EC ruling on gap funding schemes

Introduction

1. The Government's response to the Select Committee's report on the implications of the European Commission ruling on gap funding schemes for urban regeneration in England is set out in this Command Paper.

Background

2. The Partnership Investment Programme (PIP), which began in 1995, was a national programme and could be utilised anywhere in England. It was administered by English Partnerships (EP) on behalf of the Department of the Environment, Transport and the Regions (DETR).

3. PIP brought the public and private sector into partnership to tackle the regeneration of derelict sites and buildings. PIP was based on the principle of "gap funding", which meant that, following a full appraisal of the developer's application for assistance, the amount awarded would be the minimum necessary to bridge the gap between development costs and forecast end value, and enable the developer to go ahead. A clawback arrangement ensured that, if actual costs were less than forecast, or end values were higher than forecast, an appropriate part of the grant was repayable.

4. Gap funding enabled developers to go ahead with otherwise non-commercially viable projects on contaminated, derelict and disused sites, to bring them back into full economic use. The sites in question were in areas of depressed market activity and, as a result, end values were lower than development costs. The sites also tended to suffer from abnormally high development costs, for example, because of the need to deal with contamination and remove old structures.

5. On 22 December 1999, the European Commission announced its decision on whether PIP contravened the State aid rules. A State aid is any form of aid that is provided directly by the State, or indirectly through State resources, to an undertaking or group of undertakings. A State aid is regarded as incompatible with the Common Market if it distorts, or has the potential to distort, competition within the European Union. However, under the Treaty of Rome, certain types of aid are, or may be declared to be, compatible with the Common Market. The Commission's decision was the culmination of a long-running investigation into the programme, which had begun in 1996. The Commission took the view that PIP was in breach of the rules, and it could only be considered as compatible with the Common Market if it was applied in a way which complied with the derogations provided for in the Treaty. If the scheme was recast into a Regional Aid framework, so that it would operate solely in the Assisted Areas, and that grant levels would be subject to the aid intensity ceilings within these areas, it could be considered as compatible.

6. The decision meant that the vast majority of projects currently funded under PIP would become ineligible, so the scheme was closed as of the decision date, although transitional arrangements were agreed in order to protect projects which had already reached formal application stage.

Discussions between the UK Government and the European Commission between 1996 and 1999

7. The Commission began an informal review of PIP in 1996 because it became aware of several cases, particularly in the automobile sector, where the beneficiaries of PIP might have been involved in intra-Community trade. The review subsequently became a formal inquiry on 23 July 1998, when the Commission issued an appropriate measures letter, under which the Commission formally declared its intention of establishing whether State Aid was involved in the operation of PIP, to identify any such aid, and bring it into line with the requirements of the EC Treaty, and State aid rules.

8. Several meetings were held between UK Government Ministers and the Commission at which it was maintained by the UK that PIP did not constitute State aid because:

The grant given was the minimum necessary to bridge the gap between development costs and market value of the regeneration site;
It did not confer an unfair competitive advantage on the developer because any undertaking could apply for assistance under PIP, and all costs and values were assessed at open market rates;
There was negligible (if any) intra-Community trade in the development of derelict land and buildings.

9. The Commission ruled that PIP involved the use of State aid for the following reasons:

gap funding constitutes State aid because it provides a quantifiable financial incentive to a developer to invest in an area or location in which little or no private investment would otherwise have happened;
The aid favoured certain undertakings;
PIP had the potential to distort trade between Member States. An important factor in the Commission's view was that the recipients of EP's funding were undertakings active in trade between Member States.

Current position

10. The Regional Development Agencies (RDAs) are responsible for providing advice to EP on three schemes within the land and property programme: land reclamation; direct development, and the Community Investment Fund. The RDAs also administer PIP on behalf of EP. Responsibility for existing PIP projects, including those for which transitional arrangements have been made, will transfer from EP to the RDAs on 1 April 2001.

11. In the absence of gap funding, the main alternative is direct development, i.e. where the public sector acquires derelict land and either develops the site itself or in partnership with another public sector organisation. Because the site must be acquired, reclaimed and developed by the public sector, the up-front costs of direct development are approximately three times higher than gap funding. The public sector must also pay the costs of any aborted projects. In order to help compensate for the demise of PIP, the Government has made additional resources available to the RDAs. An extra £60m has been made available in this financial year, rising to £150m in 200102. Thereafter, land and property funding will form part of a new single RDA economic development and regeneration budget, with increases of £350m in 200203 and £500m in 200304 compared with current budgets.

12. The Government has notified the Commission of five new schemes. Two of the new schemes will involve the provision of State aid through gap funding. However, we expect that they will comply with the State aid rules because the schemes will only operate in the Assisted Areas and will be subject to the Aid Intensity ceilings. We believe that the other three schemes do not involve any State aid. They are an enhanced direct development scheme, an environmental regeneration scheme for soft end uses which is designed primarily to improve the environment and provide public amenities such as open spaces and playing fields, and a neighbourhood renewal scheme. We are hoping for early positive responses from the Commission on these schemes.

Longer term

13. Over the longer term, we are exploring with the Commission the possibility of a new regeneration framework under which State aid would be permitted for the physical regeneration of derelict or disused sites throughout England and the rest of the Community, subject to certain strictly defined conditions. This is, however, likely to be a long-term process. Discussions with the Commission continue to be constructive, but a successful outcome is not a foregone conclusion.

14. The Committee made two recommendations in the light of its findings, and commented on a number of aspects of the Commission's ruling.

Recommendations

(a)Outside Assisted Areas it will be even more difficult to find a suitable replacement for the Partnership Investment Programme. Regeneration will have to be done by direct development. However, it is doubtful whether the RDAs currently have the skilled personnel to undertake such work, and it will take time to build up this expertise. Direct development will also make new CPO powers essential. We recommend that legislation to provide these powers features in the Queen's speech in the autumn. Consideration will also need to be given to permitting RDAs and English Partnerships to borrow against assets.

15. The Government accepts that RDAs will need to ensure that their staff have the necessary skills to undertake direct development projects. Additional resources for this purpose have been made available to the RDAs.

16. Direct development by RDAs will not give rise to a requirement for new compulsory purchase powers. Under section 20 of the Regional Development Agencies Act 1998 a RDA has the power to acquire land compulsorily for its purposes, as set out in section 4 of the Act and for purposes incidental thereto. These purposes include "to further economic development and regeneration" and "to contribute to the achievement of sustainable development". CPO powers are also available to local authorities and to EP, who may be partners in direct development projects.

17. The Government recognises that there is a need to improve the efficiency and effectiveness of the compulsory purchase order system, whilst ensuring that the interests of those from whom property is acquired are properly safeguarded. The report of an Advisory Group that has undertaken a fundamental review of the laws and procedures relating to compulsory purchase and compensation was published on 27 July. The group recommended that action should be taken as quickly as possible to consolidate, codify and simplify the law in ways which, along with some small but significant policy changes, should ensure a quicker and fairer approach to land assembly. Comments on the Advisory Group's report were invited by 13 October. The next step will be for the Government to prepare a formal policy response, early in 2001, including proposals for eventual legislative change.

18. In the Urban White Paper we make it clear that, in the meantime, there is no reason why local authorities, the RDAs and English Partnerships should not be making use of their CPO powers in support of regeneration projects. The Government will be issuing advice to the RDAs and further advice to local authorities on these matters. In addition, a Compulsory Purchase Procedure Manual, setting out guidance and good practice for all those involved with compulsory purchase orders, will be published shortly.

19. RDAs and English Partnerships already have the power to borrow on the security of their assets, subject to the consent of the secretary of State and the Treasury. But normally, the Secretary of State and Treasury would wish to ensure that a lender does not have first call on a public body's assets. We do not propose to change this policy, although the situation will be kept under review. In addition, the extra resources which have been made available to RDAs reduces the need for RDAs and EP to take out secured loans (see paragraph 11).

(b)In the long term progress can only come about through a new regeneration framework. The UK Government must work with other European Governments to develop a co-ordinated approach to such a framework. It must impress on the European Commission the need to show unusual urgency, if our cities are to avoid further degeneration. However, we have no confidence that the Commission will allow a regeneration framework to be negotiated quickly. The Minister confirmed that this was the case.

20. The Government agrees that the best way forward would be the adoption of a new regeneration framework. Discussions with the Commission about this issue have been ongoing for several months, and will continue. As the Committee acknowledges, this is likely to be a lengthy process. The Commission is wary of the possibility of State aid abuse, and is therefore cautious in approach. The Commission has emphasised that on the rare occasions when frameworks are agreed, the Commission has in almost all cases reached its decision as a result of the development of case law around the subject, over preceding years. There is no guarantee of success in the discussions.

21. If the Commission is able to accept the idea of a new framework, we will then move on to discuss its content with them. We will wish to discuss conditions which make it possible for us to support a wide range of projects across all areas of England. The Commission will clearly wish to ensure that any new arrangement would not leave open the possibility of abuse of the State aid rules, and would be applicable across the whole EU. Conditions could be introduced to ensure proper control of large amounts of aid, and to ensure that the objectives of regional policy were not undermined inadvertently through the availability of regeneration aid in all areas.

22. The Commission's deliberations are likely to be measured, taking account of the position in other Member States. The definition of "physical regeneration" means much more in this context than just the removal of contamination, dereliction and creating a clean site. We need to achieve the physical redevelopment of sites, so that they will produce economic outputs in terms of jobs, industrial/commercial space, and housing, with the consequent social and environmental improvements which flow from this development. Regeneration sites are invariably in areas where the local land and property market has either collapsed, or operates at a very low level.

23. The sites where we need to intervene to secure development usually have high "abnormal" costs associated with their redevelopment. There may be former contamination or pollution to remove, and/or structures to demolish and clear. We apply the "polluter pays" principle to ensure that those responsible for pollution, where they still exist, have removed the contamination that they have caused, in order to make the site safe for its current use, including likely future uses for which permissions already exist. But this principle does not extend to bringing the site up to the standards required to make it appropriate for a totally new development. Former industrial land may need to be stabilised and made safe. However, many regeneration sites will not be contaminated, but simply derelict and disused, or under-used.

24. The defining characteristic of regeneration sites is that no developer is interested in taking the risk of developing them, as they will cost more to develop than any increased value (because of both high development costs and local market failure) and the developer will not get their money back. Where the market works normally, there is no need for public intervention to secure development by the private sector. The property market may not work normally for a number of reasons (more than one may apply on any site):

There may be a gap between the cost of development of a site and the potential end value of the site, and this is not something which developers as commercial operators, can meet. The main cause of the gap may be the high cost of site treatment or development;
Sites may be in areas which the market does not favour, for social and economic reasons. Market values of sites in these areas are depressed and again development costs exceed end values that could be achieved. The main cause of the gap between cost and value is the depressed land value. Development of these sites is not commercially viable;
Sites in economically disadvantaged areas are seen as risky options for development or investment, and developers tend to ignore these sites in preference to those in economically successful areas. Developers will tend to choose the least risky sites and options.

25. Market failure occurs because the physical neglect, unemployment and deficiencies in the labour market, such as lack of skills in these areas make them unattractive places to invest. Public intervention at the minimum level necessary to overcome this market failure is needed to break this situation, and get the market moving.

26. Our case for a new framework is that:

physical regeneration serves Community objectives of improving both the standard of living and quality of life within the Member States, promoting a high level of protection of the quality of the environment and promoting sustainable development (as set out in Article 2 of the Treaty of Amsterdam). We consider that a new framework would promote these Article 2 objectives;
regeneration is an economic activity for the purposes of Article 87(3)(c);
none of the existing frameworks (for example for Regional aid or Environmental aid) directly or comprehensively serves regeneration goals;
regeneration is a "horizontal" issue where a framework could apply across the full range of economic sectors (as opposed to the "sectoral" frameworks which exist for State aid to particular industries, such as motor manufacture);
all existing and potential Member States could benefit from the existence of the framework for furthering regeneration objectives.

27. The UK Government is proposing to convene a seminar to which representatives from all the Member States have been invited in order to identify the different approaches which are used to achieve the physical regeneration of derelict or contaminated land across the Community, and the extent to which private sector partners are involved in such work.

Comments made by the Committee on the Commission's ruling

(c)In recent years there have been signs of an urban renaissance in several English cities, including Manchester, Liverpool and Leeds. A crucial instrument in regenerating areas where land and buildings have very little, if any value, has been English Partnerships' Partnership Investment Programme. However, in December 1999 to the dismay of everyone involved in urban regeneration in England, the European Commission decided that the scheme was illegal.

(d)At a stroke urban regeneration in England was seriously undermined. The consequences have been spelt out clearly by our witnesses. They are nothing less than disastrous. The Partnership Investment Programme has been a uniquely successful public-private partnership, raising £2.5 billion in private sector capital. While the Commission made much of the fact that gap funded schemes will be permitted in some circumstances in Assisted Areas (but not immediately), 8090 per cent of the type of projects approved under the Partnership Investment Programme would be lost in the future. Even smaller projects such as the conversion of old warehouses into flats in run-down areas of major cities can no longer be supported by the Partnership Investment Programme. We are also faced with the prospect of developers who have built up great expertise in brownfield development losing interest in such projects.

(e)The Commission's decision is perverse and bizarre. The previous Competition Commissioner found the Partnership Investment Programme acceptable but, on the arrival of Commissioner Monti, an academic with renewed zeal and determination to search for breaches of the State Aid rules, the original Commission decision was over-turned. Although we can see why the Commission could, on the narrowest of grounds, construe circumstances in which it might be imagined that the Partnership Investment Programme might affect trade between member states, in practice no projects could result in any form of significant distortion of the single market. Moreover, the Commission's view that it is acceptable for the public sector to bear risk using tax payers' money but not the private sector is illogical. We must conclude that the European Commission took its decision casually without regard for the consequences of its action. As witnesses have stated, having made this disastrous decision, the Competition Directorate General now considers that sorting out the consequences for the deprived populations of England's cities is someone else's problem.

(f)It is extraordinary that while the Regional Policy Directorate General of the Commission spends immense sums throughout the European Union on regeneration, the Competition Directorate General has decided effectively to abolish the most efficient, effective and imaginative regeneration scheme in the European Union.

(g)Part of the problem is that the Commission had not realised the differences between conditions in England and continental Europe. The vast majority of land in England is privately owned with landholdings in an area often being fragmented between many landlords. This makes direct development by the public sector very difficult. In contrast, a much higher proportion of land in European cities is in public ownership.

(h)The UK Government preferred to bargain to keep in the pipeline all those schemes which had been submitted to the Partnership Investment Programme by 22 December 1999, rather than contest the Commission's decision. It is essential, however, that new schemes are in place for Assisted Areas by the end of the year, although the Commission does not have a record of moving to solve urgent problems with dispatch. In any event, given the intensity rules which limit the sums that can be provided by gap funding even in Assisted Areas, fewer than 20 or 30 per cent of schemes which would formerly have been funded in such areas would go ahead.

(i)Illogical and ill-considered Commission decisions such as this on the Partnership Investment Programme bring the European Union into disrepute.

28. The Government shares the Committee's disappointment with the European Commission's decision that PIP breached the State aid rules. However urban regeneration has not come to a halt because of this decision. Our policies for an urban renaissance do not depend on PIP. The Government attaches a high priority to the physical regeneration of contaminated or derelict land and buildings and is determined to find a new way of delivering the type of projects which had previously been supported by PIP. Significant extra resources have been made available to the RDAs to help compensate for the closure of PIP (see paragraph 11).

29. The Commission has the power and the duty to keep systems of aid under constant review as the single market develops. In this case they were quite within their rights to review their earlier decision that gap funding was not an aid, and to take a new decision. Whilst their decision was disappointing, it was for the Commission to interpret the rules and the decision was logical under a strict interpretation of EC law. The Government supports the Commission's stance on eradicating any abuses of the State aid rules in the Community. This will encourage fair competition, which benefits the interests of British firms in all sectors.

30. It is not the case that the Government bargained with the Commission to keep those schemes which had been submitted by 22 December 1999 in the pipeline, rather than contest the Commission's decision. The decision that PIP breached the State aid rules took immediate effect. Even if we had challenged it, the decision would still have been in force, and it would still have been necessary to close PIP to new projects. The Government negotiated extremely good transitional arrangements with the Commission, which allowed over 300 projects to proceed to their logical conclusion.

31. We expect a positive decision in the near future on two new gap funded schemes, which will operate in the Assisted Areas. Once they have been approved, they will be implemented as soon as possible.

Conclusion

32. The Government welcomes the Committee's interest in this subject. While the Commission's ruling on PIP was disappointing, it will not prevent us from delivering our regeneration policies. In the short term, the extra resources which have been made available to the RDAs will help to compensate for the demise of PIP. Subject to Commission approval, gap-funding schemes will shortly be operating in the Assisted Areas. Over the longer term, we are holding ongoing discussions with the Commission about the possibility of a new regeneration framework.