The purpose of this study is to review the use of cost allocation methods in postal state aid applications in the European Union (EU). This is an important topic because many recent postal state aid assessments by the European Commission (EC) came down to scrutinising cost allocation. Hence, this study is primarily directed to experts at regulators, competition authorities, ministries, postal operators, and policymakers in Europe.
Cost allocation carried out by economists can often become very complex very quickly, involving the use of complicated “techniques” and industry jargon that can make the net cost calculation evidence hard to understand and evaluate, even for fellow economic experts. This can lead to two different types of problems:
The purpose of this study is not to explain to readers how to apply cost allocation methods themselves. This would require far more detail than we can give in this study. Instead, the aim is to allow readers to do two things:
Regulatory reports based on fully allocated costing (FAC) models can yield important insights and provide the analyst with testable propositions, but it is the correct appraisal of the incrementality of costs that allows one to mitigate the risk of overcompensation and in consequence, cross-subsidisation of non-USO services. We start with the conceptual framework of the commercial scenario – a comparison of factual and counterfactual situations with and without the universal services obligation – which is underpinned both in the Annex 1 of the EU Postal Services Directive as well as in the EU State Aid guidelines. Then we turn to the issue of cost allocation and provide practical tools to ensure that all costs pertinent to the commercial services provision were appropriately allocated. We focus on the key criterion of incrementality that net cost calculation analysis should adhere to as well as various limitations related to fully allocated costing methods in more detail.
Altogether, based on an overview of current developments in the postal sector, a review of state aid cases, and an in-depth study of four potential pitfalls when calculating compensation for postal USPs, we derive three key policy implications.
First, we observe that a changing postal sector warrants extra care from the relevant authorities when assessing state aid applications and in particular, calculations of net costs. While the ongoing decline in letter volumes might raise the need for governmental support, the increasing relevance of parcels in operators’ product mix and resulting operational transformations complicate the identification of the amount of aid needed. Consequently, a heightened awareness of (i) sector-specific changes, (ii) simultaneously existing funding sources, and (iii) diverging methods to calculate compensation is required from regulators and competition authorities to avoid the negative consequences of over- or undercompensation.
Second, the importance of constructing a plausible counterfactual scenario for net cost calculations cannot be overstated. Historically, postal USPs have applied a range of different net cost methodologies. However, some of these methods seem to deviate from the standards set out in the EU State Aid Framework and the Postal Services Directive, which require operators to set up a plausible counterfactual scenario with financially sustainable services. It is therefore important for state aid practitioners and relevant authorities to look beyond the mere definition of the methodology applied for net cost calculations and assess the plausibility of the counterfactual scenario. For instance, ex ante (national) regulation could provide guidelines to operators on how to ensure the plausibility of the counterfactual scenario.
Third, the correct appraisal of the incrementality principle allows practitioners to cut through the complexity of cost allocation. Despite the identified limitations of fully allocated costing systems regarding their adherence to the incrementality principle, these systems offer guidance and significant efficiency advantages in cases where long run incremental costing modelling is too burdensome. Hence, this paper does not advocate against using fully allocated costing in postal state aid applications. Instead, we focus on identifying specific issues and mitigating methods related to allocating and interpreting the incrementality of common, joint, and fixed costs. In practice, it is up to the individual postal USPs to be aware of the limitations raised in this paper and to ensure the correct application of mitigating methods. The fundamental principle of incrementality shall then guide competition authorities in their state aid reviews.
Overall, careful assessment of postal state aid applications and awareness of changes in the industry are becoming even more important as competition authorities and state aid practitioners face a complex regulatory environment. Abstracting from the calculation methodology and costing standard used, the decision to grant aid to postal universal service providers should be informed by a plausible counterfactual and the correct application of the incrementality principle to avoid any adverse effects of miscalculated state aid.
The study was conducted for UPS by Copenhagen Economics. All the findings and conclusions are our own.Download