Notes of the meetings between FRIST (represented by Lord Tony Berkeley and Marian Bennett) and relevant EC directorates at the end of May 2013 on the subject of state aid (public subsidies) for transport links for small island communities and EU rules regarding public subsidies are attached here.
In a nutshell, the need for member states to intervene and provide state support for essential links to small island communities, without the burden of having to compete these services, is accepted where the scale of the operation is limited and certain other criteria apply. The threshold below which the need for competition is relaxed for air and maritime links to islands is an average annual traffic of 300,000 passenger trips (well in excess of IOS traffic).
The UK Government is free to impose a public service obligation upon the private sector operator, and compensate them financially for doing so, without having to compete the service. There is of course no obligation upon the Government to impose a public service obligation on any transport link to the IOS.
The European Commission's interpretation of ‘market failure’ is broader than that used by the UK Government for the IOS. Intervention could be justified if the service(s), frequencies and prices provided did not meet the expectations of the users (similar to the justification used for UK mainland rail and bus subsidies).
Article 106(2) of the Treaty on the Functioning of the European Union imposes the general obligation to compete services benefiting from ‘state aid’ given the potentially distorting effects of state aid upon markets within the EU. See here.
Commission Decision 2012/21 dated 20 Dec 2011 effective 31 Jan 2012 modifies the general obligation to compete such a subsidized service if the service meets four criteria and is below a certain threshold value. The decision document gives guidance about how compensation (subsidies) are calculated in the absence of a competition. See decision here.