Two South Carolina utilities have plans to abandon two nuclear reactors that are still under construction. The two reactors have cost the utilities roughly $9 billion and are less than 40 percent completed. They were expected to begin generating electricity after 2021 at cost of $25 billion — more than twice the initial $11.5 billion estimate. At the same time, demand growth has not materialized and the costs of alternative energies, such as natural gas and wind, have fallen substantially.
Scana Corporation, the project's owner, said in a statement,“Ceasing work on the project was our least desired option, but this is the right thing to do at this time.” This beats throwing more money at an increasingly unviable project.
Dr. Ward is quite right.
ReplyDelete“Humans are the only animals that honor sunk costs” according to Dr. Robert Leahy (p. 1). We find numerous examples in personal examples such as someone who continues gambling convinced their prior betting will result in a better future outcome. It is also surprisingly common in business.
For example, the Tennessee Valley Authority has invested heavily in nuclear power plants long after the demand for additional power has waned and the costs have skyrocketed far beyond budgets. The Bellafonte Nuclear Generating Station in Hollywood, Alabama never generated and cost over $6 Billion dollars since construction began in 1975 before the project was finally halted in 1988 (Flessner, p. 1). Part of the reason this seems to occur is that utilities with their monopolies can charge existing customers for new projects that have yet to produce any power.
There are a variety of psychological reasons that contribute to the sunk-cost fallacy to include the endowment effect; loss aversion; confirmation bias; and overconfidence bias (Froeb, Slide 20). Business leaders often don’t like to admit to themselves or others they made a mistake and will let their bias impede the rational decision to cease a project or change a decision. It can also hurt a career if a mistake is revealed so there is additional incentive to continue a poor policy. With the high turnover rate of executives, it is easier and often more lucrative given most incentive schemes to avoid the reversal than to admit to the error and take the accounting hit.
References:
Froeb, L. et al, 2014, Managerial Economics: A Problem Solving Approach, PowerPoint download from Learninghttps://moodle.esc.edu/pluginfile.php/2161920/mod_folder/content/0/Chapter%203.pdf?forcedownload=1
Leahy, R. (2014), Letting Go of Sunk Costs, Psychology Today, downloaded from www.psychologytoday.com/blog/anxiety-files/201409/letting-go-sunk-costs
dated 9/24/2014
Flessner, D., (2016), TVA cancels construction of next-generation nuclear reactors in Alabama, Chattanooga Times Free Press, downloaded from www.timesfreepress.com/news/business/ aroundregion/story/2016/feb/13/tvabandons-new-reactor-design-bellefonte/349984, dated February 13, 2016
This is a prime example of a sunk cost and unfortunately this is a common occurrence in the business world. Expensive projects often run way over budget and far exceed the initial time projections. Companies are force to “cut their losses” and scrap a project and move on after already investing significant resources in the “sunk” project. Leaders must be able to react and adapt to a changing environment, sometimes this means admitting to a mistake and “swallowing your pride” which is often difficulty but necessary to avoid a sunk cost trap. Assessing the process and seeking council from expert resources can help with the decision making process. Setting goals and reaching those milestones on time is important in project management. Often costs can begin to spiral out of control if leadership is not “hands on” with the decision making process. Leaders should gather data, analyze a project thoroughly from beginning to end and have contingency plans ready for action when difficulties arise. Many leaders do not want to “waste” the time and money that they have already spent. Thus, they keep plowing ahead despite all the changes taking place in their environment. In general there are two types of mistakes that you can make: you can consider irrelevant costs, or you can ignore relevant ones (Froeb, McCann, Shor, Ward 2016). The concern should be on how benefits from the current point in time compare going forward with future costs. Marginal costs and benefits are a key aspect of making the right decision on a sunk cost project. Prior investments that have been made should not factor into a current decision. These prior investments cannot be recovered nor should they be relevant as they are the definition of a sunk cost.
ReplyDeleteReferences:
Managerial Economics: A Problem Solving Approach; Froeb, L.M., B.T. McCann, M. Shor, and M.R. Ward. South-Western Cengage Learning; 4th Edition 2016