43. However successful industry may be in matching emerging technologies to market requirements many witnesses told us that successful innovation also requires bringing together an exploitable technology with appropriate finance and skilled management and personnel.

Investing in Innovation

44. The UK has a number of strengths and potential strengths regarding the provision of investment finance for innovation. The City of London is a world-class financial centre, the largest in Europe, and has enormous investment funds at its disposal. The domestic venture capital market is the most active in Europe and has invested nearly £23 billion since1983: more than 40% of all European venture capital is invested in the UK.[103] It has, nevertheless, proved difficult to bring together the vitality of the UK's financial markets and the excellence of its science base and a number of authorities, including the Bank of England, have identified an apparent inadequacy of financing as one of the reasons why the UK has failed to match the performance of other countries, and of the US in particular, in commercialising scientific and technological advances.[104]

45. Access to the appropriate level of finance, on the right terms, is important for long-term investment in R&D. Large, established companies will usually fund R&D from retained profits. For them, the main question is often the allocation of resources. For smaller firms, particularly those without a product stream, the problem is more usually one of access to external finance. There is a number of reasons why high technology firms in particular may find this difficult. Technology-based start-ups and spin-outs frequently need external finance at an earlier, and therefore riskier, stage in company development which, coupled with a perception of lower than average returns, deters investors; and, as 3i Group plc told us, the skills required of investors in the sector are higher than average because the markets for products are subject to rapid and unpredictable changes and the companies concerned are typically more volatile.

LARGE COMPANIES

46. There is a general consensus, which was reflected among our witnesses, that many UK companies and financial institutions place too much emphasis on short-term efficiency savings and too little on long-term organic growth;[105] a conclusion which is consistent with the relative decline in industrial expenditure on R&D (see paras 23-29). The availability of funds for R&D and innovation in such companies frequently depends on decisions taken about the allocation of resources between competing needs but where there are insufficient funds internally, even larger companies will have to seek external sources of finance.

Stock Markets

47. The London Stock Exchange has not been as successful as financial markets in the US in promoting high technology stocks. In part this may be due to the different structures of the financial markets in the UK and US. In the US there are, in the main, only two markets — the New York Stock Exchange and NASDAQ[106] — both of which are large and liquid. In contrast in Europe, there are 33 stock exchanges in 18 countries, most of which are very illiquid. NASDAQ in particular has developed into a powerful stock market for growth companies, with a number of notable successes such as Intel and Apple, partly because it set out to specialise in them and partly because of its emphasis on anticipated performance and not just track record which permits a higher level of business risk. Apax Partners told us that NASDAQ "has a clear entrepreneurial identity which appeals to managers of entrepreneurial companies, and so attracts new companies as new technologies evolve".[107]

48. In response to this weakness in the European financial markets, EASDAQ, a European equivalent of NASDAQ which targets growth companies, has been established with the backing of institutional investors, bankers and venture capitalists. We welcome this but it is still early days for EASDAQ and therefore difficult to measure its effectiveness. We note that 3i Group plc's early experiences with EASDAQ have been positive.[108] EASDAQ, however, can only emulate the success of NASDAQ in the States if it can become the primary market of choice for growth and technology-based companies.[109] While there remain multiple markets across Europe, operating within different rules and in different languages, this will be difficult to achieve. We recommend that the Government seeks harmonisation of trading patterns and systems across the European Union and gives support to a primary market for growth and technology-based companies.

TECHNOLOGY-BASED SMES

49. High technology SMEs will usually require some source of external finance at start-up or in the early stages of development or both. For the majority of SMEs, bank finance and, in particular, bank loans, provide an important source of initial capital but it is not often the most suitable choice for technology-based companies. High technology start-ups are often perceived to be more risky ventures than start-ups in traditional sectors (although a number of our witnesses challenged the validity of the perception) and the long lead times that can be involved in product development mean that there will be no income in the short-term with which to service loans. The alternative is equity finance which allows the investor to offset the risk against potentially higher than average returns in the long term and avoids cash flow problems for the business.

Venture Capital

50. There has been a huge growth in the volume of venture capital invested in technology-based businesses in the UK in recent years. Figures from the British Venture Capital Association (BVCA) indicate a tenfold increase between 1983 and 1996.[110] Contrary to the experience of the Science and Technology Committee in the last Parliament, many of our witnesses agreed with Oxford Instruments that "ample funding is available for most young companies in high technology".[111] Specialist firms and funds for hi-tech start-ups have been established, such as Amadeus in Cambridge, Merlin Ventures and UK Medical Ventures (which is backed by the Medical Research Council) and major capital investment companies such as 3i Group plc have increased their investments in the technology-based sector. Some high street banks also seem to have responded well to criticisms that they did not offer appropriate facilities for high technology SMEs.

51. Several witnesses argued that, despite recent improvements in the funding available for investment in technology-based companies, there was still a shortage of capital, particularly at the intermediate stage of company development when the investment required was in the region of half a million. According to the BVCA, for example, "the amount of seed capital funding available via the venture capital industry has increased in recent years but still remains the least common type of funding".[112]

52. Much of the growth in venture capital activity can, however, be accounted for by an increasing number of management buy-outs and buy-ins which now make up some 74% of the total venture capital market.[113] Venture capital for expansion accounts for another 21% of the market which means that only 5% of the available venture capital funds go to start-up finance. In contrast the venture capital industry in the US, as we found on our visit, is more ready to invest in start-ups. In 1997 it invested £5.8 billion in start-ups and early stage companies compared with an equivalent figure of £349 million in the UK.[114] In 1997 UK venture capital investment was around 0.14 % of GDP and much the same in the US.[115] In the US, however, venture capitalists seem more prepared to invest in technology-based companies which account for almost two-thirds of the total.[116] The equivalent figure for the UK is less than a quarter. Moreover, venture capitalists in the US give more assistance to the companies in which they invest, through offering assistance with corporate management or the development of business plans, for instance, than do their UK counterparts. The DTI estimates that efforts by venture capitalists in the US were typically 20% financial assistance and 80% other assistance.

53. There are several reasons why the UK venture capital industry may be cautious over investments in high technology start-ups. The level of return in the short term from seed-corn and early stage investments in high technology companies, generally low anyway, often fails to match predictions made by company management: 3i Group plc told us that 50% of the early stage, high technology firms they invest in underperform against management expectations over the first three years.[117] Further funding is often required to realise returns and therefore investors need to have resources in reserve and the ability to take a long-term view. Our witnesses were, nevertheless, convinced that there were two overriding factors which deter venture capitalists from devoting more seed funds to high technology start-ups. First, the amount of funding sought is often so small that the costs of due diligence and monitoring, which are largely fixed regardless of the size of investment, cannot in their eyes be justified.[118] Secondly, the quality of management in high technology start-ups is frequently not high enough to inspire investor confidence (see paras 62-5).[119]

54. The BVCA suggested that the Government could assist by subsidising the due diligence process.[120] We do not consider that this would be an appropriate response. It would serve to reinforce the false impression that investment in technology-based start-ups does not represent a viable investment for venture capitalists. What is needed is for the venture capital industry to adopt a more long- term approach to its investment strategy, with more of the industry following the example of 3i Group plc. It told us that "We do not believe that the returns from technology investment are unattractive to institutional investors and the returns from our own technology portfolio would support this view. The returns do however come over a relatively long time scale."[121]

55. In December 1998 the Government announced the creation of a national Enterprise Fund in partnership with the private sector.[122] It will provide some £150 million over three years, partly as venture capital for early stage, technology-based businesses and partly through an extension of the existing Small Firms Loan Guarantee Scheme. There is potential here for the Government to act as a rôle model for the venture capital industry. By investing successfully, and linking investments with the provision of management assistance to companies as the US venture capital industry does, it can demonstrate that the sector is worthy of greater attention and effort on the part of the UK venture capital industry as a whole. We recommend that the Enterprise Fund should do more than provide capital; it should be prepared to support enterprises with functions such as recruiting, management and business development. We shall monitor the implementation and development of this scheme to assess its effectiveness.

56. We welcome the launch of 'University Challenge' — a £65 million fund which provides early-stage seed funding to help exploit the commercial potential of research by enabling universities and some research institutes to create their own seed-corn funds to support spin-outs from their research. A condition attaching to awards is that the universities must provide 25% of the funding required from other sources. By taking on the larger portion of the risk, the Government can encourage investors to support technology-based companies from their very earliest stages, thus helping to close the gap in seed-corn funding. It will also enable a greater proportion of commercially viable advances to get beyond the proof of concept stage. The potential for success in this sort of scheme was demonstrated during our visit to the Oxford Trust: Oxford University is prepared to encourage proof of concept research, and through the ISIS fund, will provide seed corn funding for these activities. This has resulted in successful spin-out companies such as Oxford Assymetry and Oxford Glycosystems plc. At current funding levels however, University Challenge cannot provide all the seed-corn funds required to commercialise public sector research — nor would it be appropriate for the Government to do so. However, if the funds invested generate adequate returns, University Challenge will demonstrate to the venture capital community the benefits of investing in technology-based companies and thus draw in further investment. This should be one of its long-term objectives however, the success of the initiative should be measured by the number of new science and technology based ventures established by universities as a result of the fund.

57. As some small companies do not adequately prepare business plans, the costs of due diligence for the venture capitalist seeking to invest in can be unnecessarily high. The Bank of England, among others, has suggest that 'venture catalysts', i.e. advisers to assist smaller companies, could play an important rôle. We agree. We recommend that the Business Link network should be charged with assisting small technology-based firms in preparing for venture capital investment.

Business Angels

58. Many high technology start-ups seek funding from the 'informal' venture capital industry which consists of 'business angels' who are prepared to invest risk capital in small unquoted companies. Business angels tend to invest in smaller amounts than are economic for venture capital funds and therefore can fill the gap between debt finance and formal venture capital investments and are more geared towards investing in early stage and start-up businesses. Both the number of business angel investments and the funds involved have increased dramatically over the last five years. In 1997/98, registered business angels made 227 investments in 223 registered companies, investing a total of £34.6 million — a 28% increase over the previous year.[123] Technology-based firms receive the highest proportion of this investment but, nevertheless, the Bank of England has found that "business angels still appear to play a considerably less prominent rôle in the financing of technology-based firms in the UK than the US".[124] One of the main barriers to greater business angel investment identified by our witnesses, is a lack of information on investment opportunities (this seems generic to all firms rather than specific to the high technology sector). The DTI, with banks and other interested organisations, is supporting the development of a national organisation which is intended to help match business angels to suitable start-up companies. This is a welcome development. Business angels, however, frequently adopt a hands-on approach to their investments and often offer expertise as well as financial assistance and therefore geographical considerations become important. As the Bank of England has stated, business angels "operate most effectively through local networks".[125] Regional Development Agencies should be able to play a valuable rôle in this regard, with their greater knowledge of local economies and regional business networks. We recommend that the Regional Development Agencies should assume responsibility for working with local and regional business angel networks and business introduction agencies.

Fiscal Incentives for R&D

59. Governments in many parts of the world supplement national private sector investment in R&D by funding R&D directly through grants. Another possible mechanism available to Governments to increase national R&D efforts is to reduce the costs associated with it by providing tax relief or other rebates on R&D expenditure.

60. In its Report on The Routes Through Which the Science Base is Translated into Innovative and Competitive Technology, the Science and Technology Committee in the last Parliament made a convincing argument in favour of the introduction of fiscal incentives for R&D. Basing its position on contemporary studies and analysis of the US experience (which has operated a tax system designed to reward increases in R&D expenditure since 1981), it argued that "introducing a tax incentive to increase R&D by 0.1 per cent of GDP pa for five years could increase the rate of growth of GDP by 0.8 per cent pa from the fifth year" and that "the tax yield from the increased incomes would quickly exceed the tax loss from the tax credit".[126] Its recommendations were rejected by the then Government. However, the present Government has announced the introduction of a volume based tax credit for SMEs which will increase the existing 100% relief for R&D expenditure to 150%. Together with existing measures, this will mean that the costs associated with R&D will be reduced by 30% for companies paying tax at the small companies rate. Further, recognising the constraints on early stage companies, the relief will be extended to those companies not yet generating a taxable profit which will be able to take advantage of the relief in advance. We welcome the introduction of R&D tax credits to support small companies. It will not, however, affect the behaviour of larger companies whose commitment to innovation is just as important. We recommend that the Government should look again at extending this type of tax credit to large companies.

61. International experience has shown that fiscal incentives may not reach their full impact for some years. The ability of companies to alter their spending patterns on R&D in the short term is quite limited. A study by the Institute of Fiscal Studies has shown that in other countries where tax credits for R&D have been used, the increase in R&D expenditure in the first two years reached only around 10% of the tax forgone by the Government.[127] After five to ten years, however, the increase in R&D expenditure rises to around the same level as the tax forgone, as companies have had the time to respond to new market signals. It is important that any system of fiscal incentives is stable from year to year; is focused on the cost of development, market research, demonstrators and product launch, and that its value is monitored in the long term.

Managing Innovation and Entrepreneurship

CREATING SERIAL ENTREPRENEURS

62. The BVCA told us that "the whole debate about providing finance to support technology has tended to miss one crucial point: it is that people are supported by the investment community rather than technology". Many other witnesses made similar points and our attention was repeatedly drawn to "a shortage of seasoned managers who have the capability of building successful businesses".[128] This is consistent with evidence from a survey which found that only 7 per cent of undergraduates in the UK would consider starting their own business compared to 68 per cent in the US.[129] Many witnesses argued that to increase the pool of entrepreneurial talent in the UK, fundamental changes were required in the associated risk and reward structure. A career in an established company usually offers salary progression and relative job security. Taking on a technology-based start-up or emerging company is inherently more risky. Anecdotal evidence also suggests that to do so is less socially acceptable in the UK than in many other countries.[130] Therefore, to encourage both young people embarking on a career and seasoned corporate middle managers, with their accumulated experience and expertise, to become entrepreneurs, the potential rewards have to be high enough to overcome these disincentives. Regardless of specific incentives, gains from companies are usually taken as capital and consequently Capital Gains Tax has a major influence. Therefore, we welcome the changes in the 1998 and 1999 budgets which some witnesses argued would substantially alter the operation of Capital Gains Tax in the favour of entrepreneurs and management teams. We recommend that the Government monitors closely the impact of these changes to ensure their effectiveness in facilitating innovation. It should also monitor closely approaches to taxation and Capital Gains Tax in other member countries of the European Union.

63. The DTI has provided funding for the establishment of Institutes of Enterprise (based on the model of the Centre for Enterprise at MIT) at eight UK universities which it hopes will play a part in injecting an entrepreneurial spirit into students and academics alike by increasing their exposure to the business world. We welcome the Institutes for Enterprise; they are a step in the right direction and we look forward to them playing a more significant rôle in the future.

64. We recommend that changes in the reward structure for serial entrepreneurs be coupled with widespread publicity regarding successful rôle models and active Government support in marrying together entrepreneurs with the right technology and access to finance.

65. The high level of stigma associated with business failure in the UK is also a factor in discouraging risk-taking on the part of company managers.[131] In the US a business failure is often seen as a valuable part of an entrepreneur's experience. In contrast, in the UK a single business failure attracts a social stigma which is reinforced by an unforgiving financial community and bankruptcy and insolvency laws which do not distinguish between the responsible risk-taker and the reckless exploiter. We welcome the Secretary of State's undertaking to review the legislation on bankruptcy and insolvency to introduce a distinction between responsible entrepreneurs whose businesses have failed and those whose reckless activities have resulted in business failure.

CORPORATE MANAGEMENT

66. Adopting the right approach to innovation is as important in large, established companies as it is for SMEs and start-ups. A series of surveys, bench-marking exercises and case studies has shown that successful innovation requires the development of a corporate culture in which new ideas flourish and employees are motivated to take responsible risks.[132] We were particularly impressed by British Aerospace, whose strategic commitment to innovation is defined in its mission statement and demonstrated by its activities. Each section of the business builds innovation into its annual business plan; awards are given to innovative employees; and management practices are tested for their impact on innovation. Its commitment to facilitating innovation is underlined by its 'virtual university' — "a business strategy built upon strategic partnerships with academe and enterprise"— which is intended to prepare employees for "the challenges and market evolution which lie ahead" by providing training and development in co-operation with existing universities and by spreading best practice and innovative ideas.[133] Nevertheless, as British Aerospace accepted, an innovation culture "is a very difficult thing to institutionalise ...you cannot .. set up an innovation committee and have it perform".[134]

67. The 1998 Competitiveness White Paper stated that it is not for Government to determine how companies are managed nor to anticipate boardroom decisions.[135] We agree. Government should, however, encourage firms to adopt a long-term approach to market and technological opportunities by spreading best practice in innovation management and drawing attention to the financial and commercial benefits which can derive from technological innovation. Likewise business schools should ensure that the management of science-based innovation is properly covered in their curricula.

Intellectual Property Rights (IPR)

68. The protection of intellectual property is an important part of the process of innovation.[136] As Shell UK told us "there is limited value in investing heavily in R&D into processes and products if the results are not protected either through immediate commercialisation or longer term through patenting".[137] Through effective technology management, companies can derive competitive advantage by increasing profit margins or by delaying the entry of competitors to markets. There is also potential for revenue generation by a company licensing its under-exploited intellectual property to others.

Universities and the Exploitation of IPR

69. Most universities in the UK maintain their right to the intellectual property developed by staff and students. In many cases there are arrangements for sharing revenue with the inventor, although the proportion assigned varies considerably. In this regard, Cambridge University is an exception "Unlike almost all other universities, Cambridge University does not claim title to the intellectual property created by its employees in the course of their duties. In practice, research in the University is largely funded by the Research Councils, charities and industry, all of which external sponsors require the University to manage the intellectual property output of their funding to the benefit of the inventors and the University".[138] Professor Sir Alec Broers, the Vice Chancellor of Cambridge University, argued that this ethos motivated inventors to exploit research outputs and enabled the University to act as a facilitator "rather than compelling them to work with a potentially heavy-handed bureaucracy".[139] It has been argued that Cambridge's liberal attitude to intellectual property has been a key ingredient in the so-called 'Cambridge phenomenon' which has seen the area become one of the country's foremost hi-tech clusters, although others are less convinced that the system would work as well elsewhere.

70. The University of California ranks highest in the US in terms of gross licence income, receiving some $63 million in 1996.[140] At MIT, which ranks seventh, the annual profit from licensing arrangements is some $9 million.[141] No universities in the UK attain such high figures which might suggest that not enough is done by UK universities to exploit the IPR they hold. We were, however, warned against a straight comparison: at MIT and Harvard, for instance, the income from technology licensing represents some 2% on research income from external sources. At Nottingham University, which has generated £28.5 million in royalties over the last 15 years, the equivalent figure is 10-12%.[142] A university's ability to generate saleable IPR will depend on the research fields in which it is strong. In some instances where the results of the research can also be the final industrial product, the identification and protection of IPR can be relatively straightforward and exploitation on the part of the academic institution may be an attractive option. In many cases, and typically in those industries based on engineering and physical sciences, the path between research and eventual commercial return on exploitation can be lengthy and complex.

71. While protecting intellectual property may be good practice on the part of universities, there can be benefits in flexibility. Over-emphasis on the formal aspects of intellectual property may lead university communities to see the product of their research only as a series of inventions.[143] Such attitudes risk not only distracting Government-funded research from its first objectives of generating knowledge and expertise but also, as the Royal Academy of Engineering argued, "represents an extremely expensive way of making what are often marginal technological advances.".[144]

72. Universities must protect their intellectual property appropriately. Methods of protection will, however, vary depending on a range of factors including the nature of the invention. Consideration of intellectual property rights and patenting should not be allowed to act as impediments to the flow of knowledge and expertise which is the fuel for innovation.

Industry and IPR

73. The use of IPR varies widely from sector to sector and company to company. In some sectors, speed to market and the associated know-how are more important.[145] In many industrial fields, however, it is only worthwhile for a company to invest in the development of new products or processes if effective protection for intellectual property is available. Without such rights it would often be impossible for a company to recoup its investment in R&D. It is therefore axiomatic that an effective intellectual property management policy and infrastructure are prerequisites for the development of an innovative economy. We heard a number of criticisms from our witnesses of both the UK and EU patent systems, notably the high cost of initial filings with the EU patent office, (which can exceed £10,000) and the costs associated with defending patents through litigation. The Government placed strong emphasis on addressing weaknesses in the EU and UK patent systems in Our Competitive Future.[146] Its 'IPR Action Plan' includes working towards an EU patenting system which is both affordable and easily enforceable. We welcome these commitments but note that the German Government said that it favoured a move to the US system. These European and international differences need to be reconciled.

The Role of Government

74. As many of our witnesses acknowledged, industry carries the prime responsibility for ensuring that innovative and competitive technology is successfully brought to market. For instance the Chemical Industries Association told us that "Many of the factors which influence an industry's innovative performance are ... internal, and individual companies are in a position to do much to help themselves.".[147] Nevertheless, most witnesses agreed that "Government support, whether at national or European level, is essential to foster innovation in industry.".[148] We agree with those witnesses who told us that Government policy should be focussed upon achieving two equally important goals. First, Government must ensure that there is a strong public sector research and education base, at all levels, to provide industry with leading-edge research and the highly trained staff "which is the life-blood of technology-based industry".[149] Second, Government must provide an economic and fiscal environment that supports those who innovate, and encourages others to improve their innovative performance.

STIMULATING INNOVATION

75. There are numerous factors which may serve as stimuli to innovation, such as new marketing opportunities or competitive threats.[150] An emerging technology or a scientific advance can itself, in some circumstances, be the stimulus. In the CBI's 1998 Innovation Trends survey, most businesses identified customers and competition as the key drivers for innovation. Government grants and tax concessions scored lowest (see figure 4). Whether this response is an argument for or against extending the range and effectiveness of Government schemes is debatable but other evidence indicates that they are unlikely to be a significant driver for innovation in any circumstances.[151]

76. Nevertheless, there is a rôle for Government in stimulating innovation. Witnesses drew attention to the important part that Government could play as an honest broker, bringing together those with ideas and those with the means to turn those ideas into competitive technology.[152] The proper rôle for Government was widely seen as that of facilitator and enabler rather than an instigator of innovation. Many of our witnesses held the myriad specific schemes designed to stimulate innovation to be of only secondary importance. Most agreed that the greatest contribution that Government can make to industrial innovation is by providing a stable economy over the long term which is conducive to innovation, informed risk-taking and change.

THE ROLE OF THE PUBLICLY FUNDED SET BASE

77. An excellent SET base is a basic requirement for technological innovation. The SET base not only generates new knowledge which can be exploited by industry but can also be a valuable collaborator with industry and commerce in areas of mutual interest to ensure effective technology transfer. Successful scientific and technological research can be exploited by industry to develop both incremental and step change improvements to products and processes and to exploit or create new markets.[153] If industry is to benefit from the advances made in the publicly funded SET base, it must be aware of them and able to see how they are relevant to its needs. Many witnesses also emphasised the rôle of the SET base in the production of technically educated and scientifically trained people as essential to fostering innovation in industry. The Royal Academy of Engineering told us that "the training of a workforce with high quality skills" was one of the main ways in which Government could facilitate industrial innovation.[154] Indeed, the Royal Society of Chemistry argued that the "most important products of Government-funded research are the technically educated and trained people who are recruited into companies and who drive innovation forwards".[155] Many other witnesses made similar points.[156]

Stimulating Interaction between the Publicly-Funded SET base and Industry

78. There is a number of Government and Research Council schemes designed to increase interaction between the SET base and industry, such as Co-operative Awards in Science and Engineering (CASE), the TCS and the LINK scheme, in addition to initiatives taken by individual academic institutions and some companies. The TCS enables graduates to work within industry introducing new technology under the supervision of an academic researcher. The scheme thus covers both training and technology transfer, as well as providing associates with industrial experience which can benefit them whether they remain in industry or return to the academic environment. Projects usually last at least two years and can involve one or more associates. A review of the TCS found that every £1 million of Government investment, enough to cover around 18 projects, generated 58 new jobs, and resulted in £3.6 million of value added, £3 million of exports, £13.3 million turnover, £1.5 million capital expenditure and £200,000 R&D expenditure.[157] Around 80% of associates are offered employment with the host company at the termination of the project — which is particularly impressive as many associates are placed with SMEs which traditionally have not recruited graduates in large numbers.[158] These positive findings were supported by many of our witnesses who found the scheme to be generally effective at linking university know-how to industrial application.[159]

79. In Our Competitive Future, the Government announced a doubling of its funding for the TCS. Expenditure will increase from around £10 million per annum to £20 million (although we note that this will not necessarily involve a doubling of the number of projects which are expected to rise from some 650 at present to around 1,000 in three to four years time[160]). Nevertheless, even with its doubling, expenditure on the TCS remains small in comparison with other areas of Government support for industry. For instance, £200 million of Government assistance was given to an LG plc project in Gwent which, it is hoped, will create 6,000 long-term jobs.[161] At a cost of around £33,000 per job, that compares unfavourably with average TCS-created jobs costing some £17,000.[162] We accept that there may be a limit to the number of students available to become associates, as there may be to the number of companies able to participate by providing placements and clearly it would be impossible to orchestrate a huge increase in the programme overnight. Nevertheless we have seen no evidence to suggest that funding of £20 million for the TCS will exhaust the potential for the scheme. We recommend that Government funding for TCS should continue to increase gradually up to the time when the level of return starts to fall significantly.

80. The LINK programme, designed to promote pre-competitive research, is supported by the Research Councils and a number of Government departments in addition to the DTI. LINK brings together the commercial developers of a technology with academic partners and potential end users. Government funding for the scheme is more than matched by contributions from the private sector and over 50% of companies which now take part in LINK projects are SMEs. We wrote to a sample of current industrial participants in the field of engineering and physical sciences and the vast majority reported that they had found their experience of the scheme broadly positive both in terms of making progress towards their specific objectives for individual projects and in terms of establishing sustainable links between the company and academia, although some were critical of the high levels of bureaucracy involved.[163] RDP Electronics, for instance, told us that it had "learnt that it is very easy to work with a university to explore new technologies and the mutual benefits can be considerable".[164] We acknowledge LINK's effectiveness in strengthening long-term links between industry and the science base but recommend that steps are taken to reduce the bureaucracy of the scheme and to make it more accessible.

81. The DTI told us that most of its schemes designed to foster innovation are initially accessed by industry through the national Business Link network. This was not the experience of those LINK participants responding to our questions, the majority of which had first been drawn to the scheme through existing relations with the science base and, in particular, with universities, which suggests to us that in many cases LINK is preaching to the converted. If LINK is to reach its maximum potential, it must be effectively marketed and easily accessible not only to those companies which are already aware of the benefits of collaboration with the research base but more importantly also to those which have no experience of interaction with academia.

82. In 1997 the EPSRC launched four pilot 'Faraday Partnerships', modelled on the Fraunhofer Institutes in Germany which provide the physical resources and expertise for industrially-instigated and funded development work. By building on the expertise of existing intermediary organisations, the partnerships are intended to assist companies to communicate their needs to academic researchers, to increase interaction between universities and industry, to increase the awareness in academia of industry's requirements for new technologies and skilled scientists and engineers and to increase the exploitation within industry of the research undertaken in the SET base. Each partnership encompasses the research requirements of a specific industrial sector — one, for instance, forms a distributive centre for research and technology related to the packaging industry — and therefore adopts a multi-disciplinary approach. The creation of the Faraday Partnerships, particularly for their explicit recognition of the importance of intermediary organisations and the flow of people in the innovation process, was broadly welcomed by our witnesses, although some were critical of the limited nature of the scheme, and in particular of the absence of financial support from the DTI, and questioned whether at initial levels, the Faraday concept could be effective.[165] The DTI has since announced its intention to participate in the Faraday programme by funding four new partnerships for the next four years, which will take the total number to 20 by 2003, and by providing additional funding to the existing partnerships. On 14th September 1999, proposals were invited to set up the first four of these. The EPSRC will provide up to £1 million to each per annum, with the DTI contributing £1.2 million over three years initially.[166] We welcome the DTI's commitment to the Faraday concept as a means of transferring technology and instituting market orientated development and its announcement of additional funding.

83. There is a range of Government schemes and initiatives designed to promote collaboration between industry and the research base such as LINK, the TCS, CASE, Realising our Potential Awards, University Challenge, Institutes for Enterprise and SMART. Many of these attract significant contributions from industry. A number of our witnesses found such a large range of separate programmes confusing. While we accept that there are benefits to maintaining distinct programmes which can then be tailored to the specific needs of target collaborators, there is a risk that the effectiveness of Government efforts could be undermined if the companies are deterred from building on the assets of the science base by the complexity of the very initiatives that are intended to encourage them to do so. We have previously called for greater clarification in existing schemes designed to promote interaction between industry and the research base and recommended that consideration be given to the greater use of the successful LINK scheme as an umbrella to reduce confusion.[167] We do so again.

84. Industry and the publicly-funded SET base have different raison d'être. Companies exist to generate profits while the SET base exists to educate, to train and through research to increase the sum of human knowledge: "it is vital to get the relationship between the Science Base and industry right".[168] There is no intrinsic reason why greater interaction with industry should compromise the ability of the research base to meet its own goals. It is, nevertheless, critical that Government policy, in seeking to increase the industrial relevance and take up of the research it performs, should not overlook the science base's diverse rôles. We are adamant that the primary measure of quality in the SET base should be scientific excellence rather than the potential for commercial exploitation.

RESEARCH FUNDING AND THE RESEARCH ASSESSMENT EXERCISE

85. The amount of research funding granted by the Higher Education Funding Councils (HEFCs) to each university is determined by a formula which takes into account the number of research-active staff and research quality as determined through the periodic research assessment exercise (RAE). The most recent RAE, undertaken in 1996, has been widely criticised for undervaluing collaborative research projects, a point which we have highlighted in an earlier Report,[169] and which was reaffirmed by several witnesses during this inquiry. The University of Warwick Science Park, for instance, told us that "the dysfunctional behaviour of the academic community towards the commercialisation of research" was driven by the RAE which forces universities "to greater concentration on the outputs which generate a good research score".[170] Cranfield University stated "the undue focus of the Research Assessment Exercise on publication in refereed journals ... diverts some of the most able researchers away from innovation and into publishable research".[171] As over-enthusiasm to publish research results on the part of academics is a potential barrier to exploitation, some witnesses suggested that the RAE should instead use the number of patents generated to determine research quality.[172] We do not agree. This would drive researchers to seek patents regardless of whether patents can be exploited or whether there are means to do so. The public interest clearly lies in the easiest possible exchange of knowledge between academics and industry. Funding mechanisms such as the RAE must encourage universities to exploit their intellectual property and foster a collaborative culture in the university sector.

86. There have been a number of recent initiatives designed to encourage research of industrial relevance in the SET base. Our Competitive Future announced the creation of a new reach-out fund to reward universities "for strategies and activities which enhance interaction with business to promote technology and knowledge transfer".[173] The Higher Education Reach Out to Business, Industry and the Community (HEROBIC) fund will target funding to institutions over a four year period and is intended to give an incentive to institutions to respond to the needs of industry. HEFCE hopesthat HEROBIC will "change institutional and academic cultures in order to attach greater value to activities which are relevant to the needs of employers and industry".[174] In 1995-96 the Funding Councils disbursed £779 million of research specific funds to universities, with allocations largely determined on the basis of the RAE. The HEROBIC fund, in its first year, will stand at £10 million, although this will rise to £20 million for 2000-2001 and subsequent years. HEROBIC is, in terms of its funding, too limited to be effective. The creation of HEROBIC, although a welcome sign of intent, will not be able to affect the culture change that both we and the HEFCE are seeking if the RAE itself continues to undervalue research undertaken in collaboration with industry or research of industrial relevance.

87. The recently launched 'Institutes for Enterprise' and the 'University Challenge Fund' partially address the need for a sharper focus on research and industry interaction and while both could potentially be drivers for fundamental change in the outlook of those few universities which will be awarded funds, what is needed is a widespread and long-term mechanism to support and facilitate a culture change across a broad spectrum of institutions.

The Supply of Well-Trained Scientists, Technicians and Engineers

88. Many witnesses however also emphasised the importance of the science base's rôle in producing technically and scientifically trained people. The Royal Society of Chemistry, for instance, argued that they were "the most important products of Government-funded research ... who are recruited into companies and drive industrial innovation forwards".[175] The Chief Scientific Adviser has argued that "some 29% of the 25-34 year old age group who hold a higher education qualification in the UK do so in science and engineering ... this is above the mean of 23% for OECD countries. As far as the UK is concerned, there seems to be an adequate output of scientifically trained graduates and post-graduates".[176] This analysis, which focuses on quantity, is in stark contrast to the experience of some companies we spoke to. Several witnesses had concerns over the number of quality, well-trained scientists, engineers and technicians being produced by UK universities and flowing into industry. A similar problem occurs in the US, as communicated to us at MIT. British Aerospace, for instance, told us that it is "having difficulty ... in filling our engineering recruitment quotas from the UK institutions and for the last two or three years have actually been recruiting engineers from across Europe".[177] Hewlett-Packard also reported shortages, particularly in communications and software, and argued that the problem was not so much the quantity of graduates per se but the number of quality graduates.[178] The Institute of Professionals Managers and Specialists (IPMS) told us that "supply and demand for scientists is in a 'low level equilibrium' — a slowly sinking balance of weakening effective demand and a remorselessly weakening supply".[179] Figures certainly indicate a decline in the number of personnel engaged in R&D activity both in the public and private sectors (see figure 5). The conflict of opinion between the Chief Scientific Adviser and industrialists over the availability and suitability of science, engineering and technology graduates needs to be reconciled.

Figure 5

Source: SET Statistics 1998

¹ Statistics on R&D staff in universities have not been gathered since 1994 and therefore the figure for 1996 only represents those classified as engaged in research.

89. Witnesses also pointed out that many science and engineering graduates pursue careers in other areas which do not necessarily draw directly on their scientific or technical skills and expertise,[180] and argued that this was partly due to poor career prospects and low salaries afforded to scientists and engineers in core science activities in comparison to those in the city or management.[181] This results in a reduction in the numbers attracted to science and engineering courses at universities which then makes it even more difficult for industry to recruit sufficient quantities of high quality UK science and engineering graduates into science and engineering positions. The importance of intermediate skills in the workforce for productivity and for the successful introduction of new technologies has also been demonstrated[182] but there has been an even greater reduction in the number of support staff in science and technology than that which has occurred in graduate scientists and engineers. The number of technicians, laboratory assistants and draughtsmen employed by UK businesses has fallen from 46,000 full time equivalents in 1986 to 32,000 in 1996, a reduction of some 30%.[183] As the Generics Group argued, the vicious circle is completed by industry having to recruit lower calibre staff, less able to drive innovation forward, who do not justify the higher salaries that would be required to attract the brightest and the best. Industry is the ultimate victim of the vicious circle as its ability to innovate is compromised. The Government must recognise the need to increase the quality and levels of competence of SET graduates. The onus must then be on industry to seek ways of attracting the highest quality UK graduates in sufficient number into industrial careers.

Local Government

90. During our visit to Germany we witnessed the major contribution that local Government could make to creating a climate in which innovative companies could flourish. The technology park at Herzogenrath was just one of a number in the Aachen region which had been established by regional policy-makers keen to reinvigorate the local economy by capitalising on the asset represented by the high number of technically-qualified graduates emerging from the local university. Funds had initially been provided for the park by the State and Federal Governments but latterly the Town Council had also provided funding and now owns the site.[184] Initially the park was inhabited by existing innovative companies, including some well known companies such as Ericsson who were attracted to relocate by the subsidised rents and excellent facilities. Over time, however, the number of spin-outs and start-ups from the local university has increased.[185] Similar projects exist in the UK, but it was made clear to us during our visit that a development on the scale of the technology park at Herzogenrath would not have been possible if the Town Council had not been able to borrow money — a facility that is not open to local authorities in the UK to the same extent. The Secretary of State agreed that local Government policies could influence innovation, telling us that "the use of land and technology locally is absolutely crucial and ... local government has a crucial rôle".[186] The Government should ensure that Regional Development Agencies, in partnership with Local Authorities, are adequately resourced to provide the infrastructure for economic development and the establishment of clusters around local universities.

TECHNOLOGY CLUSTERS

91. For a technology cluster to develop, a number of factors need to come together. Clusters are usually centred on a leading research establishment or a large innovative company as sources of spin-out companies. There may be a science park or a business incubator or both to trigger new companies. Finance must be accessible and space available for development. When a number of firms competing in the same industry in the same locality generate a critical mass, more competitors, attracted by the concentration of talent and knowledge, and complementary activities are drawn to the cluster. In the Cambridge area, for instance, the growth of high technology clusters has attracted venture capitalists and various other business support services. Companies brought together by shared interests in local issues and technologies, and prepared to share the risks and opportunities associated with them, can provide a good (CEST called it the best) opportunity to stimulate sectoral innovation.[187] We saw a practical demonstration of this during our visit to the United States: Massachusetts is home to more than two hundred and fifty medical device manufacturers. At one time there was little interaction between the companies involved but following intervention by the state-run Massachusetts Technology Collaborative, which had worked with industry leaders to explore the value of greater association, a formal cluster, known as MassMedic, had been established in 1996. We were told that MassMedic enabled its members to use their strong presence to influence state and local Government policy, to develop strategic alliances and to establish more effective working relationships both between members and with premier teaching hospitals on research projects and clinical trials.[188]

92. One way in which local authorities can have a significant impact on cluster development is through their planning and local business development strategies. In the 1960s in Cambridge, for instance, the local authority allowed the development of high technology companies on green field sites — a key factor in the development of an IT cluster in that area — but efforts to establish a genome cluster in the same area have been hampered by lack of space for development and an unwillingness on the part of local planners to permit further out-of-town development on environmental grounds. The team, led by Lord Sainsbury of Turville, the Minister for Science, which reported on Biotechnology Clusters found that planning restrictions "can be a significant barrier to cluster growth" and called for "an innovative planning solution ... which meets the needs of clusters while avoiding unacceptable impacts on sensitive environments".[189]

93. On 9 November 1999, the Deputy Prime Minister announced changes to the planning system to support the growth and development of clusters which will mean that regional plans will have to identify innovative cluster areas and plan for their expansion. Guidance from the Department of the Environment, Transport and the Regions on the importance of clusters will also be included in planning guidance on local plans. It is too early to assess the impact of these changes but we welcome the Government's recognition of the importance of clusters and the changes that have been made to the planning system to promote their development.

94. While there is much anecdotal and empirical evidence to demonstrate the effectiveness of clustering in fostering innovation relatively little is known about how clusters function. The ESRC's support for further research in this area is welcome as isolating and replicating the lessons from such 'innovation engines' will be an important part of developing UK competitiveness. On 18 November 1999, Lord Sainsbury of Turville, the Minister for Science, announced the establishment of a cross-departmental Ministerial Group to drive forward work on clusters. We recommend that one of the objectives of this Group should be to understand better the ways in which technology clusters promote innovation.

104  The Bank of England, The Financing of Technology Based Small Firms, 1996. Back

105  See, for example, QQ. 371 and 495. Back

106  NASDAQ was established in 1971 as the National Association of Securities Dealers Automated Quotation. It merged with the American Stock Exchange in 1998. Back

107  Ev. p. 255. Back

108  Q. 194. Back

109  We note that NASDAQ has now announced its intention to move into the European market and may well have a significant impact on EASDAQ and other similar national markets. Back

110  Ev. p. 268. Back

111  Ev. p. 364. Back

112  Ev. p. 267. See also: Ev. pp. 364 and 267. Back

113  HM Treasury, Innovating for the Future: Investing in R&D, 1998, para 2.17. Back

114  The Williams Report, para 29. Visit to the United States. Back

115  The Williams Report, para 2.5. Back

116  R&D Scoreboard 1998, p. 9. Back

117  Ev. p. 251. Back

118  Eg Q. 505. Back

119  Eg Ev. p. 268. Back

120  Ev. p. 267. Back

121  Ev. p. 251. Back

122  Our Competitive Future, p. 19. Back

123  Bank of England, Finance for Small Firms: A Sixth Report, para 5.12. Back

124  Bank of England, Finance for Small Firms: A Sixth Report, para 5.14. Back

125  Bank of England, Finance for Small Firms: A Sixth Report, para. 5.14. Back

126  Routes, para 184. Back

127  POST, Innovation From the Science and Engineering Base, 1998, p. 12. Back

128  Ev. p. 268. Back

129  Q. 1196. Back

130  Q. 175. Back

131  Ev. p. 267. Back

132  HM Treasury, Innovating for the Future: Investing in R&D, March 1998, p. 31. Back

133  Ev. p. 264. Back

134  Q. 594. Back

135  Our Competitive Future, para 1.15. Back

136  Protection can take the form of copyright, registered design, trade or service marks or patents. Patents are the strongest form of protection and the most internationally recognised.  Back

137  Ev. p. 212. Back

138  Ev. p. 224. Back

139  Ev. p. 224. Back

140  CVCP, Technology Transfer: The US Experience, 1999, p. 37. Back

141  Visit to the United States. Back

142  Q. 1018. Back

143  Ev. pp. 64-5. Back

144  Ev. p. 65. Back

145  Ev. p. 333. Back

146  Our Competitive Future, p. 56. Back

147  See also, for example, Ev. pp. 147-8. Back

148  See also, for example, Ev. pp. 147-8. Back

149  See also, for example, Ev. pp. 147-8. Back

150  Ev. p. 75. Back

151  CBI, Technology and Innovation Brief, 1998 Innovation Trends Survey, June 1998, p. 3. Back

152  Eg Ev. pp. 147-8 and 345. Back

153  See, for example, Ev. p. 49. Back

154  Ev. p. 62. Back

155  Ev. p. 49. See also Ev. p. 357. Back

156  See Ev. pp. 2, 280 and 323. Back

157  Ev. p. 168. Back

158  Q. 888. Back

159  See, for example, Ev. pp. 300 and 391. Back

160  Q. 888. Back

161  LG plc is the Korean manufacturing company formerly known as Lucky Goldstar. Back

162  Q. 886. Back

163  Ev. pp. 260-1; 273; 273-4.7; 361-2; 368-9; 369-70; and 370-1. Back

164  Ev. p. 370. Back

165  Ev. pp. 339-40; Ev. p. 324. Back

166  Ev. p. 415. Back

167  Implications, para 102. Back

168  Routes, para 79. Back

169  Implications, paras 63-68. Back

170  Ev. p. 401. Back

171  Ev. p. 290. Back

172  Ev. p. 401. Back

173  Our Competitive Future, p. 25. Back

174  Ev. p. 309. Back

175  See also, for example, Ev. p. 62. Back

176  DTI, Quality of the UK Science Base, 1997, para 50. Back

177  Q. 598. Back

178  Q. 788. Back

179  Ev. p. 340. Back

180  See, for example, QQ. 725 and 788. Back

181  QQ. 323 and 1099. Back

182  Andy Green and Hilary Steedman, Educational Attainment and the Needs of Industry: A Review of Research for Germany, France, Japan, the USA and Britain, NIESR Report Series No. 5. Back

183  Ev. p. 344. Back

184  The total cost of the development was DM 80 million, of which DM 22 million was provided by the Town Council. Herzogenrath has a population of some 44,000 which means that the investment per head was around DM 500, that is c. £175. Back

185  Visit to Germany. Back

186  Q. 1237. Back

187  Ev. p. 275. Back

188  Visit to the United States. Back

189  Biotechnology Clusters, Report of a team led by Lord Sainsbury, Minister for Science, August 1999, paras 5.15-17. Back