The reform of State aid rules on SGEI An economic perspective on compensation

1. The reform of State aid rules on SGEI An economic perspective on compensation Lorenzo Coppi GCLC SGEI ConferenceBruges, 30 September 2011

2. Outline • Altmark and SGEI compensation • The 2005 Package’s approach to compensation – Applying Altmark? • The 2011 Package’s approach to compensation – Clarifying Altmark, achieving fiscal discipline, or both? • Conclusions

3. Altmark • The Altmarkjudgement identifies four conditions under which compensation for a SGEI confers no advantage, hence no aid: • Clearly defined public service obligation • Objective and transparent compensation parameters • No overcompensation (including reasonable profit) • Efficiency: either effective public procurement procedure, or compensation based on the costs of a typical well-run undertaking • Is the rationale behind the efficiency condition: • the efficient delivery of SGEIs? • or an application of the market investor principle?

4. The logic of the Altmark compensation test Well-run Undertakings PSO Undert. Compatible aid? Procurement Cost Compensation is not aid Cost Cost Receipts Reason. Profit Reason. Profit Reason. Profit • The logic • Public procurement is assumed to ensure lowest cost solution (i.e., cost of well-run undertaking) • If compensation is no higher than the costs of a well-run undertaking -> no advantage, no aid (consistent with MEIP)

5. The test application in the 2005 Framework Well-run Undert. PSO Undert. Comm. Costs Contr. Compatible aid PSO Fix Costs Compensation is not aid Cost Cost PSO Var. Costs All advan-tages Receipts PSO Var. Costs Reason. Profit Reason. Profit Reason. Profit • No discussion of costs of well-run undertaking • Specifies compensation calculations • Benefits to be netted out of the compensation • All advantages granted – not just receipts • Reasonable profit • Not exceeding industry average • Costs • Variable Costs related to SGEI • Fixed Costs directly related to SGEI • Contribution to Fixed Common Costs • If compensation < “cost plus” of PSO aid is compatible

6. The issues with the 2005 Package • The issues with the 2005 framework • No clarification of the well-run undertaking test • Advantages – how to value non-monetary (strategic) advantages? • Reasonable profit – difficult calculation due to lack of benchmark • The consultation – stakeholders’ requests regarding compensation • Clarification of which advantages should be included • Clarification of cost calculation method • Clarification of benchmark for well-run undertaking • An open public tender should be sufficient to rule out State aid • Quality should be as important as price

7. The 2011 Package’s approach to compensation • New cost methodology • (New and preferred) Net Avoided Cost methodology: compensation cannot exceed the net avoided cost of the SGEI (plus a reasonable profit) • (Old) Cost Allocation methodology: compensation cannot exceed the sum of SGEI’s direct costs and a contribution to indirect common costs (plus a reasonable profit) • New reasonable profit calculation • (New) cap: swap (interbank) rate + 1% • (Old) cap in case of significant commercial risk: return on capital of comparable businesses • Efficiencies provisions • Member States can define efficiency targets whereby the level of compensation is dependent upon meeting these targets • Stricter, economically sound conditions, but may need some fine tuning

8. Net Avoided Cost methodology and potentially paradoxical results Well-run Undert. PSO Undert. Allocated Cost Comm. Costs Contr. Procurement Net Avoided Cost PSO Fix Costs Costs PSO Var. Costs All advan-tages PSO Var. Costs Reason. Profit Reason. Profit • Reduction in compensation • Net Avoided Cost likely to allow less compensation than Allocated Costs • Reduction in amount of Reasonable Profits (see next slide) • Open procurement not a safe harbour • More likely a paradoxical result where public procurement (no aid?) would award more compensation than “cost plus” compensation (compatible or even incompatible aid) • Public procurement not a “safe harbour”, even with competing bidders (¶60 Draft Communication?)

9. Reasonable profit is reduced • 2005 Framework: • Appropriate rate of return on capital, given risk • Not above normal rate of return in sector • 2011 Framework: • Reference rate: Return on Capital Employed = Interbank Rate + 1% (liquidity premium) • Can be higher in the presence of commercial risk (back to normal rate of return in the sector) • What about e.g., country risk? Should the company’s cost of capital be considered? • The new reference rate will likely result in a reduction in the level of “reasonable profit”

10. Efficiency provisions may result in overcompensation • Efficiency provisions • 2011 package introduces the possibility that the level of compensation is related to reaching efficiency targets • The undertaking can keep the difference between the compensation and the reduced cost level • Would this lead to overcompensation? • Possibly, but a Private Investor would also use these incentives over pure “cost plus” methodologies • Moreover, it fosters economic efficiency and so is consistent with goal of efficient delivery of SGEI • True account separation should ensure that overcompensation would limit distortions of competition • But... is fostering the efficient delivery of SGEI an admissible goal of State aid control?

11. Conclusions • Effective public procurement is not a sufficient condition to avoid overcompensation in the presence of fixed common costs • New Avoided Costs methodology likely to result in lower compensation • New Reasonable Profit calculation also likely to result in lower compensation • Efficiency incentives will also lower compensation in the long run, may create overcompensation in the short run, but are well-worth it • The new framework drives towards more efficient provision of SGEIs, is this the role of State Aid provisions?

12. Questions? www.compasslexecon.com Email: lcoppi@compasslexecon.com