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Loss Aversion, and Why Companies Throw Good Money After Bad

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Yesterday I discussed how much I admired Daniel Kahneman’s book, Thinking, Fast and Slow, and wrote about the advice he has for avoiding biases in planning and forecasting.

Today, I want to focus on Prospect Theory, loss aversion, and how these explain why it seems companies often throw good money after bad.

Loss aversion is a key part of Prospect Theory, for which Kahneman won his Nobel.  Simply put, loss aversion says that humans are more averse to losses than they are happy with gains.  Few people will take a bet with equal chance to lose $1000 or win $1000;  they feel the pain of losing $1000 more intensely than the joy of winning $1000.

Going further, although they are economically equivalent, we feel better about a 90% chance of a $1000 loss than a 100% chance of a $900 loss.  One reason is that we are subject to decreasing sensitivity to losses as they get larger.  We experience a $900 loss more than 90% as intensely as a $1000 loss.  We are also subject to a certainty effect. We give less psychological weight than warranted to events that are highly probable but not certain.

These factors make managers prone to unfortunate gambles when faced with difficult choices.

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Thinking, Fast and Slow: Avoiding Biases In Planning and Forecasting

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I recently finished reading—no, devouring, Daniel Kahneman’s masterpiece of a book, Thinking, Fast and Slow.

Kahneman is the winner of the 2002 Nobel prize in economics, even though he’s technically a psychologist.  Most of his work has focused on the psychology of decision making.

Thinking is one of the best business books I’ve read in the past several years.  Basically, it is a comprehensive summary of many of the major findings of psychological research from the past 50 years as applied to problems we commonly face in business and other organizations.

There were four topics in the book I found particularly interesting:

  1. Biases in planning and forecasting, and how to avoid them
  2. Loss aversion, and why companies throw good money after bad
  3. When to trust intuition
  4. The superiority of algorithms in personnel selection

I’ll cover the first topic in this post and summarize the others in subsequent posts.

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Solar Sales Channels: Current Status and Likely Evolution of Residential Solar Sales in the U.S.

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Woodlawn Associates recently interviewed more than 20 solar dealers and other experts to understand what they want from manufacturers of solar modules and inverters and to help dealer-installers understand how the sales channel is likely to evolve.

In summary, we found SunPower and SMA had highest consideration rates for solar modules and inverters, respectively.  We also found that Mitsubishi, Schott, Sanyo, and Trina could gain market share in PV if they execute well.  These manufacturers had consideration rates considerably above their current market shares.

Installers told us product availability, commercial terms, and customer sales leads are among the most important purchase drivers, although the supply shortages that were endemic over the past year appear to have eased.

Leases and PPAs have become hugely important in the market, now accounting for nearly half of residential sales in some states.  The rise of such financing potentially reduces the importance of manufacturer brands, as the risk of non-performance is placed on the lease provider, not the consumer.

Many people in the industry find Sungevity’s and SunRun’s business models to be highly novel and risky, but based on our experience in other industries, they are much less so than many people think.  On the other hand, we find that solar franchising is missing some of the ingredients common in other successfully franchised industries.

Finally, since the residential sales market is highly fragmented, we think it is unlikely manufacturers will integrate downstream.

Download a complete report here.

Blown Away: The Approaching Consolidation of the Wind Turbine Industry

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In the years leading up to 2008, the utility-scale wind power industry grew rapidly.  Globally, newly installed wind generating capacity expanded at an annual rate of 33% from 2004 to 2008.  The market’s growth enticed existing players (many of which were European) to expand globally, especially in large, rapidly expanding markets such as the U.S. and China, and many new firms entered the business or announced their intention to do so.  For example, the number of utility-scale wind turbine manufacturers with sales in the U.S. market increased from five in 2005 to ten in 2009, and 80 to 90 companies attempted to sell turbines in China.

The industry’s fortunes began to turn, however, with the global financial crisis of 2008.  In 2010, new wind installations decreased about 50% in the United States, which had previously been the world’s largest market.  U.S. market leader GE saw wind turbine revenue fall by more than 30%.  Global market share leader Vestas announced the layoffs of 3,000 people, mostly in northern Europe, to realign capacity with expected demand.  Although the Chinese market has continued to grow, large domestic suppliers now dominate there, dampening hopes of both foreign vendors and Chinese upstarts.

With a larger number of suppliers chasing a considerably less robust global market, it is reasonable to ask whether everyone now in the market can be successful.  Equally important is how participants can optimize their chances of success and shareholder value.  Through analysis of economic principles and comparisons with other industries, we attempt to answer these questions in this paper.  In brief, our findings are as follows:

  • The global wind turbine industry will grow at a much slower rate of 6% to 8% annually.  The U.S. is unlikely to exceed the level of demand seen in 2009 for some time.  The Chinese market will continue to see robust capacity growth, but the rate of increase will be much lower.
  • The wind turbine industry shares several characteristics with other industries that are much more concentrated, such as gas turbines.   Considering both this and the slower market growth, we believe there will fewer turbine suppliers a few years from now.
  • Opportunities abound for OEMs to combine in ways that strengthen their chance of success.   Leading firms can acquire manufacturing or technology assets; mid-size competitors can merge and eliminate duplicated resources; cross-border mergers could increase market access.
  • The scale provided by their home market will give leading Chinese turbine manufacturers a leg up in their quest for global competitiveness.
  • Suppliers to wind turbine OEMs should evaluate how likely their current customers are to be among the industry’s long term survivors and work to diversify their customer base.

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Chinese Solar Powers Up: Lessons for the Wind Energy Industry

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We recently looked at the overseas penetration of Chinese solar photovoltaic module makers to see if there might be lessons for the wind turbine industry.  Chinese solar PV module manufacturers have rapidly increased their overseas market share.  For example, they have increased from 0% to over 30% of the California solar market in three years, and have seen similar market share gains in Germany.  Moreover, Suntech, a Chinese PV manufacturer, rated #1 in consideration rate in our recent U.S./Europe survey of solar buyers.

In contrast, the overseas penetration of emerging wind turbine manufacturers has been much more muted.

Six main factors account for the growth of the PV module makers:

  1. Cost leadership
  2. They entered market when supply was tight
  3. Solar modules are (relatively) simple, modular, and scalable, which makes entry easier for new entrants
  4. PV modules viewed as commodity-like
  5. The executive teams of the leading Chinese solar manufacturers have extensive experience outside China
  6. As businesses, the leading Chinese PV makers are relatively transparent to those outside China

The implications for wind turbine manufacturers heading into new regions are:

  1. Expect new market penetration will take a long time due to need for an operating track record.  It may be a long time before local manufacturing capacity is required
  2. Purchasing projects or doing project development can get beyond bankability issues
  3. Developing local engineering and support capabilities should be high priority in overseas expansion
  4. Certain partnerships could accelerate progress and increase probability of success
  5. Prioritize markets appropriately

Download our detailed analysis here.