By David Ruff, Portfolio Manager
The US Federal Trade Commission recently filed suit to stop Microsoft’s $69 billion purchase of Activision Blizzard, believing the deal limits gaming industry competition. Many think the order shows the FTC appears to be moving toward a more aggressive stance against US technology giants. Possibly, but to date, it’s been the European Union imposing the greater regulatory influence against these US behemoths like Apple, Meta, and Google. This ability to regulate outside the EU’s own border or exhibiting extraterritorial regulatory enforcement capability isn’t limited to US firms but spans the globe. Called the “Brussels Effect” since most of the European Union institutions are based in this Belgium city, this mechanism not only sets standards for competition review, but promulgates rules and standards which effectively determine how almost any product, anywhere in the world, is produced and marketed as well as defining how businesses should operate. We believe this phenomenon is an important factor which will continue, as well as amplify in importance. Investors should increasingly take notice of the Brussels Effect in their investment process.
The EU regulatory infrastructure is well developed, comprised of the European Council, European Commission, European Parliament, and European Court of Justice. Each plays a major role and combined these institutions exhibit tremendous “soft power” in that no other jurisdictional force in the world has the EU’s unilateral ability to regulate global markets. To be clear, a “hard power” the EU is not, at least not yet. Lacking a cohesive military and with many narratives casting Europe’s unity project as a weak and fractious coalition, few consider the continent to be in the Superpower ranks of the US or China. Moreover, with expectations for continued relative economic underperformance, most assume fading EU global influence. We disagree. Europe does matter in regulation and it has a huge market, comprised of 27 countries and 447 million consumers, roughly 36% larger than the US. This is a potent force, pervading the global financial landscape, impacting both domestic and international companies alike. Against US technology companies the EU issued massive billion-dollar fines, defined data privacy requirements, and required substantive changes to their operations resulting in significant compliance cost. For mergers in other industries, it’s usually been the EU requiring more consequential divestitures for an acquisition to gain approval.
While the EU can only enforce restrictions in its own market, its initial goal of creating a single market provided the mechanism for de facto international application of EU policies. Aligning product standards across this single market, any company inside or outside the EU and wanting access must follow EU rules. To give a few examples, a Japanese company seeking to sell plastic toys in the EU cannot include any EU-restricted chemical elements like phthalate plasticizers in their products even though they’re allowed in Japan; Argentinian cattle feeders cannot utilize growth hormones if they want to export beef to the EU; African cocoa farmers can only apply EU-approved pesticides; Monsanto GMO seed is prohibited; and Mars hard candy has to use coloring dyes specified by the EU which are more restrictive than those allowed in the US. This last example illustrates why the US does not play a bigger role in global standard setting. EU standards are almost always more stringent. The US relies on market discipline and tort law and generally prescribes regulation to address known harmful effects. Companies making harmful consumer products will face extensive legal liabilities. US policy makers presume this governs corporate behavior. These remedies are much less available in Europe. Contrastingly, the European populace is generally less trusting of corporations, putting more faith in their governments and trained technocrats to protect them from harm. Further, the EU follows a precautionary regulatory model, vigorously seeking to address possible harmful effects even before any harm has happened. In comparison, the US, in general, judges this type of policy to be over regulation and innovation inhibiting.
The EU’s market power comes largely from the concept of indivisibility. Obviously, if an international merger is struck down in the EU, it is canceled worldwide. It’s irrelevant that the merger was approved in other jurisdictions; a merger of global companies cannot be implemented in some jurisdictions and not others. The US is powerless to stop this kind of influence by the EU even though the two merger candidate companies may be US based. Additionally, for cost efficiency purposes, companies almost always set up production and distribution systems that cater to EU standards even though their product may be destined for other markets. Apple, for instance, sets the security settings on iPhones sold in the US and world based on the EU GDPR (Global Data Protection Regulation) mandate.
EU rules have become increasingly commonplace outside the EU. This occurs as companies selling into the EU lobby for EU standards to be applied at home to prevent a local-only producer from gaining a production cost advantage. In this way, the EU passively extends policy standards worldwide. The extension to less developed African and South American countries is relatively easy since these countries don’t have the infrastructure or technocratic human skill pool to set up their own regulatory regimes. It’s much easier and cheaper to take EU regulatory code off the shelf, and can sometimes be lucrative to the local government, since EU fines levied against a company for rule infractions are frequently levied locally in copycat fashion. Other jurisdictions just leverage the EU’s work. For instance, California largely borrowed EU chemical disclosure and labeling requirements. Notably, Europe also takes an active role in their regulatory standards export by negotiating their standards and values into trade pacts. The EU-Mercosur Association Agreement has yet to be approved partially due to Europe’s demand for Brazil to end deforestation of the Amazon. The EU, being the larger market in any agreement, usually enjoys the upper hand in negotiations.
Some assume the sun may be setting on the EU’s regulatory hegemony. They argue faster growth in China and developing Asia versus Europe and the developed world with the concomitant advancement of this larger consumer market will ultimately lead to the “Beijing Effect” taking over the global standard setting role. Not likely in our opinion. First, given China’s much lower GDP per capita compared to Europe, consumer protection ranks lower in leadership’s priority relative to absolute economic growth at this stage of development. Second, the globe and Asia largely accept the EU’s role as consumer protection champion as indicated by the countries and regions outside Europe adopting EU regulatory policies. This is far too ingrained for China to change. Third, while China’s sharp rise in regulatory capacity in recent years has been notable, as policy makers executed meaningful changes in areas such as competition law, financial regulations, food safety, and environmental protection, we observe China usually emulates a version of EU rules. Finally, political motivation can play a larger role in Chinese regulation, such as not yet approving the Boeing 737 MAX aircraft for “safety” concerns even as everyone else in the world has reopened their skies to this aircraft. Other countries will not follow China when it plays such political games.
Consumer protections help policy makers mollify an increasingly well-informed local population, but more importantly from a policy maker perspective, Chinese firms enjoy continued access to the EU market when they follow EU rules. This proved paramount in the cosmetics industry where, at least initially, Brussels and Beijing disagreed. China required animal testing for products sold in China while the EU stipulated products sold in their market could not be animal tested. China did not share Europe’s concern for animal welfare until their own cosmetic industry wanted access to Europe’s market. To sell in both Europe and China, China’s cosmetic producers would have to create two completely separate product research and development systems. Unsurprisingly, as of May 2021, China no longer requires animal testing for general cosmetic products, harmonizing their regulations with the EU. As this illustrates, rather than taking over, we look for China and Asia to be instruments for the continued globalization of the Brussels Effect.
Whether you view the Brussels Effect as positive or negative is of little relevance from an investment perspective. The fact is, it exists, and is likely to continue to grow stronger. This impacts the global economy, industries, and individual companies in a pervasive and powerful way. Thus, we incorporate the Brussels Effect into our investment analysis. For instance, after an intensive review, we recently passed on a promising US chemical producer due, at least partially, to our belief that the company was on the wrong side of the Brussels Effect. On the other hand, we added an attractive energy company with extensive sustainable aviation fuel capability, and invested in a testing/certification company which helps companies stay in EU compliance. In these cases, the Brussels Effect should be a tailwind. Integrating Brussels Effect analysis into our intensive research process helps us differentiate between long-term winning and losing companies. This is an increasingly relevant aspect in generating competitive equity returns.
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