—belatedly—to embrace green technology, can it remake itself quickly enough to retain its enormous clout, or will it steadily decline, along with the old-style business models of traditional automakers?

Hiltrud Werner, the sole female member of VW’s Board of ManagementCourtesy of Volkswagen
Courtesy of Volkswagen

So far, the signs of a recovery look good. Volkswagen is generating record sales and revenues; it overtook Toyota as the world’s biggest automaker by sales volume in 2016, the year after the scandal broke. Even so, competitors from California to China—younger, more agile, less hidebound by rigid structures—are nipping at its heels and, just like Volkswagen, are racing to build a new-age auto industry.

Ironically, Volkswagen’s best hope for success springs from the scandal itself, which forced the automaker to confront its deep flaws and to conclude that it faces severe threats if it remains unchanged.

Diess arrived at Volkswagen from BMW AG in July 2015, two months before -Dieselgate exploded. He was lured to Volkswagen specifically to inject new ideas and technology strategies, and to cut costs, as he had done at BMW. Now he is charged with taking a wrecking ball to old habits and creating a new culture in its place. “I was already quite sure this company had to change because of what was happening in the industry,” says Diess. “But the diesel crisis has accelerated our change process quite considerably.”

Volkswagen’s initial response to Dieselgate was not so urgent or inspired. On Sept. 18, 2015, EPA officials called a press conference in Washington, without alerting Volkswagen beforehand, and announced one of the biggest corporate frauds of recent times. Executives in Wolfsburg, 4,000 miles away, were caught off guard. They dispatched longtime CEO Martin Winterkorn to deliver a stilted half–apology on television, in German, in which he blamed “the mistakes of only a few” and downplayed the company’s responsibility. Winterkorn resigned days later, and in May of this year, he was indicted in Detroit for having misled the U.S. over the cheating.

Diess, who already sat on Volkswagen’s board of management, was relaxing on vacation in Spain when the scandal broke, and he waited a full day before flying home. “At that time, I did not have any idea of how it was going to end up, or how much it would cost,” he says. “No, no.”

Amazingly, the cheating was uncovered by sheer happenstance, when a group of graduate students from West Virginia University rode Volkswagen vehicles around Los Angeles, hopping on and off freeways, and recorded emissions on gear they had rigged up in the back. They had no expectation of finding wrongdoing; it was a simple study project. But Volkswagen’s engineers had devised the scheme to display good emission levels only during controlled tests, of the kind that most states in the U.S. require. And so the students stumbled on an international scandal.

When they brought their results to California and U.S. officials, there was a stunned response. Volkswagen, whose business depended heavily on diesel cars, had spent years boasting to Americans about its eco-friendly new “clean diesel.” In fact, it was more like selling snake oil. U.S. investigators revealed that managers in Wolfsburg had sought to stifle internal questions about emissions cheating, and that engineers who raised concerns were told to keep quiet and carry on. When U.S. authorities confronted Volkswagen with the data, it denied all knowledge.

To auto executives outside the hermetic world of Wolfsburg, the implications were clear. A global giant of their industry had not only acted criminally but also appeared blithely unconcerned about the consequences.

“I thought, Jesus Christ, how naive are these guys?” says Thomas Sedran, now Volkswagen’s senior vice president for group strategy, recalling the moment the scandal broke. Sedran was managing director of Chevrolet Europe at the time and was recruited by Volkswagen in late 2015 to help reshape the company in the wake of Dieselgate. “Why did they think it was okay to cheat and believe they would not get caught?” he says, sitting in his Wolfsburg office late one afternoon, still flummoxed by the scandal. “And even when they were caught, they still lied about it. I don’t get it.”

The answer to Sedran’s question lay not in corporate greed nor in misunderstanding foreign laws. According to many insiders and outsiders, the problem was Volkswagen’s unusually insular and rigidly hierarchical culture, which had been bred over the decades within Wolfsburg, where about 75,000 people—more than half the town’s residents—work for the company.

Volkswagen had for decades been dominated by leaders whose word was unquestioned and whose imperious style held huge political sway in Germany. Chancellor Angela Merkel has more than once intervened on Volkswagen’s behalf to dilute regulations—including EU rules that might have reined in diesel’s nitrogen oxide emissions, as they do in the U.S.

PUNCH BUG: Beetles on the assembly line at VW’s Wolfsburg plant in 1953.Keystone-France/Gamma-Keystone via Getty Images
Keystone-France/Gamma-Keystone via Getty Images

Wolfsburg’s very existence is owed to politics, and VW dominates the landscape. The Nazis created the town as an ideal factory site, since it sat in central Germany with plentiful labor. Today, the factory dominates the town, with traffic jams timed to shift changes on the assembly line. A first-division Volkswagen soccer (or Fussball, in German) team plays in the company-built stadium. The Autostadt—a showcase and theme park of cars, with rotating exhibits, which Volks-wagen opened in 2000—runs year-round cultural programs, including concerts and an international circus festival in the summer.

In interviews, experts and company insiders draw a direct connection between the scandal and Volkswagen’s rigid culture, in which mid-level managers and low-level workers were reluctant to question their superiors’ decisions, including the decision to cheat on emissions tests.

“In meetings, everyone is holding back and waiting for the boss to say something,” says Werner, adding that the tendency is found in other German companies too. At Volkswagen, she says, the lack of diversity, including in gender, reinforces that tendency. When I ask her what it is like to be the only woman on the management board, she likens it to being in a foreign country. “When you go abroad, you have to learn the language of the locals to survive,” she says. “So I have to learn the language of the men to survive.” That, she says, includes occasionally pushing in meetings for her views to be taken seriously. “I have to make it clear to them sometimes that I have also worked for 27 years in the industry,” she says. “I have fuel in my blood, just like they do.”

The structure of Volkswagen’s supervisory board, which oversees the board of managers, has remained unchanged since the 1960s. Top local officials from the Lower Saxony government (where Wolfsburg is situated) hold a 20% share, with veto power over many strategic decisions. There is also permanent representation from the Piëch and Porsche families, who founded the company, and half the members are from workers’ councils; under German law, company boards must include worker representation.

Industry analysts believe the unchanged board structure is one explanation for Volkswagen’s giant workforce of 640,000 people—about one-third bigger than Toyota’s for almost equal output. After long negotiations with management, in 2016 Volkswagen’s labor representatives and local politicians finally agreed to allow the company to cut 30,000 jobs worldwide. “When you analyze it, it is extremely inefficient,” says Arndt Ellinghorst, head of global automotive research at Evercore ISI in London, who was a management trainee at Volkswagen headquarters in the early 2000s. “It should be far better run.” In a research report to investors in May, Ellinghorst wrote that “VW’s outdated corporate structure remains a major burden to shareholder sentiment.”

That structure is also one key factor in what went wrong at Volks-wagen, say those who have examined the Dieselgate affair. “What occurred was the combination of some bad people and a bad culture,” says Larry D. Thompson, a former deputy U.S. attorney general, whom the Department of Justice appointed in April 2017 as the independent monitor of Volkswagen. As part of the com-pany’s legal settlement with the U.S. government, Thompson’s team of about 60 people now scrutinizes the internal reforms in Wolfsburg. The company culture, he says, “discouraged professional managers from speaking honestly about problems they knew about or suspected were going on.”

DIESELGATE: Clockwise, from top left: The “real-world” apparatus that researchers used to monitor emissions; A banner hanging on the fence at a Volkswagen dealer in Hanover, Germany; recalled Volkswagen and Audi diesel cars in a desert graveyard in California; former Volkswagen chief executive Martin Winterkorn testifies before a German parliamentary committee.W.V. University Center for Alternative Fuels, Engines and Emissions; Julian Stratenschulte—Picture-Alliance/DPA/AP Images; Lucy Nicholson—Reuters; Hannibal Hanschke—Reuters
W.V. University Center for Alternative Fuels, Engines and Emissions; Julian Stratenschulte—Picture-Alliance/DPA/AP Images; Lucy Nicholson—Reuters; Hannibal Hanschke—Reuters

Overhauling decades of ingrained habits will be a long process. “We need a change in the mindset,” Diess says. “Many people were focused on what was said by the top five people or probably by the CEO himself. To convince them that they have to take risks, responsibility, ownership—that is not easy.”

Still, analysts think Diess might have the best shot of anyone at changing Volkswagen, especially considering that compared with company lifers, he is an outsider. “He is unbelievably important for Volkswagen,” Ellinghorst says. “It is a huge opportunity. The trust is he will drive change in a very forceful manner.” José Asumendi, auto equity researcher at J.P. Morgan in London, agrees, calling Diess “the best CEO of the auto industry in Germany.”

There are signs everywhere that changes are underway. Some are subtle, like colleagues beginning to address each other with the German informal pronoun du rather than the formal Sie. Recently, Volkswagen issued its first companywide code of conduct, with guidelines that include human rights, gender equality, and environmental protection.

AUTOMATIC FOR THE PEOPLE: The Nazis chose Wolfsburg for Volkswagen’s headquarters in the 1930s because of its proximity to a plentiful labor force. Today, half of Wolfsburg’s population works for VW, but the assembly line is increasingly automated.Photograph by Frank Schinski for Fortune
Photograph by Frank Schinski for Fortune

Werner, as the integrity chief, has launched a campaign to spread the word about new values—including the ability to speak openly about problems. One morning in late June, I hopped aboard her “integrity bus,” a bright-painted motor coach she fills once a month with invited employees, for an hour-long drive around the Wolfsburg campus. The idea is for them to air grievances and anxieties on neutral ground, with a member of senior management—a relatively new concept at Volks-wagen. On this morning, the bus is filled with technical engineers, whom Werner says have been “stigmatized” among colleagues for being responsible for Dieselgate. “They cannot go into the canteen without people feeling they were the ones who made us pay 25 billion [euros],” she says. “That is not easy to deal with.” On board, one man says he is troubled by the strong criticisms he hears about the company. Werner tells him the company is changing and is at “a point of no return,” but she also tells him “it will take a life cycle to have sustainable change.”

However long the transformation takes, Diess is convinced that it is crucial for Volkswagen to keep growing through the industry’s tumultuous next decade. “It will be very difficult to survive with this kind of company culture, relying very heavily on headquarters, with central decisions,” he says. “You ask many times the same questions. You get slow.”

In small-town Wolfsburg, Volkswagen’s hierarchical culture is shifting, albeit slowly. In the hands of Diess—lanky and chatty, with a kinetic energy—the CEO’s buzzwords like “sharing” and “cooperation” now creep into conversations about how life is changing in the company.

As part of a major reorganization, Diess has grouped the labyrinthine company into four categories: volume, premium, luxury (Volkswagen owns high-end Bentley and Bugatti), and trucks and buses, which will be spun off as a separate entity, with an IPO perhaps as soon as next year. Each of the 12 brands is now expected to pool ideas within its group, making a broad range of decisions rather than competing among themselves for the boss’s approval. Not only will the new organization change “the mindset,” to use Diess’s term, but also it is aimed at cutting billions in expenses.

That leaner operation is critical if Volkswagen has a shot at succeeding in its most radical transformation ever: becoming a major global player in electric cars.

The scale of the electric plan is dizzying—and won’t come cheap. In May, Diess told shareholders that the company intends to invest nearly $40 billion into producing electric cars within the next four years. By 2025, Volkswagen aims to have one–quarter of the vehicles it produces be electric—millions of cars a year—and to have a 10% to 15% share of the electric-car market globally. That will require converting or expanding 16 factories around the world within four years, including one in the U.S. and five in China. Eichhorn, the CTO, says Volkswagen will also need at least six new battery factories within a decade, each of them the size of Elon Musk’s 5.5-million-square-foot Gigafactory facility in Nevada, which produces batteries for Tesla. “We want to be the technology leader in this, just as we were the technology leader in the combustion engine,” Eichhorn says.

PICTURING THE FUTURE: Designers in VW’s Future Center Europe research and development lab in Potsdam visualize concepts with the help of virtual reality.Photograph by Frank Schinski for Fortune
Photograph by Frank Schinski for Fortune

In reality, Volkswagen is racing to make up for lost time. It only launched its electric strategy in 2016 in the disastrous aftermath of Dieselgate—13 years after Musk founded Tesla. “Without the diesel crisis, Volkswagen would not have an electric platform,” Sedran says. “Just on the financials, it is not a good idea. We would have realized too late, blinded by our financial success.”

The thinking has changed drastically. While Volkswagen is late, Diess believes that with enough investment, VW can leverage its decades of producing fuel-burning cars to overtake its competitors. “We have the dealerships, the markets,” he says. In comparison to Tesla, he says, “we want to make e-cars for millions, not just for millionaires. Ramping up a car from 10,000 to a million? We can do that in every country in the world.”

Among Volkswagen’s new projects are ideas the board once rejected, like an electric car–sharing scheme the company is launching next year in German cities before going global in 2020. And when I arrived in Wolfsburg in late June, managers were buzzing with excitement over the Broadmoor Pikes Peak rally that had taken place in the Colorado Rockies days before, where Volkswagen’s custom-made electric car, called I.D. R Pikes Peak, won the race in under eight minutes. “There has been big skepticism about EVs—and we won!” cooed Michael Jost, chief strategy officer for the VW brand.

Having been caught behind the curve, the company is now focusing on what comes after electric vehicles: driverless cars. Diess believes autonomous vehicles are probably only a few years away, perhaps beginning in newly built cities in India or China.

Peter Wouda, Director of Vehicle Design, left, talks over new design ideas with Verena Thomas, Head of Design Trends, center, and Georg Bergmann, right, at the Volkswagen Future Center Europe (FCE) in Potsdam.Courtesy of Volkswagen
Courtesy of Volkswagen

Concepts that seem fanciful are, in fact, already in the design phase. In an exhibition hall in the Autostadt, a scale model of a futuristic city shows mobile robots that zoom around parking lots, recharging cars while their owners are running errands or in the office—an idea that Volkswagen is already working on with German robot manufacturer KUKA. “It is a totally new world for us,” Diess says. “The question is, Can we adopt the new technology fast enough, becoming more of a software company?”

These whiz-bang inventions—costly, and for now not Volkswagen’s core business—have injected optimism after three angst-filled years. “We have a lot to show you,” Axel Heinrich, executive director of Volkswagen’s research department, tells me excitedly, as he leads me through the building one afternoon, introducing me to some of Volks-wagen’s 600 scientists and engineers. Among their inventions are car-seat leather made from discarded banana leaves and mushroom roots rather than from animals, and digital “empathic assistants” that fit onto the dashboard and are, say the researchers, capable of conducting complex two-way conversations while you drive.

In Potsdam, west of Berlin, the Volkswagen Future Center Europe (there are two others, in Beijing and Silicon Valley) turns out full-size Styrofoam models of future cars, including adapted versions of SEDRIC, the company’s self-driving vehicle. “We talk about futures, plural,” says Peter Wouda, a car designer who runs the center, as he shows me the new virtual reality platform they have built, allowing them to tweak new designs within seconds. In the “far future,” Wouda says, “most people will not own a car.”

By the time that “far future” arrives, Diess hopes Volkswagen will be as much a tech company as an automaker. The work of transforming the company has only just begun—and is unfolding as it tries to regain its credibility after Dieselgate. “We have lost a lot of confidence of our customers,” Diess says. “I think it will take time.” In the meantime, the new VW is speeding toward that future as fast as it can.

A version of this article appears in the August 1, 2018 issue of Fortune with the headline “Inside VW’s Big Fix-It Job.”