Council of Economic Advisers: annual report 2015-2016

4. Innovation ^[34]

An economy's innovation performance has an important bearing on its dynamism, growth, and overall economic performance ^[35] . Innovation helps support growth through its contribution to improving the economy's capital stock; via business investment in knowledge-based capital, such as R&D, design, and firm-specific skills; from supporting increased total factor productivity; and, through innovative and more productive firms challenging less-productive rivals. Innovation-led growth can also support more inclusive growth, particularly if it broadens economic opportunities and rests on improved workplace practices.

Innovation itself is a broad concept. It includes research and development activities, but also encompasses the introduction of new products and processes, improvements in marketing, and changes in organisation within firms. These changes might be new to businesses or organisations themselves, with them absorbing new ideas, technology or ways of doing things from others. Innovations can also be new to the markets those organisations operate in, or to the world more generally.

The nature of innovation, and the diffusion and absorption of new innovations across an economy, are complex ^[36] . The success of a company or organisation's innovations are inherently uncertain, and associated with risk and the chance of failure. Innovation is cumulative, with previous products, learning and approaches contributing to future innovation. It is also a collective endeavour, involving those developing, financing, introducing, and working with new ideas, products, and ways of doing things. These each have implications for the role of governments and the public sector in this area.

Scotland's innovation heritage is well-known, with Scottish inventors and institutions having been responsible for significant advances in science, engineering and technology throughout recent centuries. It also has a number of strengths, including world-leading academic institutions, innovative companies across a range of sectors, and a skilled workforce. However, Scotland also faces a number of challenges, ranging from the long-standing under-investment in innovation among its business base, to the implications of the EU referendum result for Scotland's academic and business sectors.

Innovation is one of the '4I's' in Scotland's Economic Strategy, and improving Scotland's innovation performance is a challenge that has implications across the public and private sectors in Scotland. The Council is one of several groups advising the Scottish Government on innovation policy, with others including the Scotland CAN DO Innovation Forum. The Council's workstream on innovation has aimed to complement the advice being provided by these other advisory groups, providing an international perspective on Scotland's broader innovation performance and challenges, and to offer insights around how these could inform and shape the Scottish Government's innovation policy.

Scotland's performance in an international context

Among advanced economies, Scotland is mid-ranking in terms of its innovation performance, with the European Commission classifying Scotland as a 'Strong Innovator'. Scotland's overall performance is stronger than a number of European regions and countries; however, Scotland lags behind a number of the most innovative regions of both the UK and Europe ^[37] . Scotland's performance differs across enablers of innovation performance, firm activities, and innovation outputs, with notable areas of relative strength and weakness.

In terms of factors the European Commission identifies as enablers of innovation, Scotland is among the leading EU regions in terms of the share of the population educated to degree level, and in terms of public sector R&D intensity (expenditure on R&D as a share of GDP). Scotland would rank 2 ^nd among EU countries in terms of university graduates as a share of the adult population, while Scotland's expenditure on higher education R&D would be the fifth-highest in the OECD ^[38] .

However, Scotland's performance around firm innovation activities is more mixed ^[39] . Scotland's firms appear to under-invest in research, as private sector R&D intensity (business expenditure on R&D ( BERD) as a share of GDP) is low by international standards, and is substantially below both the UK rate, and the EU and OECD averages ^[40] . Scotland's firms invest around the EU average on non-R&D innovation. Scotland's rates of patent applications are also lower than the EU average, while Scotland also has a notably lower share of SMEs innovating in-house than the EU average. However, Scotland's innovative SMEs are amongst the most likely to collaborate with others in their innovation activities within the EU ^[41] .

Scotland's investment performance is partly explained by industrial structure - a relatively low proportion of Scotland's private sector jobs are concentrated in R&D intensive sectors - but also by expenditure within those sectors. For instance, R&D expenditure per job within Scotland is lower than high performing countries within R&D intensive sectors. Expenditure is overly reliant on a small number of firms: in 2014 the top 5 firms accounted for almost a third of R&D spending, and the largest companies (400 employees and over) accounted for over 60 per cent of total BERD expenditure ^[42] .

When it comes to Innovation Outputs, Scotland lags behind the leading regions of the EU, both in terms of introducing innovations, and wider economic effects ^[43] . While Scotland's share of SMEs introducing marketing or organisational innovations is close to the EU average, the share of SMEs introducing product or process innovations is substantially lower than the EU average.

These findings are supported by analysis of the Community Innovation Survey, which shows that Scotland has a lower share of 'innovation active' businesses than both the UK and the EU average. It also reveals that, while Scotland's larger businesses are more likely to be innovative than smaller or medium-sized businesses, Scotland particularly lags behind other European countries in terms of the innovation rates of medium-sized businesses and large-sized businesses, as Table 2 illustrates.

Table 2: Share of Innovation Active by Business Size, 2010-12

	Small	Medium	Large	All
Scotland	46.3%	48.2%	58.8%	47.1%
UK	49.0%	56.8%	56.6%	50.6%
Germany	63.3%	74.3%	92.2%	66.9%
Denmark	47.5%	57.5%	79.7%	51.1%
Austria	48.7%	70.9%	84.0%	54.4%
Sweden	52.8%	65.6%	81.9%	55.9%
Finland	48.1%	65.0%	77.7%	52.6%
EU (28)	45.2%	60.5%	76.4%	48.9%

Source: Eurostat and Scottish Government analysis of the UK Community Innovation Survey

Scotland's Innovation Landscape

There are a substantial number of organisations involved in providing funding and support to innovation in Scotland. These include a variety of private sector, public sector and other actors, such as Higher Education institutions and Innovation Centres. Organisations such as Scottish Enterprise, Highlands and Islands Enterprise, and the Scottish Funding Council, have roles that cut across several aspects of Scotland's innovation system. Scotland also sits within the broader UK innovation system, and a wider system of European funding and support.

Figure 2 provides a high level illustration of the different actors involved in the system, and their roles.

Figure 2: Participants in the Scottish Innovation System

There are Scottish, UK and European dimensions to support for innovation and research. Support for innovation can also take a variety of forms, from direct grant support, through to equity investment, support for knowledge exchange activities, and advice and support for business development.

Financial support for innovation and research in Scotland is provided from Scottish, UK and European sources. EU and UK funds are usually run on a competitive basis and depend on Scottish Higher Education Institutes and businesses bidding and winning. While funding is not guaranteed, Scotland has traditionally performed well, especially in terms of academic participation in EU programmes (such as Horizon 2020) and funds from Research Council UK. For instance, as of November 2015, Scotland had secured funding of over €158 million from Horizon 2020, over 11 per cent of the funding awarded to the UK. Within this, Higher Education Institutions and research institutes had secured €132 million, while Scottish businesses had secured around €22.5 million.

Funding from Scottish sources (such as the Scottish Funding Council, Scottish Enterprise, or Highlands and Islands Enterprise) is generally disbursed through variety of specific schemes or competitions that require businesses or Higher Education Institutes to make a case for funding in line with the programme's requirements. In addition, there are financial instruments that can be used to support innovative, business-led projects (such as the Scottish Investment Bank, and the Co-investment Fund). Individual schemes have distinct criteria, and often operate within sectoral or geographical restrictions.

Opportunities and Challenges for Scotland

In his statement to Parliament on the Draft Budget for 2016-17, the Deputy First Minister outlined the broad direction of reforms for Scotland's innovation approach, based around the need to further align approaches to innovation, pool funding, and simplify both the landscape and access to support. This is set against the backdrop of the tightening fiscal environment faced by the Scottish public sector, and reforms to innovation at the UK level, such as the simplification of support offered by bodies like Innovate UK.

The evidence considered by the Council, our experience of Scotland, and discussions both within the Council and with bodies such as the Scotland CAN DO Innovation Forum, all suggest that Scotland has a number of strong foundations that can be built on. Scotland has a number of highly innovative companies with presences in important sectors, such as life sciences and digital industries, and a strong research base underpinned by world class universities and research institutes. Combinations of these factors, in areas like Edinburgh's digital cluster, have helped bring international-level success in these areas.

However, the evidence also points to Scotland having a smaller base of innovation-active companies than both the UK overall, and a number of Scotland's international competitors. There is still scope to encourage and achieve greater collaboration between Scotland's academic institutions and its business base, although there has been progress in recent years on this front.

There are a number of challenges for the Scottish Government and its partners around reform of innovation support. In our discussions, the Council have emphasised the importance of taking a systematic approach to thinking about these challenges, and using a systematic approach when undertaking reform. In order for reforms to be well-targeted and designed, it is important that they rest on a solid understanding of not only how new knowledge and research is undertaken, but also to how innovations spread and are adopted throughout the Scottish economy, and how this is helped by bodies and actors that operate within the system. This would underpin a common understanding of the system's strengths and weaknesses, the assets that can be built upon, and the vulnerabilities that need to be addressed.

Alongside this, our discussions have highlighted the importance of the Scottish Government and its partners having a shared vision of the kind of economy that Scotland should have, the role of innovation within this, and of where Scotland's ambitions are on innovation. Related to this is what the Scottish Government and its partners view their role as being within the innovation economy in Scotland. A traditional view of the public sector's role focuses on addressing market failures, or creating 'level playing fields'. However, the Council believes that this view misses several important dimensions of the position that the public sector occupies.

The US experience shows that Government can play an important role at each stage of the 'innovation chain', not just at the basic research stage ^[44] . The public sector has an important role as a long term investor, as a provider of patient finance, and setting and supporting 'mission-oriented policies' that can guide and influence others' innovation activity.

Mission-oriented policies can be defined as systemic public policies that draw on frontier knowledge to attain specific goals. It is policy driven by challenges which are not amenable to simple solutions but require simultaneous changes in behaviour and innovation across many different sectors, by both public and private actors. Mission-oriented policies use the positive potential of public organisations to take risks and spur coordinated action to solve these difficult problems. These have the potential to improve a country's innovation performance, with wider economic and social benefits. However, adopting such an approach in Scotland requires assessments of the opportunities open to Scotland, and the areas where its assets and expertise can be best directed.

The Council's discussions have emphasised the importance of the Scottish Government and its partners being prepared to lead by example, in particular through making long term, patient investments. However, underpinning these are the need for a clear view of where Scotland's competitive strengths lie, an ability to flexibly and rapidly appraise and respond to emerging opportunities. It also requires the Scottish Government and its agencies to look to foster collaboration between and within Scotland's institutions, agencies, and business base; to reappraise the range and variety of support they provide, to ensure they are focused on supporting the outcomes that are sought for Scotland's economy; and to move away from areas where investments are not productive. These are challenging, and complicated by the important role played by both EU and UK funding in supporting institutions and research in Scotland.

Underneath this is a broader, and more profound challenge: how to change the culture around innovation in Scotland. In part, this includes moving towards a mission-oriented approach, should Scotland's assets and opportunities permit it. However, it also relates to the wider challenge of Scotland's firms becoming more dynamic. In part, this means taking a broader view of innovation than one that focuses simply on R&D, and on science-based activities; instead, moving towards a position where Scotland's business base continually seeks to improve their products, processes, and ways of doing business are important contributors to every businesses' competitiveness. This will be a profound shift, but one that is necessary to improve Scotland's economic performance.