Introduction
The Commission’s block exemption regulations and the guidelines do not cover exhaustively State aid for all conceivable policy objectives. For example, there are no specific rules on investment subsidies for large enterprises in non-assisted regions. This does not mean that Member States may not grant State aid to a large company to manufacture a product they consider important. Rather, it means that they have to justify the need for the aid and demonstrate the benefits to the economy and the EU as a whole.
A case in point is a recent Austrian aid measure to enable Sandoz to maintain and modernise its penicillin production in Kundl (Tyrol). The Commission approved the aid in decision SA.62915. The measure was assessed directly on the basis of Article 107(3)(c) TFEU.
The aid beneficiary is Sandoz Gmb, a manufacturer of generic medicines and antibiotics. It is a subsidiary of the Swiss-based Novartis group.
At its site in Kundl, Sandoz manufactures about 4000 tonnes of Amoxicillin, the world’s most used antibiotic, and employs about 5000 persons. Sandoz is the only undertaking in the EU that produces the core intermediate 6-Aminopenicillanic acid [6-APA], which is the basis for all penicillin antibiotics.
However, Sandoz faces strong competition from cheaper producers outside Europe who use less expensive chemical processes. According to the Commission decision, “(29) in order to remain competitive, Sandoz had two options: either to outsource the API production or to make a major investment to modernise its facilities and processes, including a further rationalisation of the fermentation and the switch to the state-of-the-art, less costly enzymatic synthesis process”.
The aid measure
The purpose of the aid was to support the modernisation of Sandoz’s Amoxicillin manufacturing process in Kundl in order to prevent the closure of the Kundl facilities and the move of Amoxicillin production outside of Europe. Maintenance of a competitive, integrated production of Amoxicillin in Kundl would diversify and strengthen the EU’s supply chains for essential and life-saving medicines.
The investment for modernising the existing facilities and rationalising the production process would cost more than the alternative option of shifting production to a non-European location.
The aid was in the form of a direct non-repayable grant of EUR 28.8 million. The aid was to be granted in several tranches, between 2023 and 2026.
“(34) The total cost for implementing the project amounts to EUR [around 150] million […] Sandoz would contribute EUR [around 100] million from own funds, while around EUR [between 10 and 15] million would be funded from existing national schemes.* EUR 28.8 million would be granted under the measure. The total amount of funding from the national schemes referred to above will depend on the actual cost of the relevant work streams and the precise amount of eligible costs and will only become apparent once the final settlement of accounts has been carried out. If the total amount of funding under those national schemes exceeds EUR [between 10 and 15] million, Austria commits to reduce the funding granted under the notified measure, so that the total amount of public funding granted by Austria to the project would in no event exceed the identified funding gap of EUR […].”
* At this point, footnote 44 of the decision indicates that the other aid would be contributed by i) the GBER-based scheme SA.101861, ii) an approved RRF scheme, and iii) an R&D tax credit scheme.
The Commission decision clarified that “(35) in addition, Sandoz would invest another EUR […], in order to further rationalise the production of FDFs in Kundl. Sandoz Austria’s total investment in the modernisation and rationalisation of the production process in Kundl would thus amount to EUR […]. That rationalisation step is not part of the notified measure.”
The integrated process used by Sandoz would be modernised and streamlined with i) the construction of a new production and validation plant to implement the enzymatic synthesis process in replacement of the conventional chemical synthesis; ii) the development of the penicillin fermentation process in order to improve its sustainability and reduce manufacturing costs; and iii) the improvement of the enzymatic synthesis of 6-APA.
The description of the project indicates that it involves both capital expenditure and operating expenditure. We will return to the Commission’s assessment of the operating expenditure at the end of this article.
Funding gap
The only way that State aid that falls outside existing rules can be justified is on the basis of funding gap analysis.
“(56) Austria submitted a funding gap analysis carried out by Sandoz Austria, comparing the cost of modernising the current production facilities with that of sourcing the API from [a non EU-country]. As shown in Figure 3 [all data in Figure 3 are deleted as business secret], the conclusion of the funding gap analysis is that, in the best-case scenario, the investment generates a negative net present value (NPV) of EUR […], as compared to outsourcing, discounted at a rate of […] corresponding to Sandoz Austria’s weighted average cost of capital (WACC).”
“(57) This means that to ensure a competitive production, Sandoz could bear a maximum of EUR [around 100] million of the project cost (the total project cost of EUR [around 150] million minus the identified funding gap of EUR […] million. As set out in recital (34), a maximum of EUR [between 10 and 15] million of the funding gap would be financed from existing national measures. The notified measure aims to bridge the remainder of the funding gap, equal to EUR 28.8 million.”
“(59) The WACC for Novartis group companies is calculated by Novartis Group Finance on a yearly basis using the Capital Asset Pricing Model and is the mandatory discount rate for evaluating investment options within the Novartis group. This resulted in a WACC of […] for Sandoz Austria for the investment project under assessment. According to Austria, the average WACC of companies in the pharmaceutical sector in Austria was between […]”.
In this connection, it should be noted that PWC estimates the average WACC of pharmaceutical companies to be around 8%.[1]
PWC calculates the cost of equity as follows:
Risk-free rate: 2.5%
Market premium: 6.0% – 8.0%
Beta: 0.9
These rates result in a range of 7.7% – 9.4%.
PWC calculates the cost of debt as follows:
Risk-free rate: 2.5%
Risk premium: 1.1%
Tax advantage: 1.1%
These rates result in debt cost of: 2.5%
The derived WACC is then a range of 7.2% – 8.8%.
Compatibility with the internal market
There was no doubt that the Austrian measure in question constituted State aid. The Commission considered that the measure did not fit into any of the existing guidelines. Therefore, it proceeded to assess it directly on the basis of Article 107(3)(c) of the Treaty on the Functioning of the EU.
Assessment on the basis of Article 107(3)(c) determiens whether two conditions are satisfied:
i) whether the aid contributes to the development of an economic activity or an economic area; and
ii) whether the positive effects of the aid outweigh the negative effects triggered by the distortion of competition so that the affectation of trading conditions between Member States that would not be contrary to the common interest.
The aid did contribute to the development of an economic activity. Next, the Commission examined whether the aid also incentivised Sandoz to do something it would not do without the aid. In this respect it confirmed that “(85) production of Amoxicillin in the EU was no longer competitive and the company had thus initially decided in 2019 to outsource the APIs production to Asia, having rejected a modernisation of the EU sites as too costly”. “(89) In a scenario without aid, the integrated production of Amoxicillin APIs would effectively cease in the EU, which would result in a concomitant decline in economic activity. Moreover, the production of 6-APA – which is an essential intermediary for all penicillin types – would completely disappear from the internal market, and all remaining relevant production sites would be located in a single third country.”
With respect to the balancing of the positive and negative effects of the aid, the Commission noted in paragraphs 94-106 of the decision the positive effects of maintaining competitive production of Amoxicillin and its inputs in the EU.
In relation to possible negative effects, the Commission, first, reiterated that “(107) any State aid has the potential of distorting competition in the internal market by improving the beneficiary’s position as compared to competitors. Before State aid can be found compatible with the internal market, its potential negative effects must be limited by mitigating factors. In its decisional practice, the Commission has established four criteria to be fulfilled in this respect, namely the aid must be (i) necessary; (ii) proportionate; (iii) appropriate; and (iv) transparent.”
The Commission noted that “(109) Sandoz Austria’s competitors are mainly producers located outside the EU, as Sandoz Austria is currently the only vertically integrated producer of Amoxicillin in the EU […] In the EU, Sandoz Austria’s only competitor for the production of Amoxicillin APIs is Centrient Spain. This is the only segment where it competes with Sandoz Austria, as it does not produce 6-APA nor FDFs for final consumption in the EU […] Centrient Spain sources the key intermediary 6-APA from outside the EU and has a market share of around 36% for the production of Amoxicillin API, as compared to around 8% for Sandoz Austria.”
“(111) The Commission also notes that the measure will entail no capacity increase for Sandoz Austria, as the final output of Amoxicillin is contingent on the amount of starting material and 6-APA produced, which will remain constant […] Moreover, the investment occurs in a growing market, where the CAGR for Amoxicillin APIs in Europe has reached around 5% and has been higher than that of the rest of the world”.
Then the Commission examined the need for aid, as seen from the perspective of the granting Member State, its proportionality, its appropriateness as a means of state intervention, and whether it would be granted in a transparent manner.
Necessity of the aid
“(116) As regards the necessity of the aid, […], the production of API has moved in the last decades to third countries. This means that Sandoz Austria is now the only vertically integrated producer of Amoxicillin APIs in the EU”.
“(117) Modernising and rationalising Sandoz Austria’s EU production process would require investments of around EUR [around 150] million for building a production and a validation plant in Kundl and further rationalising the production process. Austria has submitted a funding gap calculation demonstrating that the project has a significant negative NPV of -EUR […] million […] the existence of this negative NPV means that implementing the modernisation project would not trigger sufficient returns on investment over the reference period to be profitable for Sandoz Austria.”
“(118) Moreover, […], a cheaper option for increasing its competitiveness than modernising the Kundl plant would be for Sandoz Austria to source the Amoxicillin API from outside the EU, as its only competitor Centrient Spain is already doing for 6-APA.”
“(121) The aid is thus necessary for triggering the investment for the modernisation of Sandoz Austria’s Kundl site for the integrated production of Amoxicillin APIs.”
Proportionality
“(122) As regards the proportionality of the aid, the Commission has to verify that the aid is limited to the minimum necessary for reaching its objective. In general, the proportionality of the aid can be ensured by carrying out a tender. However, in view of the significant barriers to entry and the important time lag in setting up the necessary know-how and skills, in the present case, the Commission considered it appropriate to assess the proportionality of the aid on the basis of the funding gap calculation submitted by Austria […] The latter shows that the investment project has a negative net present value of EUR […] million.”
“(126) The counterfactual scenario […] was discarded only after Austria accepted to compensate the company for the higher costs triggered by the modernisation of the EU production process”.
“(127) The notified aid bridges, next to EUR [between 10 and 15] million funding from existing national measures […], the remaining funding gap of the project.* The full amount of EUR 28.8 million granted under the measure does not exceed the funding gap and thus the minimum necessary to make the investment happen. As set out in recital (34), Austria committed to ensure that the total amount of public funding granted to the project (national measures and notified measure) would in no event exceed the identified funding gap of EUR […] and, if necessary, to reduce the amount to be granted under the notified measure accordingly.
* At this point, footnote 56 of the decision states that “even if all national support measures of EUR [between 10 and 15] million were to constitute State aid within the meaning of Article 107(1) TFEU, they would together with the measure just cover the established funding gap of EUR […] million.”
“(128) The Commission considers on this basis that the aid is proportionate.
Appropriateness
The Commission assessed appropriateness in a single paragraph. “(129) The amount of the notified aid is based on and strictly limited to bridging the remainder of the identified funding gap of the project, i.e. the cost difference of maintaining the integrated production in the EU as compared to the counterfactual. Granting only part of the sum of the identified funding gap could not make the investment sufficiently profitable for enabling Sandoz Austria to carry out the modernisation project, all the more so as outsourcing would be more in line with Novartis group policy than continuing an integrated production […] Similarly, providing aid in the form of a loan or a guarantee would also not have the effect of closing the identified funding gap and would thus not serve the purpose that the notified measure pursues. The Commission therefore considers that the chosen aid instrument is appropriate to overcome the lack of profitability of the project over the reference period, as the funding gap could not be bridged through other, less distortive aid instruments such as a loan or a guarantee.”
Even though the Commission decision does not explicitly explain why other forms of aid were not appropriate, what it implies is that the calculated gross-grant equivalent of State aid embedded in a zero-interest loan or a free guarantee would not be as large as the needed grant of nearly EUR 29 million.
Transparency
Austria committed to publish relevant information regarding the aid on a national State aid website. Therefore, the Commission found the aid to be transparent.
Operating aid
The Commission also examined the costs that were to be supported by the aid measure. Some of those costs concerned operating expenses. Therefore, it also assessed the compatibility of operating aid.
“(131) Part of the overall investment costs for the modernisation of Sandoz Austria’s Amoxicillin APIs production process in the EU concern costs for operations. According to the case law [the decision cites case C-594/18 P, Austria v Commission (Hinkley Point C), paragraph 119], operating aid can, in principle, not fulfil the requirements of Article 107(3)(c) TFEU, given that it merely maintains an existing situation or lowers the operating expenditure which an undertaking would have had to bear in any event in the course of its normal business, and can thus not be regarded as facilitating the development of an economic activity.”
“(132) However, while it is true that, absent the aid, Sandoz would exit the production of Amoxicillin APIs in Europe, this is not due to the fact that Sandoz has an unviable business model or that its operations are overall inefficient but rather to the fact that the global concentration of Amoxicillin production in Asia has rendered a profitable production in Europe extremely challenging. This has created a situation where, in the hypothesis of continuing the production process in its current manner, it would be more profitable for Sandoz to source Amoxicillin APIs from Asia than to produce in-house in Europe. This would result in all 6-APA supplies for Europe being sourced from a single country outside of the EU.”
The Commission went on to observe that “(133) Sandoz is willing to undertake a major investment in order to modernise the production process, including significant energy and raw material savings as well as benefits in terms of research, development and innovation. The investment thus also results in a more environmentally-friendly production process and implements innovative processes with regard to the fermentation of penicillin V and the coupling of 6-APA.”
It is puzzling why the reasoning in the two paragraphs above would justify support of operating costs. Any inefficient company could lower its costs by moving to a cheaper location. What the Court of Justice said in case C-594/18 P is something different. It observed that the aid facilitated investment in the development of an economic activity, even if it supported operating expenses. In that case operating was needed to lower the funding gap [see paragraphs 120-121 of that judgment].
Next, the Commission noted, correctly, that “(134) the project presents a funding gap of EUR […], as compared to the counterfactual. This approach takes account of all revenues and costs of the project and compares them to the revenues and costs of a scenario without aid, with the result that the funding gap precisely represents the amount of aid necessary for implementing the project, without a strict delineation between operating and investment costs. While a limited outflow of operating costs occurs during the ramp-up phase of the new plant, this in no way corresponds to a continued subsidisation of the production process. In any event, the aid is much lower than the total capital expenditure of the project, which amounts to EUR […]. The aid is narrowly calibrated to cover not more than the demonstrated funding gap, and thus enable Sandoz to carry out the investment and prevent the ceasing of production in the EU.”
Indeed, it is inherent in Funding Gap analysis that operating costs are taken into account. Where State aid is calculated according to the Funding Gap, the GBER and the guidelines require that the amount of aid remains below the eligible investment costs. Therefore, it is good that the Commission stressed in the paragraph above that the aid in this case did not exceed the investment costs. What it should also have done is to examine whether the covered amount of operating costs would raise the funding gap above the initial cost of the investment. Perhaps it did it but did not mention it in the decision.
It concluded that “(135) the aid under assessment is not limited to maintaining the existing situation or lowering the operating expenditure which Sandoz Austria would have had to bear in any event in the course of its normal business. On the contrary, without the full amount of the aid, no investment in production capacity would take place. The operating expenditure is therefore necessary to achieve the purpose of preventing the cessation of the production of Amoxicillin APIs in the internal market. It follows that the operating aid under assessment facilitates the development of the economic activity […], in the same way as the portion of the aid that covers Sandoz Austria’s capital expenditure on the project at hand.”
Following this finding, the overall conclusion of the Commission was that the benefits outweighed the harm to competition caused by the aid and therefore, it was compatible with the internal market.
[1] The PWC analysis can be accessed at:
https://evaluationdata.pwc.de/kapitalmarktdaten-gesundheitswesen-pharma/
