Following the UK’s transition out of the EU, and to make use of additional post-Brexit flexibilities to support businesses, and levelling up, the Department for Business, Energy & Industrial Strategy (BEIS) has launched a consultation document (Condoc)[1] on the design of a UK subsidy regime to replace the European Commission (EC) State Aid Framework. This considers four broad themes:

• Qualification of public aid as a subsidy: Three tests, similar to the EC’s State aid tests, based on whether: (i) aid is being provided by a public body; (ii) to one or more economic actors to whom it may confer an economic advantage; and (iii) could have an impact on trade. Whilst not mentioned by BEIS, the application of the market economy operator principle (MEOP) appears reasonable to test the economic advantage.
• Exemptions and low-risk subsidies: The exemptions are akin to the EC General Block Exemption Regulation (GBER). However, the limits being proposed by BEIS are lower, particularly when compared to the EC Temporary Framework, put in place to afford EU Member States greater flexibility in dealing with COVID-19. It is noted that some types of subsidies are less likely to be harmful than others, however, BEIS does not go as far as to state that these can be exempted from further evaluation.
• Evaluation of a subsidy: BEIS sets out six key principles that should be used to assess whether the benefits of the subsidy outweigh the harm and a subsidy is the most appropriate form of intervention. This is the area where the proposals diverge from the EC State aid framework most and where we are concerned around the trade-off between flexibility and ambiguity, as detailed more fully below.
• Enforcement and notification: The proposed role of the Competition and Markets Authority (CMA), or another independent body, in reviewing the application of the six principles and details on notification and enforcement.

After reviewing the consultation document in detail, there are four areas that we consider BEIS should contemplate further:

Constraints to flexibility

Flexibility is the key theme running through the Condoc. It is envisaged that post-EU freedoms will allow the UK to provide flexible and tailored financials to businesses. Under the EC State aid regime, subsidies are typically considered to be measures of last resort. By contrast, the Condoc embraces subsidies as an enabler of economic welfare and levelling up. However, there still exist constraints on the UK’s flexibility in relation to permitted subsidies. These need to be reflected in the proposal, with clearer guidance on where the constraint is binding or where the UK Government is willing to adopt a less stringent approach. There are aspects of the UK’s post-Brexit subsidy control regime that will have the effect of curtailing any flexibility embedded in the system at inception.

The UK is bound by international trade rules

These include the UK-EU Trade and Co-operation Agreement (TCA), the EU State aid rules regarding energy and trade between Northern Ireland and the EU, other Free Trade Agreements and the less stringer World Trade Organisation (WTO) rules. The TCA is ostensibly similar to the EU State aid regime, in terms of both qualifying support as a subsidy and assessing the subsidy against governing principles to limit negative effects on trade and investment. The prohibitions under the EU regime are largely replicated in the TCA, for example disallowing unlimited guarantees or rescue without restructuring. These requirements flow through into the Condoc and its focus is more on positive measures of supporting government policy objectives and R&D. However, our experience with the EU framework tells us that support to individual companies is a key part of any subsidy regime: distinguishing those companies that are viable post restructuring and those that are not can be tricky. This is likely to be an area that the EU will keep an eye on.

Role of the CMA in fostering competition

Subsidies may result in the backing of one sector, project, company or UK region over another, reducing competition with consequent impact on consumer welfare. The CMA will be acutely aware of this and, in line with its remit, may be more likely to support umbrella schemes than those favouring specific economic actor(s). However, the CMA’s presumed focus on protecting competition may put it at odds with other stakeholders with competing policy objectives. The Condoc does not prescribe a methodology for balancing differing objectives. As such, the CMA may step in to provide guidance that limits subsidy flexibility and may be inclined to review a larger number of subsidies. In instances where public bodies need to move quickly in the award of subsidies, a lengthy ex-ante evaluation process may thwart this.

Competing demands on public funds

The UK Government’s bank balance has been depleted by COVID-19 and value for money (VfM) considerations will be critical in allocating funds. The Condoc stays silent on VfM, perhaps assuming that a VfM assessment will have been completed in advance of the subsidy review. BEIS could set a minimum hurdle rate (IRR) for investment. However, unless it internalised social benefits, this would not reflect the benefit of using subsidies in missing markets, as an R&D pump primer and any environmental measures for example. Whilst the IRR could theoretically be expanded to include social benefits, such a calculation is inherently difficult for projects with higher levels of uncertainty and risk of failure. At least some of the R&D projects that the government will be looking to support will presumably have those characteristics.

Without public funds being available for subsidies, there is a real possibility that the UK will not be able to use its newly found freedoms. Absent sufficiently pointed guidelines or a robust evaluation framework, subsidy control could easily become part of the political business cycle.

The recently published Penrose review of UK competition policy[2] clarifies that to keep the UK economy “competitive and successful”, free of distortions and politically independent, the UK’s ability to use subsidies more freely should be exercised with extreme caution.

Qualification as a subsidy

The guidance and questions being consulted upon lack detail. Whilst increasing the flexibility to award subsidies, this ambiguity may also lead to increased risk and uncertainty due to the increased likelihood of challenges and judicial reviews down the line. As such, where government support can be structured on “commercial terms”, this should presumably be perused in the first instance. This route avoids the qualification of a measure as a subsidy, as well as the complexity and uncertainty of considering exemptions or evaluating the subsidy’s impact.

Block exemptions and low-risk subsidies

The EU State aid guidelines include the GBER, which sets out aid categories that do not require notification to the EC as a subsidy. The limits and type of aid that do not require notification were made more generous under the EC Temporary State aid framework. The Condoc sets out exemption thresholds based on considerations in the TCA and are lower than those adopted by the EC in its Temporary Framework. Given that the impact on trade is likely to be limited if the UK chooses to follow the EC limits, there is an argument that the UK should do so – at least as long as the EC Temporary Framework is in force.

BEIS notes that some subsidies are likely to be associated with a lower risk of causing harm and there will be instances where a subsidy is beneficial. This could be the case for subsidies correcting for missing markets; or a socially sub-optimal investment level due to free-riding or high social value failing to be internalised. Subsidies may also enable Government to meet policy objectives, including addressing regional imbalances. The guidance could benefit from additional detail on the objectives that the Government is seeking to achieve and the specific types of subsidies that are considered beneficial or less likely to cause harm in achieving objectives. For example, this might include subsidies pointed to a particular sector, those designed to pump private R&D on an open-access basis, or those granted following a competitive procurement process. Accompanying this with a bolder statement from BEIS that these are presumed to be compliant (and a detailed evaluation or review by the CMA will thus not be required, unless appealed) would reduce both the risk and effort of providing the support and is likely to lead to more “beneficial” subsidies being provided swiftly.

Evaluating subsidies

There are instances where a subsidy may be harmful. For example, where winners are picked and competition is weakened, incentives to operate efficiently are dampened or the agony of failing firms is prolonged with no long-term hope of viability. These types of subsidies need greater consideration to ensure that there is a net benefit and that trade and competition are not materially adversely impacted.

BEIS sets out six key principles to guide the decision to grant a subsidy, largely based on standard economic principles long adopted by economic regulators and competition authorities. The principles require interventions to address a specific market failure or policy objective in a proportionate, net positive manner which brings about a change in behaviour of the recipient in the least costly and distortive way, without compensating for costs that would otherwise have been funded. It is proposed that the Government will issue a template to record how the terms of the principles have been met when designing the subsidy.

Application of these principles will be tricky. The principles are overarching, subject to nuances, and stakeholders will place different weights on their relative importance. Their application is dependent upon the breadth of alternative options that are considered – for example, umbrella schemes, sectoral policy or regulatory changes, tax policies, demand stimulation, M&A activity; and the time period over which the intervention is being considered – for example, if an immediate behavioural change is required then the options for achieving this are more limited. Their application also involves subjectivity and an assessment of future harm and benefits to trade and competition, as well as a determination of whether there are the least costly and distortive methods to achieve the aim. Experience in merger control, which largely focusses on harm versus benefits, exposes the range of opinions that are likely to be put forward, the difficulty in balancing harm and gains, the time and expertise required to make a judgement, and the likelihood of a lengthy appeal process.

There is likely to be no single agreed answer from applying the principles. This should be acknowledged, and an evaluation framework developed to guide their application. Questions that the evaluation framework would need to address include:

• Are the six principles cumulative, so that a subsidy failing or part failing to satisfy one is deemed to be non-compliant? In a similar vein, do all principles have to be considered equally or is there scope for stakeholders to place more weight on some than others? In considering whether a subsidy is the least costly/distortive response:
  • How broad a set of alternatives should be reviewed?
  • For example, policy changes could be an alternative to subsidies – but these may require sponsoring by other government departments, e.g DECC or HMRC, or changes to sectoral specific regulations or their implementation by independent economic regulators: should these options be considered plausible alternatives against which a subsidy is compared?
  • What is the appropriate balance between short-term and long-term and how should intertemporal comparisons be made?
  • For example, a less distortionary measure may be available in the longer term only. In this case, a mechanism is needed for weighing this up against more intrusive and, potentially, anti-competitive measures in the shorter-term.
  • Similarly, how are the potential effects on different groups of stakeholders and consumers weighed?
  • For example, a subsidy to a particular industry or region may bring positive employment or price effects to this industry/sector but adversely affect others: such trade-offs may need to be addressed.
  • How do competition principles align with the subsidy rules?
  • For example, on the one hand, failing to provide a subsidy may result in a firm exiting the market and consumers being impacted from less competition.[3] On the other hand, a subsidy may weaken efficiency incentives and distort competition between firms.
  • How should social benefits be incorporated into the analysis?
  • Recognising spending constraints, is there a minimum return of investment that should be incorporated?
  • What is the relevant period for the assessment: over what time period should the costs and benefits be calculated?
  • Should there be a plan for the state to exit the measure? For example, where support is aimed at R&D and pump priming, at which point is that objective met and how is it ensured that the public continues to benefit, negative consequences of market power are limited and private sector investment is not crowded out.

Conclusion

Flexibility to direct government funding towards key policy objectives, pump-priming investment and enabling levelling up is crucial, particularly as the country emerges from COVID-19 with even tighter financial constraints and a greater focus on VfM. Weighed against this flexibility is the requirement to uphold trade rules and (domestic) competition, reduce the potential for State aid litigation and to provide public authorities with the confidence to utilise subsidies where beneficial and impactful.  

In its subsidy control design, BEIS is tending towards flexibility (and ambiguity) over processes.  However, a better balance could be achieved by allowing greater flexibility at the initial stages of the assessment so as to encourage the use of subsidies where they increase economic welfare; and a more defined process in the evaluation of subsidies that may cause harm so as to provide more certainty as to how they are assessed.

In our view, this first requires BEIS to be bolder on exemptions and defining low risk (i.e. low harm or beneficial) subsidies that are presumed compliant ex-ante and for which further evaluation is not required. Second, for those subsidies which have a higher potential to cause harm, we recommend that BEIS provides an evaluation framework that reduces ambiguity in complying with the six key principles it has put forward.

How can A&M help?

A&M Economics provides advice on State aid and subsidy schemes to public bodies in designing schemes, ensuring compliance with guidelines and notifications, and to corporates who are either seeking government support or otherwise need to assess (or challenge) the compliance of schemes with guidelines and undertakings. At A&M, we provide a unique combination of leadership, operational experience, and financial/econometric skills to support companies transition under new regimes and legislation. Get in touch with one of our senior experts.