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Introduction: Objective justification of price differentiation

In a landmark judgment 25 years ago [February 1988], the Court of Justice established that business behaviour that appears to deviate from normal market practices can still conform with the market economy operator principle [MEOP] which is a variation of the better known market economy investor principle [MEIP]. Both principles are based on the same logic: the pursuit of profit.

Apparently unusual pricing behaviour can be in conformity with the MEOP if it can be objectively justified. This very important elaboration of the MEIP was first promulgated in the judgment in case C-67/85, Kwekerij Gebroeders van der Kooy BV v Commission.[1] The case concerned the charging of lower tariffs for natural gas used to heat glasshouses of horticultural producers in the Netherlands.

The gas provider, Gasunie, was at that time controlled by the State and its unusual practice of charging preferential tariffs was attributed to the State. Gasunie argued that it took the decision to lower its tariffs in order to offer incentives to horticultural producers not to convert to alternative sources of energy such as oil and coal.

The Court pointed out that “29 … the preferential tariff was applicable only to undertakings engaged in hothouse horticulture. In that sector, heating costs account for a large part of production costs. If, in such circumstances, the tariff applied to those undertakings displays a downward trend which is not reflected by the tariffs applicable to undertakings in other sectors, that is prima facie evidence for the conclusion that the preferential tariff constitutes aid.”

But then the Court made an important qualification. “30 That would not be the case, however, if it were demonstrated that the preferential tariff was, in the context of the market in question, objectively justified by economic reasons such as the need to resist competition on the same market from other sources of energy the price of which was competitive. In determining whether such competition is a real prospect account should be taken not only of the different price levels but also of the costs involved in conversion to a new source of energy, such as replacement and depreciation costs for heating equipment.” [emphasis added]

It follows that when a State-owned or controlled company does not charge uniform prices, there is a risk that the lower prices which benefit only some undertakings or sectors may contain State aid. However, the van der Kooy judgment gives the possibility to such State-owned or controlled company to justify its differential pricing on objective grounds by demonstrating that the price variation is economically justified in order to maintain the loyalty of its customers or attract new customers. [I do not examine here, nor did the Court examine in 1978, whether such a practice could be incompatible with Article 102 TFEU that prohibits abuse of dominant market position when an undertaking would, inter alia, by “apply dissimilar conditions to equivalent transactions”. This would require, first, a finding that the undertaking in question holds a dominant position. At any rate, even though until recently price discrimination has been thought to be per se illegal, after the Post Danmark judgment of last year, it can no longer be presumed that price discrimination is automatically illegal. Its exclusionary effect must be proven.[2]]

EU courts routinely declare that when a public authority forgoes revenue by granting discounts [e.g. low-interest loans, preferential electricity tariffs, land priced below market rates, etc] it confers an advantage to certain undertakings, and if all the other conditions of Article 107(1) TFEU hold, then such discounts constitute State aid. However, we see in the van der Kooy judgment that a rational market operator may justifiably forgo revenue to retain its customers. It gives up a small part of the revenue, which is a “gift” to the beneficiaries, in order to secure the bulk of the revenue.

The Market Economy Operator Principle

The European Commission has recently had to deal with a similar case. It concerned the sale of wood from public forests in the Land of Bavaria, in Germany.[3] The seller, BaySF, was the State-owned forest manager which entered into a long-term supply contract with a wood producing undertaking, Klausner. Klausner was Austrian but had saw mills in the Land of Thuringia, in Germany. BaySF charged lowered prices and offered more favourable terms in two 10-year contracts it signed with Klausner. As a result, competing saw mills that were paying higher prices submitted a complaint to the Commission alleging the granting of State aid through lower prices.

The contracts provided for the delivery of 500,000 m3/year in Bavaria and of 400,000 m3/year to Klausner Thuringen at prices that ranged from EUR 45 to EUR 60 per m3, depending on quality. There was also a clause allowing for prices to be increased by EUR 2/year. By contrast, contracts signed by competitors were based on prices that were by EUR 2 to 6 higher and provided annual price increase or indexation of EUR 4/year.

These differences do not appear in themselves to be out of the ordinary. What made the contract signed with Klausner suspicious was that, first, it required Klausner to build a saw mill in Bavaria and, second, politicians in Bavaria praised the deal for contributing to regional employment and development. Therefore, it seemed that Bavaria was not acting as a private investor in pursuit of profit but was motivated by public policy objectives.

Commission assessment

The Commission began its investigation into whether the contract contained State aid by noting that during the relevant period, wood prices were at an historic low. Moreover, in same period Klausner itself sold wood at EUR 2 below the agreed prices with BaySF and with indexation of EUR 2/year. The Commission accepted that the indexation of only EUR 2/year was reflected in other private contracts and, therefore, it was not unusually low. By contrast, the higher margin of indexation and the higher prices in the contracts of BaySF with the complainants were found by the Commission to be reasonable because those contracts were substantially different. They were for much smaller quantities [about a fourth] and for shorter duration [2 years].

Then the Commission noted that in the relevant period there was oversupply of wood. Bavaria produced about 30% more wood than the capacity of local saw mills. Given the fact that wood is heavy and, therefore, expensive to transport, the excess supply could not be easily disposed in other markets.

Under these conditions, the Commission acknowledged that “52 … it was logical for BaySF, as it would have been for a private seller, to find an additional, large client for its product so as to make sure that its products would not remain unsold. By agreeing to a long-term contract with Klausner and requiring that it established itself inside Bavaria, BaySF made certain it would have a stable and significant customer in the medium and long term, a client, moreover with incentives to maintain a long-term supply relationship with BaySF. This way, BaySF ensured that its future sales would be guaranteed and against better prices than in the recent past.”

The Commission also observed that “55 It should furthermore be remarked that Klausner, given its negotiating position as a very large customer in a buyers’ market, can reasonably be expected to obtain attractive prices in standard commercial negotiations, at the very least as effectively as its competitors, in particular since it was already a regular customer and the prospect of establishing an operation in Bavaria would logically lead to an increase of its purchases from BaySF.”

For these reasons, the Commission concluded that “63 In the light of the above, the actions of BaySF should be considered in line with the Market Economy Operator Principle. The BaySF behaved as a rationally acting entity operating under market economy conditions. The transaction therefore does not involve State aid.”

The Commission also dismissed the allegations concerning the public policy objectives of Bavaria as irrelevant. “64 The fact that some German authorities have praised the contract with Klausner for employment and environmental reasons is of no effect for this analysis. State aid is an objective concept. Even if the authorities acted only from these motives, the fact that the terms of this contract can be justified on the basis of the Market Economy Operator Principle, is sufficient to conclude that there is no advantage granted and there is no State aid involved.”

However, the statements of the Commission in paragraphs 52 and 55 of the Decision, which are quoted above, are contradictory. If Klausner was a very large customer with negotiating power and if its negotiating power was strengthened by the fact that the excessive supply in wood market at the time made it a “buyer’s market”, why would BaySF want to impose contractual obligations on Klausner that went beyond the normal clauses defining quantities, quality and prices? Requiring Klausner to build a saw mill would simply impose a cost on Klausner. Moreover, given that wood is expensive to transport, Klausner itself would have an incentive to build the saw mill in close proximity to its main source of supply. Then by processing the raw wood close to the forests of BaySF and then transporting it to its customers, the cost of transport per m3 of processed wood would be proportionately smaller because the value of processed wood is larger than for an equivalent volume of raw wood.

The behaviour of BaySF is difficult to explain and strongly appears not to be motivated by purely commercial objectives. According to the standards established in paragraph 30 of the van der Kooy judgment which is quoted above, the Commission should have investigated whether Klausner would have found it uneconomic to build a saw mill in Bavaria and whether the discounts that were granted by BaySF could provide sufficient compensation to offset the excess costs of a saw mill.

Testing the MEOP

It is interesting to consider how the Commission could have tested conformity with the MEOP. If Klausner had to be obliged to build the saw mill in Bavaria, it is reasonable to assume that the sum of the investment in the saw mill [E] and the cost of operating the mill [C] over the duration of the contract [i.e. 10 year] was less than the revenue [R], that could be generated from the sale of the processed wood for the same 10-year period [in symbols, (E + C) > R]. It is also safe to assume that due to transport costs, it was uneconomic to ship raw wood to Klausner’s Thuringia mill, process it and then ship it back to customers in Bavaria. It is likely that the Thuringia mill did not have sufficient operating capacity, given that the two contracts were for roughly the same quantities. This would have meant that the Thuringia mill would have to double its output [in symbols, (E + C + 2T) > R, where T is transport cost].

What gain could BaySF hope to obtain by requesting Klausner to build a saw mill in Bavaria? First, it would find a new source of revenue. Let [N] stand for the net revenue from sales to Klausner. Second, as was noted by the Commission, excess supply would be eliminated and BaySF could charge higher prices on sales to other saw mills. Call the extra revenue from the difference in prices [D]. Therefore, the total gain [G] of BaySF is G = N + D – d, where [d] is the discount offered to Klausner. BaySF acted economically rationally if G ≥ 0. This means that

(1)       N + D – d ≥ 0 or N + D ≥ d

For its part, Klausner also acted economically rationally if

(2)       d ≥ E + C – R [which is Klausner’s excess cost]

By combining the two inequalities we can derive that

(3)       N + D ≥ d ≥ E + C – R or N + D ≥ E + C – R

Condition (3) shows that rational behaviour required that the net gains of BaySF should have been larger than the excess costs of Klausner. This makes intuitive sense too because otherwise BaySF would have no reason to treat Klausner preferentially. To put it differently, the discount that appeared as a “gift” to Klausner was the “sacrifice” that BaySF had to make in order to secure Klausner as a customer.

More generally, the MEOP is satisfied when the value of the discount that a market operator gives to a customer generates extra revenue that exceeds the cost of that discount to the market operator.

Condition (3) should have been relatively easy for the Commission to verify, but it did not. In this respect, its analysis fell short of the standard of evidence required by the Court of Justice for the MEOP.

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[1] It can be accessed at:

http://curia.europa.eu/juris/showPdf.jsf?text=&docid=93651&pageIndex=0&doclang=EN&mode=lst&dir=&occ=first&part=1&cid=190912

[2] C‑209/10, Post Danmark A/S v Konkurrencerådet. It can be accessed at:

http://curia.europa.eu/juris/document/document.jsf?text=&docid=121061&pageIndex=0&doclang=en&mode=lst&dir=&occ=first&part=1&cid=193633

[3] Commission Decision SA.19045 concerning “alleged aid of the Land Bavaria (Bavarian State Forest Enterprise) in form of long-term supply agreements for wood with the company Klausner”. It can be accessed at:

http://ec.europa.eu/competition/state_aid/cases/241967/241967_1327364_82_2.pdf



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