Nuclear power plant cancellations: sunk costs and utility stock returns.

Nuclear Power Plant Cancellations: Sunk Costs and Utility Stock Returns

Abstract

This study empirically examines the impact of decisions to cancel nuclear power plants on electric utility common stockholders. The reaction of common stock prices to initial announcements of 58

nuclear power plant cancellations covering the period 1974 through 1984 is analyzed. Decisions to cancel nuclear power plants under construction were associated with significant negative excess stock returns. Furthermore, the larger the sunk costs relative to a utility's common equity at the time of the cancellation, the larger the stock price decline, on average. This relationship was more evident as regulators moved toward allocating relatively greater proportions of the sunk costs to investors.

Introduction

In May 1982, Duke Power announced that it was canceling its Cherokee nuclear power plant. Duke Power had invested over $633 million in the partially completed plant. This sunk cost figure represented over 30 percent of Duke's precancellation net worth. Cincinnati Gas and Electric, with two other electric utilities (American Electric Power and Dayton Power and Light), announced the cancellation of the Zimmer nuclear power plant in October 1983. Zimmer's total sunk costs equaled approximately $1.8 billion; Cincinnati's share amounted to $716 million or almost 90 percent of the utility's 1982 net worth.

The Cherokee and Zimmer cancellations are two examples of the recent substantial reduction in the commitment to nuclear power by U.S. electric utilities. Since 1972, over 120 nuclear units have been canceled by electric utilities; over $15 billion had been spent on these units. These cancellations represented over one-half of the total previously ordered nuclear generating capacity, and no new nuclear units have been ordered since 1977.

The decision to cancel a nuclear power plant is important in terms of its impact on the affected utility's future cash flows. Even in a favorable regulatory environment, the affected utility rarely will be allowed a sunk cost recovery system that results in a zero net present value. As a result, the initial announcement of a nuclear power plant cancellation should be treated by stock market investors as a negative informational event. Furthermore, larger price declines should be associated with cancellations involving larger sunk costs.