2.2.1 The adverse effects of State aid

State aid is a remarkable phenomenon. It can be both harmful and beneficial. On the one hand, Member States may have valid reasons to grant State aid. On the other hand, State aid can have adverse effects.

The damaging effect of State aid is that it may create distortions of competition. This is harmful, because competition is generally considered to be desirable. According to economic theory, competition increases welfare, because competition leads to efficiency. There are three types of efficiency: productive efficiency, allocative efficiency and dynamic efficiency.1

Productive efficiency means that goods and services are produced at the lowest possible cost. Productive efficiency is achieved when a certain input is used in such a way that results in a maximum output, or alternatively, when a certain output is produced with a minimum input.2

Allocative efficiency is based on the economic notion that resources are scarce and can be used in alternative ways. Allocative efficiency is achieved when the scarce resources are used in such a way that will optimally benefit society at large. This is the case when the marginal willingness to pay equals the marginal production costs.

Productive and allocative efficiency are static concepts, in the sense that they focus on maximising welfare at a specific point in time. By contrast, the third type of efficiency is dynamic: this focuses on maximising welfare over a period of time.3Dynamic efficiency is achieved by investments and innovation. The link with competition is clear: competition may induce undertakings to innovate.

Thus, competition increases efficiency, which – in turn – increases welfare. From this viewpoint, State aid is harmful, because it creates distortions of competition. These distortions can occur in several ways.

In the first place, State aid gives the beneficiary undertaking an unfair competitive advantage over other undertakings which did not receive State aid. This results directly from the characteristic of selectivity of State aid. State aid is a selective advantage; an advantage that is only granted to certain undertakings. It is an artificial competitive advantage. It is contrary to the ideal of “competition on the merits”.

In the second place, if a Member State recapitalises undertakings which do otherwise not have access to capital (and would subsequently have to leave the market), then State aid can frustrate the normal market functioning. The normal market functioning is based on the principle of “survival of the fittest”.4 As the AG noted in the case C-526/14, “it is in the nature of any economic activity that some undertakings – generally the most poorly performing – will fail and leave the market, and their investors, consequently, lose all or part of their investments”.5 Keeping inefficient undertakings artificially alive negatively affects productive efficiency.6

In the third place, State aid influences expectations and incentives. Under normal market conditions, undertakings have an incentive to invest in R&D and innovation, because this will increase their market share. The market share of the competitors will decrease and they may even have to leave the market. However, if undertakings expect that the State will support undertakings in difficulty, then this will reduce their incentives to invest in innovation.7 State aid not only affects the incentives of the potential beneficiaries of State aid, it also affects the incentives of undertakings that are very successful. If those undertakings expect that their inefficient competitors will be rescued by the State, then this reduces their effort to succeed. Since the State aid allows their inefficient competitors to remain on the market, the reward for success is reduced.8 This, in turn, reduces the effort to be successful on the market. This might result in a decrease of dynamic efficiency.9

In the fourth place, State aid may lead to subsidy races between Member States.10 If one Member State is granting excessive aid to its undertakings, then other Member States may follow and also give excessive aid to their undertakings. So granting aid may provoke a reaction from other Member States (theso-called “tit-for-tat-strategy”11).

In the fifth place, State aid may create moral hazard.12 If undertakings know or expect that they will be rescued when they are about to fall, then they are more inclined to take (excessive) risks. They enjoy the upside, but do not bear the downside of their actions.13 This is especially the case for undertakings that are considered to be “too-big-to-fail”. Thus, moral hazard may lead to excessive risk-taking.14

At this point, it might be useful to elucidate one other aspect: moral hazard and distortions of competition are sometimes bracketed together.15 This raises the question to what extent they are different distortions: is moral hazard a distortion of competition? In the sense that moral hazard creates perverse incentives and leads to excessive risk-taking, moral hazard is different from competition distortions. Nevertheless, the too-big-to-fail status which creates the moral hazard problem, also creates a distortion of competition: the prospect that the bank will be rescued by the State may make it easier for the bank to raise funding on the market (at a lower cost). In other words: the prospect of State aid may artificially reduce the funding costs of the bank. This gives the bank an undue competitive advantage.16 This is clearly a distortion of competition.