Key takeaways
Viability Gap defines lawful subsidy parameters
Shows when public funding is justified and proportionate.
No fixed format, but clarity Is crucial
Use clear, evidence-based forecasts to support decisions.
Market failure drives subsidy justification
Demonstrates why private sector cannot deliver alone.
Subsidy Control law seeks to regulate the public sector's involvement in commercial markets. This involvement can be through outright gifts like grants to businesses, or other engagement with them on sub-commercial terms, such as transfers of assets or making loans to them at undervalue.
The problem is that such engagement is unfair, as competitors don't get the same benefit, meaning the beneficiary business can undercut its competitors. As a result such engagements are generally treated as unlawful subsidy to the business.
Subsidy Control law is enshrined in the Subsidy Control Act 2022 and the associated Statutory Guidance and Regulations. These provisions enable a public body (such as a local authority) to assess whether (a) a subsidy arises to the business, and if so, (b) whether it would be reasonable to award it under a set of Subsidy Control Principles, hence making it lawful. In answering both questions a Viability Gap assessment is most useful.
What is a Viability Gap?
Viability Gap is a generic term encompassing any calculation or forecast showing a need for a subsidy.
For example where a grant is provided to a commercial real estate developer, the Viability Gap may be represented by a development appraisal, where the need for the subsidy is represented by the difference between development cost and the development value anticipated on practical completion.
Another example is by usage of financial appraisal techniques, for instance when performing a 5 case options appraisal for a subsidised project. It is important that only monetised costs and revenues are taken into account, rather than the wider public benefit that accompanies a benefit:cost analysis.
Description | £ |
Initial Investment Cost (including provision for reasonable developer's profit / contingency) | A |
Present value of operating returns over the estimated useful economic life of the asset | B |
Viability Gap | A-B |
The idea is that the value of the subsidy should not exceed the Viability Gap. The entries may include provisions for reasonable profit, contingency and professional fees, but only depreciation to the extent the asset is not subsidised. Present value is arrived at by discounting future costs and revenues (operating returns) to the current year in which the initial investment cost is incurred. The operating returns should be forecast over the estimated useful economic life of the asset generating them, for instance the period until the asset needs further substantial upgrade or becomes obsolete.
Is there a set format for a Viability Gap?
Not under Subsidy Control law and hence the above are examples only. The object is to provide a reasonable estimate or forecast now (at the time the Subsidy is given), even if the actual results eventually do not transpire as predicted. The latter can be further addressed through a repayment / clawback of subsidy provision in a funding agreement with the beneficiary if needed.
The format used above is based on standard investment appraisal techniques used in management accounting for decision making purposes and is a format with which Subsidy Control law enforcement authorities are most familiar with. These are referred to in management accounting terms as "Net Present Value" (NPV) forecasts, the Viability Gap typically representing a negative NPV, and hence an insufficient rate of return to if the counterfactual situations where the project is not undertaken and the amount of the subsidy is instead invested in something else, like a deposit in an interest bearing bank account ("do nothing" approach).
However it is presented, the Viability Gap should clearly show how the subsidy assists the recipient in achieving a specific objective and hence changes its behaviour in undertaking the project. It would additionally show that there are unlikely to be alternative means of delivering the project outside of subsidy. Finally it assists in showing at least a limited market failure in the area in undertaking it.
For instance in energy and environmentally beneficial projects, the Viability Gap could be the deficit between the additional cost of employing low emissions technology and the reductions in energy costs resulting from the savings, if revenues remain the same before and after the investment (as seen for instance in fuel cell, bio methane or electric batteries for public transport).
Where can a Viability Gap be useful?
A Viability Gap therefore is a way of showing that a project cannot be of interest to the private sector as any benefits it generates does not cover its initial capital costs. It is essentially therefore an expression of market failure in terms of the inability of the private sector to engage in such a project without subsidy. It is then up to the public authority to show that market failure is worth rectifying, and why.
If a Viability Gap exists, it may form the parameters of a lawful subsidy. The parameters include defining the amount, timing, terms or even form of the subsidy. This would be useful evidence of reasonableness under the Subsidy Control Principles. It may also be required under a Streamlined Subsidy Scheme, which is a kind of block exemption from having to consider the Principles.
Very often the cause of the Viability Gap can be readily identified for instance the use of subsidy to cover site abnormals (like de-pollution or remediation), conservation deficit (for instance the additional costs in preserving the artistic or heritage aspects of a building) or activity (for instance provision of community / social services alongside commercial operation). These factors typically make it uneconomical for the private sector to engage in the project without subsidy and often arise in land or community regeneration projects carried out by local or regional authorities.
If a Viability Gap does not exist, this may be evidence that the engagement by the public body is not a subsidy at all, but rather an investment on purely commercial terms which the public sector is just as entitled to do as the private sector. This is referred to as the "Commercial Market Operator (CMO)" principle. However lack of Viability Gap does not automatically translate into CMO, as a further step is needed, that being that the positive return is within the range of returns a private sector investor would be interested in.
It follows from the above that a sub-commercial engagement which leaves an insufficient or nil Viability Gap may not be lawfully provided as a subsidy, as it may not be considered a reasonable intervention. This would open the subsidy to challenge from a competitor for instance, within a limited period of time from it being given (and published, where applicable).
Conclusion
A Viability Gap is useful in showing the reasonableness of a planned subsidy, particularly in terms of whether it is proportionate and required in delivering the objectives of the planned subsidy. There is no set format for presenting such a calculation or forecast, but the most familiar formats to enforcement bodies is expressing is as a difference between the initial investment costs of the project and the present value of its operating returns within the estimated useful economic life of the asset created / upgraded by the subsidy.
This article covers an area which is complex and hence not a substitute for detailed legal and accountancy advice. For further information or guidance please contact Jay Mehta.
