The Law, Economics and Art of Compensation for Public Service Obligations

State aid in the form of compensation for public service obligations must exclude any intangible benefits from the obligation, but may include reasonable profit.

The Commission guidelines for State aid in agriculture and forestry, the block exemption regulations covering agriculture, forestry, fishery and aquaculture, and the Regulation on de minimis aid for fishery and aquaculture have been prolonged to 31 December 2022.

Introduction

The correct calculation of the amount of State aid that is needed by a provider of a service of general economic interest depends crucially on the credibility of the “counterfactual” scenario: what the provider would do without the aid. The General Court had to assess, among other things, the credibility of the counterfactual scenario in its judgment of 15 October 2020, in case T‑316/18, První novinová společnost [PNS] v Commission.[1]

Background

PNS, successor to Mediaservis, applied for annulment of Commission decisions SA.45281 and SA. 44859 declaring that the compensations granted by the Czech Republic to Česká pošta for the performance of its postal activities under a universal service obligation [USO] for the period 2013 to 2017 constituted State aid compatible with the internal market, pursuant to Article 106(2) TFEU.

Presence of serious difficulties

The first plea of PNS was that the Commission should have opened the formal investigation procedure because it had encountered serious difficulties in determining the compatibility of the aid. It claimed that the presence of serious difficulties was demonstrated by the length of the informal stage of assessment and by the incomplete, according to it, analysis of the Commission.

The General Court rejected the claim that the informal stage was excessively long. With respect to the second claim, the applicant put forth several argument to prove that the Commission did not carry out a full assessment of the State aid to Česká pošta.

Non-charging of VAT

The first argument concerning the alleged incomplete assessment was that the Commission failed to consider properly the non-charging of VAT by Česká pošta.

The General Court explained that although the Commission did not address the complaint concerning the VAT in its decision, it did take into account the impact of the VAT exemption on services covered by the USO.

The General Court then made a smart observation. “(165) Furthermore, even if it were established, non-charging of VAT in respect of services not falling within the scope of the USO would have had no effect on the NAC [net avoided cost] calculation relating to the USO, since, as is apparent from paragraph 25 of the 2012 SGEI Framework, that calculation consists in 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. As the Commission observes, whether or not non-charging of VAT for services falling outside the scope of the USO did or did not occur should be reflected both in the factual scenario and in the counterfactual scenario. That non-charging of VAT would therefore have no impact on the calculation of the amount of compensation granted to the second intervener.”

Consequently, it also rejected the second part of the claim concerning serious difficulties.

Benefits from non-USO services

Next, the applicant alleged that Česká pošta, as a result of its dense network, benefited from a number of other income-generating services, such as financial services, which were not properly assessed by the Commission.

The response of the General Court was that “(176) as regards the additional sources of revenue generated by [Česká pošta’s] network, the Commission took them into account in the counterfactual scenario, which falls within the assessment of the merits of the decision”.

“(177) The fact that the Commission did not break down in detail the other services in question cannot, in itself, establish that its examination of the case was incomplete or insufficient, especially in the context of the method of calculating NACs”.


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The overall profitability of Česká pošta

The applicant claimed that Česká pošta showed profits and therefore it did not need to receive compensation for its services under the USO.

“(185) Showing profits even without the compensation, it should be pointed out that the overall profitable situation of the USO operator cannot in any way preclude loss-making results for the discharge of the USO. Otherwise, the very scheme of the compensation for the discharge of that obligation would be called into question. In other words, the method of calculating NACs is independent of the operator’s other results.”

“(186) In short, no profitable operator would agree, moreover, to take over a USO at the risk of having to offset the resulting net costs against its profits generated by its other activities.”

I am not sure that this statement is true for all SGEI providers. After all, the General Court has told us in other cases [e.g. BUPA] that the correct definition of SGEI/PSO involves “compulsion” or the imposition of an obligation through an act of entrustment. The Commission itself has approved public service compensation that is less than the net extra costs of the SGEI/PSO [see for example the decision on the UK’s Royal Mail]. Indeed, in order to reduce the amount of subsidies they have to grant, some Member States have forced their universal postal operators to cross-subsidise their public mission with profits from services that fall outside that mission.

Then the General Court made a rather surprising but, as we will see below, correct statement. “(187) It must be stated that there is nothing in the 2012 SGEI Framework to prevent the proceeds of the compensation from being allocated to items other than the USO, since that is a management decision of the operator.”

“(188) The applicant’s reading of paragraph 21 of the 2012 SGEI Framework is manifestly incorrect.” “(189) As provided in paragraph 21 of the 2012 SGEI Framework, ‘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.”

“(190) However, and as the Commission correctly observed, it does not in any way follow from paragraph 21 of the 2012 SGEI Framework that the compensation must be allocated to cover the net cost of the USO, but only that it must not exceed that cost.”

“(191) It is clear that the applicant is confusing the amount of compensation with its allocation.”

The SGEI Framework requires Member States to calculate the amount of compensation primarily on the basis of the net avoided cost [NAC] methodology. However, it also allows them, under certain conditions, to use the cost allocation methodology. With respect to the cost allocation methodology, the Framework stipulates clearly at point 29 that “the costs to be taken into consideration include all the costs necessary to operate the SGEI”. This indicates that costs which are not necessary for the SGEI must not be included in the compensation.

However, under the NAC methodology inclusion of extraneous does not make any difference to the amount of PSC. However, the situation is a bit more complex. First, I explain with the use of a simple numerical example why extraneous costs do not affect the derived amount of the PSC and then I qualify this conclusion in one particular case.

Assume that the following financial data apply to a postal operator:

With PSO Without PSO
FC Fixed costs 200 200
VC1 Variable cost 1 [PSO]

+ share of FC

1000 + 180 500 +165
VC2 Variable cost 2 [non PSO] + share of FC 100 + 20 100 + 35
R1 Revenue [PSO] 900 700
R2 Revenue [non PSO] 150 150
N’ Net outcome before PSO

[R1 + R2 – VC1 – VC2 – F]
n.a. + 50
N” Net outcome after PSO

[R1 + R2 – VC1 – VC2 – F]
– 250 n.a
NAC Compensation = N” – N’ – 250 – 50 = – 300

[The compensation is expressed as a negative number because it is what the company needs to receive to offset the losses from the PSO and achieve its previous profitability. Another way to derive the PSC of 300 is to proceed as follows: The extra costs from the PSO are 500 [= 1000 – 500], while the extra revenue from the PSO is 200 [= 700]. The difference is 300.]

It is true that the section on the NAC in the SGEI Framework does not specify the costs that may be covered by the compensation. But this makes no difference to the maximum amount of PSC that may be granted to the operator. Consider what may happen when the operator receives PSC of 300. It covers the extra cost of the PSO and restores the profit it earned before the PSO. Now, the operator allocates part of that PSC, say, 50 to the cost of services not covered by the PSO. Immediately, it will record an extra profit of 50 in relation to non-PSO and an extra deficit of 50 in relation to PSO. Hence the nature of the NAC methodology is such that SGEI providers cannot benefit from including unrelated costs in the PSC because any revenue from the unrelated activities will be used to reduce the amount of PSC!

Furthermore, consider what happens when the operator exaggerates its operating costs, say by 20, in both the factual and counterfactual scenarios. In the factual scenario, its net extra costs will increase to 270. In the counterfactual scenario its profit will decline to 30. The difference between the two scenarios is still [270 + 30]. Therefore, the inclusion of extraneous costs has no impact.

However, the conclusion above must be qualified in an important respect. In network sectors such as postal services, the SGEI provider is normally the incumbent operator who owns the network which is necessary for the delivery of the service. Hence the identification of the counterfactual scenario in these situations is an exercise in what is likely to happen if the incumbent is no longer obliged to provide a universal service. Indeed, point 25 of the SGEI Framework requires that “due attention must be given to correctly assessing the costs that the service provider is expected to avoid and the revenues it is expected not to receive, in the absence of the public service obligation.” It is not an easy task to identify the costs that can be avoided by an operator that has been traditionally providing a universal service and, therefore, the counterfactual is a situation that has not been ever observed. However, a well-managed operator should be able to know which of its services are loss-making. Therefore, in practice the counterfactual scenario corresponds to a situation where the loss-making services are discontinued. We will see later that indeed this is what the Commission had considered in this case and this is what the General Court endorsed. But it is not always so simple because the NAC methodology itself cannot indicate the size of the fixed costs that are necessary for a smaller operation. In the numerical example above, I assumed that the fixed costs remain the same in the two scenarios. It does not have to be so. This implies that the smaller the fixed costs in the counterfactual scenario, the larger the amount of profit in that scenario, and, therefore, the larger the compensation with the PSO. It follows that an operator who intentionally underestimates that cost in its counterfactual scenario will have more resources when it receives the PSC to support expansion of its commercially profitable services. Therefore, for incumbent SGEI providers a miscalculation of the PSC they need can also lead to misallocation of resources.

Pricing policy and possible cross-subsidisation of non-PSO services by PSO services

The applicant claimed that Česká pošta had pursued a pricing policy that resulted in cross-subsidisation of non-eligible services with State aid.

The General Court rejected that claim. “(198) It should be pointed out that, from an accounting point of view, the Commission cannot be criticised for not having carried out a more detailed examination of the measure at issue and for relying on the accounts submitted, since those accounts showed separately the costs and revenue relating to the activities connected with the USO and those relating to other activities, in accordance with an allocation key approved by the national regulatory authority and subject to annual review by an independent auditor.”

“(200) As regards activities falling outside the scope of the USO, it is sufficient to note […], that those prices are set freely and are subject to the law of supply and demand, so that any tariff differentiation can logically emerge from them.”

“(202) For the sake of completeness, it should be pointed out that the 2012 SGEI Framework does not in any way preclude a USO operator from being able freely to allocate the compensation paid for that purpose to other services, with the result that the applicant’s argument cannot succeed and the fourth complaint must be rejected.”

Again, this statement is a bit surprising because nowhere in the SGEI Framework is such a clarification made, but it must be acknowledged that this is the inevitable consequence of the logic of the NAC methodology.

Overcompensation

The applicant submitted that the Commission committed manifest errors of assessment by finding that overcompensation of the net costs resulting from the discharge of the USO was precluded.

First, the General Court recalled the provisions of Article 106(2) TFEU. “(233) Article

106(2) TFEU provides that undertakings entrusted with the operation of SGEIs are to be subject to the rules contained in the Treaties, in particular to the rules on competition, in so far as the application of such rules does not obstruct the performance, in law or in fact, of the particular tasks assigned to them and that the development of trade must not be affected to such an extent as would be contrary to the interests of the Union”.

“(234) In allowing derogations to be made from the general rules of the Treaty in certain circumstances, Article 106(2) TFEU seeks to reconcile the Member States’ interest in using certain undertakings, in particular in the public sector, as an instrument of economic or fiscal policy with the Union’s interest in ensuring compliance with the rules on competition and the preservation of the unity of the internal market”.

“(235) What Article 106(2) TFEU seeks to prevent, through the assessment of the proportionality of the aid, is that the operator responsible for the public service benefits from funding which exceeds the net costs of the public service”.

“(236) In that regard, paragraph 21 of the 2012 SGEI Framework provides that the amount of compensation granted to an SGEI provider must not exceed what is necessary to cover the net cost of discharging the public service obligations, including a reasonable profit. As is apparent from that paragraph, net cost means net avoided cost or costs minus revenues where the net avoided cost methodology cannot be applied.”

“(237) According to paragraph 24 of the 2012 SGEI Framework, the net cost necessary, or expected to be necessary, to discharge the public service obligations should be calculated using the net avoided cost methodology where this is required by Union or national legislation and in other cases where this is possible.”

“(238) Annex I to the Postal Directive provides for the application of the net avoided cost methodology for the calculation of the net cost of the USO in the postal sector.” “(239) Thus, in the contested decision, the Commission assessed the possible existence of overcompensation under the NAC methodology.”

“(240) Paragraph 25 of the 2012 SGEI Framework states: ‘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. Due attention must be given to correctly assessing the costs that the service provider is expected to avoid and the revenues it is expected not to receive, in the absence of the public service obligation. The net cost calculation should assess the benefits, including intangible benefits as far as possible, to the SGEI provider.’”

“(241) By way of comparison, according to paragraph 28 of the SGEI Framework, under the cost allocation methodology, the net cost necessary to discharge the public service obligations can be calculated as the difference between the costs and the revenues for a designated provider of fulfilling the public service obligations, as specified and estimated in the entrustment act.”

On the basis of the above principle, then the General Court went on to examine each of the specific pleas of the applicant.

Unreliable accounting system in the light of paragraph 31 of the 2012 SGEI Framework

The applicant complained that the Commission did not properly establish the existence of an appropriate accounting separation between the activities falling within the USO and those outside it, in breach of paragraph 31 of the 2012 SGEI Framework.

The General Court observed that “(248) paragraph 44 of the 2012 SGEI Framework provides that, ‘where an undertaking carries out activities falling both inside and outside the scope of the SGEI, the internal accounts must show separately the costs and revenues associated with the SGEI and those of the other services in line with the principles set out in paragraph 31’.”

“(249) Paragraph 31 of the 2012 SGEI Framework, which appears in the part of that Framework relating to the methodology for determining net costs based on cost allocation, provides: ‘Where the undertaking also carries out activities falling outside the scope of the SGEI, the costs to be taken into consideration may cover all the direct costs necessary to discharge the public service obligations and an appropriate contribution to the indirect costs common to both the SGEI and other activities. The costs linked to any activities outside the scope of the SGEI must include all the direct costs and an appropriate contribution to the common costs. To determine the appropriate contribution to the common costs, market prices for the use of the resources, where available, can be taken as a benchmark. In the absence of such market prices, the appropriate contribution to the common costs can be determined by reference to the level of reasonable profit the undertaking is expected to make on the activities falling outside the scope of the SGEI or by other methodologies where more appropriate.’”

The General Court noted that “(251) the Commission did not confine itself solely to the finding of an accounting system separating the activities falling within the discharge of the USO from those outside it.”

“(252) The Commission observed that [Česká pošta’s] accounts were based on an accounting system which had been audited in the context, inter alia, of the Czech Republic’s accession to the European Union.” “(253) The Commission added that the […] accounts were audited on an annual basis by an independent operator”. “(254) The Commission conducted a thorough analysis of the accounting system, in particular of its reliability”.

Failure to take account of the cost-orientation of the pricing policy, in breach of paragraph 25 of the 2012 SGEI Framework

“(259) The Commission examined whether the Czech authorities had determined the amount of compensation from the USO in the light of whether there was an unfair financial burden for [Česká pošta] […] the Commission described the compensation mechanism provided for in the Czech Law on postal services in order to compensate for the net costs ‘representing an unfair financial burden’ […] it found that [Česká pošta] received compensation for the part of the net costs of the USO which was considered to be an unfair burden on the undertaking”.

Cost allocation methodology

The applicant also argued that the Commission should have used the cost allocation methodology instead of the NAC methodology. This is a weird argument because the NAC methodology excludes fixed costs, so the PSC is smaller than under the cost allocation methodology.

The General Court replied that “(264) as is explained in paragraph 27 of the 2012 SGEI Framework, the Commission regards the NAC methodology as the most accurate method for determining the cost of a public service obligation. In that framework, provision is therefore made for the application of the cost allocation methodology only in the alternative, where it is impossible or inappropriate to apply the net avoided costs methodology.”

“(265) Furthermore, the applicant has not shown that it was impossible or inappropriate to apply the NAC methodology in the present case. Moreover, as is stated in paragraph 238 above, that methodology is expressly provided for in the Postal Directive.”

Pricing of services

Then the General Court turned its attention to the pricing of postal services.

“(267) It should be noted that, in the postal sector, the obligation of cost-oriented prices, possibly increased by an appropriate level of profit, must often be reconciled with other obligations imposed on universal service providers, such as the obligation to set the price of the universal service at an affordable and uniform level.”

“(268) In high cost areas, if tariffs were to be calculated strictly based on cost, postal services would not be considered affordable. That difficulty justifies the imposition of universal service obligations and the possibility of compensating for the cost of such obligations. Those obligations are based on the premiss that, under market conditions, the services in question would not be offered in the entire territory of a Member State. The provision of some services within the universal service thus can be fulfilled only at a loss or at a net cost which falls outside normal commercial standards.”

“(269) Thus, the need to reconcile the various obligations imposed on the universal service provider may prevent each service from being provided at a price which enables the full costs attributed to it to be covered.”

“(270) The NAC methodology makes it possible, on account of its characteristics, to take account of the fact that the operator responsible for the USO in the postal sector may be required to charge an affordable or even uniform price for the same USO service throughout a territory, while bearing different costs in order to provide that service in different geographical areas.”

The General Court explained that the essence of counterfactual analysis in the NAC methodology was the “(273) question of estimating the USO’s net cost by assessing the extent to which the operator responsible for the USO would increase its profits if it were not obliged to provide the universal service.”

“(274) That is why, in the contested decision, the Commission analysed the factual scenario, namely the net cost borne by [Česká pošta] when it discharges the USO, and then the counterfactual scenario provided by the Czech authorities, namely the net cost or profit of [Česká pošta] if it did not discharge the USO.” [Remember, Česká pošta was the incumbent operator and the counterfactual scenario was a hypothetical scenario.]

“(276) As regards the counterfactual scenario, the Commission found that the Czech authorities had identified those elements of the universal service which the second intervener would not provide under market conditions, namely the operation of certain post offices, the delivery of letters five days a week for certain delivery rounds, and certain secondary processes.”

Then the General Court recognised that “(278) the application of the NAC methodology may lead, following the assessment of the counterfactual scenario, to the identification of a net cost that can be compensated despite the fact that, in the factual scenario, the price charged for the discharge of the USO already makes provision for the costs to be covered and for an appropriate level of profit. That is why, as the Commission stated in the defence, it is conceivable that a profitable operator would be entitled to compensation for the USO under that methodology.”

This is because the factual scenario already includes the USO for which the operator receives a certain amount of State aid. Therefore, the essence of the application of the NAC methodology to an incumbent operator is to recalculate the amount of State aid that should be granted to it. This exercise may lead to a larger or smaller amount of compensation, depending on the hypothetical scenario of absence of PSO, and the likely evolution of demand and technology and possible market entry or exit of competitors.

Counterfactual scenario

Then the Court turned its attention to a plea alleging incorrect counterfactual scenario. The applicant claimed that the Commission wrongly took the view that, in the absence of the PSO, Česká pošta would downsize its network and reduce the frequency of its deliveries. Indeed, this is an important issue.

The General Court observed that according to the Commission “(297) the costs and revenues relating to the operation of the post offices were recorded in the accounts of each of those offices and that the second intervener allocated revenues and costs to the post offices in order to assess their profitability. It is therefore on that basis that the number of post offices which would or would not be retained in the counterfactual scenario was set and that the impact of the closure of certain post offices on the costs and revenues of the second intervener was analysed.”

“(299) It is rational that, under market conditions, namely in particular in the absence of obligations relating to the density of its network and the frequency of delivery, [Česká pošta] would change its conduct. That change would consist of closing post offices that are loss-making and maintaining those that are profitable and of changing the delivery frequency in certain geographical areas in order to reduce its costs.”

“(300) Accordingly, the Commission did not commit a manifest error of assessment when it found […], that the counterfactual scenario developed by the Czech authorities was credible on the ground that it was based on rational assumptions which reflected [Česká pošta’s] efforts to optimise those business decisions by reducing its costs and increasing its revenues.”

Furthermore, “(302) the negative impact on demand associated with the reduction of the postal network was taken into consideration when the counterfactual scenario was developed. The Czech authorities took into account the fact that the closure of certain post offices would lead to a change in demand and would influence both the costs and revenues associated with postal and non-postal services.”

Therefore, the General Court rejected the plea on the counterfactual scenario.

Remedial measures

The applicant alleged misapplication of section 2.9 of the SGEI Framework. According to the applicant the aid was allowed without any remedial measures to prevent serious distortion of competition.

The General Court recalled that “(322) pursuant to paragraphs 52 and 53 of the 2012 SGEI Framework which appear in Section 2.9 of that framework, if, in some exceptional circumstances, serious competition distortions in the internal market could remain unaddressed and the aid could affect trade to such an extent as would be contrary to the interest of the Union, the Commission examines whether such distortions can be mitigated by requiring conditions or requesting commitments from the Member State.”

The Court found that “(324) the Commission removed the doubts as to whether there was a distortion of competition resulting from overcompensation of the net costs and ultimately found the measure at issue to be compatible for the purposes of Article 106(2) TFEU.”

“(325) Thus, in the absence of any doubt as to an overcompensation of the net costs and therefore as to the existence of a distortion of competition, the Commission was a fortiori under no obligation to impose conditions or commitments on the Czech Republic, as such conditions or commitments can be envisaged only where there are serious distortions of competition.”

This is a problematic interpretation of the SGEI Framework. If distortion of competition can simply be prevented by not allowing overcompensation, then paragraphs 52 and 53 of the Framework are superfluous. In view of the fact that the SGEI Framework has other provisions that prohibit overcompensation, we must understand that the purpose of paragraphs 52 and 53 is to prevent distortions that arise for reasons other than overcompensation, such as, for example, that State aid enables an incumbent operator to preserve its dominant position.

The General Court added that “(327) in accordance with paragraph 54 of the 2012 SGEI Framework which appears under Section 2.9 of that framework, ‘serious competition distortions such as to be contrary to the interests of the Union are only expected to occur in exceptional circumstances’ and that ‘the Commission will restrict its attention to those distortions where the aid has significant adverse effects on other Member States and the functioning of the internal market, for example, because they deny undertakings in important sectors of the economy the possibility to achieve the scale of operations necessary to operate efficiently’.”

“(328) The circumstances of the present case cannot be regarded as exceptional circumstances, within the meaning of paragraph 54 of the 2012 SGEI Framework.” “(329) That is all the more so since it is apparent from recitals 143 to 151 of the contested decision that the Commission checked sufficiently that any risk of overcompensation of the provision of the USO was averted.”

On the basis of the above findings, the General Court rejected all the pleas of the applicant that the Commission encountered serious difficulties in the assessment of the measure and should have opened the formal investigation procedure.


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

http://curia.europa.eu/juris/document/document.jsf?text=&docid=232477&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=9762536


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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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