Smoothing paths: The next generation in industry and innovation policy

Successive governments over decades have embraced industry policy as a way to boost economic growth, in many cases urged on by industry advocates – who often benefit.

But others, including many economists, are questioning the benefit of industry assistance. Some even claim that firms and industries grow despite, rather than because of, government assistance.

The potential effectiveness of industry policies is increasingly being debated. Israel’s high-tech industries, Germany’s national champions policy, and Singapore’s public investment in many industries are cited as evidence that industry policy works.

It is timely to ask what we know about policies that do work, those that might and those that do not.

Businesses have divergent views on innovation

To inform industry policy, it is necessary to understand what motivates businesses to innovate.

On behalf of the Office of Innovation and Science Australia (OISA), Nous Group recently undertook extensive consultation with businesses across Australia to explore innovation from their perspective in order to better understand what drives them to invest in innovation and what stops them. This work informed OISA’s recently released report on stimulating business investment in innovation.

Many businesses invest in innovation only under pressure, and when they do it is motivated by reducing their costs to stay competitive rather than investing to improve their performance and win new customers. Many also took a narrow view of innovation, seeing it as something that requires research and development (R&D). This view excludes investment in intangible and incremental improvement – like new accounting systems, organisational restructures or strategies to improve workplace culture. They saw government innovation programs as being about new-to-the-world products, rather than something for them.

A clear message from the innovation journeys of the more than 180 businesses that we engaged with was that successful innovators had four characteristics:

1. they took a deliberative approach to thinking about their investment and the changes they expected it would bring
2. they had a culture and leadership that encouraged all staff to be open to, and look for ways for, doing things better
3. they were customer-focused and customer-engaged across the whole organisation
4. they saw themselves as part of an ecosystem, so collaborated with other businesses and engaged with research organisations.

While it is difficult for governments to support businesses to adopt these characteristics, businesses do respond to the environment that governments influence.

Can proactive industry policy stimulate economic growth?

With the views of businesses in mind, the debate about the place of industry policy can be better informed.

There is a broad consensus in the public policy sphere that governments providing quality economic infrastructure, an educated and healthy workforce, property rights, and a sound judicial system matters for the success of firms and industries. And most agree that ensuring sound regulations to govern firms and protect consumers and the environment is also important.

The more contentious policy question is whether governments can stimulate economic growth through proactive industry policy. The Productivity Commission has long argued that protection – through tariffs, quotas and local content requirements – simply pushes up costs for firms that use these inputs and also prices for consumers.

The effectiveness of industry policies in generating externalities, spill-overs and flow-on effects has traditionally been dismissed as ineffective and distorting the allocation of resources, to the detriment of economic growth.

But new economic thinking questions this conclusion.

Smart policy can drive collective benefit

We know that policies that promote positive externalities can benefit all firms in an industry and potentially all industries, so governments have an interest in fostering them.

Scale means the cost-benefit calculation for government investment in collective infrastructure improves and we enter a virtuous cycle. Government provision of better infrastructure can boost the productivity of other firms in a region, and productivity growth in industries that input into other industries – such as energy, transport, ICT and finance – flow through to gains in other parts of the economy.

Governments can grow industries by changing the risk calculus for businesses. Financial markets can fail to consider the economy-wide returns to firm investments, so investments with higher social returns could miss out on funding. While market finance should be available if the private return is positive, high costs for financial institutions to assess risk in unfamiliar industries and technologies can restrict investment.

Where there is a significant potential shared upside of innovation to government and society, government can stimulate this through sharing the downside risk too. Government loans can enable firms to develop a product and market, after which they can graduate to market finance.

Government can also support the consideration of new technologies. Existing firms can be locked into existing technology, so as their research and development goes along an existing path, fundamental change is difficult. Industry policy that supports trials can limit the downside risk.

In addition, new areas of economic activity can be sensitive to regulatory policy (actual or anticipated). Governments should work with nascent industry members to develop a supporting regulatory regime. This can require a significant public investment, such as in standards, which individual firms cannot deliver. Governments can be proactive rather than responsive in this space, to avoid being captured by existing players and locking in old technology and standards.

Procurement can be a powerful tool for governments

Then there is the power of government procurement, which can actively encourage innovation that does have spill-over and flow-on effects, particularly in social and environmental policy areas. Governments are major funders, so if they are risk-averse, this stymies the whole industry.

Government procurement plays a big role in creating market opportunities. Australia's higher education market, for example, is a successful export industry (our third largest) grounded in public funding.

One case study from our consultation illustrates the enabling role that procurement can play.

Subcon is a young Western Australian business that solves hard engineering problems for oil and gas companies. The business leveraged its experience in offshore rig engineering to bid to construct an artificial reef being procured by WA Fisheries. While Subcon was not successful in the first instance, the feedback it received encouraged it to try again, and it succeeded in its bid to develop an artificial reef in New South Wales using a new approach. This led to a new line of work for the business, including using artificial reefs for coastal stabilisation in Mauritius and repurposing old oil and gas structures as artificial reefs.

The research partnerships the business has developed are demonstrating the value of leaving offshore decommissioned rigs in place as they have developed thriving fish ecosystems, which would be destroyed if the rigs are removed. It is a rare instance where the best thing for the environment has a lower cost to government and industry.

Government procurement can provide a platform for an industry (such as higher education) or enable alternative approaches (such as the artificial reef project).

This does not mean that government procurement should be hostage to industry development. But it does mean that governments should be aware of the effect their procurement has on the industry ecosystem. This effect is through influencing the level of demand, and providing a platform for businesses to learn how to provide a quality and innovative service.

Yet procurement tenders often do not realise this potential. Many tenders are too tightly defined to encourage innovation, the arm’s-length approach makes it too risky for small and medium enterprises to engage, and value is assessed using too narrow criteria.

Making these procurement practices more open to engagement, to different approaches, and to a more comprehensive approach to assessing value would greatly assist Australian SMEs to compete more effectively for government procurement. The challenge for governments is to balance this ambition with the need to ensure taxpayers get value for money. (You can read more in Nous Group’s post-commencement evaluation of the Department of Industry, Innovation and Science’s Business Research and Innovation Initiative (BRII) Pilot.)

Success can depend on effective execution

Industry policy and innovation policy go hand in hand. But good ideas can come asunder if they are poorly implemented.

There are some dos and some don’ts that arise from our recent experience:

• Do facilitate exit. For innovation, failing fast is good. And for incumbents in areas badly affected by structural change, the focus should be on smoothing the transition for displaced workers.
• Do encourage non-R&D innovation as well. Embracing new-to-the-business innovation such as new systems, processes and structures can be a shortcut to improving productivity.
• Don’t spread funds so widely that the activity is always underfunded. This can mean concentrating effort, but pick winners at a technology or market level rather than at a firm level.
• Don’t throw good money after bad. Make it clear when the funding stops. Have clear benchmarks for expected performance and stop funding points.
• Do use competition to allocate funds. But ensure that project selection is arm’s length from politics and done by market experts.
• Do capture the upside of investments. Use contingent loans as well as taxes on economic activity.

At a time when Australia is looking to raise productivity growth in an uncertain global environment, industry policy is too important to be dismissed as a relic of an earlier political era. While some of the previous strategies have rightly been left behind, there is plenty that government can do.

This article was written with input from Principal Steve Corcoran, Principal Andrew Benoy, Principal Jenny Gordon, Director Jo Rossiter and Consultant Ethan Barden.

Published on 25 February 2020.