Unit 11: State Aid
When there is a difference between the private benefit/cost and the social benefit/cost of producing a good or a service, where the edge exists between individually and collectively optimal behaviour, "market failures" exist. In such a situation, when there is state intervention, it can help improve allocation of resources where markets are affected by these market failures. However, it may confer an advantage to the recipients, potentially distorting competition. State aid can take the form of: lump-sum grants, interest and tax relief, loan guarantees, government holding of a company, the provision of capital on preferential terms to a company.
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Different types of market failures:
- Market power
- Economies of Scale
- Externalities
- Transaction costs
- Asymmetrical information
- Moral hazard
Market Power
- Governments use competition law to mainly deal with issues related to market power, and state aid is generally not used to address market power.
Externalities are either costs or benefits generated to an external party by the by the activities of a separate party. Consider positive externalities arising from spillover benefits of research - For example, investment in basic research may generate market-wide use of the research. However, since its not directly applicable to anything that might generate economic returns for the firm, the marginal private benefit is much lower than the marginal social benefit.
Governments can subsidise by providing grants to firms engaging in R&D research, providing subsidised interest rates to firms taking loans to expand research capabilities.
Public goods represent govt expenditure that has a special case of externalities. For example, national defence.
Transaction Costs and Asymmetric Information
- Costs of due diligence and monitoring
- Imperfect information may arise when the future is inherently uncertain
- Information asymmetries refer to agents having different amounts of relevant information: risk taken for lending money, likelihood of fraud being penetrated.
Moral Hazard
- Generally has to do with unresolved principal-agent problems.
- asymmetric info between client and the firm
- misaligned incentives
- incomplete contracts
- for example, bank and firm - firm may have more information about the opportunities and risks associated with the product, funds may be directed to risky investments, complete contracts covering all such eventualities may not be feasible.
Adverse Selection
- Clients' WTP is reduced when faced with the risk of low quality.
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GBER states that in some cases ex ante notification may not be required. Aside from block exemption, in other cases, the commission must be notified - the commission addresses the following questions:
- Is the measure state aid? (transfer of state resources, a selective economic advantage has been conferred on the recipient, potential to distort competition, potential to affect trade
- can the state aid be exempted?
- are there other means for granting aid?
- transfer of state resources?
- application of MOEP test
- state transfers selective only if it affects one firm or a set of firms in the market
- if the measure is state aid, could it be considered legal under a horizontal rule? following maybe considered compatible with the internal market > aid to promote economic development in areas where standard of living is low, aid to promote execution of an important project, aid to facilitate the development of certain economic activities. The rationale behind horizontal rules is to strike a balance between the negative effects of state aid and its positive effects.
- can the measure be compatible with other rules?
commission has followed principles of a balancing test where positive effects of state aid are measured against the negative effects of state aid (well defined objective, appropriate instrument, limited distortion to competition).
- the framework for services of the general economic interest is an example where economic analysis is extensively used.
- the SGEI framework uses a horizontal framework : determining cost and revenues of the undertaking, allocating costs between commercial and entrusted activities, setting a benchmark for rate of return, how to incentivise and measure efficiency in service provision
SGEI is defined when the required services would not be provided by the market, either because:
- the cost of providing the service exceeds the revenues
- the market does not provide such services at a socially acceptable price
if the service can be provided at a price and level of access compatible with general interest, it is not SGEI.
Net cost of Provision of the SGEI
- The commission's preferences are that a net avoided cost methodology be applied to calculate the amount of compensation required, and that the methodology be based on forward looking assessment covering the lifetime of the contract
- this methodology involves calculating the difference between the net cost or profit for the same provider or operating with the obligation, and the net cost or profit for the provider without the obligation.
The amount of obligation must not exceed the net cost and a reasonable rate of profit:
- IRR is usually the commission's method of calculating profitability.
- Alternative measures used to calculate profitability include: ROE, ROCE, ROA, ROS > ROCE is is calculated by dividing EBIT by total capital (that comprises of debt and equity)
- ROE and ROCE involve measuring equity capital
- Benchmark for profitability - while this may depend on the sector, type of service and characteristics of the compensation mechanism, the commission provides a safe harbour for the rate of return - a rate of return that doesnt exceed the relevant swap rate plus a premium of 100 basis points is regarded as reasonable in any event.
State Aid in Tax Rulings:
- Selectivity and Economic Advantage
- appropriate reference system?
- does a measure deviate from the reference system
- is the deviation justified by the logic of the system
The Market Economy Operator Principle:
- The MEOP tests whether the transfer of resources can be considered as state aid
- It tests whether a particular deal struck by state would have also been acceptable by a private investor.
- Ex ante examination
Application of MEOP -
- A transaction's compliance with market conditions can be directly established through:
- where the transaction is carried out through "pari passu" by public entities and private operators
- when it concerns the sale and purchase of assets, goods and services carried out through a competitive, non-discriminatory and unconditional tender process.
If empirical methods are not possible,benchmarking analysis can be carried out.
Rate of Investments:
- IRR
- NPV
- Ex ante analysis of investment decisions
- MEOP must be applied on an incremental basis and must be applied only for the current project at hand.
- Discount rate used should resemble the case of a private investor's discounting rate, i.e., the investor will expect to earn atleast the cost of capital, this is nothing but WACC.
- The CAPM model is usually used to calculate the WACC.
return on capital of asset = risk free rate + expected market return + Beta of the asset
How does the commission assess the effect of state aid on competition:
- If MOEP fails, it is usually state aid that is being given out
- The commission must usually provide evidence on: information on the relevant market, the firm's market position, the pattern of trade
- The commission has recognised that the level of distortion in the competition created by a measure depends on:
a. procedure for selecting beneficaries
b. characteristics of market and beneficiaries
c. the amount and type of aid
Risk finance aid:
- SMEs may find it difficult to get finance due to asymmetric information resulting in a market failure that causes high transaction costs to the investor and an increase in risk aversion.
- To assess the compatibility of risk finance aid measures, the commission applies the following criteria:
a. contributes to a well-defined objective
b. aid will bring about material improvement in the market
c. must represent an appropriate policy instrument
d. incentivise additional investment
e. proportionate to the market failure
f. negative effects of aid must be limited
g. the process of aid must be transparent
Risk finance aid may:
- crowd out investment that would have taken place absent state funding
- special advantage leading to distortion of competition
- provision of capital to inefficient firms
Research and Development and Innovation Aid:Market failures that might prevent the market from reaching its optimal R&D investments:
- Positive externalities
- Informational asymmetries
- coordination failures
Aid for R&D, feasibility studies, construction and upgrade of research infrastructure, aid for innovation activities, innovation clusters.
Aid intensities are estimated as a % of gross eligible costs allowed at each stage of R&D and depending on the size of the firm.
Again, might:
- crowd out private investments
- state aid might promote inappropriate or unwanted R&D ventures
- Rivals incentives to invest in R&D is reduced
Aid for rescuing and restructuring firms that are in difficulty -
- rescue aid is urgent and temporary in nature
- restructuring aid often involves permanent assistance
- in the case of employment, failure may lead to redundancies
In order to approve rescue aid, aid must fulfil the following conditions:
- temporary liquidity support in the form of loans
- financial cost of loan must comply with commission guidelines, such that the level of renumeration that a beneficiary is required to pay for rescue aid reflects the underlying credit worthiness.
- Failure rates are associated with business cycles
- Determinants of survival are to be found outside of rescue and restructuring aid
Aid to financial institutions
- Restoration of long term viability
- Avoidance of distortion to competition
- Aid limited to the minimum
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