STATE SUPPORT IN CERTAIN ‘SENSITIVE’ SECTORS OF UKRAINE’S ECONOMY

The Law on State Aid to Undertakings was adopted by the Verkhovna Rada in July 2014 and comes fully into force in August 2017. In line with commitments in the EU-Ukraine Association Agreement and under the Energy Community Treaty, the Law positions the Anti-Monopoly Committee of Ukraine (AMCU) as the regulator of State aid in the country and the repository of the State aid Register, requires pre-notification, analysis and approval of new State aids by the AMCU, requires a review of existing State aids (those pre-dating August 2017) and their alignment with EU State aid rules and sets up a system of monitoring and reporting concerning State aids in Ukraine.

State aid is essentially about the impact on competition and trade of subsidies, tax breaks and other forms of government supports which benefit some firms and, therefore, can impact negatively on other firms which do not receive such benefits. Every country (including Ukraine, all Member States of the EU and the WTO) supports economic activity to a greater or lesser extent by various instruments including subsidies, tax reliefs and other less direct supports.
The EU system of State aid regulation has evolved strongly over 60 years to ensure that – aside from the agriculture sector and relatively small amounts of State support in particular – only well justified interferences with competition and trade in the form of State aid are permitted. In the EU, the European Commission is the regulator and the AMCU in Ukraine is expected to operate similarly, and in line with EU State aid rules and Court judgments, in applying the new Law in Ukraine.

State aid can be categorised in several different ways. The most common categorisations are: Horizontal State aid and Sectoral State aid. These basic categorisations focus on the essential purpose of State aid measures; where horizontal measures typically are open to firms in all or many different sectors and aimed at regional development, SME development or other “horizontal” development purposes such as the promotion of commercial research and innovation. In this area, the EU State aid rules are generally quite flexible, more permissive than prohibitive and allowing a degree of policy experimentation in the policies of individual EU Member States. Sectoral State aid, in contrast, focusses on the problems of individual firms or industrial sectors and is seen as more problematic for competition and trade, less effective as part of industrial policy and thus requiring more substantive justification if it is to be approved under the State aid rules. This is particularly the case where a sector faces structural problems of global competitiveness and over-supply and the EU generally regards such sectors as “sensitive sectors” e.g. coal, steel, shipbuilding. Particularly strict State aid rules apply in such cases.

In March of 2015 the EU funded Project “Harmonisation of Public Procurement System in Ukraine with EU standards” published a Study on State Supports to Undertakings in Ukraine. The Study was prepared in order to provide the Government of Ukraine, interested public institutions and non-governmental organisations with a general overview of the legal framework and the scope and forms of State support to undertakings in Ukraine in recent years. It is based on publicly available data on State budget expenditures, budgetary revenue foregone and public liabilities registered during a period of three to five years that can be categorised as support to economic activities in Ukraine – whether or not these are ultimately “State aid” under the Ukrainian Law. The Study sets out information on the main forms and general structure of public support to undertakings in Ukraine based on the overall findings of this research and official statistics on subsidies and other forms of State supports currently available to undertakings in Ukraine.

In this article, the main findings of the Study concerning State support to certain specific sectors (notably sensitive sectors) are examined from the general standpoint of the EU State aid rules applicable to those sectors with a view to determining generally which types of sectoral State support measures from recent years would or would not be permitted in the future under the EU State aid rules.

EU and Ukrainian legislation concerning sectoral State aid

Under Articles 107 to 109 of the Treaty on the Functioning of the European Union, State aid (aid by or through State resources) which confers an advantage on an undertaking or on the production of certain goods or services is prohibited in principle if it has an actual or potential effect on competition and trade. This general prohibition is subject to several important exemptions (notably agriculture, State aid of a social character, State aid for natural disaster relief, de minimis State aid) and the European Commission must be notified, in most cases, of plans to apply new State aid measures with a view to obtaining an exemption from the general prohibition on the merits of the notification. The grounds for exemption in such cases are set out generally in Article 107.3 of the Treaty.

While the most important basis for exemption, in practice, relates to horizontal State aid, Article 107.3(c) of the Treaty provides that State aid to facilitate the development of certain economic activities may be exempted from the general prohibition rule. This means that sectoral aid may be approved even though, as noted above, the European Commission has general negative attitude to sectoral aid as it is considered more damaging to competition and trade. Nonetheless, sectoral State aid may be permitted where it contributes to the achievement of broader EU economic and social aims: e.g. where it is needed to correct serious regional imbalances, to accelerate certain activities, where it is desirable for social reasons etc. Where sectoral State aid supports a project of significant European interest and has a cross-border dimension in the EU, the European Commission tends to take a positive view (support for Airbus Industries being a notably important case). In addition, State aid to support culture and heritage (notably including support for national language publications and media and film making generally) is also positively assessed in the main.

At the same time, the European Commission has either prohibited State aid (other than under specific conditions) or produced special guidelines regarding certain sectors. These guidelines take precedence over any other State aid rules and they bind the European Commission in its case handling assessments. In the EU there is no single legislative document containing general sectoral aid rules. The guidelines concerning State aid to particular industries are and were developed when it becomes evident that the industry faces a situation of particular difficulty throughout the EU. In that setting, the European Commission typically develops such guidelines to indicate the Commission’s policy on State aid to this industry. In many cases, this is intended to seriously restrict or almost totally prohibit further State aid to a sector (e.g. when the sector is in global or EU-wide over-supply – the logic being that further State aid is a pointless waste of money and particularly damaging to the competitive position of surviving firms in that sector). Classic sensitive sectors of this type are coal, steel and shipbuilding. In other cases, the problems may be different (e.g. the need to encourage the sector’s development). In such cases, the guidelines can be more permissive with a clear focus on the EU development goals.

Up to August 2017, the Ukrainian authorities are free to assist particular sectors in any way they deem appropriate, including via the provision of State aid. Indeed, sectoral support has featured considerably in Ukrainian industrial policies until early 2015, with a focus on supporting so-called “priority sectors”, the provision of sectoral tax benefits and measures to avoid the bankruptcy of a range of State owned enterprises. From August 2017 onwards the relevant EU rules will be applicable in line with the general approach of the Law on State Aid to Undertakings.

One of the present difficulties with the Law on State Aid to Undertakings is that it does not contain substantive rules to clarify to economic Ministries and regional or local authorities how much or what type of State support or State aid they may or could provide in the future to sensitive sectors or indeed to other sectors. This is to be addressed by more detailed secondary legislation under Article 6 of the Law before the Law comes fully into force.

The basic approach of the European Commission to sectoral State aid
In EU Law, the European Commission considers that sectoral State aid can be authorised where it is needed to correct serious regional imbalance, to encourage or accelerate certain activities where it is desirable for social reasons or to neutralise certain distortions of competition due to action outside the EU. In this vein, the European Commission has developed a number of criteria against which it examines sectoral aid proposals notified to it. The main criteria are the following:

• sectoral State aid should be limited to cases where it is justified by circumstances in the industry concerned;
• State aid should lead to a restoration of long term viability by resolving problems rather than preserving the status quo and putting off decisions and changes which are inevitable;
• unless granted over relatively short periods, State aid should be reduced progressively and clearly linked to the restructuring of the sector concerned;
• the amount of State aid should be proportionate to the problem it is designed to resolve so that distortions of competition are kept to a minimum;
• industrial problems and unemployment should not be transferred from one Member State to another.

Moreover, it is a common feature of sectoral rules for sensitive sectors that State aid should not be given to investment projects which would result in capacity being increased. In addition, there is a general negative view on support for the general running costs (operating State aid) of firms in sensitive sectors as this simply provides temporary relief for a firm that should, on competition grounds, exit the market.

A closer look at important sectors such as coal, steel and the banking sector illustrates somewhat different approaches related to specific aspects of these sectors.

The Steel sector

A long and serious crisis in the coal and steel sectors in 1970s prompted the enactment of special regimes in the EU for State aid in these sectors. Specific features of the steel sector include the continuing over-capacity of the sector at European and world level and the substantial amounts of public funds granted to the restructuring of the steel sector in the past and, indeed, the extensive funding of attempts to diversify industrial production in traditional steel producing regions and areas. The present State aid rules on the steel sector note that surviving steel companies currently function without additional support or investment aid. Accordingly, investment State aid to the steel sector is prohibited, irrespective of the size of the investment and despite the fact that the location of the majority of steel plants are in regions recognized as encountering under-development and high unemployment. Thus under the EU State aid rules on the steel sector, and allowing for permissible de minimis State aid, the essential approach is:

• regional investment State aid as well as rescue and restructuring State aid are forbidden;
• research and development and innovation State aid, employment State aid and training State aid may be permitted.
• State aid in connection with the closures of steel plants may also be permitted.

The Coal sector

As in the case of the steel sector, structural changes in the international and EU energy markets forced the coal industry in the EU to apply major modernisation, rationalisation and restructuring efforts since the 1960s. In addition to competition from crude oil and natural gas, there has been growing competitive pressure on the EU coal industry from coal imported from outside the EU. In the past, these factors have resulted in many coal undertakings getting into financial difficulties and receiving State aid.

In the light of what has been allowed in the past, the present approach of the European Commission seeks to reduce classic forms of State aid in the sector and encourage further reductions in costs at remaining EU coal mines coupled with further capacity reductions to increase the competitiveness of surviving mines. Therefore, the criteria that are used by the European Commission for the assessment of State aid notifications concerning the coal sector are the following:

• rescue and restructuring State aid in the coal sector is not permitted;
• some horizontal support measures focused on the coal sector or coal regions (e.g. regarding State aid for research, development and innovation, State aid for environmental protection and State aid for industrial training or re-training) may be allowed;
• in the context of the closure of uncompetitive mines, State aid to the coal industry may be considered allowed if it complies with certain specific mine closure requirements;
• in very exceptional cases, some operating State aid to cover the current production losses of coal production units may be allowed, subject to specific conditions.

The Financial sector

As noted earlier, a substantially permissive scheme of State aid rules was introduced in the EU since the international financial crisis of 2008 to ensure the survival and recovery of viable EU banks which were hit by the effects of the crisis. These rules are based on the European Commission’s facility under the Treaty to allow State aid justified by “exceptional occurrences”. Even though they have existed now for seven years, these rules are regularly adjusted and regarded by the European Commission as “temporary”. At this stage, the EU rules of relevance here provide generally as follows:

• the rules are aimed at improving the restructuring process and the level playing field between banks;
• banks that ask for a recapitalization are required to work out a sound plan for their restructuring before they can receive recapitalisations or asset protection measures;
• a restructuring plan must include a capital raising plan convincingly demonstrating how the bank will become profitable in the long term;
• when a public recapitalisation is urgently necessary to avert risks to financial stability, it can still be temporarily approved before the full restructuring plan is ready, provided that the competent supervisor confirms that an immediate intervention is necessary;
• in case of capital shortfalls, bank owners and junior creditors are required to contribute as a first resort, before banks can ask for public funding. Exceptions to this requirement are possible where financial stability is at risk or where a bank has already managed to significantly close the capital gap, and the residual amount needed from the State is small compared to the size of the bank’s balance sheet.
• the rules provide that failed banks should applystrict executive remuneration policies. A cap on total remuneration is set out for this purpose as long as the entity is under restructuring or relying on state support. This will give management the proper incentives to implement the restructuring plan and repay the aid.

EU rules on State aid for the Rescue and Restructuring of undertakings in difficulty

Apart from sector specific State aid initiatives, a very common traditional form of State aid is an intervention to address the needs of a particular firm facing commercial and financial difficulties. In most EU Member States (especially older Member States), key firms in many sectors (e.g. airlines, coal mines, steel mills, shipyards etc.) have been rescued and/or restructured at least once using different types of State aid measures. Over time, and certainly since the late 1990s, the EU has imposed much stricter constraints on State rescue and restructuring initiatives. Growing concerns about competition and trade impacts were an important motivator for this. A further factor was a general tendency of many of these interventions in the past to fail and for the firms in difficulty to request, and often receive, further tranches of bail out support from the State.

Under the present EU State aid rules on rescue and restructuring of undertakings in difficulty, specific rules apply to three types of State aid: rescue support, restructuring assistance and temporary restructuring support.

Rescue State aid refers to support for a firm’s liquidity which is provided to ensure that the firm meets its short term obligations. It provides a brief respite from a firm’s financial problems (for up to 6 months) and its legitimate purpose under the EU rules is to keep the firm in business while a restructuring or liquidation plan is put in place.

Restructuring State aid is intended to restore the long-term viability of the firm on the basis of a feasible, coherent and far-reaching restructuring plan (which usually must be approved by the European Commission). Thus, the legitimate purpose of Restructuring State aid is to facilitate the reorganisation and rationalisation of the firm and its activities on a more efficient basis. Typically, this means withdrawal from loss-making activities, the restructuring of those existing activities that can be made competitive again and, possibly, diversification in the direction of new and viable activities. It may also involve financial restructuring in the form of capital injections by new or existing shareholders and debt reduction by existing creditors.
The EU also recognises the legitimacy of temporary restructuring State aid measures specifically in the case of SMEs in difficulty and the rules on this are designed to simplify the granting of State aid for restructuring SMEs. The maximum duration of such State aid is 18 months (it is shorter than for the standard restructuring support) and can only be in the form of loans or loan guarantees. The recipient firm is also only required to provide a simplified version of the restructuring plan in comparison to the detailed one required generally in respect of restructuring support.

The Rescue and Restructuring Guidelines apply to State aid for all undertakings in difficulty, except to those operating in the coal or the steel sectors and those covered by specific rules for financial institutions, without prejudice to any specific rules relating to undertakings in difficulty in a particular sector.

Recent trends in the amounts of EU sectoral State aid and sectoral State supports in Ukraine

Amounts of sectoral State aid in the EU

According to the data published in the European Commission’s State Aid Scoreboard, sectoral State aid, in nominal terms, decreased substantially over the five-year period 2008-2013 from €12.4 billion in 2008 to €4.6 billion in 2013. The level of State aid in the coal sector (mining of hard coal) during the period 2007-2012 decreased from €3.6 billion in 2007 to €2.2 billion in 2012. State Aid for the steel sector during the period 2007-2012 also decreased considerably. In 2007 it amounted to €239.5 million and in 2012 it was €11.4 million.

Sectoral State supports in some sensitive sectors in Ukraine

According to the recently published Study on State Support to Undertakings in Ukraine, substantial amounts of sectoral support were provided in Ukraine in the last five years.

Support in the steel sector

Ukraine’s steel (metal) producing sector plays an important role in the national economy, employing some 322,000 workers, contributing approximately 20% to 25% of Ukraine’s total industrial output – or up to 5% of GDP, thereby generating about 30% to 35% of all commodity exports. The structure of Ukraine’s ferrous metal industry includes around 200 enterprises. Of these, 19 are integrated steelworks and foundries, 12 are pipe producers, more than 20 are various metal-ware producers, 12 are coking plants, 14 refractory plants, 12 are mining enterprises/ferroalloys plants, and more than 100 are scrap and by-product processors.

In the period covered by the Study, State support measures were mainly aimed at the development and restructuring of the sector, specifying particular objectives and timeframes in various regulatory acts. An important instrument of State support to the sector involved so-called Joint Memorandum of Understanding (MoU) between the Government, steel producers and ore mining enterprises in Ukraine. In the period from 2009 to 2013, two MoUs were signed: one for the period from 2008 to 2012 and the second one in 2013. Despite the fact that such MoUs were not considered to be legal acts, because they were enacted by special Government resolutions and orders, they set out mutual obligations on the parties for particular short-term measures to support steel producers and to protect the domestic market against external economic impacts, often caused by substantial price fluctuations in world markets.

Measures to support the mining and metallurgical industries under the first MoU were mainly implemented in the following forms:

• reduction of the regulated price of natural gas for mining and metal producing companies;
• abolishing the surcharge on the natural gas tariff for mining and metal producing enterprises;
• suspension of increases in regulated retail tariff for supply of electricity to undertakings in mining and metal producing sectors;
• fixing rail transportation tariffs for mining enterprises and metal producers;
• preferential tariffs on supply of electricity for production needs of certain electro-metallurgical enterprises;

The declared objective of the second MoU (which was effective from 1 June 2013 to 1 June 2014) was to further support metallurgical enterprises whose financial performance indicators had deteriorated due to a falling world prices for their products and increased prices for energy and raw materials, as well as for services of natural monopolies. Under the terms of this MoU, the Government agreed to establish certain tax benefits, lower tariffs for rail transportation services provided for enterprises in the metal and mining industry and initiate certain other support measures. However, this MoU was not implemented as there was a general failure by the signatories to adhere to some of their commitments.

In addition to the MoUs, further tax and customs benefits were introduced for investment projects carried out by metal producers and processors.Benefits for undertakings implementing investment projects included: lower tax rates and no income tax liability until 31 December 2017 as well as a reduced 8 percent tax rate applicable until 31 December 2022; exemptions and the accelerated depreciation allowances for certain “groups” of assets; exemption from customs duty for imported equipment intended for use in the technological processes of the steel industry, etc. However, up to the end of 2014, no official data concerning benefits to undertakings, working in the regime of approved investment projects in the so called “import-substituting metallurgy” sector, or concerning amounts of benefits granted under this title, were published.

Support in the coal sector

Coal mining is a key sector of the Ukrainian economy, both as a supplier to other indus¬tries (power and heat generation, metallurgical coke production) and a major employer (300,000 jobs). Coal mining accounted for 3.2% of Ukraine’s industrial production in 2014, down from 4.3% in 2013 due to the impact of military conflict in the coal-rich eastern re¬gion of Ukraine. In volume terms, production by state-owned mines accounted for 36% of 2014 total coal output. And most of the State owned companies were loss-making.

The State Support Study reveals that direct budget support to the coal industry between 2009 and 2012 ranged from 11 billion UAH to 17 billion UAH annually. A certain share of this budget support was distributed through the State Treasury directly to recipients while the main provider of this direct support in 2012 was Ministry of Energy and Coal Industry. This support provided in the year 2012 was intended for:

• restructuring of the coal and peat mining industry (1,078 million UAH);
• partial coverage of the cost of production of marketable finished coal products (10,172 million UAH);
• improvement of health protection and labour safety standards at coal-mining enterprises; in particular, through the installation of modern air control devices and degassing devices in mines (41 million UAH);
• assistance to coal and peat-mining enterprises in constructing necessary production capacities (1,293 million UAH);

In addition to the direct support from the State budget, indirect support through tax benefits was also provided. This included corporate income tax reductions amounting to some 85 million annually from 2010 to 2013. Moreover, Government guarantees for loans were also provided on the basis of special regulations. The legal acts concerning the provision of these guarantees were either directed to support some individual enterprises or the whole of the energy and coal sector.

Support for the financial sector

In Ukraine, as in the case of EU countries, the banking and financial services sector was the most affected by the financial crisis of 2008 to 2009, including the largest and most important banks and other financial institutions. Therefore, the National Bank of Ukraine implemented anti-crisis measures to help the financial sector and initiated the recapitalisation of a number of banks with the participation of the State together with the provision of Government guarantees and the expansion of depositor protection mechanisms.
In addition, a specialised bank for financial restructuring was established in 2011 on the basis of PJSC “Rodovid Bank”, which has a specific mandate for five years to deal with the troubled assets of State-owned banks and banks recapitalised with State participation.
This recapitalisation was a temporary measure, targeted at regaining stability and to support the capitalisation of the financial system. From 2008 to 2011, a total amount of 54.8 billion UAH was directed for additional recapitalisation of banks, including State-owned banks. The Study points out that:

“These activities facilitated, to some degree, a reduction of the social and economic strain. However, they failed to bring the expected results in terms of restoring solvency and viability of the recapitalised banks. As this recapitalisation was a temporary measure, targeted at regaining stability and to support the capitalisation of the financial system, an exit strategy should have been developed for the State, in order to refund the State budget expenses due to participation in the recapitalisation of banks.”

The primary result at this point is the large number of state owned banks for the time being. Moreover, Government’s share in the authorised capital of PJSC “Rodovid Bank” amounts to 99.99%, in PJSC “ACB ‘Kyiv’” 99.94% and in PJSC “Ukrgazbank” 92%.

Support for the rescue and restructuring of undertakings in Ukraine

According to the Study, in recent years there have been only a few cases where the Ukrainian Government initiated programmes designed to assist the restructuring of undertakings and these related exclusively to State-owned enterprises. The main sectors concerned in restructuring and liquidation support were the chemical mining industry and coal and peat mining enterprises. The Ministry of Economic Development and Trade of Ukraine developed and approved an Action Plan for the restructuring and liquidation of State-owned enterprises in the mining chemical industry, and for necessary environmental measures related to the core industrial activities and restructuring of the enterprises mining iron ore.

According to Ministry of Economic Development and Trade, a large number of State owned enterprises in Ukraine are companies in difficulty (technically bankrupt). This is an important consideration. Indeed, it is likely that the Study understates the extent of de facto rescue support to State owned enterprises as there are other cases where operating subsidies and supports under horizontal programmes were also provided. In that regard, the Study shows that a considerable amount of operating support was provided to undertakings in various sectors of Ukraine’s economy. Examples include support provided to the aircraft industry and the shipbuilding industry in Ukraine which received direct subsidies from the State budget or preferential taxation for undertakings operating in these sectors. Indeed, overall budget revenue foregone arising from tax benefits to the aircraft construction and shipbuilding sectors in 2013 amounted to 514 UAH million and 107 million UAH respectively.
Aircraft building enterprises, in accordance with the Customs Code of Ukraine, also enjoyed preferences in the form of exemption from import duties. The State also provided direct support to the undertaking in the aircraft construction and shipbuilding sectors in the form of direct subsidies from the State budget to compensate local budgets for their losses in land taxes from such enterprises.

Conclusions

While it is necessary to be cautious in using recent State support practices and data to comment or draw conclusions regarding possible future trends concerning State aid in Ukraine, the following points can be made related to the overview of sectoral support presented here.

First, unless the legislation facilitating the sectoral supports in different sectors has legally expired or is repealed before August 2017, the various measures, whether active or not and whether funded or not, will need to be included in the Ukrainian State Aid Register; and any activity related to these will be subsequently monitored by the regulator.

Secondly, rescue and restructuring support to the coal sector, prohibited under EU rules, will not be possible after August 2017. Moreover, any new tax benefits or new loan guarantees in the sector would need re-designing, in order to be acceptable, with a focus on supporting the closure of uncompetitive mines and research, development and innovation, environmental protection or training activities for the sector.

Thirdly, various operating supports in the steel sector together with tax and customs benefits for investments carried out by metal producers and processors would be likely, if continued or repeated, to contravene the EU rules on State aid to the steel sector.

Fourthly, in the context of rescue and restructuring of firms in difficulty, the Ukrainian authorities should take careful account, especially in regard to the many loss-making State owned enterprises, of the highly restrictive State aid rules that apply in regard to such actions. In regard to possible privatisations (after August 2017), for example, the State might envisage the need to offer various incentives to buyers (including the writing off of debts or tax incentives). These would immediately involve potentially problematic State aids. Similar account should be taken of the detailed EU rules in sensitive sectors which are significant in Ukraine – notably coal, steel, energy and shipbuilding.

Finally, it can be noted that the public finance crisis in Ukraine may prove to be pivotal in avoiding possible repetitions of potentially questionable State support measures or potentially problematic new State aid initiatives. Indeed, it is clear from present Government policy that, in response to a very deep crisis in public finance, substantial public expenditure cut-backs are being made in Ukraine together with the removal from March 2015 of most sectoral tax exemption or tax reduction provisions in earlier tax legislation. Furthermore, in its recent initiatives to revive the ailing and economically significant State owned enterprise sectors, the Government is focused exclusively for the present on non-financial interventions to try to restructure these via improved mechanisms of corporate governance. This type of approach effectively avoids State aid considerations.

Authors: Dr. Eugene Stuart and Sigitas Cemnolonskis

The contents of this article are the sole responsibility of the Crown Agents and its Consortium partners and the opinions expressed in this article are not to be understood as in any way reflecting an official opinion of EUROPEAID, the European Union or any of its constituent or connected organisations.

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