How to Compensate for the Extra Cost of Public Service Obligations: Step-by-Step Guidance on a Complex Calculation

4. February 2020 | State Aid Uncovered by Phedon Nicolaides

The “net avoided cost methodology” takes into account only incremental costs.

Introduction

The two most difficult issues in the design of State aid measures to support services of general economic interest [SGEI] are the proper definition of the public service obligation [PSO] and the identification of the “counterfactual” on the basis of which the public service compensation [PSC] is calculated.

In the period 2017-2019, the Italian postal service, Poste Italiane [PI], was obliged to reduce the tariffs it applied to items mailed by publishers and non-profit organizations. At the same time, it was compensated for the forgone revenue [the difference between the normal tariff and the reduced tariff] from the handling of items such as books, newspapers, and informative publications by non-profit organisations.

Most of the postal services delivered by PI are part of the universal service obligation [USO] which has been entrusted to PI since 1999. PI is partly privatised, with the state retaining about 64% of the shares. A USO is a PSO whose general terms are defined in secondary EU legislation so that there is a high degree of uniformity across the EU.

The “normal” tariff mentioned above was the tariff defined by the USO. In other words, the reduced tariff for books, newspapers and magazines was lower than the regulated USO tariff.

For the period 2017-2019, the PSC in question amounted to EUR 171.74 million, as follows:

EUR 57.53 million for 2017.

EUR 59.32 million for 2018.

EUR 54.89 million for 2019.

The Commission assessed the compatibility of the PSC with the internal market [i.e. Article 106(2) TFEU] in decision SA.48492.[1]

Existence of State aid

The Commission easily concluded that the PSC constituted State aid in the meaning of Article 107(1) TFEU.

PI engages in an economic activity and therefore it can be classified as an undertaking. The compensation is provided by the state and is attributed to the state, as both the PSO and PSC have been decided by the state.

The PSC is selective because it is an individual measure that confers a benefit. At this point the Commission decision cites the “standard” judgments for proof of the selectivity of individual measures [C-15/14 P, Commission v MOL, EU:C:2015:362, paragraph 60; C-270/15 P, Belgium v Commission, EU:C:2016:489, paragraph 49; T-314/15, Greece v Commission, EU:T:2017:903, paragraph 79.]

It is also interesting that, after its defeat in the Spanish digital broadcasting cases, the Commission also takes care to provide more explanation why an individual measure is selective. It added, “(29) in any case, it does not appear that other undertakings in the same or other sectors in a comparable factual and legal situation benefit from the same advantage.” The problem, of course, is that this sentence does not really elucidate how other undertakings in other sectors, which do not collect and deliver mail items, can be in a comparable situation. This is because it does not specify what it is that is being compared.

The PSC conferred an advantage to PI because it offset the extra costs of the PSO. At the same time, the PSC did not satisfy the four Altmark conditions. Since the Altmark conditions are cumulative, it was sufficient for the Commission to show that at least one of them was not satisfied. In this case, the Commission focused on the fourth condition.

“(34) The Commission notes that PI was not selected through a public procurement procedure responding to the standards of the Altmark rules as laid down in points 63 to 68 of the SGEI Communication.”

“(35) According to point 75 of the SGEI Communication “If the Member State can show that the cost structure of the undertaking entrusted with the operation of the SGEI corresponds to the average cost structure of efficient and comparable undertakings in the sector under consideration, the amount of compensation that will allow the undertaking to cover its costs, including a reasonable profit, is deemed to comply with the fourth Altmark criterion”.”

“(36) The Italian authorities did not provide any information to the Commission as to whether the compensation was determined on the basis of an analysis of the costs which a typical undertaking, well-run and adequately provided with means to meet the public service obligations, would have incurred, taking into account the relevant receipts and a reasonable profit from discharging the obligations.”

“(37) The Commission therefore concludes that the fourth Altmark criterion is not complied with in this case.”

Given that postal services also have a cross-border reach and that there are several players in the market [e.g. TNT, DHL, GLS, FedEX], the PSC to PI did affect trade and distort competition.

Compatibility of the State aid

The Commission assessed the compatibility of the PSC on the basis of Article 106(2) TFEU and in particular the 2012 SGEI Framework because the PSC exceeded EUR 15 million which is the threshold for the applicability of the 2012 SGEI Decision.

The Commission began its analysis by making the following three preliminary but fundamental remarks about the boundaries of the discretion of Member States and its own powers to check the policy choices of Member States for a “manifest error”.

“(56) The Commission recalls that, in the absence of specific Union rules defining the scope for the existence of an SGEI, Member States have a wide margin of discretion in defining a given service as an SGEI. The Commission’s competence in this respect is limited to checking whether the Member State has made a manifest error when defining a service as an SGEI.” [The seminal judgments cited are T-289/03, BUPA and Others v Commission, paragraphs 166-169 and 172; T-17/02, Fred Olsen, paragraph 216]

“(57) In that regard, the Union Courts have ruled that there are certain minimum criteria common to every SGEI and that the inability of a Member State to demonstrate that a particular service fulfils those criteria constitutes a manifest error in defining this mission as an SGEI38. According to the Union Courts, those criteria are the presence of an act of the public authority entrusting the operators in question with an SGEI and the universal and compulsory nature of that service”. [Emphasis added] [See T-289/03, BUPA and Others v Commission, paragraph 172]

“(58) The Commission has further explained in its 2012 SGEI Communication that it considers it inappropriate to attach specific public service obligations to an activity which is already provided or can be provided for satisfactorily and under conditions, such as price, objective quality characteristics, continuity and access to the service, consistent with the public interest, as defined by the State, by undertakings operating under normal market conditions. The Commission’s assessment in this regard is also limited to checking that the Member State has not made a manifest error.”

Therefore, the proper definition of an SGEI requires, at minimum, the following:

An act of a public authority [the provision of the SGEI does not depend on the goodwill of a company].
Definition of a service that goes beyond what the market provides or definition of a service that remedies a market inadequacy or market gap.
Imposition of a specific obligation on the provider [the provision of the SGEI does not depend on the choices of company].
Universal supply to all those citizens and in all areas for which the market has been found not to supply sufficiently or satisfactorily.

Compatibility with the criteria of the 2012 Framework

Genuine service of general economic interest as referred to in Article 106 TFEU and public consultation: “(59) In the present case, the Commission considers that the Italian authorities have sufficiently demonstrated that their designation of the reduced tariffs offered to publishers and not-for-profit organizations as an SGEI is not vitiated by a manifest error.”

“(60) First, as the Italian authorities explained, the reduced tariffs aim at favouring the pluralism of press, promoting democracy, and supporting officially recognized not-for-profit organisations, which are objectives of general interest.”

“(61) Second, the Italian authorities demonstrated that the SGEI consisting in the reduced tariffs offered to publishers and not-for-profit organizations meets the minimum requirements identified in the case law of the Union Courts to be qualified as a genuine SGEI. In particular, that SGEI has been entrusted to PI by acts of public authority […]. Moreover, PI is legally obliged to offer the reduced tariffs to publishers and not-for profit organisations”.

“(63) Third, the reduced tariffs offered to publishers and not-for-profit organizations SGEI does not appear to be a service that could feasibly be provided by undertakings operating under normal market conditions. PI has been entrusted with the Universal Service Obligation, which requires it to deliver postal services and integrated products across the territory of Italy. To carry out this obligation PI has developed a vast capacity and infrastructure, such as post offices, delivery vans, and delivery workers. By accessing this infrastructure and capacity for the distribution of the press, PI can realise both economies of scale and synergies with the universal service network, and it can therefore deliver this service at comparatively low cost.”

Need for an entrustment act specifying the public service obligations and the methods of calculating compensation: “(75) The responsibility for the operation of an SGEI must be entrusted by way of one or several acts, the form of which may be determined by the Member State. The act or series of acts must specify at least: the content and duration of the public service obligations; the undertaking and, where applicable, the territory concerned; the nature of any exclusive or special rights assigned to the undertaking by the authority in question; the parameters for calculating, controlling and reviewing the compensation; and the arrangements for avoiding and recovering any overcompensation.”

The Commission found that the PSO clearly defined and imposed by law.

Duration of the period of entrustment: “(78) The duration of the entrustment [must be] “justified by reference to objective criteria such as the need to amortise non-transferable fixed assets”, whereby the duration should not exceed the depreciation for the most significant assets required to provide the SGEI.”

“(79) The Italian authorities confirmed that the entrustment of PI for the reduced tariffs is limited to three years, for the period 2017-2019, in order to allow the amortization of the costs of the activities that are necessary to supply the service.”

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An appropriate accounting system:

Transparency of financial relations between Member States and public undertakings: The relevant Italian law “(82) imposes separate accounts within the internal accounting system of PI. [It] provides that the auditing firm responsible for certifying the accounts of the universal service provider must also check that the accounts comply with the rules on accounting separation.”

“(83) The Italian authorities further explained that the integrated accounting system of PI consists of:

a) The General Accounting System: costs and revenues are recorded in function of their nature;
b) The Analytical Accounting System: the above costs are attributed to cost centres;
c) The Activity Based Costing (ABC) System: this is a more advanced system of cost calculation that bases its analyses on the processes and activities carried out within the company, in order to identify the associated costs incurred to obtain products and/or services.”

“(85) Already in its previous decisions in 2006, 2008, 2012 and 2015, the Commission concluded that the methodology used by PI to separate accounts between costs and revenues of the services of general economic interest and costs and revenues of commercial activities reflected a correct allocation of its costs among these different types of activities. Therefore, this methodology was found to be suitable to assess the costs and revenues from the various services provided by PI as well as for determining the extra costs of the universal postal service entrusted to it when applying the net accounting cost method.”

“(88) In particular, as regards the press distribution mission specifically, PI’s analytical accounting system separates costs over four categories:

(a) Direct costs: these are the costs relating to components specifically used to obtain a given product or service. These are exclusively transport costs that are outsourced to external suppliers.

(b) Direct production costs: these are the costs of divisional production structures whose activity contributes to the delivery of products or services. These are costs of production, i.e. (i) acceptance and sorting, performed at logistics centres; (ii) transport directly performed by PI; and (iii) delivery, performed by the delivery centres through postmen. These costs are allocated via specific drivers (e.g. FTE, square meters, “worked hours”, number of vehicles).

(c) Indirect production costs: these are the costs of the non-operational divisional structures, such as the general division and territorial area division structures, which have the task of developing production strategies for the post, financial and residual business, and of implementing them in full. These costs represent the contribution of press distribution services to the costs of the coordination structures of the operating divisions (in the case of press distribution services, mainly those of the postal services division).

(d) Central costs: these are central support, orientation and control activity costs incurred for the purpose of ensuring operational consistency of the activities carried out by the divisions with central policies and strategies. These costs represent the contribution of press distribution services to the costs of coordination structures and company staff.

Application of an exception in EU public procurement rules:

Compliance with Union public procurement rules: “(90) Aid will be considered compatible with the internal market on the basis of Article 106(2) of the Treaty only where the responsible authority, when entrusting the provision of the service to the undertaking in question, has complied or commits to comply with the applicable Union rules in the area of public procurement. This includes any requirements of transparency, equal treatment and non-discrimination resulting directly from the Treaty and, where applicable, secondary Union law.”

“(91) The Italian authorities refer to the decision of 20 November 2012, where the Commission acknowledged that the entrustment to PI complied with Union public procurement rules, as the SGEI under assessment is supplied via the same network of the universal service and the only player able to carry out this mission in the Italian market is PI.”

“(92) The Italian authorities submit that the measures at issue are covered by the “sole provider exemption” pursuant to Article 32(2)(b) of Directive 2014/24/EU56. In support of their claim, they provided the following arguments:

a) PI, which is the operator providing the universal postal service in Italy, provides the SGEI at issue through the same network which it uses for the postal universal service. PI is, as such, the only player able to supply the SGEI in question on the whole national territory in compliance with the applicable requirements (in terms of price, quality, density and delivery frequency);
b) The compensation which PI receives from the Italian State for the reduced tariffs in favour of publishers and not-for-profit organizations contributes only marginally to the maintenance of the network needed for the provision of the service. Therefore, this compensation would not suffice to enable a competitor to set up a network comparable to PI’s network. In fact, because this compensation is not sufficiently high for the SGEI at issue to be provided independently from the postal universal service network, an operator other than PI would not have the economies of scale that make the provision of the SGEI at issue less costly for PI, which is, however, undercompensated for its universal service mission.”

Absence of discrimination: “(97) Paragraph 20 of the 2012 SGEI Framework provides that ‘where an authority assigns the provision of the same SGEI to several undertakings, the compensation should be calculated on the basis of the same method in respect of each undertaking’.”

“(98) The SGEI of the reduced tariffs offered to publishers and not-for-profit organizations is not assigned to ‘several undertakings’, but only to PI. Therefore, the Commission considers that, because PI is the only entrusted entity there cannot be a question of discriminatory compensation between SGEI providers within the meaning of paragraph 20 of the 2012 SGEI Framework.”

Amount of compensation: Here the Commission assessed the correctness of the “net avoided cost” [NAC] methodology for determining the amount of the PSC.

“(100) According to paragraph 25 of the 2012 SGEI Framework, “Under the net avoided cost methodology, the net cost necessary, or expected to be necessary, to discharge the public service obligations is calculated as the difference between the net cost for the provider of operating with the public service obligation and the net cost or profit for the same provider of operating without that obligation.”

Counterfactual scenario for the transport and distribution of publications

“(102) The NAC methodology requires on the one hand the design of a counterfactual scenario in which the operator concerned rationally conducts its economic activity and where it aims to maximise profits without being subject to the public service obligations imposed by its entrustment. On the other hand, the NAC methodology requires an estimation of the costs and revenues of that operator in this counterfactual scenario. This assessment must take into account the competitive constraints to which the operator would be subject in the counterfactual scenario.”

“(103) In the absence of the press distribution SGEI, PI would remain subject to the USO, which includes the obligation for PI to transport and deliver the press at a separate (and higher) USO-specific tariff. If PI was not subject to the press distribution SGEI, it would therefore seek to maximise its profit by optimising its press delivery tariffs, constrained by the maximum imposed by the USO tariff.”

“(104) Poste Italiane’s choice of tariff in the counterfactual scenario depends crucially on two factors: (i) its delivery costs and (ii) changes in demand because of changes in price. If

PI’s press distribution service is loss making, it would generally seek to raise tariffs for two reasons: it would reduce the losses incurred per unit delivered and it would reduce the number of loss-making units that have to be delivered. If the press distribution service is profitable, then raising tariffs a priori increases the profit per unit delivered, but could lower the overall profit because of reductions in demand. The Italian authorities have confirmed that, given that the press distribution mission is a loss making activity, tariffs in the counterfactual scenario would increase. Volumes in the counterfactual scenario would therefore be lower.”

The explanation in paragraph 104 is correct. But even if the press distribution were not loss making, PI could still seek to raise tariffs, in case the lower tariffs were not profit maximising. For the vast majority of goods and services, a price increase always reduces demand, regardless of whether the price is at the point where it maximises profit or not. The more difficult question is how much demand is affected by an increase in price.

“(105) Reductions in demand because of an increase in the rate of the tariff (price) arise mainly from two sources: (i) the response of press editors and final customers or readers (direct demand effects); and (ii) the response of competitors such as transport and logistics firms offering similar services, as well as the existence of substitutes, such as kiosks or digital offerings (competitive constraints).”

Also, on the cost side, a reduction in output or volume affects costs and especially costs/unit. The Commission observed that “(107) PI is able to realise economies of scale: as its volumes fall, costs fall less-than-proportionately.” The advantage of economies of scale when volume increases becomes a disadvantage when volume decreases.

“(108) Given the decreases in cost and volumes observed above, it follows that the press distribution mission had a cost elasticity to volume of […] over the 2015-2017 period. This cost elasticity implies that upon a decrease in volumes, costs would decrease by […]% of that relative decline. By using this parameter, it is possible to calculate the evolution of costs in relation to changes in volume.”

“(109) The cost elasticity to volume takes into account the fact that with lower volumes PI would be less efficient and would have a higher unit cost in the counterfactual scenario. Given that volumes in the counterfactual scenario would be lower (see recital (104)), this relative increase in costs reduces PI’s counterfactual profit and therefore the NAC.”

Then the Commission clarified that account separation is not enough for determining the NAC. Account separation normally ensures allocation of all costs, both variable and fixed. The NAC identifies only the incremental costs.

“(113) The NAC applies a logic of incrementality: only those costs that are incremental to the public service mission, i.e. which would not be incurred at all in its absence, should be taken into account for the calculation of the NAC. Cost accounting based on a separation of accounts works differently: pursuant to the Postal Directive, for example, costs that are common to various services can be allocated to each by use of a certain allocation key.”

Here the Commission pointed out that direct costs and direct production costs were considered to be incremental. “(114) Direct costs concern transport costs that are outsourced to external suppliers specifically and only for the distribution of the press. Direct production costs such as acceptance and sorting are performed at logistics centres with clearly separate processes between the press distribution mission and other activities.”

However, “(115) indirect production costs and central costs are not so clearly incremental to the press distribution mission. They are common costs which Poste Italiane has allocated in part to the press distribution cost centre. While it is reasonable to assume that the costs of a coordination unit would decrease following a general downsizing of the press distribution mission, the Commission considers that the Italian authorities have not demonstrated conclusively that these costs are incremental to the press distribution mission in their entirety.”

The consequence of failing to prove that costs are incremental to the PSO is that they are not deducted from the total costs in the counterfactual scenario, resulting in a smaller difference between the actual and counterfactual situations and, consequently, leading to a smaller PSC. This is exactly what is explained in the next paragraph of the decision.

“(116) In the absence of a clear and unambiguous demonstration of their full incrementality, these costs will not be taken into account for the calculation of the NAC. This assumption reduces PI’s costs proportionately to volumes in both the factual and counterfactual scenario. By allocating fewer costs to the press distribution mission, the reduction in volumes in the counterfactual scenario results in a lower avoided cost in absolute terms. This is therefore a conservative assumption that has the effect of lowering the NAC.”

On the revenue side, “(121) the maximum USO tariff of EUR […] that PI can charge in the counterfactual is lower than its variable cost per unit (see recital (118)). Even in the optimal counterfactual scenario, therefore, PI would incur a loss on each item delivered. If PI were to set its tariff in the counterfactual scenario at any point below the USO tariff, it would increase its losses in two ways compared to setting it at the USO tariff: its loss per item distributed would increase, and it would have to deliver more loss-making items. In optimising the NAC, it is therefore clear that PI would set its counterfactual tariff at exactly the rate of the USO tariff, a ceiling to which it is bound.”

“(122) The reaction of PI’s customers of press delivery services to changes in the price of such services is expressed by the price elasticity of demand. As described in recital (9), there was a 5-month period in 2010 when PI applied the USO tariffs to its press distribution mission. By observing the reduction in demand for PI’s press delivery service that followed the increase in tariffs during this period, it is possible to obtain an estimate of the price elasticity of demand for PI’s press distribution services. The advantage of this approach is that, because it is based on a real situation, in principle it takes account of all real constraints PI faced.”

The Commission considered that in order to calculate the revenue in the counterfactual scenario, “(127) the price elasticity of demand would have to be adjusted upwards (in absolute value), that is, the assumed demand would become more elastic. A more elastic demand would imply a larger reduction of demand for PI’s services in the counterfactual scenario. As PI incurs a loss on each item delivered even in the counterfactual scenario (see recital (121), a larger reduction in volumes would lead to a lower counterfactual loss, and therefore a higher NAC.”

This was in favour of PI.

“(129) Because PI will seek to increase its tariffs up to the USO level in the counterfactual scenario (see recital (121)), there will be a reduction in demand and lower volumes as a result. The precise change in volumes can be estimated using the price elasticity of demand as established in recitals (122)-(123). In addition, PI further assumes a structural decline in volumes of […]% per year from […] million items in 2017 – a continuation of the decline in volumes over the 2015-2017 period (see table 2 above), which is reflected in both the factual and counterfactual scenarios.”

The NAC formula

“(130) The identification of the costs (see recitals (106) – (118)), tariff (see recitals (119) – (121)), price elasticity of demand (see recitals (122) – (128)) and volumes (see preceding recital) permits the calculation of the profit of PI in both the factual and counterfactual scenarios. The NAC consists of the difference between these two profits and is equal to EUR [180-230] million over the 2017-2019 period”.

The formula that was used to calculate the NAC was as follows:

Actual situation/scenario

Volume [A] in million units

Tariff [B] in eur/unit

Average Variable Cost [C] in eur/unit

Revenue [D] in million euro = A x B

Total Variable Costs [E] in million euro = A x C

Result [F] in million euro = D – E

Counterfactual situation/scenario

Tariff [G] in eur/unit

Tariff increase [H] = G/B – 1

Price elasticity [I]

Volume decrease [J] in million units = A x H x I

Volume [K] in million units = A + J

Revenue [L] in million euro = K x G

Variable costs [M] in million euro = K x C

Result [N] in million euro = L – M

Net Avoided Cost

NAC [O] in million euro = N – F

Verification of compensation: “(132) The exercise consisting in an assessment of the net avoided costs of the press distribution mission will be made at the end of the notified period. As a result of this, the Italian authorities commit to verify that PI is not receiving compensation in excess of what is set out in the SGEI Framework. In this regard, an assessment will be carried out upon the conclusion of the period for which the compensation is granted. If such assessment will demonstrate that the compensation received by PI is higher than the net costs related to the fulfilment of the public service mission at issue, a mechanism to repay the State of the excess amount will be implemented in the following year.”

The amounts of the maximum compensation was determined to be:

2017: EUR 57.5 million

2018: EUR 59.3 million

2019: EUR 54.9 million

Efficiency incentives: “(137) Member States, in devising the method of compensation, must introduce incentives for the efficient provision of an SGEI of a high standard, unless the Member State can duly justify that it is not feasible or appropriate to do so. In addition, point 40 of the SGEI Framework adds that “efficiency incentives can be designed in different ways to best suit the specificity of each case or sector. For instance, Member States can define upfront a fixed compensation level which anticipates and incorporates the efficiency gains that the undertaking can be expected to make over the lifetime of the entrustment act.”

“(138) The Italian authorities underlined that the compensation level provided to PI for the delivery of the SGEI is fixed and defined upfront at EUR 171.74 million for the years 2017-2019. In addition, as described in recitals (127) et ss. above, the SGEI mission at issue is undercompensated. These measures already appear as an incentive for PI to reduce the costs foreseen for the execution of the mission.”

“(139) The Commission considers that the fact that PI is undercompensated and that the amounts of the compensation are fixed and controlled by the State are essential elements to introduce in themselves efficiency incentives which favour an efficient provision of the press distribution mission.”

Transparency: “(142) The Member State concerned must publish on the Internet or by other appropriate means information on: the results of the public consultation or other appropriate instruments referred to in point 14 of the SGEI Framework, the content and duration of the public service obligations, the undertaking and the territory concerned, the amounts of aid granted to the undertaking on a yearly basis.”

The Italian authorities confirmed that they would publish the following information:

“a) the content and duration of the public service obligations;