Innovation strategy: economic evidence paper

2. Drivers of Innovation

There are many factors that can influence the rate of innovation in an economy and the gains to economic growth that it brings. This section considers the key drivers, drawing on the available evidence on their role in encouraging innovation and Scotland's performance in each area.

2.1 Private and Public Investment in R&D

Investment in R&D, whether it is public or private, is generally considered a central pillar of innovation. By seeking new knowledge through research, companies innovate by developing, designing and enhancing products, services, technologies and processes.

Analysis by the UK Government^[6] finds that private R&D investment successfully fosters innovation in firms, especially in terms of process innovation and the introduction of new-to-business and new-to-market innovative products. The research does not find evidence to suggest that public R&D crowds out private R&D. Instead, it finds that public R&D seems beneficial as it supports new-to-market innovative products, with different impacts by UK region and firm size.

A review of Scotland's R&D investment performance is provided in section 4.1.

2.2 Organisational and Management Structures and Practices

Innovative success is dependent on far more than just investment. Within firms, the organisational and management structures themselves can have a significant effect on the propensity to innovate. Recent ONS research^[7] exploring the relationship between management practices and innovative activity found that firms with a higher management practice score were significantly more likely to undertake R&D. Additionally, the relationship between productivity and R&D was significantly stronger for firms with a higher management practice score.

Innovation policy tends to focus on how best to encourage businesses to undertake research and innovate themselves, but it is also important to consider how best to empower businesses to adapt their organisational structures to adopt existing innovative technologies and practices. This is important, because widespread productivity gains from effective utilisation of general-purpose technologies such as electricity in the 19^th - 20^th centuries and digital technologies in the 21^st century have tended to emerge slowly despite obvious benefits. If technological diffusion is slow, it can dampen productivity growth because of the impact of 'laggard firms' on the performance of the overall economy.

ONS research^[8] looking at management practices across the (NUTS 1) nations and regions of Great Britain over the period 2016 - 2020 found that of the 11 regions, Scotland saw the biggest improvement in its management practice score over the period and held the joint highest mean score in 2020 (along with the Southeast of England).

2.3 Human Capital

The level of human capital^[9] within an economy and the skills of the labour force also play a significant role in innovation, both directly and indirectly. In a direct sense, this will spur innovation as educated and well-trained workers are more likely to introduce new products or implement new processes. In an indirect sense, highly skilled workers can drive innovation as they are more able to absorb new knowledge and ideas, thereby maximising knowledge and technology spill overs of innovations from other firms. This knowledge absorption element of human capital is especially relevant for digital skills, which are becoming increasingly more important as a driver of innovation.

For example, the 2021 Digital Economy Business Survey (DEBS) 2021 found that digital technology helped around a third of businesses to create new or significantly improved products or services. It also made business processes more efficient (59% of businesses), increased skills (48%) and enhanced competitiveness (41%). DEBS shows promising results for digitalization in Scotland^[10]. 97% of businesses reported being connected to the internet, and almost all digital technologies saw an increase in use from 2017 to 2021. However, the uptake of some technologies is still fairly low, such as management software (20%) and data analytics (40%).

Digital skills are essential if businesses are to benefit from digital adoption and to develop better business models. However, only 1 in 5 Scottish businesses felt fully equipped with digital skills in 2021 - 15% reported that they were not very well equipped and had considerable skills gaps. While many businesses reported skills gaps, 46% of those surveyed were not taking, or planning to take, any action to address digital skills gaps. Amongst businesses with relevant skills gaps who were not taking action to address them, the most commonly cited barriers include 'resource or time constraints', and costs. Of the businesses that reported skills gaps, 23% were not able to identify specific skills for improvement, highlighting some knowledge barriers.

2.4 Culture and Ecosystem

A key enabler of innovation is that of an innovative culture or eco-system, both at the firm and industry level. Innovation centres, innovation networks and clusters play an important role in supporting innovation (and, indeed, entrepreneurial) ecosystems. At the firm level, a workplace culture that connects workers to the strategic direction of the firm and facilitates opportunities for employees to participate in organisational decisions can be instrumental in encouraging a continuous flow of ideas that support innovation efforts. At a sector wide level, peer-to-peer business networks, industry clusters, and academia-industry collaboration can have significant effects in the sharing and development of new ideas, as well as facilitating the adoption of new knowledge and technologies. A good example of a sector level innovative culture is Silicon Valley, where academia, private sector and US government have all converged to create an environment that has enabled numerous tech start-ups to flourish.

2.5 Enterprise and Entrepreneurship

Entrepreneurship is a central driver for a growing, innovating and dynamic business base. Entrepreneurship can be defined as the ability to identify business opportunities and to translate them into viable business propositions that deliver economic impact and desirable social and environmental change. By innovating through the creation of new technology and processes, entrepreneurs cause productivity increases as those innovations diffuse across the economy. Furthermore, entrepreneurs are the primary source of 'creative destruction'^[11] whereby incumbent firms are displaced, and resources are reallocated in a more efficient way, leading to long term productivity growth.

While there is no target for the start-up survival rate in Scotland, there is a significant gap to close if Scotland is to match the best performing advanced economies. For instance, to match the best performing OECD countries, Scotland would need to raise its 3-year and 5-year business survival rate by around 20 percentage points^[12]. Additionally, Scotland has a deficit of high-growth firms when compared with other countries, and there is evidence of constraints to business growth in the wider enterprise ecosystem.

The Scottish Government's National Performance Framework (NPF)^[13] tracks Scotland's business creation using the Total Early-stage Entrepreneurial Activity (TEA) rate^[14]. On this measure, Scotland's entrepreneurial activity has gradually improved over time but remains significantly below that of other advanced economies, sitting in the second quartile of OECD countries^[15]. Scotland's TEA rate would have to increase by around 70% if it is to match the performance of other small, advanced economies like Ireland^[16].

Successful, advanced entrepreneurial economies tend to feature thriving eco-systems, often operating through a "triple helix" of private sector, public sector and universities and linked to sectoral clusters. Edinburgh is a good example of this in action within Scotland.^[17] Nurturing entrepreneurial ecosystems requires building cultural, social and material attributes,^[18] including education, role models, access to peers, celebration of success, learning from 'failure', social ties, entrepreneurial networks, skilled workers and access to talent and appropriate and diverse investment capital. Entrepreneurship can flourish when these attributes are supported by key institutions including universities (which are often anchor institutions), favourable government policies and appropriate infrastructure including transport, super-fast broadband and access to cultural activities including, for example, attractive places for entrepreneurs to come together in a "market-square" type environment.^[19]

The funnel model outlined in Scottish Technology Ecosystem Review^[20] provides a useful illustration of the importance of the local ecosystem in determining the rate of narrowing of the number of firms as they move through the stages from start-up to scale-up. It notes the opportunity that exists to improve ecosystems to close the gap between Scotland's current rate of funnel decay and the natural rate^[21]. Further detail on the funnel model is provided in Annex 1.

2.6 Inward Investment and Exporting

Analysis underpinning Scotland's Inward investment plan^[22] found there are strong links between Scotland's university knowledge base, inward investment and innovation, and that foreign owned businesses typically invest more in business R&D spending. Additionally, these inward investors can further boost innovation in the Scottish economy through their engagement with domestic businesses. This can either be due to increased competitive pressures spurring innovation in domestic firms (competition effects), or through domestic businesses adopting the innovative processes of foreign owned firms (demonstration effects). Demonstration effects can also drive innovations through supply chains, as inward investment companies may share knowledge with domestic suppliers in order to improve inputs to production. Furthermore, employees of innovative inward investment companies may use the knowledge they have gained to start their own innovative companies.

Similarly, Scotland's export strategy, A Trading Nation^[23], notes that, as well as driving business performance and scale, access to international markets and competition drives innovation and productivity growth. Evidence indicates that there is a strong correlation between exporting and innovation. Innovative businesses are more likely to export, and the experience of exporting can be a strong driver of investment in innovation and R&D as businesses compete in new markets. Additionally, evidence from the Enterprise Research Centre^[24] finds that internationally active SMEs are three times more likely to introduce innovative products or services than those focusing entirely on the domestic market. Currently only one in five UK SMEs are exporters. However, estimates suggest that between nine and 12 per cent of non-exporting firms within the UK could become exporters.