Public Service Obligations and Award for Damages

public bus

Providers of public services must keep separate accounts. The parameters for calculating the compensation for the extra costs of public services must be determined in advance. Awards for damages do not constitute State aid. However, no damages can be awarded as a substitute for incompatible State aid.

 

Introduction

It is often asked how compensation measures for public service obligations should be designed. This issue is the subject of Commission decision 2016/2084 concerning additional public service compensation for Arfea, an Italian bus company.[1] The Commission has dealt with at least two similar cases in the past year or so. All three cases concern alleged public service obligations and extra compensation ordered by Italian courts. In the two previous cases, the Commission concluded that concessions did not constitute obligations imposed unilaterally by public authorities. In addition, according to the Commission, the judgments of the national courts were seriously flawed. More importantly, court-awarded damages themselves constituted State aid.

In this case too, Italy notified State aid in the form of public service compensation [PSC] for the extra costs incurred by Arfea for alleged public service obligations [PSO] that had been imposed on it.

Arfea had succeeded in proceedings before a domestic court to obtain PSC for the provision of passenger transport services by bus. Arfea had secured concessions which had been granted by the Piedmont Region in Italy.

Since part of the PSC was provided before the notification, the Commission classified it as non-notified and, after an initial exchange of information with Italy, also proceeded to open the formal investigation procedure.

The Commission had doubts on the following:

  • Whether the Altmark conditions were satisfied.
  • Whether the PSC was exempt from notification.
  • Whether the PSC was compatible with Regulation 1370/2007.
  • Whether the funds received by Alfea were State aid or award for damages that did not constitute State aid. [Paragraph 29 of the decision]

Arfea operated 28 concessions, 27 of which on intra-regional routes. In 2007, following a judgment of the Italian Supreme Administrative Court awarding retroactive PSC, Arfea requested additional PSC from the Region of Piedmont because, according to Arfea, the amount of compensation it had received did not cover in full its operating deficit.

The Italian court appointed an expert to calculate the additional compensation. The Commission decision describes as follows the methodology used by the expert:

(a) Calculate the difference between the net costs and revenues originating from the provision of PSOs.

(b) From the amount calculated under (a), deduct the public contributions already granted to Arfea (the ‘verified deficit’).

(c) The verified deficit was then compared to the net financial effect ‘equivalent to the total of the effects, positive or negative, of compliance with the public service obligation on the costs and revenue of the public service operator’.

To this end, the expert calculated the net financial effect following the methodology indicated in the Annex to Regulation 1370/2007. [Paragraph 14]

The Commission decision further indicates that “(15) […] According to the expert, some costs can be allocated directly, while some common costs can only be separated by making an indirect attribution of such costs to Arfea’s public and private activities. The indirect allocation of common costs was done on the basis of parameters indicated in the so-called ‘base model’ prepared by Arfea allegedly on the basis of instructions provided by the Region. Such parameters indicated the percentage of activity for the urban and inter-city public service performed in the Region and the percentage of other private activities (e.g. bus rentals). The expert applied these percentages to the common costs for which it was allegedly not possible to keep separate accounts.”

“(17) The expert agrees with the calculations made by Arfea’s consultants on the reasonable profit, which is defined as an average remuneration of capital, based on the following assumptions:

(a) The invested capital was calculated as the net assets of Arfea resulting from the accounts (in 1997: ITL 7,98 billion) minus the regional contributions for investments. The amount was then reduced to reflect the proportion of the assets used to provide public services only, using the relevant percentage of Arfea’s activities. The resulting amount for 1997 was ITL 1,6 billion. (b) Based on the formula chosen by the consultant for calculating the required return on invested capital, the relevant rate of return was set at 12,39 % for 1997 and 10,81 % for 1998.”

“(18) Finally, the expert maintains that the unit costs of Arfea in 1997 and 1998 are coherent with those of a typical well-run undertaking providing similar services on the market.”

“(19) As a result, the additional compensations for 1997 and 1998 (EUR 1 196 780 for 1997 and EUR 102 814 for 1998) would correspond to the difference between the verified deficit and the net financial effect, minus the public contributions already paid by the Region.”

The calculations of the expert appear to be reasonable. Yet, as will be seen below, the Commission rejected them. It is important to understand why. There are at least three reasons for the rejection. First, assumptions about allocation of fixed costs are fine before operations start. However, after operations start, any assumption may lead to too many cost items falling under the PSC. Second, profits have to be adjusted to reflect the risk borne by the operator. Compensation that covers most costs and thus reduces risk should correspondingly lead to lower profit. Third, claims about “typical well-run undertakings” have to be backed up with hard evidence. This is itself a near impossible task.

Existence of State aid

There was no doubt that the PSC was provided through state resources, that it was selective and that it was capable of affecting cross-border trade. Hence, the decisive issue was whether the PSC conferred an advantage to Arfea. For this purpose the Commission had to examine whether the PSC was granted in compliance with the Altmark criteria.

With respect to the 1st Altmark criterion, the Commission noted that Italy did not explain what PSO had been imposed on Arfea. On the contrary, Italy was of the view that Arfea had not been entrusted with any PSO. [Naturally, the Italian authorities had notified the compensation that the domestic court had instructed them to provide because they did not want to make any payments to Arfea.]

Then the Commission explained that “(53) […] the notion of public service obligation relates to conditions imposed on an operator, which that operator, if it were considering its own commercial interest, would not assume or would not assume to the same extent without reward. Moreover, these conditions must be clearly defined by the authority in an entrustment act. In that regard, Arfea has not been able to explain precisely what public service obligations had been imposed upon it nor to show that these PSOs had been clearly defined in an entrustment act.”

With respect to the 2nd Altmark criterion condition, the Commission observed that no parameters for the calculation of the PSC had been determined in advance. They had been determined solely on an ex post calculation made by the court appointed expert. The Commission also disputed the correctness of the calculation because, due to the absence of separate accounts, it was based on assumptions which had not been properly explained. “(56) Such an approach is in contradiction with the second Altmark condition and any compensation granted on that basis constitutes State aid.”

With respect to the 3rd Altmark criterion, the Commission restated the well-understood principle that “(58) […] when an undertaking carries out both activities which are subject to PSOs and activities which are not subject to PSOs, it is not possible to determine precisely what are the costs incurred in the discharge of PSOs in the absence of a proper separation of account between the different activities of the provider.” Italy was of the view that Arfea had not properly separated accounts.

More importantly, “(59) […] the cost allocation done by the [court appointed] expert has been done ex post, based on the base model prepared by Arfea’s consultants, which determined percentages of costs to be allocated to the different activities of Arfea.”

In addition, “(60) the Commission considers that the profit levels taken into account by the expert for the calculation of the amounts of compensation are higher than what can be considered as a reasonable profit in the meaning of the third Altmark condition. (61) The expert considered that a rate of return on invested capital of 12.89% for 1997 and of 10.81% for 1998 was a reasonable profit rate; these rates being based on the yield of Italian 10-year State bond (6.8% for 1997) plus an average risk premium (4.8% for 1997) corrected upwards to take into account Arfea’s own financial situation (by 1.28 for 1997). (62) In that regard, the Commission observes that the risk premium determined by the expert is particularly high, given that the risk to which Arfea was exposed was rather limited. Indeed, Arfea operated the concessions on the basis of an exclusive right, which shielded it from competition from other operators, and the compensation determined by the expert compensated the alleged full cost incurred in the discharge of public service obligations. (63) Moreover, the Commission notes that, while the expert noted that the transport sector benefited from an average risk below market, it corrected the risk premium upwards in order to take into account Arfea’s own financial exposure which was higher than the sector’s average. By doing so the expert therefore did not take into account the risk of a typical transport company but Arfea’s own risk, which was higher than the average of the sector.” The Commission concluded that the 3rd Altmark criterion was not fulfilled.

Since the Altmark criteria are cumulative, there was no need for the Commission to proceed to the 4th Altmark criterion in order to determine that the PSC constituted State aid.

Then the Commission considered whether the aid should have been notified under Regulation 1191/69. Under that Regulation, PSC was exempted from notification only if it was unilaterally imposed on an undertaking. In the case of Arfea, the initial concession was only for a year and could be extended only after a request by the concessionaire. Therefore, subsequent PSO contracts were voluntary. The Commission referred to the latest case law according to which “(78) […] As recalled by the General Court in its judgment of 3 March 2016 in Simet case T-15/14, a voluntary adhesion to a contractual relationship is different from a unilateral imposition of PSOs and does not give rise to an obligation of compensation under Regulation (EEC) No 1191/69.”

The Commission also pointed out that the bus routes, timetables and list of tariffs which were attached to the concession agreements could not be considered as imposing unilateral PSOs on Arfea. This is because the concession agreements were voluntarily concluded by Arfea.

Moreover, the fact that Arfea requested the renewal of the concessions and even paid a concession fee it was “(83) […] hardly reconcilable with the imposition of any public service obligation […] As observed by the General Court in its judgment of 3 March 2016 in Simet case T-15/14, it is difficult to admit an undertaking would ask for the renewal of a concession, taking into account the obligations attached to it, while the execution of that concession is not in its commercial interest.”

The Commission also found that the PSC was not in conformity with the method laid down in Regulation 1191/69.

It, therefore, proceeded to assess the compatibility of the aid on the basis of Regulation 1370/2007 which applies Article 93 TFEU that, in the field of transport, is lex specialis with respect to Article 107(3) and Article 106(2). Not surprisingly it found that the awards to Arfea did not meet the requirements of Regulation 1370/2007, primarily because the PSO was not correctly defined and because the calculation of the PSC did not follow the methodology laid down in that Regulation. The fatal error of Arfea was not to keep separate accounts.

Compensation v award of damages

Interestingly, the last issue examined in the Commission decision was whether the funding that was awarded by the Italian court in favour of Arfea was PSC or compensation for damages. The Commission first reiterated the general principle that “(104) […] under certain circumstances, [for example, tort or unjustified enrichment] compensation for damages due to the wrongful act or other conduct of the national authorities does not constitute an advantage and is therefore not to be considered as State aid within the meaning of Article 107(1) of the Treaty [see joined cases C-106 to C-120/87, Asteris and others v Greece]. The purpose of compensation for damage suffered is different from that of State aid since it aims to bring the damaged party back to the situation in which he found itself prior to the damaging act, as if the latter had not occurred”.

“(105) However, for compensation for damages to fall outside the State aid rules, it must be based on a general rule of compensation [see Commission decision N 304/2003 on Dutch aid in favour of Akzo-Nobel in order to minimise chlorine transport; Commission decision N 575/2005 on Dutch aid for relocation of car dismantling company Steenbergen]. Moreover, in its judgment in Lucchini, the CJEU held that a national court was prevented from applying national law where the application of that law would have the effect to ‘frustrate the application of Community law in so far as it would make it impossible to recover State aid that was granted in breach of Community law’ [C-119/05, Lucchini]. The principle underlying this pronouncement is that a rule of national law cannot be applied where such application would frustrate the proper application of Union law [T-15/14, Simet v Commission]. In that regard, the General Court has held [in T-15/14, Simet] that an award of damages that would consist in the indemnification of a prejudice suffered as a result of the imposition of public service obligations could not escape to the qualification of State aid merely because it consisted in an award of damages, as this would allow the circumvention of Articles 107 and 108 of the Treaty”.

On the basis of the above principles, the Commission concluded that, first, the Italian court has misapplied Regulation 1191/69. Second, Arfea could not receive compensation for the bilaterally agreed concession contracts and therefore an award for alleged damages would be in breach of Articles 107 and 108 of the Treaty. “(109) This is because such an award would produce the exact same result for Arfea as an award of public service compensation for the period under review, despite the fact that the concession agreements governing the services in question were neither exempt from prior notification, nor complied with the substantive requirements of Regulation (EEC) No 1191/69 or Regulation (EC) No 1370/2007”. “(110) The availability of such an award would thus effectively enable the circumvention of the State aid rules and the conditions laid down by the Union legislator under which competent authorities, when imposing or contracting for PSOs, compensate public service operators for the costs incurred in return for the discharge of PSOs. Indeed, an award of damages equal to the sum of the amounts of aid that were envisaged to be granted would constitute an indirect grant of State aid found to be illegal and incompatible with the internal market. As recalled above, the General Court has made clear that, in such circumstances, State aid rules cannot be circumvented merely because the measure at stake would consist in an award of damages [Opinion of 28 April 2005 in Joined Cases C-346/03 and C-529/03, Atzori, paragraph 198]”.

Consequently, the Commission ordered Italy to recover any compensation for being incompatible with the internal market.

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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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