Foreign direct investment screening in the EU: time to address weaknesses

By Mihails Kozlovs, Member of the European Court of Auditors, Dean of Chamber IV – Regulation of markets and competitive economy

Introduction

The European Court of Auditors (ECA) in its role as the European Union’s (EU) external auditor audits not only the implementation of the EU budget, but also assesses the economy, effectiveness, and efficiency of EU policy actions.  One of the areas that we vetted recently in terms of the above and, in order to improve accountability and transparency, was the screening of Foreign direct investments (FDI) in the EU (See the Special report 27/2023: Screening foreign direct investment in the EU). Indeed, when it is decided to task, fully or partially, EU institutions with design and implementation of an EU policy, we are all interested if and to what extent the intended results of this important step have been achieved.

Openness to FDI is a key principle of the EU’s single market, and foreign investment can enhance growth and innovation in capital-receiving countries. However, investment in strategic sectors that are vital for security and public order in the EU (e.g. ports, nuclear plants, semi-conductors, or dual-use microchips) may at times create a risk of unwarranted control by non-EU investors (e.g. those involved in criminal activity, or controlled by foreign governments or armed forces). This risk has increased especially over the last years due to the new geopolitical environment and increasing vulnerabilities stemming from the EU’s dependencies. Clearly, the paradigm of unquestioned globalisation, off-shoring and (almost) unconditional transfer of technologies (especially in the outward direction) has been under constant review, arguably for good reasons.

Until very recently, many EU countries did not have any investment screening mechanism at all. The EU’s FDI screening Regulation (the Regulation, see here), that entered into full application in October 2020, established a cooperation mechanism for the first time, enabling member states and the Commission to share screening information and risk assessments on FDI. It aimed to ensure a coordinated approach (that has been missing up to that point) to the screening of FDI in strategic sectors that are vital for the security and functioning of the EU’s economy.

Although the Regulation was established using the EU’s exclusive competence for common commercial policy under Article 207 TFEU, the responsibility for national security and public order lies solely with the member states pursuant to Article 4(2) TEU. Therefore, it is up to member states to introduce (or not) a screening mechanism and define its scope. Moreover, the member states’ authorities are the only ones that can take decisions on individual FDI. In 2022 two thirds of all EU Member States had a FDI screening legislation in place (see the EU Commission’s Third Annual Report on the screening of foreign direct investments into the Union).

The ECA Report

The main objective of the ECA audit was to assess whether the EU framework for screening FDI (including the cooperation mechanism) is efficient and effective at addressing security and public-order risks. We examined both its design and its implementation by the Commission, reviewed a representative sample of cases notified by member states and assessed by the Commission, and all opinions the Commission issued between 2020 and 2022. The audit scope did not include the member states’ screening laws and decisions.

Our main finding after carrying out the audit work was that overall, the Commission has taken appropriate steps, within the current legal boundaries, to establish and implement a framework for the screening of foreign direct investment in the EU. However, we concluded that significant limitations still persisted across the EU, reducing the effectiveness and efficiency of the framework at identifying, assessing and mitigating security and public‐order risks. In simpler terms, if the EU desires to have a fully effective mechanism, the EU legislator would benefit from considering both structural and operational improvements.

First, due to the Regulation’s enabling rather than harmonising nature (and the Regulation still remains unchanged), there were member states and still are, that do not have an FDI screening mechanism in place (while at the same time some of them are by far the largest recipients (or conduits) of FDI). Also, the standards put in place for the screening mechanisms are minimal. Member states are under no obligation to inform the Commission or other member states of their final decisions in cases where the Commission or other member states respectively issue opinions or send comments identifying likely risks to security or public order. In addition, the Commission’s recommendations are not binding, and some terms, like the notion of “likely to affect security or public order” are not explained. Also, it is often not very clear which transactions are subject to screening. All this created and continues to create multiple blind spots and thus compromises the legitimate need for the EU to safeguard its security and public order interests.

Second, significant differences between the FDI screening mechanisms have led to a situation where, on the one hand, a large number of FDI is not subject to screening, and on the other – a substantial number of low‐risk or ineligible cases have overburdened the system. In our audit we tried to compare the aggregate number of notifications submitted by groups of member states in 2020 to 2022  to their respective FDI stock based on 2019‐2021 data. We were expecting a certain degree of correlation between the size of economies, the level of inward FDI and the number of notifications. But it did not materialise. Six member states with their respective share of 22 % of the total FDI stock together submitted 92 % of all cases, whereas a group of nine member states with screening mechanisms and their respective share of the FDI stock of 36 % submitted the remaining 8 %. A third group of 12 member states that did not screen or provide notification of any cases in the same period accounted for approximately 42 % of the average FDI stock of the EU. Clearly, in our view, this impacts the effectiveness of the framework and limits the overview that the Commission and other member states can have.

Thirdly, the Commission’s risk assessment certainly provides EU added value not only by identifying risks to security and public order relating to factors under Article 4 of the Regulation, but also by contributing to forward‐looking thinking on potential vulnerabilities and critical dependencies as they arise at EU level. However, the current approach has limitations in covering all types of risk, such as assessing past criminal or security‐related risks presented by individual investors at EU level. We found issues also with the quality of the Commission’s assessments that we reviewed regarding the description of the identified risks and their likelihood, links between the risk and the investment, quantification of the potential impact of an acquisition, consideration of other national and EU policies, the distinction between different roles and responsibilities of shareholders and management, and the highlighting of potential financial EU support to address certain risks.

And finally, in our view the information and data that the Commission and member states had provided were not sufficient to assess the efficiency and effectiveness of FDI screening and EU‐level cooperation. In its reports the Commission should focus more on critical risks and approaches to mitigating them. Also, the scope and quality of the underlying data should be improved.

Conclusion

In view of the above, we recommended that the Commission seeks the necessary amendments in the Regulation to strengthen the EU FDI screening framework by clarifying the key concepts of the framework and avoiding the current blind spots and inefficiencies and assesses national screening mechanisms for compliance with regulatory standards. This should cover streamlining of some practices like pre‐screening as well as aligning of criteria, timeframes, and processes across member state screening mechanisms. The Commission should also improve the cooperation mechanism and its assessments for providing better justification of mitigating actions related to high‐risk cases and improve the reporting process.

The Commission envisaged a review of the FDI Screening Regulation in its Communication on the Economic security strategy in June 2023 as part of the EU trade and investment policy toolbox. We believe that our findings would contribute to this process. If implemented, they would strengthen the framework while maintaining the right balance between ensuring on the one hand, that the EU remains an investment-friendly market and open to global capital, and, on the other hand, it sufficiently and reasonably, protects its security and public order.