Economic Analysis in EU State Aid Control | Barcelona GSE Regulation and Competition Seminar Series

European Commission, DG Competition, CET

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Economic analysis in EU State Aid Control

Adina Claici

European Commission (DG COMP/Chief Economist Team)

Barcelona, GSE

3 February 2012

Disclaimer (EN): the views expressed are those of the author and cannot be regarded as stating an official position of the European Commission


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EC competition policy: Three pillars

Antitrust Policy Merger Control State Aid Control

• Preventing cartels and other anticompetitive agreements

• Preventing abuses of dominant position

• Preventing anticompetitive mergers and acquisitions

• Limiting distortions to competition and trade resulting from state subsidies; allowing aid when it is in the common (EU) interest


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State aid in DG COMP

DG

PolicyENERGY &ENVIRON.

IT FINANCIALBASIC

INDUSTRIESTRANSPORT State aid Cartels

Antitrust

Mergers

State aid

CET

Antitrust

Mergers

State aid

Antitrust

Mergers

State aid

Antitrust

Mergers

State aid

Antitrust

Mergers

State aid

Regional

R&D

Network

Enforcement

HR

State aid


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1. Introduction

2. Existence of aid (MEIP)

3. Compatibility of the aid

4. Case study: DELL Poland (2009)

Overview

European Commission, DG Competition, [Directorate], [Unit]

1. Introduction

5


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Rationale of EU State Aid control

• Avoid negative cross-border externalities– Member States strategically promote national

economic/social interests

– Possible subsidy races (prisoners' dilemma)


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“Two faces” of State aid

• State aid may pursue sound public policy objectives of the Member States

– Efficiency objective (address a market failure)

– Equity objective (enhance equity)

• Negative effects: State aid may distort competition and trade

– Allocative inefficiencies (loss of welfare)

– Distributional concerns (shifts in welfare)


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Art. 107 TFEU: a two-step approach

• Article 107(1) TFEU: notion of state aid and general prohibition

“Any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, insofar as it affects trade between Member

States, be incompatible with the common market”.

• Articles 107(2) and 107(3), 106(2) TFEU: derogations (aid compatible with Treaty)


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State aid instruments

• Grants

• Tax exemptions

• Soft loans

• State guarantees

• Repayable advances

• Capital injections

• Hybrid instruments

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2. Existence of aid

Market Economy Investor Principle

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Existence of aid

• Necessary conditions under 107(1)– Measure is granted out of State resources

– Economic advantage to undertakings• The state does not act as a private investor (MEIP is not met)

– Measure is selective and distorts competition (or threatens to)• Capable of affecting the competitive balance between the recipient firm and its

competitors

• As opposed to general measure applying equally to all firms in a Member State

– Effect on intra-Community trade


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Objective

• To establish whether and to what extent an aid measure confers an economic advantage on the recipient of the aid

• An investment undertaken by the state should be considered state aid in the meaning of art 107(1) if the compensation the state receives in exchange is lower than what a private investor would have expected under such circumstances (it is not market conform)


Assessment

• Empirical analysis of the investment

• "Pari passu" principle• A public contribution from public funds does not involve State aid

if it takes place at the same time as a significant capital contribution on the part of a private investor (operating under normal market economy conditions) made in comparable circumstances – the "concomitance" test

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Empirical assessment of MEIP

ü Evaluate the investment (forward-looking)

üMeasure the expected return on the investment

üDetermine the opportunity cost of capital

ü Apply the MEIP


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Evaluate investments

Basic principle in financial theory:

– A private investor would carry out an investment project if the expected return on this investment is higher than the opportunity cost of capital (i.e., the return that the investor can expect to make with other investments of similar risk in the capital market)


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Evaluate investments

• Steps

– Ex-ante expected return = estimation of the overall return on the investment at the time the investment is made

– Estimate the opportunity cost of capital, i.e. the return that could be achieved with equivalent risk in the financial markets

– Profitability: only returns that exceed the opportunity cost of capital can be considered profitable by a rational investor


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Measure expected return on the investment

• An investor is only interested in the ex-ante return on his investment and not on the accounting profitability of the company (=ex-post, annual info), i.e. the monetary gains (cash flows) received from the investment over the entire life time of the project

t t+1 t+2 t+3 t+4 t+5 …

NPV -I CF1 CF2 CF3 CF4 CF5 … TV


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• Present value of the project

– NPV= •(Discounted CF) – Investment

• If NPV>0, the project is profitable for a private investor

• IRR = Internal rate of return (%)

– The rate of discount that makes NPV=0


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• How to determine IRR?

– Correct forecast of future cash flows based on a detailed and realistic business plan

• Income streams typically for max 10 years

• Later on, apply e.g. a constant growth rate

– Solve for the discount rate • NPV (CF, I, discount rate)=0


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Determine the opportunity cost of capital

• Industry benchmarks

– Check reliability

• Typically, there are 2 broad sources of capital:

– Equity capital (E)

– (Financial) debt capital (D)

• The total cost of capital is the weighted average cost of capital (WACC), taking into account the proportion of equity capital and the proportion of debt capital


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• Calculate WACC

– The sum of equity capital and debt capital gives us the total capital (C), expressed in euro.

– These 2 sources of capital have each a certain cost• Ke the cost of equity capital, expressed in %

• Kd the cost of (financial) debt capital, expressed in %

C

DK

C

EKWACC de +=


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• If the project is fully financed with equity capital

• Capital Asset Pricing Model (CAPM)

eKWACC =


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• CAPM

– Rf is the risk-free rate, expressed in % ;

– (Rm – Rf) is the market risk premium, expressed in % ;

– ß is the “Beta”, a measure of the systematic (non-diversifiable) risk

)( fmfe RRRK −+= β


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• In practice– Rf is approximated by the yield on a treasury bond

– (Rm – Rf) is typically estimated as the return difference between a broadly based market index and treasury bonds

– ß is directly drawn from a professional data provider in case the company is stock market quoted

• The beta of non-listed companies can be approximated using betas of comparable listed companies and making an adjustment for difference in leverage


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Apply the MEIP

• An investment is market conform if

– IRR>WACC– or, in other words, NPV (WACC) >0


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Apply the MEIP (Example)

NPV for different values of WACC

5

6

7

8

910

11 12 13 14 15 16 17 18 19 20-150

-100

-50

0

50

100


Useful links

• In the empirical assessment of the MEIP in various cases, the Commission used both theoretical insights and market values from the following sources:

– Brealey & Myers, Principles of Corporate Finance (any edition)

– Pablo Fernandez (IESE)

– Aswath Damodaran (Stern School of Business, NYU)

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Case example (MEIP 'pari passu' )

• City of Amsterdam investment in fibre network (2007)– Broadband access network

• (total equity investment €18 mil)

– 3 investors: Amsterdam municipality, 2 private investors

– Detailed analysis of the business plans

– The two private investors invested on equal terms with the municipality

• All investing parties would have to support any losses in the event of an underperforming business

– Conclusion: the investment is conform to the MEIP and therefore does not involve state aid


3. Compatibility

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Compatible aid under Art. 107(3) TFEU• Art. 107(3) EC: the following types of aid “may be

considered” compatible(a) economic development of most disadvantaged regions of Community

(b) important common European project or serious disturbance in the economy of aMember State

(c) development of certain economic activities or certain economic areas

(d) culture and heritage conservation

(e) other categories as may be specified by a decision of the Council

• Margin of discretion à frameworks and guidelines, block exemption regulations


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Compatible aid – guidance

R&D&I Training

Environment Risk capital

Regional development Rescue & restructuring

Employment Services of General Economic interest

. . . . .


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State Aid Action Plan (2005)

• Objective: “Less and better targeted aid”

àstrike a better balance between – benefits of state aid (public policy)

– costs of state aid (distortions)

• Formulated as a “balancing test” • A conceptual framework for analysing state aid cases

• So far implemented in guidelines that were up for renewal


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Balancing test– Is the aid measure aimed at a well-defined objective of

common interest? – Does the aid address a market failure?

– Does the aid enhance equity?

– Is the aid well designed to deliver the objective of common interest?

– Is State aid an appropriate policy instrument?

– Is there an incentive effect (does the aid change the behaviour of firms?)

– Is the aid measure proportional (could the same change in behaviour be obtained with less aid?)

– Are the distortions of competition and effect on tradelimited, so that the overall balance is positive?


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Common interest

• State aid may contribute to the common interest in two ways:

– Efficiency objective• alleviate market failures (economic analysis)

– Equity objective• improve social outcomes in terms of social or regional cohesion


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Common interest – efficiency objective

• Market failures (where markets are unlikely to produce efficient outcomes)

– Externalities (negative or positive)• E.g.: environmental tax, R&D subsidy, training

– Information asymmetries• Provision of finance - Adverse selection, moral hazard

• Main motivation behind the Commission’s policy towards state aid support to risk capital in the context of SMEs

– Coordination problems (e.g. in contracts)


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Common interest – equity objective

• Regional aid– Economic cohesion by reducing the gap

• Aid for the provision of SGEI– When the market cannot adequately offer services to citizens

• Employment aid– Help disadvantaged workers to enter the job market

• Aid for rescue and restructuring– Prevent losses of employment

• Aid for cultural products– Preserving cultural diversity


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Well-designed instrument

• INCENTIVE EFFECT: State aid must lead the recipient to change behaviour

– Analysis of the counterfactual: assess whether an investment project is profitable for a company without aid

– Screening device: if no incentive effect the presumption is that the aid has overall negative effects

• Assume "free money" cannot have positive effects


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• INCENTIVE EFFECT

– Methodology• Measure the NPV = • expected CF discounted at the cost of capital

– Compare situation with aid with the counterfactual• NPV without aid < 0 ?

• NPV with aid > 0 ?


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• INCENTIVE EFFECT

– Proof: internal documents to demonstrate that the beneficiary would not undertake the targeted activity without aid

• Business plans

• Profitability calculations

• Risk assessment

• Available external information


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• Proportionality

– Could the same result be reached with less aid and less distortions?

– Aid should not exceed the minimum necessary

– Linked to incentive effect (NPV with aid should not be too high)

– Case: Ford Genk (2006)• Part of the aid was prohibited


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Distortion of competitionALLOCATIVE INEFFICIENCIES (loss of welfare)

1. Product market distortions

qPrevention of exit for inefficient firms

qDistortion of dynamic incentives/moral hazard§ Crowding out effect (mixed evidence in the literature)

§ Firms anticipating that profits will be affected by state aid may find it optimal to reduce own efforts and lower incentives to innovate

qCreation or maintenance of market power


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Distortion of competitionALLOCATIVE INEFFICIENCIES (loss of welfare)

2. Distortions in input markets (choice of a particular location)

• Scenario 1: add production

• Scenario 2: shift production (SUBSIDY RACES!)

3. Distortions between different sectors

4. The shadow cost of taxation


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Distortion of competition

DISTRIBUTIONAL CONCERNS (shifts in welfare)

1. Across Member States

2. Within Member States


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Balancing positive and negative effects

• Case-by-case basis

• Potential remedies– Design of the measure

• Reduce the amount (proportionality)

• Reduce the selectivity (open procedures, general measures)

– Impact on competition• Reduce the capacity of beneficiary

• Behavioural commitments

• Open licensing of IPR


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4. Case study Dell Poland (regional aid)


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Control of regional aid

• Objective: to promote the economic development of certain disadvantaged regions (“assisted areas”), yet limit the distortions of competition and trade

• Main tools

– Defining the regions eligible to receive regional aid

– Setting maximum aid intensity for each region

– Specific conditions, e.g. for large investment projects (LIP)


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Dell Poland (2009)

• Aid for a new Dell production facility in Lodz (PL)

• Products concerned• Desktop PCs

• Notebook PCs

• Servers

• Total investment cost: EUR 189 million

• Aid amount: EUR 55 million (28% aid intensity)


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In-depth assessment• Formal investigation procedure and in-depth assessment if

criteria para 68 RAG are met:

• Market share of beneficiary > 25 % OR

• Capacity increase > 5 % in under-performing market

• In-depth Assessment Communication sets out application of “balancing test”, i.e. analysis of

i. objective of common interest

ii. design of the aid measure (including incentive effect/proportionality);

iii. distortions of competition and trade; balancing.


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Market share test (para 68a RAG)


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Capacity increase test (para 68b RAG)


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In-depth assessment: aid objective

• Objective of the aid: economic development of the Lodz region

– Lodz region: “a) region” (GDP per capita 41,5% of EU average)

– Investment would create 2500 direct jobs, 1300 indirect jobs

– Externalities (localized): knowledge spill-overs/cluster effects, multiplier effect


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Incentive effect

• Central concept: the counterfactual (what would have happened without aid)

• Scenarios – The aid has no incentive effect (= prohibition)

– The aid gives an incentive to make an investment that would otherwise not be profitable (“Scenario 1”)

– The aid gives an incentive to opt to locate a planned investment in the relevant region rather than elsewhere (“Scenario 2”)

• Implications for the theory of harm


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Incentive effect• Dell intended to build a new production facility, the

only question was where (i.e. Scenario 2)

• Dell had made a comparison of costs and benefits of several locations. Ultimate choice was between Lodz (PL) and Nitra (SK).

• Without aid, Dell would have gone to Nitra. The aid served to overcome a cost disadvantage of Lodz relative to Nitra

• Dell internal company documents showing the trade-offs

• LECG study with complementary analysis


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Incentive effect / proportionality

• Dell internal company documents and LECG study quantifying cost differences in NPV terms


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Negative effects

• Arguably, Nitra (SK) “lost out” on the investment: effect on trade (location effect)

• Limerick´s (IRL) existing Dell facilities: not affected by the aid

• Scenario 2 incentive effect: In principle no impact of the aid on product market competition (capacity levels, market power, dynamic incentives of other companies)


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Balancing

• Aid considered positive overall (in line with the EU common interest)

• Lodz (PL) considered more “in need of regional development” than Nitra (SK)– Formal: Lodz higher maximum aid intensity (50%) than

Nitra (40%), based on GDP figures underlying regional aid maps (2000-2002)

– Additional: Nitra appeared to better develop than Lodz in recent years (in terms of GDP per capita, unemployment rates, poverty rates, migration rates)


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Conclusion - Dell Poland

• Delicate trade-offs

• Analysis of incentive effect (counterfactual) crucial to assess theories of harm

• Proportionality test instrumental in limiting subsidy races


Some references

• Neven, D. and V. Verouden, "Towards a More Refined Economic Approach in State Aid Control", Chapter 4 in EU Competition Law – Vol IV: State Aid, 2008

• Dewatripont, M., "The Economics of State Aid Control: Some Remarks", Competition Policy International, 2006

• Besley, T. and P. Seabright, "The effects and policy implications of state aids to industry: An economic analysis", Economic Policy, 1999

• Hans W.Friederiszick and M. Tröge, "Applying the Market Economy Investor Principle to State Owned Companies", Competition Policy Newsletter, 2006

• http://ec.europa.eu/competition (rules, decisions)

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THANK YOU!

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Economic Analysis in EU State Aid Control | Barcelona GSE Regulation and Competition Seminar Series

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Transcript of Economic Analysis in EU State Aid Control | Barcelona GSE Regulation and Competition Seminar Series