Services of General Economic Interest: How to Compensate and Induce more Efficiency

Even traditional monopolists, like postal operators, have to comply with the rules on compensation for the extra costs of public service obligations. SGEI providers can be compensated in a way that induces them to become more efficient.

 

Introduction

This article examines case Commission decision SA.38788 concerning compensation for the UK Post Office Ltd [POL] in the period 2015-18.[1] It is worth recalling that the compensation provided to the Post Office in the period 2012-15 [about €1,390 million] was the first case that was assessed on the basis of the 2012 SGEI package [approved by Commission decision SA.33054]. In its 2012 decision, the Commission also endorsed a working capital facility of up to €1,384 million which would have provided POL with sufficient liquidity to carry out its public service obligations. In fact, the Commission found that that liquidity facility was provided on market terms and therefore did not constitute State aid. Therefore, it is possible for the state to support an SGEI provider in its public mission and at the same time invest in it as a private investor.

POL provides a wide range of services through its nationwide network of 11,700 post office branches. It is owned by the UK government. POL itself owns and manages directly 337 [3%] of those post offices. The post offices of the remainder [97%] of the network are owned and managed by private operators, who have entered into agreements with POL to manage a post office.

The business activities of POL are divided into four main categories: i) mail and retail services; ii) financial and banking services; iii) government services [e.g. licences]; and iv) telecoms services. POL is under public service obligations only for the first three categories.

The UK intended to provide partial funding [around €859 million] for POL’s provision of public services for the period between 2015 and 2018. This funding was to compensate POL partially for the extra costs of delivering the network SGEI and for investment outlays.

The public service obligations

The UK government has imposed on POL the following public service obligations:

  1. To maintain a post offices network above its optimum commercial size that includes at least 11,500 post offices and meets minimum access criteria so that nationally, 99% of the UK population can be within 5km and 90% of the population can be within 1.5km of their nearest post office branch [more detailed criteria are defined for rural and urban areas].
  2. To provide the following services: i) Processing of social benefit payments and national identity and licensing applications; ii) providing payment facilities for public utilities; iii) providing access to postal services and access to cash / banking facilities and UK savings instruments.

The net extra cost calculation

The UK calculated the net cost of the network using the “net avoided cost methodology”. According to this methodology, the SGEI net cost is the difference between the expected net cost for POL when providing the SGEI [“Scenario A”] and the expected net cost or profit for POL when operating without any obligation of providing the SGEI on the basis of an optimal commercial strategy [“Scenario B”]. In the latter scenario POL would reduce both the network and the services it provides, resulting in cost savings. There would be a drastic reduction in the number of post offices from 11,700 to 3,600. The avoidable costs are the variable costs that would be saved by not delivering specific products and the fixed costs of the offices that would be closed down. However, in Scenario B certain costs would still have to be incurred because they would be necessary for the operation of the remaining post offices, irrespective of closure of any non-commercial offices. In other words, in Scenario B, POL would make changes in relation to: i) the network size [i.e. smaller optimal commercial network of post office branches]; ii) the scale of its service offering [i.e. withdrawal of certain services].

The formula used to calculate the amount of compensation was:

(1) Net income of Scenario A = Revenue – Costs

(2) Net income of Scenario B = Revenue – Costs

(3) Net avoided costs = (2) – (1)

(4) Compensation = (3) – X

It is important to note that the UK intended to grant an amount of compensation – which, as mentioned above, was EUR 859 million – that in fact was less than the net avoided cost by an undisclosed amount of X. The decision does not explain why the UK government decided to under-compensate POL. It is worth asking whether under-compensation made sense. I think it did. Suppose that under Scenario A, POL incurred losses of 20 while under Scenario B it would make a profit of 12. By providing compensation that was equal to the difference between the two scenarios, the UK government would in fact protect POL’s profits. By under-compensating POL, it was as if it exposed POL to competition which would force it to become more efficient. In addition, we do not know whether the profits under Scenario B exceeded POL’s cost of capital. If they did, then compensation that was equal to the difference between the outcomes of the two scenarios would guarantee POL supernormal profits. That would make no sense from a public policy perspective. As we will see below, the Commission found that POL was expected to make only reasonable profit as measured by the rate of return on sales. But return on sales does not really tell us much about the costs that POL incurs to raise capital.

Existence of State aid and Altmark

Having established how the compensation was to be calculated, the Commission moved on to determine whether it constituted State aid. Although the Commission accepted that a genuine PSO had been imposed on POL, it had no doubt that the compensation was State aid because it did not satisfy the fourth Altmark criterion. “(68) In its 2012 POL Decision, the Commission already concluded that this compensation was not Altmark compliant. The UK authorities did not provide any new elements in the current notification demonstrating that the compensation for the delivery of the SGEIs by POL respects all Altmark conditions, nor argue in favour of their fulfilment. In particular, the UK authorities have not provided information substantiating that POL is being compensated according to the costs of a typical well-run undertaking within the sector. In the absence of this information the Commission is not in a position to consider that the fourth Altmark condition is met.” [Emphasis added]

At this point it is necessary to make the following observation. Under the 2012 SGEI framework, the entrustment of a PSO must comply with public procurement procedures. In other words, the designated provider must be competitively selected. However, neither in 2012, nor in 2015 was POL selected competitively. Nevertheless, the UK did comply with the relevant public procurement rules. According to the EU public procurement directives, when a supplier is the only one on the market, there is no need for a tender [Article 40(3)(c) of Directive 2004/17 and Article 31(1)(b) of Directive 2004/18/EC]. The Commission did acknowledge both in the 2012 decision and in the present decision that there was no other provider in the market with the same network [please see below the text cited from paragraphs 100 & 101 of the decision]. The UK complied with the SGEI framework but how could it comply with the 4th Altmark criterion that requires either competitive selection or benchmarking of costs? A competitive tender would have been futile. An attempt to compare the costs of POL with those of a “typical” undertaking in the sector would have been useless as there was no other undertaking. Benchmarking against the costs of postal providers in other Member States would have been irrelevant as the conditions of operation in other Member States were not genuine market conditions. Most of them, if not all, were subsidised. We also know from other Commission decisions, that the Commission understands the benchmarking exercise to be a comparison of own costs with those of other similar undertakings. It would not have been possible for POL to argue that its costs were as low as they could be. Must we infer, therefore, that the 4th Altmark cannot apply to natural monopolies? No answer to this question has been provided so far.

Then the Commission examined the conformity of the PSC with the 2012 SGEI framework which lays down the compatibility criteria for PSC that exceeds €15 million per year. The findings of the Commission were as follows.

Compatibility

Genuine SGEI and entrustment

The PSO was a genuine SGEI. It was necessary for postal and basic financial services to be available in a local, accessible and secure environment, especially for certain groups such as the elderly and rural residents. The market did not provide those services in all localities.

The act of entrustment did spell out the nature of the tasks assigned to POL as well as the scope and the general operational conditions of the SGEI. The entrustment agreement included i) a precise description of the SGEIs, ii) the methods of calculating partial SGEI compensation and iii) the procedure that applied for recovery of any overcompensation. Moreover, the duration of the entrustment period was justified by reference to objective criteria. The three-year period of entrustment did not exceed the period required for the depreciation of the most significant assets required to provide the SGEI.

The entrustment act delineated a separate network SGEI mission and ensured that the PSC was ring-fenced to finance exclusively the network SGEI and not the delivery of commercial services.

Public procurement rules

Paragraph 19 of the 2012 SGEI framework makes the compatibility of SGEI compensation conditional upon compliance with EU public procurement rules. As already mentioned above, “(100) […] in its 2012 POL Decision, the Commission has accepted that, at the time, POL was the only operator whose network and contractual relationships actually satisfy the requirements for the provision of the Network SGEI, as described in the entrustment. In these circumstances, the Commission considered that the negotiated procedure without prior publication, which is followed to entrust POL with the Network SGEI, was justified under EU public procurement rules.” “(101) As regards the next funding period, according to the UK, POL remains the only possible provider of the Network SGEI because no other physical network operator present today in the UK meets the UK’s needs.”

Amount of PSC and verification of the absence of overcompensation

Paragraphs 21-25 of the 2012 SGEI framework stipulate that the amount of compensation must not exceed the net cost of discharging the PSO, including a reasonable profit. The net cost should be calculated using the net avoided cost methodology. The Commission accepted that the PSC of POL was calculated correctly and on the basis of reasonable assumptions. The Commission also checked that there was no double-counting with the mixing of revenues of costs of Scenarios A and B.

An interesting point mentioned in paragraph 128 of the decision is that the UK government decided that the income generated from POL’s non-SGEI activities had to contribute to the financing of the SGEIs entrusted to POL. This further assured the Commission that the contribution from the non-SGEI activities would reduce the SGEI net cost and any risk of overcompensation.

Reasonable profit

The Commission found that in the counterfactual scenario, POL achieved a net return on sales of 6.4%. This was considered to be in line with rates of return of previous Commission decisions. The Commission also observed that POL’s main competitor for bill payment services, earned a return on sales of 19% in 2011. Consequently, the Commission concluded that POL’s expected rate of return was not excessive.

Efficiency incentives

According to paragraphs 39-43 of the 2012 SGEI framework, Member States have to include efficiency incentives in their compensation mechanisms. Member States may, for example, define upfront a fixed compensation level which anticipates and incorporates the efficiency gains that the undertaking ought to achieve. Or, Member States can define productive efficiency targets in the entrustment act.

In this case, the POL received compensation on condition that it would reach pre-determined efficiency targets. In order to achieve those targets against declining SGEI funding, POL had to increase the efficiency of its operations, not only in relation to its physical network, but also in respect of the income that the network generated and the level of costs it incurred. POL is obliged to repay excess compensation to the UK beyond the net costs of the service which include a reasonable profit The Commission also noted that there was an incentive effect stemming from the fact that POL was only partially compensated. POL would receive a fixed upfront compensation that was below the expected net costs of the SGEI.

In addition, POL could keep extra profits up to the amount of the next extra costs. Since POL was under-compensated, it could reduce the extent of under-compensation by becoming more efficient.

The Commission also checked whether the UK had in place procedures to ensure that efficiency was not to be achieved at the expense of quality.

Separation of accounts

POL did maintain separate accounts for the SGEI and the non-SGEI.

Avoidance of undue distortion

In the decision the Commission recalled that “(132) […] fulfilment of the other requirements set out in the Framework is usually sufficient to ensure that the aid does not distort competition in a way that is contrary to the interests of the Union.”

In addition, it found that “(134) […] the network transformation does not involve inducements for a retailer to switch away from a competitor to POL by its clarifications that POL’s investments in a new post office branch do not act as inducements for a retailer to switch away from a competitor to POL”.

“(137) Moreover, the UK has made a network access commitment to allow for competitor access to POL’s network in circumstances where it is demonstrated that no alternative outlet exists in a particular geographic area of the UK.” “(138) This commitment that provides for operators offering services that compete with POL’s Product SGEIs to access POL’s network will mitigate any risk of foreclosure.”

On the basis of the above, the Commission concluded that the PSC satisfied the conditions of the 2012 framework and that it was compatible with the internal market.

———————————————————-

[1] The full text of the Commission decision can be accessed at:

http://ec.europa.eu/competition/state_aid/cases/256622/256622_1651530_118_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.

Comments

  1. An excellent article, and a good case study on state aid to SGEI. The interactions between the state aid regime and the public procurement regime are particularly interesting as they are two sides of the same coin. EU officials from DG Comp and DG Grow however sometimes know surprisingly little about how each other’s regimes operate.

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