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Compensation for public service obligations may be fixed at less than the net extra costs of the provider of the public service to induce it to become more efficient.

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Book your seat for the State Aid Requirements for SGEI on 07-08 May in Ghent to discuss and exchange on the latest developments on the SGEI package, methods for calculation of compensation, Altmark criteria and various case studies.

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Introduction

Every three years the UK determines the compensation it provides to the Post Office Limited (POL) for the extra costs of the public services it provides. Commission decision SA.48224 approved the compensation for the next three-year period ending in 2021. The Commission found it to be compatible with Article 106(2) TFEU.[1] It is worth recalling that the compensation that was approved in 2012 by the Commission was the first that was assessed under the 2012 EU Framework on services of general economic interest (SGEI).

POL is a state-owned company that provides a wide range of postal, basic financial and other services through its nationwide network of 11600 post office branches. POL owns and managed directly about 337 (3%) of these post offices (so-called Crown Branches). The remaining 97% of the branches are owned and managed by independent businesses on behalf of POL (so-called Agency Branches). Many Agency Branches operate within small shops selling stationery, food, newspapers and magazines.

 

Amounts of compensation

The amounts of the public service compensation (PSC) approved in past Commission decisions for each three-year period were as follows:

  • 2012: £1,155 million or €1,390 million.
  • 2015: £640 million or €859 million.
  • 2018: £370 million or €419 million.

As can be seen, instead of the PSC increasing, at least in line with inflation and other rising costs, it has been decreasing. This is because the UK has been reducing the PSC in order to force POL to improve the efficiency of its operations. The decision explains that the UK government wants POL to use the profit from the commercially viable services to cross-subsidise the loss-making branch network and related services. Accordingly, “(18) the SGEI compensation to be provided to POL for the New Funding Period will be less than the forecast SGEI net cost. Therefore, the notified measures provide for only partial compensation for POL’s provision of the SGEIs. The remainder of the forecast SGEI net costs for the New Funding Period will be covered by the profit generated by POL’s non-SGEI activities, including its offer of certain financial and telecoms services to the public.” Therefore, the consequence of the lower PSC is not only that POL is incentivised to reduce its SGEI costs, but also to reduce the costs of the non-SGEI operations and the profit it derives from them which it can use to cross-subsidise the SGEI.

 

The public service obligation

POL was entrusted with the following tasks that made up its public service obligation (PSO):

  1. Maintenance of a branch network above its optimum commercial size. That network had to consist of at least 11500 branches and had to cover 99% of the UK population (with maximum distance from a post office of no longer than 5km).
  2. Provision of the following services: Processing of social benefit and tax credit payments to the public; processing of national identity and licensing scheme applications; providing universal payment facilities for public utilities; providing access to postal services; and providing access to basic cash / banking facilities, especially for rural customers and those on social benefits.

However, compensation was to be provided only for the maintenance of the branch network. Therefore, the Commission decision did not examine the revenue and costs associated with postal and other services.

 

Net cost of the SGEI

The UK calculated the net cost of the network SGEI using the “net avoided cost methodology” (see the 2012 SGEI Framework). The SGEI net cost is the difference between the net cost of providing the SGEI (called scenario A in the decision) and the profit of POL when it does not have any obligation to provide the SGEI (called scenario B). In the case of POL, the PSC was less than the difference between the two scenarios.

Scenario A involves the maintenance of at least 11500 branches. Scenario B involves just a few hundred branches. Branches in scenario B are profitable. That is, their revenue exceeds the direct and shared costs. Interestingly, the Commission observed in its decision that the number of profitable branches increased in comparison to the previous period and also that the costs per branch had decreased. Both of these developments were the result of investment in new technologies and equipment and modernisation of operations.

In scenario B the income of the commercial branches is assumed to be fully retained (100%), while the income from non-commercial branches is assumed to migrate to the commercial network in line with retention rates estimated according to past experience.

With respect to costs POL divides them in four categories: direct costs, shared costs, sustaining costs and other costs. Direct costs cover personnel and branch operating costs. For scenario B, the direct costs of non-commercial branches are assumed to migrate to commercial branches at the same rate as revenue. Shared costs are those fixed costs incurred by POL in order to support the branch network (e.g. IT system costs, cash supply and logistics costs). Sustaining costs also do not vary with a change in the volume of output and cover allocated overheads (e.g. network management). Other costs include depreciation costs and exceptional investment costs which are costs that cannot be capitalised.

The PSC covers both normal net operating costs and certain exceptional investment costs.

 

 

Compatibility of the PSC

There was no doubt that the PSC constituted State aid in the meaning of Article 107(1) TFEU. The PSC did not satisfy the Altmark conditions because POL was not selected competitively, nor was it shown to be a typical, well-run and adequately provided undertaking, as the fourth Altmark condition requires. The Commission assessed the compatibility of aid on the basis of the 2012 SGEI Framework because the PSC exceeded €15 million per year.

 

Entrustment and duration

The entrustment document included a set of precise requirements for the network SGEI and the product SGEI. A funding agreement imposed an obligation on POL to deliver the SGEI according to those requirements. The entrustment outlined the compensation methodology, the parameters for the calculation of the compensation and the procedure for preventing overcompensation. The entrustment period of three years was considered appropriate.

 

Genuine SGEI and public consultation

Maintenance of a branch network covering the whole territory of the UK was a recognised SGEI. Commission found that the UK has carried out the requisite consultation in order to determine citizens’ needs for locally provided services. In paragraph 80 of the decision, the Commission noted that “according to the information provided by the UK, the above-described public needs for the Network SGEI would not be met under normal market circumstances.” This market insufficiency is of course the standard justification for state intervention and the granting of State aid in the form of compensation. But this also begs the question how it was assumed that in scenario B – i.e. the scenario without SGEI – a certain proportion of the revenue and costs of the non-commercial branches would migrate to commercially viable branches. This implies that some of the public needs would indeed be met under normal market conditions.

 

Compliance with EU public procurement rules

Although POL was not selected after a competitive procedure, it was “(94) the only operator whose network and contractual relationships actually satisfied 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 was followed to entrust POL with the Network SGEI, was justified under EU public procurement rules.”

 

Amount of compensation and the net avoided cost methodology

The Commission accepted that the methodology applied by POL was compliant with the 2012 SGEI Framework. It considered favourably that the calculations had been verified by an independent financial adviser and that all assumptions had been benchmarked against similar businesses. Given that the PSC was less than the difference between scenarios A and B, the Commission was assured that overcompensation was avoided.

 

Efficiency incentives

“(110) According to points 39-43 of the 2012 SGEI Framework, Member States have to include efficiency incentives in their compensation mechanisms. In this respect, efficiency incentives can be designed in different ways to best suit the specificity of each case or sector. For instance, Member States can define upfront a fixed compensation level which anticipates and incorporates the efficiency gains that the undertaking can be expected to make over the lifetime of the entrustment act. Alternatively, Member States can define productive efficiency targets in the entrustment act whereby the level of compensation is made dependent upon the extent to which the targets have been met.”

In the case of POL, the PSC was less than the net extra cost of the PSO. For this reason the Commission considered that “(111) this partial compensation structure strongly incentivises POL to increase its efficiency. This is because, provided that POL is not over-compensated, POL is entitled to retain any efficiency gains that it can make in its delivery of the SGEIs (e.g. POL could retain a greater proportion of its profit from non-SGEI activities if its net SGEI costs were lower).”

 

Separation of accounts

POL would keep separate accounts for the SGEI and the non-SGEI operations, according to international accounting standards.

 

Absence of overcompensation

The PSC was significantly less than POL's forecast SGEI net cost. The Commission’s view was that under those conditions there was “no prospect of any overcompensation”.

On the basis of the above analysis the Commission concluded that the State aid in the form of compensation was compatible with the internal market on the basis of Article 106(2) TFEU.

 

 

And … Brexit

The Commission also added that “(133) Since the United Kingdom notified on 29 March 2017 its intention to leave the Union, pursuant to Article 50 of the Treaty on European Union, the Treaties will cease to apply to the United Kingdom from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification, unless the European Council, in agreement with the United Kingdom, decides to extend that period. As a consequence, and without prejudice to any provision of the withdrawal agreement, this decision only applies until the United Kingdom ceases to be a Member State.”

 

A few observations on the scope of the PSO and cross-subsidisation

The examples below demonstrate the savings for the UK from a broad definition of the SGEI/PSO that covered the whole of the postal network.

 

Example I: Operations with no fixed costs

Assume that POL’s commercially viable part of the network can be described as follows:

Revenue: R1 = 100
Cost: V1 = 60
Profit: P1 = 40

Further assume that POL’s commercially unviable part of the network can be described as follows:

Revenue: R2 = 150
Cost: V2 = 200
Loss: L2 = 50

The UK could have limited the scope of the SGEI/PSO only to the non-commercial, loss-making branches. In that case, the net extra costs would have been 50 (= 200 – 150) because POL would not have operated any of those loss-making branches in the absence of the SGEI.

However, the UK defined as the SGEI/PSO the whole network of at least 11500 branches. By doing that, it forced POL to cross-subsidise the net cost of the unprofitable part with the net revenue from the profitable part. The loss or net cost with the SGEI is 10 (= (200 + 60) – (150 + 100)). The profit or net revenue without the SGEI is 40 (= 100 – 60). Therefore, the net extra cost – 10 – 40 = – 50.

At first glance, it seems that the PSC is the same. It is 50 in either case. This is true because the UK has to compensate POL for the extra cost of the unviable branches plus the forgone profit from the viable branches. Therefore, one may ask why did the UK bother to define the scope of the SGEI/PSO so widely as to cover 11500 branches. The reason is that the amount of compensation is in the future will be reduced by efficiencies not only in the operation of the unviable branches but also in the operation of the viable branches.

 

Example II: Operations involving fixed costs

Assume that POL’s commercially viable part of the network can be described as follows:

Revenue: R1 = 100
Variable cost: V1 = 60
Fixed cost when the viable part operates separately: F1’ = 20
Fixed cost when the viable part operates in the overall network: F1” = 30
Profit: P1 = 20

Further assume that POL’s commercially unviable part of the network can be described as follows:

Revenue: R2 = 150
Variable cost: V2 = 200
Fixed cost when the unviable part operates separately: F2’ = 20
Fixed cost when the unviable part operates in the overall network: F2” = 30
Loss: L2 = 50

If the UK had limited the scope of the SGEI/PSO only to the non-commercial, loss-making branches, the net extra costs would have been 70 (= 200 + 20 – 150).

Since the SGEI/PSO covers the whole network of at least 11500 branches, the net cost with the SGEI is 40 (= (200 + 60 + 30) – (150 + 100)). The net revenue without the SGEI is 20 (= 100 – 60 – 20). The net extra cost is – 40 – 20 = – 60.

Now we can see that the amount of compensation is reduced because of savings in fixed costs, most notably from economies of scale.

 

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[1] The full text of the Commission decision can be accessed at: http://ec.europa.eu/competition/state_aid/cases/272645/272645_1971679_97_2.pdf.

 



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