Turbulence ahead? The new state aid guidelines for aviation

According to the European Commission, the new state aid guidelines ‘are a key ingredient for a successful and competitive European aviation industry’.[1] They set out the conditions under which member states and local authorities can grant state aid to airports and airlines in the EU, and are part of the Commission’s state aid modernisation strategy. This strategy aims to foster growth in the EU by encouraging more effective aid, focusing the Commission’s scrutiny on cases that have the largest impact on competition.

This article discusses the implications of the guidelines, focusing on the financing of airport infrastructure as well as the negotiation of agreements between airports and airlines.

What are the main changes in the guidelines?

Since the Commission’s previous guidelines were introduced in 2005, the aviation sector has changed considerably.[2] Low-cost airlines have expanded significantly, while some more traditional ‘flag carrier’ airlines have experienced difficulties. Many hub airports currently have significant capacity constraints, with forecasts that, by 2035, around 2m flights will not be able to be accommodated.[3]

The new guidelines have a critical role to play in light of the expected bottleneck in the European aviation sector. Indeed, the Commission has recognised that:[4]

Airport capacity needs to be optimised and, where necessary, increased to face growing demand for travel to […] areas of Europe otherwise poorly connected, which could result in a more than doubling of EU air transport activities by 2050.

Given these developments in the aviation sector, the guidelines introduce a number of changes. The new rules on start-up aid and investment aid are applicable only to aid from now on (i.e. which is subject to the new guidelines). The new rules on operating aid are applicable to aid granted before now (i.e. the guidelines will apply retrospectively). The box below highlights the main changes.

What do the guidelines imply for the financing of airport infrastructure?

The 2014 guidelines impose new restrictions on the amount of aid that is allowed for financing airport infrastructure, particularly for larger airports (as shown in the box below).[5] However, the rules in the new guidelines in relation to the financing of airport infrastructure are more flexible for those airports located in geographically remote regions.

As shown in the box above, the new guidelines impose fewer restrictions on aid for infrastructure received by smaller airports. The Commission has recognised that smaller airports are likely to face difficulties in attracting private financing at the appropriate price to be able to undertake the necessary infrastructure projects. This is in line with a large body of academic literature that has found that investors in smaller companies require higher returns than investors in larger companies that are otherwise similar.[6]

However, under the Commission’s new guidelines, larger airports—defined as those with more than 5m passengers per year—are allowed aid to finance airport infrastructure only ‘under very exceptional circumstances’.[7] The Commission does not provide an example of these ‘exceptional circumstances’, although it explains that they occur when there is a clear market failure, when it has not been possible to finance investments on capital markets, and where a very high level of positive externalities is associated with the investment. These are discussed further below.

What are the implications for airports planning infrastructure investments?

As a result of the new guidelines, larger airports in particular may face greater challenges in demonstrating that state funding for infrastructure investments is compatible with state aid law. However, as highlighted in Oxera’s 2013 report for the UK Parliament’s Transport Select Committee, certain large investments in infrastructure are unlikely to be viable without state funding.[8] Oxera’s analysis showed that the construction of a new hub airport in the South East of England would not be commercially viable without state funding in the region of £10bn to £30bn, depending on passenger numbers. This is due to the significant time for investment in infrastructure to generate sufficient returns, combined with the complexities and risks associated with large projects.

What do the guidelines imply for the negotiation of airport–airline agreements?

The Commission’s guidelines also have significant implications for agreements negotiated between many airports (particularly smaller regional airports) and airlines. In contrast to the previous guidelines, which did not stipulate any explicit rules on how to ensure compliance with the MEO test, the new guidelines introduce some high-level principles that will be relevant to any new airport–airline agreements.

What methodology does the Commission recommend for assessing the compatibility of airport–airline agreements?

The Commission’s guidelines emphasise the role of financial analysis in assessing whether agreements between airports and airlines are in line with the MEO test. In particular, they stipulate that the existence of aid can be assessed through incremental profitability analysis, from the perspective of the airport at the time it signs a deal with an airline. According to the Commission:[9]

arrangements concluded between airlines and an airport can be deemed to comply with the MEO test when they incrementally contribute, from an ex ante standpoint, to the profitability of the airport. [emphasis added]

This is in line with the approach that would be adopted by a rational private investor, which would be likely to assess the revenues gained (both aeronautical and non-aeronautical), and the additional costs incurred, as a result of the agreements between the airport and airline.

As an airline is not in a position to be able to assess the extent to which the revenue it generates covers the airport’s incremental costs, the burden of proof is on the airport. Indeed, the Commission has stated that:[10]

The airport should demonstrate that over the duration of the arrangement it is capable of covering all costs stemming from the arrangement (for example, an individual contract or an overall scheme of airport charges) with a reasonable profit margin on the basis of sound medium-term prospects when setting up the arrangement. [emphasis added]

In the MEO assessment, costs that the airport would have to incur anyway independently of the arrangement with the airline should not be taken into account.

In the new guidelines the Commission has acknowledged that airports differentiating prices charged to airlines represents a standard business practice and, provided that it is commercially justified, is in line with the MEO test:[11]

the Commission considers that price differentiation is a standard business practice, as long as it complies with all other relevant competition and sectoral legislation. Nevertheless, such differentiated pricing policies should be commercially justified to comply with the MEO test. [emphasis added]

Is there a role for market price benchmarks?

In its guidelines, the Commission expresses strong doubts that it is currently possible to use market price benchmarks to establish aid-free arrangements. This appears to be on the basis that there are only a relatively small number of fully privately owned airports in Europe, and prices charged by privately owned airports may not provide a useful benchmark, as these airports often compete for the custom of airlines against airports that may have benefited from state support.

The concerns raised by the Commission in the new guidelines implicitly presuppose that private airports compete with airports that have received state aid. Although it is possible that competition may drive airports’ prices towards incremental costs, privately owned airports are unlikely to set loss-making prices.

Furthermore, as acknowledged by the Commission, airports across the EU are currently witnessing ‘growing involvement of private undertakings’.[12] There are thus a number of airports in Europe whose prices are not set on the basis of social or regional considerations.

Although the Commission is currently expressing doubts, it is possible to establish a robust benchmark that can be used to derive a market price. The analysis of airports’ business plans can provide valuable evidence, given their inherent subjectivity, but comparator analysis should also be considered. The advantage of this latter approach is that it is based on actual market evidence, rather than the hypothetical scenarios outlined in the business plan.

The likely impact of the guidelines on the European aviation landscape

The Commission has so far published only a few decisions on state aid cases in the aviation sector, although it is currently undertaking at least 28 in-depth investigations of airports and airlines, and expects to reach a final view on these cases by September 2014.[13] The decisions that are published over the next six months will provide valuable insights into how the Commission is applying the new guidelines.

The Commission expects that loss-making airports should be able to transform themselves during the ten-year transitional period, and that only the most inefficient airports will close as a result of the new guidelines.[14] According to the Commission’s impact assessment, no airports handling over 500,000 passengers are likely to close as a result of the new guidelines, although smaller airports may close if they fail to improve efficiency and increase revenues. This is in contrast to the concerns raised by the European Regions Airline Association that around 80 regional airports may be forced to close, as well as general speculation in the press that ‘dozens of smaller airports may face cutbacks or even closure’.[15]

However, according to the Commission, based on the example from the UK where many small airports are commercially viable, the Commission has ‘reason to be optimistic and to believe that the number of closures will be low’.[16]

Any significant closure of airports could have costs from the perspective of socioeconomic development and integration within the EU. Accordingly, the Commission has not ruled out further changes to the guidelines in the future.[17] It would be helpful, however, if the Commission could clarify how it intends to assess the socioeconomic and integration impacts of any airport closures. At this stage, it is too early to predict how the landscape of the European aviation industry will be altered as a result of the new guidelines. This will only be known with time as the outcome of the tension between the requirement for state funding to support loss-making airports and the fact that, in general, demand for air travel outstrips capacity in Europe becomes clearer.

Contact: James Kavanagh