Issues in Investment Appraisal: The Challenge of Financing Large Engineering Projects

1. Issues in Investment Appraisal:The Challenge of Financing Large Engineering Projects Graham M Winch Centre for Research in the Management of Projects

2. The standard investment appraisal model net present value is : discounted cash flow is : Σ where Cout is the (negative) investment cash flow (CAPEX) Cin is the (hopefully positive) return (income less OPEX) r is the rate of return expected by investors (inflation + X)

3. Some problems with NPV • sophisticated tool backed by elegant mathematical tools • remains the cornerstone of project selection • but both incomes and outgoings are uncertain • in the Knight/Keynes sense • data about future states are by definition unavailable • data gap filled by subjective probabilities • allow the reduction of uncertainty to risk • open up the toolbox again

4. The sirens of subjective probability • Savage and personal probabilities • Foundation of neo-classical economics and decision sciences • Essential for quantitative decision-making under uncertainty • Formalised elicitation methods assume : • Complete definition of all possible events and their impacts • Predetermined scales for measurement of those events • Well-trained dispassionate experts will not exhibit systematic bias • Fischoff (1992: 431): “a debiasing procedure my be more trouble than its worth if it increases people’s faith in their judgmental abilities more than improves the abilities themselves” • The problem of low probability/high impact events

5. Project selection under uncertainty • Large engineering projects typically selected under conditions of uncertainty, not risk • Cost and benefits many years in future • They are large enough to change their environment (Merrow), hence generate unintended consequences • Stakeholder action creates a dynamic context • Two alternative theories of project selection under uncertainty • Escalation (Staw and others) • Strategic misrepresentation (Flyvbjerg and others)

6. Project escalation • The tendency to throw good money after bad • retrospective <> prospective rationality of CBA • Escalation of commitment driven by • Post hoc justification of earlier decisions • The consistency model of leadership • Experimental results • “individuals invested a substantially greater amount of resources when they were personally responsible for negative consequences” (Staw 1976: 39) • Essentially a psychological explanation • Supported by case studies of Expo’86, Shoreham and Taurus (Drummond) • Presumes that original investment appraisal was honest, but overtaken by events.

7. Strategic misrepresentation • the tendency to underestimate costs (Cout) • the tendency to overestimate benefits (Cin) • systematically optimistic investment appraisals • The problem of optimism bias • Supported by large data set of outcomes of major projects • an organisational explanation • Under scarce resources project promoters are incentivised to produce favourably biased investment appraisals • Project promoters typically move on before project completion • Financier lock-in to projects • Argues that the original investment appraisal was dishonest

8. The evidence from the Channel Fixed Link Eurotunnel is, in effect, bust; it cannot repay its debts on it current operating basis. Now the tunnel is built, the pubic interest is in maximising its use, yet the Anglo-French treaty that created it forbids public support to help it do so. Financial Times Leader, February 23rd 2004

9. Project performance

10. Comparative performance

11. CFL : Evidence for Strategic Misrepresentation • Deliberate overestimation of Eurostar passenger numbers at 17m p/a • Admitted by Guillaume Pepy, Chair of Eurostar group upon opening of phase 1 of CTRL (Financial Times 29/09/03). • "The project price ...... was put together to convince the governments, it was a viable price, a promoter's price. What it was not was a contract price. We should never have undertaken to do the work for anything like the sums that were in the submission to the governments" • Taylor Woodrow representative (cited Byrd 1994: 27). • Clash of negotiating cultures : "In banking you bid high and then trim your margin: in contracting you bid low and then get your profits on the variations" • Colin Stannard, Eurotunnel CFO, (Stannard 1990: 53) • “as the marketer of the issue [of Eurotunnel equity] I had successfully sold the market at pup” • David Freud, project financier (Freud 2006: 357)

12. CFL : Evidence for escalation • The project was "assembled round a hole like a Polo mint...[there was] no client driving it forward with a vision of what the operator needed to have“ • Joint CEO Sir Alistair Morton (Financial Times 19/9/95) • "le premier problème est qu'il n'existait pas de maître d'ouvrage, c'est-à-dire de client, face au constructeurs" • Joint CEO André Bénard (La Tribune 18/6/93).

13. Some inferences • Strategic misrepresentation was the driving dynamic on the CFL project • Subsequent escalation facilitated by a weak client • Funders (e.g. Japanese banks) were locked in by uselessness of partially completed facility • Were they victims of escalation or Mrs Thatcher’s handbag? • A project without sovereign guarantee failed to avert optimism bias • The “financial discipline” of the private sector was absent

14. Generalising from the case • “we had to have the concrete on the table in a hurry” • PM Storebælt fixed link (cited Bonke 1998:10) • “the initial numbers were done on the back of a fag packet in 1995” • Gerald Corbett, CEO of Railtrack on West Coast Main Line, (cited Freud 2006: 275) • “I haven’t seen this much lard since I handed out blue ribbons at the Iowa State Fair” • Ronald Reagan on Boston Central Artery Tunnel (cited Hughes 1998: 210)

15. A broader issue : the pervasiveness of uncertainty The world of project finance “was dominated by powerful characters accustomed to taking tough decision under immedidate pressure in a gossip-fuelled marketplace. The currency was not cash but chaos. Transactions invariably took place at the edge of feasibility, conducted against a competitive background under great time pressure. I found few committees of experts considering all the evidence available in wise conclave. Much more typical were decisions taken on the fly by whoever happened to be available, based on a fraction of the full information” • Freud 2006: 356

16. A broader issue : the competitive dynamic “No one will ever know how many ill-conceived water projects were built by the Bureau and the Corps simply because the one agency thought the other would build it first…. The Corps of Engineers and the Bureau [of Reclamation] squandered their political capital and billions in taxpayers’ money on vainglorious rivalry, with the result that much of what they really wanted to build does not now exist, and probably never will.” (Reisner 1993 : 201 & 213)

17. Understanding the organisational dynamics of investment appraisal The role of future-perfect thinking The struggle for resource allocations Stakeholder free-riding The sociology of optimism bias The role of third party review Understanding the psychology of investment appraisal The interface between psychology and decision sciences Heuristics and biases in perceptions of probability and impact The psychology of optimism bias The dynamics of funder lock-in New ways of thinking about the future Projects are the principal means of deliberately creating the future The redundancy of project risk management Making good sense An agenda for research

18. A closing thought? “the Hitch Hiker’s Guide to the Galaxy skips lightly over this tangle of academic abstraction, pausing only to note that the term ‘Future Perfect’ has been abandoned since it was discovered not to be” • Adams 1980: 80