Price Discounts and Compensation for Public Service Obligations: A Case of Questionable Need for Aid

school busses
SGEI can be defined and public service obligations can be imposed only when the market underprovides. The parameters of compensation must be determined in advance. Public service compensation may not exceed the next extra costs of the SGEI or PSO. Member States are free to devise their own method of compensation, but irrespective of the method used, compensation must comply with the basic requirement that it may not exceed the net extra costs.

Introduction
 
[1]In this article I examine Commission Decision SA.34155 concerning compensation of school bus transport in Rhineland-Palatinate, Germany.[2] The Commission assessment of this measure was partly triggered by a complaint. Therefore, the ensuing Decision also addresses the arguments raised by the complainant. 

The case law of EU courts and decisional practice of the Commission on services of general economic interest [SGEI] stipulate that public service compensation may not exceed the difference between costs and revenues of the SGEI. At first sight, this suggests that the SGEI provider receives aid that is merely sufficient to ensure the commercial viability of the SGEI in question. The aid, therefore, is necessary. However, I will point out that this case is an apt example that some forms of compensation result in unnecessary aid. As I will explain later on, this is because of the way costs are apportioned between SGEI and non-SGEI activities.

This case is particular also because I believe it is the first – or at least one of the few – which have been assessed directly on Article 93 TFEU [and which does not concern coordination of transport which comes under Article 93]. Normally, SGEI measures are assessed on the basis of Article 106(2) TFEU or in the case of land transport, on the basis of Regulation 1370/2007 and its predecessor Regulation 1191/69.

Background

The compensation for public service obligations [PSO] concerning school bus and tram transport in the Land Rhineland-Palatinate aims to ensure open access to education by providing cheap public transport tickets to pupils, students and trainees who can then have access to transport to their schools, universities and training places. The scheme also pursues specific social aims by reducing the financial burden on families with children as well as environmental aims by supporting public transport, which is more eco-friendly than individual motor car transport [paragraph 11 of the Decision].

The notified measure imposes a PSO on all bus and tram undertakings in the Land Rhineland-Palatinate, obliging them to offer reduced rates to students. This reduction must amount to at least 15% of the standard rate for adults.

In return for discharging that PSO, the bus and tram undertakings are entitled to compensation. The public service compensation [PSC] corresponds to the difference between the reduced rate for students and the standard rate for adults, for transport services provided within the Rhineland-Palatinate.

However, the German measure unusually imposes two caps to prevent overcompensation. In addition to the limitation of PSC to the difference between the reduced rate for students and the standard rate for adults, the maximum amount of PSC is also calculated in accordance with the rules laid down in the Annex of Regulation 1370/2007. In order to ensure that no transport undertaking receives compensation exceeding the amount of this second cap, the granting authority carries out an ex post over-compensation control.

The calculation of the cap considers the following:

(a) The undertakings have to establish their net costs.

(b) The accounts of the compensated services subject to the PSC must be separated from the accounts connected to other activities.

(c) Only costs incurred by carrying out the PSO within the geographical area of Rhineland-Palatinate can be taken into account. These costs are derived from the profit and loss accounts and have to be attributed to transports carried out under the relevant law.

(d) The revenues to be taken into account include all commercial revenues linked to the PSO [e.g. sale of tickets, advertising].

(e) The calculation takes into account a reasonable profit.

(f) The cap is calculated as follows: Max PSC = cost + reasonable profit – revenues.

If after ex-post control it is established by the granting authority that overcompensation was paid to a transport undertaking, the excess amount has to be paid back immediately plus interest.


Existence of State aid

The first issue examined by the Commission was whether the PSC satisfied the Altmark criteria “(29). Regardless of whether the first three Altmark criteria are fulfilled in the present case, the Commission notes that the beneficiaries are not chosen pursuant to a public tender and that the notified measure does not ensure that the compensation granted does not exceed the costs of a well-run undertaking. Although the measure includes an over-compensation control mechanism, the compensation cap is calculated on the basis of net costs, and those net costs are not required to correspond to the costs of a well-run undertaking. Since it cannot be excluded that the costs taken into account in the overcompensation control mechanism are above the comparable costs of a well-run undertaking, the Commission considers the fourth Altmark criteria not to be met in the present case. Therefore, the existence of an advantage in favour of the bus and tram undertakings cannot be excluded”.

Compatibility with the internal market

When Member States impose PSO on undertakings operating in the land transport sector, they must comply with Regulation 1370/2007. The Commission noted that it is not allowed to authorise compensation that falls within the scope of Regulation 1370/2007 when such compensation is not in conformity with that Regulation.

However, according to Article 3(3) of Regulation 1370/2007 Member States may exclude from the scope of the Regulation measures concerning the transport of students, apprentices and persons with reduced mobility. But they must notify these measures which are then assessed directly on Article 93 TFEU. Indeed the German measure in question is probably the first case for which the Commission applied Article 93, outside the field of coordination of transport.

Article 93 provides that aid shall be compatible with the internal market if it is reimbursement for the discharge of obligations inherent in the concept of a public service.

The Commission defined the following criteria for declaring aid compatible with the internal market under Article 93:

(1) The aid must be granted for the discharge of a genuine and correctly defined public service.

(2) The parameters for compensation must be laid down in advance in an objective and transparent manner.

(3) The amount of compensation must not exceed what is necessary to cover the net cost of discharging the public service obligations, including a reasonable profit.

(4) Where an authority assigns the same public service to several undertakings, the compensation for the discharge of that service should be calculated on the basis of the same method in respect of each undertaking.

(5) The aid must not lead to distortions of competition contrary to the common interest [paragraph 39].

It should be noted that the first three conditions are the same as in Altmark, Regulation 1370/2007, and the 2012 Decision on public service compensation and the 2012 Framework on public service compensation. Moreover, the first three conditions plus the last one are the same as under Article 106(2). Thus there is consistency across different rules concerning SEGI and public service obligations.

Public service obligation

“(41) . . . The entrustment of a public service obligation implies the supply of services which, if it were considering its own commercial interests, an undertaking would not assume or would not assume to the same extent or under the same conditions. The Commission thus considers that it would not be appropriate to attach specific public service obligations to an activity which is already provided or can be provided 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”.

“(44) The Commission notes that private undertakings would not, if they were only considering their own commercial interests, offer [a 15%] price reduction to the same extend or under the same conditions and would not take the aims pursued by the notified law into account”.

However, the text of the Commission Decision provides no indication that Germany had actually submitted any study that proved that private bus companies would not offer the reduction. If we consider that children and students have the alternative of using bicycles or being taken to school by their parents, then perhaps a bus company would voluntarily offer a discount of 15% in order to attract customers with higher elasticity of demand [in fact, that such alternatives exist is alluded in paragraphs 42 & 43 of the Decision]. Moreover, paragraph 52 of the Decision makes it clear that a 15% reduction does not have to be loss-making [see below]. But why would a bus company voluntarily forgo 15% of revenue? The answer is that it would do so if students would not be willing to pay the full adult price. Price discrimination according to the elasticity of demand is a standard commercial practice. Therefore, it is rather surprising that the market gap was presumed rather than proven. In the Annex of this article I provide a numerical example that shows that discounts, far from being loss-making, can in fact increase profitability.

Predetermined compensation parameters

The notified measure establishes in advance, in an objective and transparent manner, the parameters on the basis of which the compensation payment is to be calculated. The compensation corresponds to and is limited to the difference between the reduced rate for students and the standard rate for adults. In addition, there is a second cap to the compensation, which is to be calculated in accordance with the Annex to Regulation 1370/2007.

All bus and tram undertakings operating in Rhineland-Palatinate receive compensation on the basis of these parameters, which means that all those undertakings receive compensation in all cases on the basis of the same principle.

The Commission concluded that the parameters of compensation were to be calculated in advance and in an objective and transparent manner.

No overcompensation

Although students paid 15% less than adults, the Commission noted crucially that “(52) . . . this system for the calculation of the applicable compensation is not based on the costs for carrying out the transport services at stake, but on the reduction in price”. Therefore, “it cannot be excluded on the basis of this first cap alone that no over-compensation is granted to transport undertakings”. This is in fact the reason why the measure introduces a second cap in the form of an ex-post over-compensation control on the basis of the Annex to Regulation 1370/2007.

The second cap is calculated as follows: max PSC = cost + reasonable profit – revenues. The costs are the net costs of the public service obligation for predefined transport services (with the distance in km). It should be noted that the methodology established in that Annex allows for full cost allocation [i.e. variable costs plus a share of fixed costs] just like in the 2012 Decision on PSC. By contrast, the 2012 Framework on PSC takes into account incremental costs [which allows service-specific fixed costs but excludes costs which are fixed at the level of the company].

Relevant revenues include all commercial revenues from sale of tickets, other revenues from activities such as advertising as well as any kind of grants from the state. As with the relevant costs, also only revenues connected with compensated services are considered.

The accounts of the compensated services must be separated from the accounts connected to other activities.

The reasonable profit to be taken into account is in line with the concept of a reasonable profit as defined in the Annex to Regulation 1370/2007. According to that Annex, “reasonable profit must be taken to mean a rate of return on capital that is normal for the sector in a given Member State and that takes account of the risk, or absence of risk, incurred by the public service operator by virtue of public authority intervention”.

It is interesting to note that, in responding to a complaint that the notified measure favours undertakings with higher costs, the Commission stated the following:

First, there was no over-compensation.

Second, only costs resulting from the discharge of services in an economical and efficient way were to be considered in the calculation of the amount of compensation [how this was to be ensured it was not explained].

Third, even if undertakings with higher costs would receive a higher amount of compensation, “this does not lead to higher profits but merely reflects higher costs and, therefore, does not lead to distortions of competition contrary to the common interest” [73].

Then the Commission asserted that “(75) … the aid is necessary and has an incentive effect since, as was already mentioned above, private transport undertakings would not offer the same discounts for pupils, students and trainees without the aid”. Once more, this is an assertion rather than a fact.

Non-discrimination

Given that the measure applied to all bus and tram undertakings operating public transport services Land Rhineland-Palatinate, the aid was found to be granted without discrimination.

No distortion of competition contrary to the common interest

“(77) . . . At the current level of development of State aid law, the Commission usually considers that that condition is complied with if it has been demonstrated that there is no risk of overcompensation”.

“(79) As to the argument by the complainant . . . that the notified law will lead to a distortion of competition between different bus or tram undertakings operating within the Rhineland-Palatinate, by favouring undertakings operating in urban areas over those operating in rural areas, the Commission notes that the notified measure indeed leads to a certain re-distribution of compensation payments. However, in this regard the Commission is only competent to ensure that the notified measure is in accordance with the State aid rules and in particular to control whether undertakings do not receive over-compensation”.

Article 107(2)(a) TFEU

In an unusual approach, the Commission also considered that the measure was compatible with the internal market under Article 107(2)(a) TFEU. This was because:

i) The aid was effectively for the benefit of final consumers. On this point, the Commission rejected an argument by the complainant as “irrelevant that the reduction in price is not directly paid to consumers but rather to the transport undertakings, as the decisive criterion must be seen in the fact that the reduction ultimately and effectively benefits consumers” [89].

ii) The aid had a social character [it covered students].

iii) The aid was granted without discrimination as to the origin of the service providers.

On the basis of the above reasoning, the Commission concluded that the notified measure was compatible with the internal market under Article 93 TFEU as well as under Article 107(2)(a) TFEU.

Annex

As I explain above, the Commission seems to have assumed that the market would not voluntarily offer discounts to students and considered that the imposition of the obligation on bus companies to offer a 15% discount filled a market gap. Below, case I presents an example whereby bus companies would voluntarily offer discounts. PSC would be unnecessary. Case II presents a counter-example whereby bus companies would not voluntarily offer discounts. But as shown, even in this case, aid may be unnecessary.

Case I: Bus operators would offer discounts

The following example shows that a bus company may voluntarily offer discounts to groups of passengers with high elasticity of demand in order to attract them and in the process increase its profitability. In this case, the granting of State aid may be unnecessary.

Let’s assume that a bus can carry 50 passengers and therefore a bus company incurs the following costs per bus per route per trip:

Variable costs [VC] = 300

Fixed costs [FC] = 150

Total costs [TC] = 450

With these costs, the company breaks even by charging a price of 9 per passenger [= 450/50]. The VC per passenger are constant at 6 [300/50] which implies that the 50 passengers must pay an additional 3 per ticket in order to fully cover the fixed costs of 150. That is, the price of a ticket is 9 = 6 + 3.

However, assuming that at a price of 9, the company can attract only 30 adults [who do not normally use bicycles to go to work]. But if the bus attracts only 30 passengers, the company will have to charge a price of 15 [= 450/30]. At this high price, even adults would turn to bicycles.

If the reservation price of students is 8.5, the company can do the following. It can charge 10 to adults and 8.5 to students, which corresponds to 15% discount. Total revenue will be:

Revenue from adults [Ra] = 300 [= 10 x 30]

Revenue from students [Rs] = 170 [= 8.5 x 20]

Total revenue [Rt] = 470

By differentiating its prices, the company succeeds to cover its costs and makes a profit of 20 [= 470 – 450].

But before the company offers the discount to students the state imposes a PSO on it that covers only the carrying of students. The PSC for the cost of the PSO is the difference between the adult price and the discounted price, i.e. PSC = (10 – 8.5) x 20 = 30.

However, as explained earlier, Germany established a double cap for the PSC. The first cap was the difference in prices while the second cap was that the PSC could not exceed the net costs of the PSO which is the net cost of the carrying of students.

The portion of the fixed costs that can be allocated to the carrying of students can be derived by multiplying total FC by the share of the students in total passengers; i.e. 20/50 = 40%. Therefore the net costs of carrying students are [the costs and revenue of the carrying of adults must be excluded because they are outside the scope of the PSO]:

NCs = Vs + (40% x FC) – Rs = (6 x 20) + 60 – (8.5 x 20) = 180 – 170 = 10

Under the double cap system, the PSC that is actually granted may not exceed the lower of the two caps [30 or 10]. In other words, the allowed PSC is 10. Consequently, the total revenue of this company increases by 10 to 480, and its profit rises from 20 to 30. The company would have been able to operate profitably without the subsidy and would have voluntarily offered a discount of 15% to students. The carrying of students only appears to be loss-making because of the allocation of fixed costs.

So, what is happening here? This result is not unusual in the case of companies which supply customers with different elasticity of demand and incur both variable and fixed costs. By price discriminating and by charging a price that is sufficient to cover the variable costs of supplying the customers with the high elasticity of demand, or the low reservation price, they manage to attract more customers. Ceteris paribus, this strategy is always more profitable.

This implies that, as we saw above, the PSC was unnecessary. This is because the company would have provided the service to students at a discount and would have remained commercially viable. Once more, its profit without compensation is

R – C = (Ra + Rs) – (VCa + VCs) – FC

= [(10 x 30) + (8.5 x 20)] – [(6 x 30) + (6 + 20)] – 150

= (300 + 170) – (180 + 120) – 150

= 470 – 300 – 150

= 20

Case II: Bus operators would not offer discounts

In this case, the imposition of an obligation to offer discounts forces bus operators to do something they would not otherwise do. Assume that a bus can carry 50 passengers. A bus company incurs the following costs per bus per route per trip:

Variable costs [VC] per passenger = 1

Fixed costs [FC] per trip = 440

The bus company has carried out a market survey and has found that the price that maximises its profits is 10. At this price, it attracts 50 customers. With 50 passengers, its total costs, TC, are 490 [= (50 x 1) + 440]. Its revenue is 500 [= 50 x 10]. In other words, it makes a profit of 10.

Further assuming that the reservation price of students is 8.5, under these conditions the bus company has no incentive to offer discounts voluntarily because, as the bus runs at capacity, any passenger with a discount will only replace a full-fare passenger. The company will gain 8.5 but will lose 10.

Now the state imposes a public service obligation and, for instance, 5 students get on the bus and replace 5 full-fare passengers. The revenue and costs of the company are as follows:

Revenue = Ra + Rs = (45 x 10) + (5 x 8.5) = 450 + 42.5 = 492.5

Costs = Ca + Cs + FC = (45x 1) + (7 x 1) + 440 = 490

The company still makes a profit of 2.5. But it is entitled to compensation as follows:

Cap 1: 5 x (10 – 8.5) = 5 x 1.5 = 7.5

Cap 2: NCs = TCs – Rs = [VCs + share of FC] – Rs = [5 + (440 x 5/50)] – (5 x 8.5) = 5 + 44 – 42.5 = 6.5

Since cap 2 results in lower compensation, the bus company gets 6.5 and its total profit increases from 2.5 to 9.

Once more, we can see that the compensation is unnecessary because the company would have been able to cover its costs. The compensation only appears necessary in accounting terms, because part of the fixed costs is allocated to the carrying of students.

Of course, this reduces the profitability of bus companies. But this is the nature of all state regulations on business. Eventually, regulatory costs are incorporated in the normal operating costs and there is no need for compensation. Whether such costs should be imposed on market operators is a different issue altogether.

 

 


[1] I am grateful to Mihalis Kekelekis and Christian Lund for comments on an earlier version. I am solely responsible for any views expressed in this article.

[2] The text of the Commission Decision can be accessed at:

http://ec.europa.eu/competition/state_aid/cases/249123/249123_1526826_204_2.pdf

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About

Phedon Nicolaides

Dr. Nicolaides was educated in the United States, the Netherlands and the United Kingdom. He has a PhD in Economics and a PhD in Law. He presently holds positions at the College of Europe and the University of Maastricht. He has published extensively on European integration, competition policy and State aid. He is also on the editorial boards of several journals. Dr. Nicolaides has organised seminars and workshops in many different Member States, and has acted as consultant to several public authorities.

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