Saturday, May 20, 2017

A case study in combating bias

Following several disappointing investments, the German electric utility RWE overhauled its decision-making processes. Learn how from the CFO who spearheaded the effort.

I feel that decision biases are so critical; to first recognize and then combat, that we have two sessions now dedicated to this in our Driving Organic Growth Through Innovation class at Kellogg. This is an interesting article on how critical this is. This are excerpts from an interview with the Quarterly  with Bernard Gunther with the German electric company RWE.

The Quarterly: Tell us a bit about the circumstances that motivated RWE’s management to undertake a broad debiasing operation.
Bernhard Günther: In the second half of the last decade, we spent more than €10 billion on big capital-expenditure programs and acquisitions in conventional power plants. In the business cases underlying these decisions, we were betting on the assumptions of ever-rising commodity prices, ever-rising power prices. We were not alone in our industry in hitting a kind of investment peak at that time. What we and most other peers totally underestimated was the turnaround in public sentiment toward conventional power generation—for example, the green transformation of the German energy system, and the technological progress in renewable generation and related production costs. These factors went in a completely opposite direction compared to our scenarios.
Conventional power generation in continental Europe went through the deepest crisis the industry has ever seen. This ultimately led to the split of the two biggest German players in the industry, E.ON and RWE. Both companies separated their ailing conventional power-generation businesses from the rest of the company.

The Quarterly: As you analyzed the decision-making dynamics at work, what biases did you start to see?
Bernhard Günther: What became obvious is that we had fallen victim to a number of cognitive biases in combination. We could see that status quo and confirmation biases had led us to assume the world would always be what it used to be. Beyond that, we neglected to heed the wisdom of portfolio theory that you shouldn’t lay all your eggs in one basket. We not only laid them in the same basket, but also within a very short period of time—the last billion was committed before the construction period of the first billion had been finalized. If we had stretched this whole €10 billion program out over a longer period, say 10 or 15 years, we might still have lost maybe €1 billion or €2 billion but not the amount we incurred later.
We also saw champion and sunflower biases, which are about hierarchical patterns and vertical power distance. Depending on the way you organize decision processes, when the boss speaks up first, the likelihood that anybody who’s not the boss will speak up with a dissenting opinion is much lower than if you, for example, have a conscious rule that the bigwigs in the hierarchy are the ones to speak up last, and you listen to all the other evidence before their opinion is offered.
And we certainly overestimated our own abilities to deliver, due to a good dose of action-oriented biases like overconfidence and excessive optimism. Our industry, like many other capital-intensive ones, has had boom and bust cycles in investments. We embarked on a huge investment program with a whole generation of managers who hadn’t built a single power plant in their professional lives; there were just a few people left who could really remember how big investments were done. So we did something that the industry, by and large, hadn’t been doing on a large scale for 20 years.
The Quarterly: On the sunflower bias, how far down in the organization do you think that went? Were people having a hard time getting past their superiors’ views just on the executive level, or all the way down?
Bernhard Günther: Our investigation revealed that it went much farther down, to almost all levels of our organizational hierarchy. For example, there was a feeling within the rank and file who produced the investment valuations for major decisions that certain scenarios were not desired—that you exposed yourself to the risk of being branded an eternal naysayer, or worse, when you pushed for more pessimistic scenarios. People knew that there were no debiasing mechanisms upstairs, so they would have no champion too if they were to suggest, for example, that if we looked at a “brilliant” new investment opportunity from a different angle, it might not look that brilliant anymore.
The Quarterly: So, what kind of countermeasures did you put in place to tackle these cultural issues?
Bernhard Günther: We started a cultural-change program early on, with the arrival of our new CEO, to address our need for a different management mind-set in light of an increasingly uncertain future. A big component of that was mindfulness—becoming aware of not only your own cognitive patterns, but also the likely ones of the people you work with. We also sought to embed this awareness in practical aspects of our process. For example, we’ve now made it mandatory to list the debiasing techniques that were applied as part of any major proposal that is put before us as a board.
It was equally important for us to start to create an atmosphere in which people are comfortable with a certain degree of conflict, where there is an obligation to dissent. This is not something I would say is part of the natural DNA of many institutions, including ours. We’ve found that we have to push it forward and safeguard it, because as soon as hierarchy prevails, it can be easily discouraged.
So, for example, when making big decisions, we now appoint a devil’s advocate—someone who has no personal stake in the decision and is senior enough in the hierarchy to be as independent as possible, usually a level below the executive board. And nobody blames the devil’s advocate for making the negative case because it’s not necessary for them to be personally convinced; it’s about making the strongest case possible. People see that constructive tension brings us further than universal consent.

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