Council of Economic Advisers: Chair's report 2016-2018

4 - Workstream 2: Innovation

Remit:

• To provide an international perspective on Scotland's broader innovation performance and challenges, and
• to help identify specific actions that could be taken forward to illuminate and improve Scotland's performance.

Key activities: issue response to UK industrial strategy consultation; insight and comment on investment banks, especially around work of Mariana Mazzucato.

Innovation is one of the four drivers in Scotland's Economic Strategy for supporting both increased competitiveness and tackling inequality. The Council has been taking forward a workstream on innovation, which has concentrated on placing Scotland's performance in an international context, exploring issues related to mission-oriented innovation, and developing an appreciation of the challenges facing Scotland.

In late 2016, the Council decided to refocus the workstream to advise on dimensions of industrial strategy. This consideration included government plans relating to manufacturing and other key activities in the Scottish Government's Innovation Action Plan launched in January 2017. The focus has been innovation in the context of the provision of patient capital for investment and business growth.

Also in January 2017, the UK Government launched a Green Paper on Industrial Strategy ^[15]. The Council believed that this was an opportune moment to contribute to this dialogue and reflect Scottish priorities. Boosting access to finance in Scotland – especially for SMEs – and supporting innovation continue to be a focus of the Council. In April 2017, we provided an independent submission ^[16] to the White Paper, presenting the case for a national investment bank in Scotland.

In September 2017, the Scottish Government Programme for Government 2017-18 announced the appointment of Benny Higgins (formerly of Tesco Bank) to launch the development of a Scottish National Investment Bank. Since then, the Scottish Government published the Implementation Plan in February 2018 and developments are moving forward; and so this has been an exciting area to contribute to.

This section provides an overview of the evidence considered by the Council regarding the innovation performance and policy context in Scotland, and the discussions around the role of an investment bank, plus the Scottish Government developments in establishing a Scottish National Investment Bank.

4.1. Context

Scotland's Innovation Performance

The term innovation covers the development and implementation of new technologies and practices. The UK Innovation Survey 2017 results showed that 46% of enterprises were innovation active in Scotland in the 2014-16 period, this is down from 51% in the previous period (2012-14) driven by a decline in wider (organisational/marketing) innovation activity (rather than product/process innovation).

Internationally, Scotland lags behind the UK, the EU and the OECD in terms of overall Gross Expenditure on R&D expenditure as a share of GDP. The gap with other countries is largely as a result of relatively low business R&D spend in Scotland. Whereas Scotland's Higher Education R&D expenditure as a share of GDP ranked fifth highest in the OECD in 2016.

For business expenditure on R&D as a share of GDP, Scotland trails the UK, the EU and OECD (see Figure 4 below); highlighting that there is significant scope for businesses to increase investment. However, there are some signs of improvement; business expenditure in R&D rose in 2016 to exceed £1 billion for the first time.

Figure 4: Business Expenditure on R&D (as % of GDP), 2001-2016

Source: Scottish Government

Innovation and Industrial Landscape in Scotland

Having a thriving and dynamic innovation ecosystem is essential for improved productivity, competiveness, and growth. Scotland is renowned as an innovative country, with many Scottish inventions having been instrumental in progressing industry and the day-to-day living of people across the globe. Today, innovation amongst universities, businesses, and independent organisations, continues to mark the Scottish industrial landscape. Finance provided by a number of both public and private organisations supports much of this. The box below highlights a number of actions the Government is taking to grow innovation in Scotland. These actions considered by the Council cover initiatives to strengthen the role of manufacturing, boosting innovation, and increasing international trade and investment across sectors.

Furthermore, industrial policy is an approach that supports particular sectors to promote productivity and growth for those sectors and for the whole economy. Industrial policies are returning to prominence in the UK, driven by the financial crisis of 2007-2008 and its aftermath; by examples of successful industrial policies pursued by other developed and developing countries; and given energy by the EU referendum result. The Scottish Government's approach to industrial policy looks at investment as well as integrating new technology, innovation, methods, processes, skills, and business models into the company base.

Scottish Government Policy Action

• The Innovation Action Plan for Scotland: published on January 2017, this sets out four key steps and associated actions to support Scotland's innovation.

  1. Directly encouraging more business innovation: setting a goal in Programme for Government 2017 to double Business Enterprise Research and Development (BERD) from £871 million in 2015 to £1.75 billion by 2025, and committing an additional £45 million over the next three years to Research & Development grants for business to support this.

  2. Using public sector needs and spend to catalyse innovation: launched the £9 million CAN DO Innovation Challenge Fund, which uses private sector innovation to solve public sector challenges and providing £600k part funding for CivTech - the world's first cross-public-sector tech accelerator.

  3. Supporting innovation across sectors and places: developing and delivering the National Manufacturing Institute for Scotland - a centre for manufacturing excellence and a skills academy that will be a hub for stimulating innovation, improving productivity and increasing investment in the sector, with Strathclyde University as the anchor university.

  4. Making best use of University research, knowledge, and talent to drive growth, and equip Scotland's people with the tools and skills needed to innovate: including the £500k College Innovation Fund; and, continuing to support the network of eight Innovation Centres, including backing for the £1 million Innovation Centres: Cancer Innovation Challenge.

Access to Finance in Scotland

To sustain a thriving innovative landscape, a strong capital and investment base is essential. The Council therefore considered access to finance in Scotland.

Data from the Small Business Survey 2016 indicates that 68% of SMEs in Scotland that applied for external finance obtained some or all finance sought, while 12% did not receive applied-for funding. The survey however indicates that only 16% of Small and Medium Enterprises (SMEs) applied for finance in the 12 months analysed. This figure reflects a relatively low demand for finance. In addition, 11% of SMEs in Scotland also reported needing, but not applying for, finance in the previous 12 months, an increase from 9% reported in the 2015 Survey. ^[17]

Figure 5: Business investment % GDP, Scotland, 1998-2016

Source: Scottish Government

Furthermore, in Scotland, business investment as a share of GDP decreased from 10.9% in 1998 to 6.9% in 2005 (see Figure 5 above); and has remained relatively stable between 2005 and 2016 at around 7.5% on average. Data for the first three quarters of 2017 indicated that business investment as a share of GDP in Scotland fell to around 6.1% on average over the first three quarters. If this trend continues in Q4 2017 then 2017 will represent the year in which business investment has made its lowest contribution to GDP across the whole time series.

The Council also reviewed the report on the Scottish Risk Capital Market, which showed total annual early stage risk capital investment in Scotland reached £334 million. However, this figure does not reflect the majority of activity or underlying trend since a small number of very large, or 'megadeals' (above £10 million) each year can skew overall market activity. After removing megadeals, the total investment for 2016 is £189 million, the highest point for over a decade.

The main source of patient capital in Scotland is at the early investment stage undertaken by business angels and business angel syndicates, who provide equity investment to a number of young, innovative Scottish companies. Scotland currently has a well-developed and professional informal investment market, with 18 active business angel syndicates, supported by their trade body, LINC Scotland. The most recent risk capital market report shows that business angels, angel syndicates, and equity crowd funding platforms doubled their investment activity in 2016 compared with 2015.

After consideration of the evidence, it is clear that there is a persistent funding gap in the provision of microfinance, debt, and early stage equity for SMEs in Scotland, presenting a business case for government intervention. As the market for SME finance is continually evolving, the precise scale and nature of the funding gap changes over time. However, funding gaps that exist reflect two broad factors:

• Long-standing structural and systemic gaps that primarily affect certain types of firms (e.g. start-ups, early stage high-growth companies and technology-intensive firms); and,
• Cyclical gaps in lending that affect a range of SMEs and reflect changes in economic conditions and regulatory requirements

The debt gap in Scotland is estimated to range between £330 million and £750 million per year in Scotland ^[18]. Gaps exist from the very smallest levels of finance (microfinance from £500 to £25,000) and from £25,000 to £100,000 and extend up to £1 million - £2 million. For more information, please see the Scottish National Investment Bank Implementation Plan ^[19].

Scottish Government Policy Action

To support the access to finance in Scotland, the Scottish Government and its agencies work proactively to supply products and services to support businesses. The approach centres on increasing the level of funding available to SMEs; expanding and deepening financial support and advice for SMEs; and, providing easier access for SMEs seeking finance. Therefore, providing support to growth businesses: "Investing in ambition", tools include:

• The SME Holding Fund: a Fund-of-Funds model which supplies microfinance, debt and equity to SMEs, as well as supporting the capacity and capability of Scotland's business angel market to increase the supply of capital available to young, innovative businesses;

• The Scottish Growth Scheme: a 2016 Programme for Government announcement providing a £500 million package of support for the 3 year period to June 2020. Targeting, high growth, innovative, technology based, and export focused businesses. Currently two substantive components in place: First product, the £200 million Scottish–European Growth Co-investment Programme, provides equity funding above £2 million; and the new, additional funding to support early stage equity funding up to £2 million.

Scottish Enterprise operates initiatives to directly incentivise business innovation, and commercialise R&D from Scotland's universities and research base. In addition, European funding, particularly from the European Regional Development Fund (ERDF), has been used significantly across Scotland and is a key source of capital for the SME Holding Fund. Scotland is able to access ERDF whilst it is part of the European Union, and the current Programme of EU funds (2014-22) will be the last available to Scotland, therefore it is important that the Scottish Government use the available resources to secure a long-term legacy.

4.2. Discussion

Patient Capital and Investment Banks

In 2017, the Council considered evidence on the role of government in providing patient capital, and the opportunity and challenge of potentially establishing a national investment bank in Scotland. Patient capital is the name given for long-term capital, where investors are willing to forgo shorter term, immediate returns in anticipation of more substantial returns over a much longer period, typically 10-15 years and often provided in the form of equity, debt, loan guarantees, or other financial instruments.

Over recent years, a national investment bank (also known as promotional or development bank) ^[20] has been suggested as a policy vehicle to address the importance of increasing the supply of patient capital within the economy ^[21]. Investment banks are defined as: 'legal entities carrying out financial activities on a professional basis which are given a mandate by a Member State or a Member State's entity at central, regional or local level, to carry out development or promotional activities'. ^[22] They are public entities, whereby the state owns a substantial share of their equity, with the purpose of facilitating access to finance for start-ups and SMEs that face obstacles to raising financing from the market.

Considering an Investment Bank for Scotland

The Council considered approaches to supporting patient capital; in particular, we considered the examples of public banks and funds operating within Europe. We discussed the international evidence in the context of the Scottish Government approach to the provision of long-term capital to SMEs; the Scottish Government's main policy tools (for example the SME Holding Fund); and the potential benefits and opportunities created by a national investment bank ^[23].

Key evidence considered in these discussions was the research carried out by Mariana Mazzucato - and co-authored by Honorary Research Fellow Laurie Macfarlane - in the role of Director Institute for Innovation and Public Purpose, University College London. Two working papers were considered. The first paper ^[24], drawing together the evidence of six international state investment banks and the opportunities for state investment banks in the UK. And, the second paper ^[25], investigating the design of eight international investment banks and how these affect the provision of patient capital. Overall, Governments have historically played a key role in bringing about technological advances, and in doing so have created many high growth businesses.

Investment banks offer loan products and other types of financial instruments to SMEs either directly, or in an intermediary capacity, usually via commercial banks in order to ensure complementarity and avoid duplication of private sector provision. In addition, some national governments also provide investment banks with state guarantees and with funding to lend to SMEs. While almost all investment banks are involved in SME lending, a small number also lend for other purposes, such as to regional or local levels of government to invest in infrastructure and through public-private partnerships.

In exercising their roles in support of SMEs, investment banks can carry out a variety of economic functions ^[26], including:

• Address market failures such as lack of access to finance for SMEs, thereby serving as a public policy instrument;
• Provide countercyclical financing during periods of economic and financial crisis, to help counter the decline in commercial banking activity that typically follows economic or financial crises;
• Promote economic development and strengthen national and regional competitiveness; and
• Increase understanding of access to finance issues for start-ups and SMEs.

The Council's discussions highlighted a few areas where patient capital could help to contribute to long-term growth in Scotland, including investing in science and research. In particular, our discussions emphasised that an investment bank could prove a valuable tool in driving forward business start-ups, business growth and stimulating innovation led growth. Most importantly, to move towards inclusive growth in Scotland, the private sector needs to grow, invest, and innovate to create good quality jobs and opportunities.

Resulting from these considerations, the Council provided an independent submission ^[27] to the 2017 UK Government Industrial Strategy Green Paper ^[28]. This focused on the provision of patient capital in the devolved context, and the constraints within the current UK institutional arrangements.

Challenges in Establishing a National Investment Bank

After consulting a range of evidence, the Council agreed that to pursue the development of a national investment bank for Scotland would be a positive step, though would require substantial preparatory work to ensure effectiveness. The potential increase in innovation led growth resulting from the activities of a Scottish national investment bank merits the effort in pursuing the creation of such an institution for Scotland.

The Council considered the challenges associated with the establishment of an investment bank within a Scottish context and the preparatory work required. This includes the requirement for a clear understanding of UK Government and potential EU approvals required. In addition, officials made clear early in development that the governance structure underpinning the institution would need to be determined in advance of its establishment. This would include establishing the extent of government control, through the institution's memorandum, its shareholding structure, initial appointments to the institution's board and subsequent appointment arrangements, supervision arrangements, and control of financing decisions.

Consideration was also given to the impact on Scottish Government budgets in light of the agreements between devolved administrations and UK Government. This was especially in relation to the classification of an investment bank as either a Public or Private Sector institution.

Scottish Government Policy Action

• The Development of the Scottish National Investment Bank

The First Minister announced in the Programme for Government 2017-18 that the Scottish Government will establish a Scottish National Investment Bank (the Bank). Benny Higgins was appointed to lead on development of an Implementation Plan for the Bank. An open consultation ran from October 2017 to November 2017, and received over 1000 responses.

In February 2018, an Implementation Plan (IP) with 21 recommendations was published which provided an overview for the focus of the Bank's proposed activities and arrangements. Cabinet has subsequently endorsed the IP on 17 April, and Parliamentary support has been confirmed in a debate on 8 May in the Scottish Parliament. The vision set out for the Bank is that:
"The Scottish National Investment Bank will provide finance and act to catalyse private investment to achieve a step change in growth for the Scottish economy by powering innovation and accelerating the move to a low carbon, high-tech, connected, globally competitive and inclusive economy."

The Council reviewed the published IP and the set of principles to inform investment and governance. Key points include:

• The Bank will necessitate setting up a new public body;
• The Bank will offer financing (debt and equity that must be repaid) on a commercial basis, typically over a 10-15 year period;
• Recommended target capitalisation of £2 billion over 10 years, taking the Building Scotland Fund and initial capitalisation into account;
• The Bank should be operationally and administratively independent from Ministers with an independent Chair and Board who will make decisions about how to invest and where to invest and in which sectors to invest;
• Ministers should set the overall strategic direction for the Bank in the form of missions; and
• The Bank will not offer retail banking services (i.e. take deposits, offer mortgages, or operate a branch network).

However, the IP notes that a key dependency remains the requirement of a dispensation from HM Treasury for the Bank to carry cash balances between financial years, and any restrictions or limitations that they propose in relation to this.

In terms of the operations of the Bank, the Implementation Plan recognises that Scotland has well-established public sector support; providing funding and financing advice, and the provision of funding and financing directly or indirectly to companies seeking to grow. The IP therefore recommends that the new Bank should integrate existing financing activities provided by SG and its agencies into its remit and operating model, thereby building on the success of operations and initiatives underway, and offering an opportunity to develop strengths and build on existing skills. The Scottish Government recognises this will be a key piece of early work in transition planning.

Reflections and Recommendations for Innovation

Concerning industrial policy

The Council were encouraged by the work on industrial policies in Scotland including the policies to support manufacturing in Scotland. We advise investigating opportunities beyond existing areas of manufacturing including new areas of science. Recognising Scotland's unique advantages is essential to informing development of industrial strategy for Scotland. In addition, investigating synergies across and between manufacturing and service sectors could inform strategy, and all industrial policies should consider regional impacts.

Concerning the role of an investment bank

The Council's workstream on innovation across 2017-18 has mostly centred on the role of an investment bank. The period 2016 to 2018 has been pivotal for the future delivery of patient capital in Scotland. The Council has played a significant role in investigating the opportunities for Scotland that a national investment bank may provide, and are encouraged by the progress already made. We recommend the Scottish Government continue to review international and UK evidence of investment banks, and similar institutions, in the development of the Scottish National Investment Bank; including investigating the impact of an investment bank on the wider financial ecosystem.

The Council is supportive of the development to date of the Scottish National Investment Bank, including the publication of the Implementation Plan in February 2018. We encourage on-going and thorough consideration of, and clarity on, the proposed operations and governance of the Bank, to ensure effectiveness and sustainability. The ambition to address cross-sectoral challenges could be pivotal in creating change and we recommend developing a set of missions that are framed around Scotland specific challenges. In particular, when developing the Bank, we recommend considering the role of the Bank to encourage innovation, and therefore innovation led growth. Additionally, the scope of the Banks activities should also focus on Small and Medium Sized Enterprises, but should also be sufficiently flexible to provide capital across a range of business types.

For the Council, most of this workstream relating to the Scottish National Investment Bank is now complete. Going forward, we will keep a watching brief on the development on the Bank and provide advice as and where appropriate.