In the meaning of regional aid rules, diversification in a “new activity” is not the same as diversification in a “new product”. A “new process innovation” must be different, in the sense of being distinct from an existing process, must be substantial, in the sense that it covers the whole production process and must be new, in the sense that it has not been implemented by others.
Introduction
The Commission has recently approved individual regional aid, of nominal value of EUR 34 million, for a large project carried out by Hamburger Rieger, a paper manufacturer. The decision of the Commission is detailed and elaborate and therefore has much didactic value.
Hamburger Rieger was classified as a large undertaking. The project concerned investment in a second paper plant of the company in Spremberg in the German land of Brandenburg. The site of the plant is in an Article 107(3)(c) area with maximum aid ceiling of 20%.[1] The aid aimed to induce Hamburger Rieger to make the investment in Spremberg instead of the alternative site of Trostberg in Bavaria.
Germany notified the aid because it exceeded the threshold laid down in Article 4(1)(a) of the GBER. In areas where the maximum ceiling is 20%, the notification threshold for projects exceeding EUR 100 million is EUR 15 million [= (50 million x 20%) + (50 million x 20% x 50%) = 10 million + 5 million].
The project
Under Article 14 of the GBER, and the regional aid guidelines [RAG] for 2014-2020, investment aid to large enterprises is allowed in Article 107(3)(c) areas only when it is for a new activity. Germany confirmed that the project would establish a new production process in the meaning of paragraph 15 of the RAG. Apparently, the synergies between the existing and new production lines were “very limited”.
The second plant would produce paper for packaging by using exclusively recycled raw materials [waste paper] sourced locally. The innovative aspects of the production in the second plant were a new method of removing impurities from the materials used as input and the manufacturing of the packaging paper through a different process. “(14) An independent expert report … confirmed that the innovative stock preparation process would be implemented for the first time globally.”
The eligible investment costs were EUR 371 million in nominal value or EUR 363 million in present value on the basis of a discount rate of 1.17%. The nominal investment costs were broken down as follows:
Building: EUR 81.89 million.
Equipment: EUR 13.55 million.
Machinery: EUR 275.56 million.
The total amount of aid [in the form of a direct grant] was EUR 34 million in nominal value or EUR 32.9 million in present value. That is, the envisaged aid intensity for the whole project, in real terms, was 9.1%.
The investment would enable Hamburger Rieger to double its production capacity in the region and was expected to create 195 new jobs and about two indirect jobs for every direct job.
In addition to the direct and indirect job creation, Germany argued that the project would lead to improvement in labour skills [as Hamburger Rieger would provide training] and diversify sources of employment in the region.
Compatibility of the aid
The Commission examined whether the aid measure conformed both with the general conditions for regional aid and the specific conditions that apply to individually notified aid. It began its assessment by clarifying the requirements for individual notification.
First, the aid exceeded the threshold of EUR 15 million. Second, Article 14(3) of the GBER allows aid to large enterprises only for investment in new activities. The investment by Hamburger Rieger was not for a new product but for a new process.
The Commission observed that the basis for approval was paragraph 15 of the RAG. “(58) According to paragraph 15 of the RAG, regional aid to investments of large undertakings in c-areas is considered compatible only if it is granted for initial investments that create new economic activities in these areas, or for the diversification of existing establishments into new products or new process innovations. Aid for these activities is individually notifiable unless it supports initial investments that create new economic activities in these areas. The resulting individual notification obligation for “new products” and “new process innovation” cases applies independently from the aid amount envisaged.”
This is an important statement for two reasons. It confirms that “process innovation” is not enough. It must be “new”. We will see below how the Commission confirmed that the process was “new”. In addition, it stresses that diversification into a “new activity” is different from diversification into “new products”. However, it does not really explain how a new activity differs decisively from a new product.
The Commission elaborated that “(66) the capacity extension of the Spremberg establishment constitutes an initial investment in the meaning of the RAG.” “(67) However, an initial investment in the form of a mere capacity extension does not qualify as an initial investment which creates new economic activities.” “(68) Therefore, the capacity extension investment of a large company in a ‘c’ region can only be eligible for regional investment aid, if the investment is based on a new process innovation or if it is related to the diversification of existing establishments into a new product. However, the “new product” window is not applicable as the plant is already producing white testliner, and as white testliner is a well-established standardised product. In the present case the capacity extension investment in the existing Spremberg establishment is based on a new production process and can only be considered eligible for regional investment aid, if it is based on a new process innovation in the meaning of paragraph 15 of the RAG.” Therefore, a new production process may still result in the same product, but through different means.
The Commission acknowledged that “(71) the RAG do not provide a definition of the concept of “new process innovations”, nor do they lay down precise criteria for the assessment of such types of initial investment cases.” “(72) The Oslo Manual and the GBER define a process innovation as “the implementation of a ‘new’ or ‘significantly improved’ production or delivery method. This includes significant change in techniques, equipment and/or software.” The GBER definition excludes minor changes or improvements, increases in production or service capabilities through the addition of manufacturing or logistical systems which are very similar to those already in use, ceasing to use a process, simple capital replacement or extension, changes resulting purely from changes in factor prices, customisation, localisation, regular, seasonal and other cyclical changes and trading of new or significantly improved products.”
“(73) As the RAG require that the eligible investment should not only rely on a “process innovation”, but on a “new process innovation”, the Commission considers that only those “process innovations” which have a high degree of novelty should be considered eligible.”
“(74) Based on the above the Commission decides that for an envisaged production process to qualify as a “new process innovation” in the meaning of paragraph 15 of the RAG, it has to represent a substantial (fundamental) change to the state of the art of the relevant production process, and not an incremental or routine improvement. The Commission also takes the view that the eligibility of an investment can only be confirmed if the innovative element is not limited to introducing a punctual improvement, with relevance only for a minor part of the production process, but that the change which the new process innovation introduces to the state of the art, shall have a significant impact on the overall production process. Furthermore the Commission considers that the required novelty of the process innovation is only ensured if the new innovative production process is applied for the first time in the given sector in the EEA.”
The Commission concluded that those conditions were met primarily because:
i) The new process was introduced on a world-wide basis for the first time and was protected by a patent.
ii) The process innovations had a significant impact on the entire production process.
Application of the common assessment principles
According to paragraph 80 of the decision, the assessment under the common assessment principles of the RAG takes place in three steps:
i) First, “it is checked whether minimum requirements regarding credibility of counterfactual scenario, appropriateness, incentive effect, and proportionality of the aid and its contribution to regional development are met”. [RAG, sections 3.2-3.6]
ii) Second, “it is verified, that the aid does not lead to manifest negative effects (blacklist) that would prohibit the granting of aid, e.g. aid exceeding the allowable maximum aid intensity ceiling, creating overcapacity in a sector in absolute decline, attracting an investment that would have gone without the aid to another region with a similar or worse off socio-economic situation, or causal for the closure of activities elsewhere in the EEA”. [RAG, section 3.7.2]
iii) Third, “for not blacklisted aid projects meeting the minimum requirements, a balancing is carried out to ensure that the contribution to regional development outweighs the negative effects on trade and competition”. [RAG, sections 3.7.1 and 3.7.4]
Appropriateness of regional aid
According to paragraph 50 of the RAG, the aid must be an appropriate policy instrument in the sense that no other less distortive type of aid or instruments are available. “(84) Section 3.4 therefore introduces a double appropriateness test. Under this first appropriateness test, Member States have in particular to identify the bottlenecks to regional development and the specific handicaps of firms operating in the target region, and to clarify to what extent bottlenecks to regional development could also successfully be targeted by non-aid measures. Under the second appropriateness test, the Member State has to indicate why – in view of the individual merits of the case – the chosen form of regional investment aid is the best instrument to influence the investment or location decision.”
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What paragraph 84 of the decision calls the first appropriateness test should not be confused with the second assessment principle which is the “need for state intervention” [section 3.3 of the RAG]. Appropriateness is a comparative concept. The essence of what is explained in paragraph 84 is that it has to be shown, first, that aid is more effective than non-aid and, second, that investment aid is more effective than other forms of aid, especially in cases where the aid is granted outside an operational programme financed by structural funds.
With respect to the need for aid, the Brandenburg region is disadvantaged in comparison with the average of other regions in Germany.
With respect to the form of the aid [grant], the Commission considered that “(87) a direct grant constitutes an appropriate aid instrument to achieve the desired objective as the amount of aid necessary to bridge the viability gap between the locations of Spremberg and [Trostberg] can only be made available to the firm by direct grants.” Indeed, a funding gap can only be bridged by a grant.
Incentive effect
Paragraphs 64-65 of the RAG set out the “formal” requirements for demonstrating the existence of an incentive effect: investment can only be made after submission of the application for aid. The Commission found that this condition had been respected.
The RAG also requires verification that the aid is necessary to provide a “substantive” incentive effect for the investment. A credible counterfactual scenario has to show what would happen without aid. The Commission has to verify that this scenario is “realistic” and
“credible”. According to paragraph 68 of the RAG, a counterfactual scenario is credible if it is “genuine and relates to the decision-making factors at the time of the decision.”
Paragraph 61 of the RAG stipulates that the “substantive” incentive effect can be proven in two possible scenarios: without aid the investment would not be sufficiently profitable (scenario 1); or without aid the investment would take place in another location (scenario 2).
Germany invoked scenario 2. It submitted proof that a comparison had been made between the costs and benefits of making the investment in Spremberg and the alternative location of Trostberg in Bavaria.
The Commission found that counterfactual scenario was credible because there was evidence confirming that the board of Hamburger Rieger decided to make the investment but that the choice of location was determined on the availability of State aid.
All the costs and revenues linked to the two locations were compared over a ten-year period.
The investment at the Spremberg site was estimated to be about EUR 5.5 million lower in nominal value than that in Trostberg. On the other hand, production costs over the ten year period in Spremberg would be considerably higher than in Trostberg by about EUR 49 million in nominal value. After taking into account differences in training costs, taxes, and residual values, it was found that Spremberg would have a cost disadvantage of EUR 38.5 million in present value (EUR 46.5 in nominal value).
Two observations are worth making at this point. First, although the analysis is about the compatibility of investment aid, the method that is used to prove the need for the aid takes into account operating costs. This is an inherent feature of the funding gap method that is used here.
Second, the size of the funding gap is partly determined by operating costs such as training expenses. The company made a commitment to train its workers. The expected improvement of labour skills was used by Germany as evidence of the beneficial effects of aid. However, it is not clear how Germany would ensure that that commitment would be honoured, especially when aid is granted up front while training may take place at different intervals later on. The decision does not impose any obligation on Germany in this respect.
Proportionality of the aid
Compatible aid must be limited to the minimum. “(109) The aid amount [may not exceed] … the net extra costs (“net-extra cost” approach) of implementing the investment in the area concerned, compared to the counterfactual in the absence of aid. … The aid amount should not exceed the difference between the net present value of the investment in the target area with the net present value in the alternative location, while taking into account all relevant costs and benefits.”
The Commission found that indeed the aid did not “(110) exceed the difference in costs of between the two possible locations of Spremberg and Trostberg.”
Then the Commission made an interesting comment. “(111) The Commission notes that even if aid is granted, the Spremberg still registers a cost disadvantage of about EUR 5.6 million relative to the alternative location. In earlier cases approved under the comparable rules of the IDAC, then Commission accepted that limited differences between aid and net handicap are not only in line with the proportionality test, but also do not put into question the incentive effect of the aid. The Commission notes that the remaining cost disadvantage could be acceptable for Hamburger Rieger due to certain, non-quantifiable and strategic advantages of locating the investment in Spremberg, in particular the existence of a reliable and known supplier network”.
As regular readers of the blog may have noticed, in some other cases the Commission authorised aid amounts that were smaller than the calculated funding gap. When I reviewed those cases I questioned whether the project operators acted rationally. It was puzzling that they went ahead with an investment that was shown beforehand to be financially unviable. My conclusion was that they were not, of course, acting irrationally. It was more probable that they were hiding revenues or exaggerating costs to get the Commission to approve the aid. But now the Commission appreciates that excessive reduction of the amount of requested or granted aid is suspect. Since companies do not easily spend EUR 5.6 million on “non-quantifiable and strategic advantages”, I very much hope that the Commission has received more detailed information about the nature of these advantages than what is revealed in the decision.
Absence of “manifest” negative effects on competition and trade
The Commission found that the aid had no “manifest” negative effects for the following reasons. First, the (adjusted) aid intensity ceiling was not exceeded. The maximum adjusted aid amount that corresponds to EUR 363 million is EUR 32.9 [= 50×0.2 + 50×0.2×0.5 + 263×0.2×0.34 = 10 + 5 + 17.9] which is equivalent to aid intensity of 9.1%. The aid that was granted was precisely EUR 32.9 million or 9.1%. “(118) Therefore the double cap condition, laid down in paragraph 83 of the RAG, resulting from the combination of the net extra cost approach (“aid limited to the minimum necessary”) with the allowable ceilings is respected.”
Second, the aid would not create overcapacity in a market in absolute decline. Verification of this condition was not necessary in this case because without the aid the investment would be made in Trostberg.
Third, there was no counter-cohesion effect. “(120) Paragraph 121 of the RAG lays down an anti-cohesion effect provision that applies exclusively for scenario 2 situations. This provision prohibits the region with the lower project-specific viability to participate in subsidy races to the detriment of equally weak or worse-off regions. The provision thus does not prevent the target region from compensating the disadvantage compared to an alternative region with a higher project-specific viability and a better socioeconomic situation (i.e. with regard to a non-assisted area, or an area with lower aid intensity ceiling), provided its project-specific viability exceeds that of other possible locations with the same or an higher aid intensity ceiling.”
“(121) Germany confirms that the aid beneficiary considered only one other alternative EEA location for the investment project, namely , i.e. a non-assisted area (as it is not included in the Regional Aid Map). This information is backed by publicly available information. Therefore, the Commission considers that the aid has no anti-cohesion effect.”
Fourth, there was no closure of activities elsewhere, nor any relocation. Hamburger Rieger had not closed down the same or similar activity in the EEA in the previous two years, nor did it have any concrete plans to do so within two years after completion of the investment.
The Commission concluded that the aid had no manifest negative effect on competition or trade.
Balancing of positive and negative effects of the aid
The Commission also found that there were no undue negative effects on competition. There was no creation or reinforcement of a dominant market position, nor creation or reinforcement of overcapacities in an underperforming market.
Moreover, the effect of the investment on trade flows between Member States would be largely the same since Hamburger Rieger would make the investment anyway.
Therefore, the overall conclusion of the Commission was that the aid was compatible with the internal market.
A concluding comment: The aid is compatible, but is the country better off?
The nominal amount of aid was EUR 34 million. This money would create 195 jobs directly. The aid per job was EUR 174,000. This is more than five times the average annual manufacturing wage (gross). If we take into account indirect jobs as well [about 390, or a total of 585 jobs], the aid per job was EUR 58,000 or almost twice the average annual manufacturing wage. One wonders whether a grant to a single company was the most appropriate instrument to make the region more attractive. Perhaps a better approach would have been an explicit job subsidy which could attract other less capital-intensive companies that would need less aid and could perhaps create more jobs per euro spent.
Moreover, it should also be considered that a similar number of jobs would have been created anyway elsewhere in the country [in Trostberg]. The forgone benefits to the country from not having those jobs in Trostberg should be subtracted from the regional benefits from the jobs that were created in Spremberg. Even if one argues that one job in a less prosperous region like Spremberg is more valuable than a job in a more prosperous region like Trostberg, the forgone benefits from alternative jobs in Trostberg should have still been taken into account. But, of course, this is not the job of State aid control.
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[1] The full text of the Commission decision SA.43624 can be accessed at:http://ec.europa.eu/competition/state_aid/cases/262014/262014_1770298_115_2.pdf.
