Case Study: Eurotunnel: “One of the world’s greatest engineering success stories” Based on the case materials specifically identify the key judgemental errors made by the private parties involved with the project: MANAGEMENT During the period of 1987 to 2005 there are 3 changes of the Board of Directors of Eurotunnel. Most of the behavioural finance that listed below incurred during the first management period. Overconfident Overconfident behavioural is a well-established bias in which someone’s subjective confidence in their judgments is reliably greater than their objective accuracy, especially when confidence is relatively high.
Management’s overconfident seen through overestimate the chances of success and underestimate the associated risks of its decision. The management’s overconfidence reflected from following evidences: * Management overestimate the chance of project success as stated in Eurotunnel prospectus of 1987. The justification was that “Whilst the undertaking of a tunnelling project of this nature necessarily involves certain construction risks, the techniques to be used are well proven. The directors believe… that 10%… would be a reasonable allowance for the possible impact of unseen circumstances on construction costs. In reality the tunnel project was delayed and cost double as much as estimated from ? 4. 9bn in 1987 to ? 10. 1bn in 1994. * The project estimated the tunnel to be opened in June 1993 but in reality it was delayed about 12 months due to construction problems and cost overruns, and finally opened in 6 May 1994. The tunnel full operation also delayed about 4/5 months due to safety regulation. * Management was underestimate their competitors hence the Eurotunnel unable to achieved its forecasted market share and revenues. In the beginning, Eurotunnel thought that it will be the market leader soon after the tunnel operated and will gain 2/3 of market share. While the Tunnel was being built, the ferry companies had invested heavily in new large efficient vessels in preparation for the opening of the Tunnel and had introduced various efficiency measures. The unpredicted price war launched by ferries in summer 1995 with ferry prices 30% lower than 1994. * Eurostar also has to struggle against fierce competition from airline companies. * Management also underestimated the complexity of the system.
In particular, the number of fail-safe elements in the system made it very difficult to operate partially. If someone was working on an element, an alarm would go off which would shut the system down. This was compounded by the fact that a central part of the commissioning is the training of operative staff, so system shutdowns could not be overridden as this would have effectively trained staff to ignore warning signals. Over optimism Over-optimism bias is the demonstrated systematic tendency for people to be over-optimistic about the outcome of planned actions.
This includes over-estimating the likelihood of positive events and under-estimating the likelihood of negative events. Through the Eurotunnel projects this bias seen through these facts: * The traffic and revenue forecasts for Eurotunnel have proved to be over optimistic. * In 1987 prospectus predicted only moderate fall in cross-Channel prices due to opening of the Channel Tunnel. In 1990 projected average revenue per car was ? 64. 5, then in 1993 was ? 56 then the actual revenue/car to be ? 49. 5 in 1995 and ? 34. 4 in 1996. (Anchoring and adjustment??? * Passenger use was forecast at 16 million when it was actually 6 million, freight volume at 7 million tonnes when it was actually 1. 7 million tonnes. * Need introduction………. “The directors intend that dividends will be paid to shareholders as soon as possible. As shown in the projections, good operating performance by the Group should allow a first dividend to be paid in 2006…. Should the outcome be better than that indicated, Eurotunnel may be able to pay dividends earlier than 2006. ” (Eurotunnel Financial Restructuring Proposal, April 1997)
Loss Aversion Management have an aversion to sure loss and continue a failing project when they should terminate the project. * The construction projects shown a big cost overrun. Total construction costs (? m) estimated in Nov 1987 as ? 2,710m, and increase more than 47% in 1990 to ? 3,970m then increase about 79% in 1993 to ? 4,840m. * Instead of terminate the project, the management summon more funds through equity offers and new debts. * Eurotunnel currently [2004] has debts of ? 6. 4 billion and made record losses last year of ? 1. 3 billion.
The group’s problems have included higher interest costs, a fall in travel caused by the economic downturn and fierce competition from cross-Channel ferries. * Need to revise later on…. Following the issuing of the Systems Acceptance Certificates for the fixed equipment and the rolling stock, commissioning could begin, but was not fully completed by the issuing of Tests on Completion until January 1995. The original commissioning period planned was 6 months from December 1993 to May 1994, but, effectively, it doubled to 12 months. As problems mounted it was decided to prioritise the commissioning of the freight services.
Freight shuttle services started in May 1994, and a full 24 hour service in November of that year. The through freight came into service in the June. The IGC finally gave approval for the operation of limited Eurostar services in August 1994, but a full public service was delayed until the November. The IGC finally gave approval for the commencement of limited passenger shuttle services (Le Shuttle) on an invitation-only basis in August 1994, but full services for the public were not implemented until December of that year, and the final train was not received from Bombardier until July 1995, over 24 months late.
Only the rail freight service met the deadlines that had been stated in the Rights Issue prospectus of May 1994, and even the launch of this service was behind the programme envisaged earlier in the year of a March start for freight, and a May start for passengers. ——- Patrick Ponsolle, the co-chairman of Eurotunnel placed the main source of these problems with the IGC. However, many of the problems with the commissioning were generated by the way the project was managed. Ponsolle admitted that the time required to commission the system was underestimated.
The problems were that due to the tortuous negotiations between TML and Eurotunnel, there was for a long time no clear date for the handover. Due to the delays to the construction programme, the commissioning was then fast-tracked in order to bring forward the revenue-earning period. This meant that construction and commissioning were taking place simultaneously, with one shift on construction and the other on commissioning. SHAREHOLDER Over Optimism * Eurotunnel raised substantial amounts of equity in four public offerings uring the construction of the Tunnel, mainly from small shareholders in France and the UK. The marketing of the shares was pitched towards small shareholders with a strong emotional appeal based on linking Britain to the Continent, rather than on hard evidence of traffic and revenue potential. * “This is an ideal investment to finance the studies of your children; you receive nothing at the beginning, but in turn, the value of your shares will treble in seven years! ” (Eurotunnel’s MD at time of 1987 IPO) Loss Aversion Due to cost overrun during the construction stage, more finance was needed and the banks and shareholders were trapped into pouring in more and more money to get the project finished, in the hope of eventually recouping the money already spent. * As one result of loss aversion behavioural, the shareholders tend to use many different (unconscious) strategies against mourning and bearing loss including denial or blame others. In April 2004, Bank controlled board thrown out and replaced by shareholder representatives. Instead of declare bankruptcy because of low share prices and operating revenues, the shareholders tend to have an aversion of sure loss. In January 2007: French Commercial Court approves Eurotunnel’s final ? 6. 2bn restructuring plan, to be voted on by shareholders where Eurotunnel won its fight for survival yesterday after shareholders overwhelmingly backed a restructuring plan. Affect heuristics The affect heuristic is a heuristic in which current affect influences decisions. The potential investors have been wooed with a television and print advertising blitz during the pre-launching of Eurotunnel’s equity offering. BANKS Eurotunnel investment project: Key judgemental errors made by Banks In bank section, we can analyse banks by split them into two groups. 1) 5 Banks who are promoters and founder shareholders, these groups hold 30. 7% of total Eurotunnel project’s share by the time the project was originated in 1986. This group consists of 1. 1 Two UK banks: Midland and Natwest . 2 Three French banks: Credit Lyonnais, Banque Nationale de Paris, Banque Indosuez 2) 220 Banks who are in bank syndicate provide project’s loan in 1987 These banks made a wrong decision in the investment as listed below: 1) Overoptimistic: Eurotunnel was planned to start since 1802, however, it is actually started by 1986 and became the biggest innovative project by that time. Investors looked on just the bright side as there will be lots of benefits if the project launch successfully.
Along with the project, banks also hired a second set of consultants individually to evaluate and project market and revenue for Eurotunnel annually on top of Eurotunnel project’s team did themselves, by a group of traffic and revenue consultants. However, the result from banks’ consultants had no significantly deviation from the report from a group of traffic and revenue consultants. The report from a group of traffic and revenue shown that in 1994 and 1995, the project expected to have 71. 66 million and 77. 72 million passengers respectively. However, the actual number of passenger was much less which were 32 million in 1994 and 36. million in 1995. Even with yearly revision, consultants misforcasted not only numbers of passengers, but also project revenue that was predicted too high. The data that was used by banks’ consultants was bias. While consultants should focus on the feasibility of Eurotunnel project itself, they then focused on the bigger scope i. e. economic growth and market size. This misinterpreted and mislead the decision of banks in the initial investment of the project from 5 banks as shareholders in 1986 and in continual investment to provide syndicate loan by 220 banks in 1987.
Moreover, banks had no or less experience in this kind of investment, then the contract made was disadvantageous between shareholders and construction companies. Though there was a penalty to fine construction companies mentioned in the contract since the beginning of the project, banks needed to absorb the incurred cost due to project delay due to construction companies will responsible just for some limited area only. On top of that, there was no proper project cost evaluation. When construction companies submit the cost of the project, banks thought that this cost has already included buffer of the uncertainty of the project.
However, in reality, construction company use low cost in order to win the bid. With all of these, banks couldn’t control or challenge higher cost of construction when the construction companies claimed for more investment. 2) Confirmation Bias: Banks tended to believe the data from consultants which only looks on the positive side and benefit from the project. However, the report missed out lots of information. For example, the implementation of safety design has not been finalized since the beginning of the project or competitors’ reaction including ferries and airlines.
Another support evidence is Japanese banks who were about to provide loan to Eurotunnel in 1987 did ask for government‘s guarantee or the official support for the project. Though no one guaranteed or provided official support, Japanese banks at the end decided to provide the loan to the project as they assumed that there was an implicit government’s guarantee. 3) Overconfidence: The projection of the project indicated that project was feasible to gain market share at 66. 67% from total ferry market since the first year of the project launch.
This shown that banks was overconfident. They forgot to see the whole picture of the markets. They did not understand market structure, consumers’ behaviour, and competitors’ reaction at all. They even did not consider that those competitors could create price war in order to protect their own market share. Even with before the launch of Eurotunnel, Ferries Company prepared new vessels in order to create strategy to fight with Eurotunnel in terms of the service frequency and other attractive service such as duty free goods.
Also, by looking just the success of the project and believing in just one side of the data, banks as shareholders missed out some of project’s opportunities i. e. ticket system which help company to sell ticket at different price rather than just single price. 4) Loss aversion: Banks chose to invest more and more money in the project rather than stop it as they believed to get benefit and return on investment from the project in the future. Banks passed the risk of loss to individual shareholders by raising funds from public sectors.
This idea then reversely restricted banks’ decision in the long run. Due to overrun construction cost all through the project, Eurotunnel faced lots of debt that cannot be paid. Banks then needed to do restructuring to help the project in 1998. This was the best way for bank to maintain the availability of the project though it means to maintain this chronic financial distress. Bankruptcy is not the option for banks to choose as there was pressure from legal and political parties due to this concerns to lots of people. Construction Companies
Due to geological problems arose during the construction of The Eurotunnel the cost of the project increased approximately at 80% over the initial budget and reached at 4,84bn? on May 1994. The geological problems arose because the contractors underestimated the necessity for accurate geotechnical research because this would require added cost. Finally, the geomorphology of the ground was different compared to what it was expected. Hence, a major change in the design of the tunnelling system occurred and as a fact this increased the cost of the construction project (“Engineering Geology of the Channel Tunnel”, by C.
S Harris, M. B Hart, P M Varley and C D Warren, 1996). The judgemental biases in the geotechnical section was that the team of engineers had been so overconfident of the data acquired before the construction of the project that they believed they would not meet wet layers of ground. Hence the confidence of engineers grew disproportionately in larger scale compared to the accuracy of data provided. In addition, even if the engineers had all the geotechnical data, the accuracy of their estimation would not have improved significantly.
In this case only the level of confidence of engineers would have been increased (“Behavioural Investing” A practioner’s guide to applying behavioural finance James Montier, John Wiley and Sons Ltd, 2007). Therefore, in every case managers should be sensitive to information they receive and they should not feel overconfident about their information and the fact that more information does not lead to better accuracy. The second factor which led to judgemental biases was the traffic errors forecast. The construction firms overestimated the number of total cross-Channel passengers as well as the reactions from the competitors.
Hence, the actual percentage of passengers crossed the tunnels were only 45% of the traffic predictions. This case is a good example of anchoring and adjustment. Construction companies produced some initial previsions which were very optimistic. Even though construction firms during the construction face adjusted their predictions by lowering the traffic volume, their predictions were still very optimistic. (FINANCIAL DISTRESS, LENDER PASSIVITY AND PROJECT FINANCE : THE CASE OF EUROTUNNEL, by Laurent Vilanova, 2006). Another issue of heuristic biases was that The Eurotunnel management nderestimate the reactions of the competitors, mainly the ferries companies. The latter started a price war and as a consequence of this price war The Eurotunnel management forced to reduce its price, decreasing the revenues (FINANCIAL DISTRESS, LENDER PASSIVITY AND PROJECT FINANCE : THE CASE OF EUROTUNNEL, by Laurent Vilanova, 2006). Finally, The Eurotunnel had to face the competition from airline companies and this fact also underestimated. The third factor affected by judgemental biases was the fact that the parts involved in the project, shareholders, construction companies and banks, faced conflict of interest.
Therefore, the banks underestimated the fact that there was conflict of interest with construction companies, because the latter had interest only during the construction phase, while banks had long-term interest because the repayment of the project would start after the commercial development of the project(European Management Journal “Neither Shareholder nor Stakeholder Management: What Happens When Firms are Run for their Short-term Salient Stakeholder”, Volume 25,Issue 2, Laurent Vilanova, 2007).
Further, representativeness of heuristic arose when The Eurotunnel decided to become public and its management at the time of Initial Public Offer (IPO) made very optimistic forecasts for the future earnings of the shareholders. Hence, a conflict of interest between the banks and the new shareholders, mainly individuals, arose because it was considered that the management of The Eurotunnel made overoptimistic predictions, favouring the banks. In addition, it should be noted the fact that new shareholders, mainly individuals, ignored the reliability of evidence from the management of The Eurotunnel.
Finally, construction contract errors contributed to the overrun of the cost of The Eurotunnel. For instance the existence of independent construction team in the two sides of the tunnel led to asymmetry of information (www. referenceforbusiness. com). Further, The Eurotunnel management could not control the intervention of the Intergovernmental Commission (IGC) during the construction projects. As a consequence of this fact, the construction project delayed and cost overrun because the ICG intervened and changed some of the specifications of the project (Eurotunnel Group Business Information, Profile, and History, http://companies. rank. org/pages/1470/Eurotunnel-Group. html). In addition banks and Eurotunnel management focused on bonus for construction companies and they did not pay any attention for penalties in case of delays or cost overruns. ——————————————– [ 1 ]. Baron, Johnathan (1994). Thinking and Deciding. Cambridge University Press. pp. 219–224. [ 2 ]. Castles, Chris (2003). The economics of the Channel Tunnel–Success or failure? [ 3 ]. Winch, GM (1998). Le Groupe Bagnolet. www. blackwellpublishing. com/winch/case. oc [ 4 ]. Optimism Bias (2001). http://en. wikipedia. org/wiki/Optimism_bias [ 5 ]. Break even analysis: Eurotunnel, Mind Your Business (2008). http://www. bized. co. uk/current/mind/2008_9/181108_a. htm [ 6 ]. Eurotunnel: history of an investor’s nightmare, Times Online, April 7, 2004. http://www. timesonline. co. uk/tol/news/article1056892. ece [ 7 ]. Milmo, Dan (2007). Eurotunnel saved by shareholder support. http://www. guardian. co. uk [ 8 ]. Lohr, Steve (1987). Eurotunnel’s Day of Reckoning. http://query. nytimes. com
