When it comes to technological innovation, Europe is now lagging behind not only the US and Japan, but also China. Recently China overtook the EU with R&D expenditure equivalent to 2.1% of GDP. Today, of the world’s 15 largest digital firms, not one is European. This loss of leadership is important not only in terms of jobs and growth. It also has much wider ramifications, like being best positioned to shape standards and rules globally.

While there may be no shortage of innovative ideas, great minds or entrepreneurial spirit in Europe, most new European companies do not make it beyond the start-up phase. Or, if they do, they move their business out of Europe. Cases like Skype, Beddit, Shazam or Minecraft – all bought up by the likes of Apple and Microsoft – are just a few well-known examples.

Image: Cbinsights/OECD/Eurostat/DG Research and Innovation - Unit for Analysis and Monitoring of National Research and Innovation Policies

What is driving this trend can be explained in terms of “the three Fs” – Funding, Fragmentation and Frame of Mind.

1. Funding

Industry 4.0 technologies offer substantial benefits and opportunities for humankind, but they will not materialize without substantial long-term investment in cutting-edge innovation. In the US, technological developments and investment in intellectual property in the last decades (so-called patient capital) have been the main drivers behind its economic and productivity growth.

European entrepreneurs are lacking access to formidable pools of patient capital that can help them take their business to the next level. Such support, however, is readily available elsewhere: more than 60% of all Chinese investment in Europe is undertaken by state-owned enterprises that enjoy strong institutional support and access to cheap capital to fund such takeovers.

Despite the positive developments observed in recent years in Europe, risk capital markets lack critical mass. There are two major gaps that need to be addressed: one is at the earliest stages of business development, when innovative ideas need significant financial support to make the leap to commercialization. Such investments in early and seed stages were nine times higher in the US than they were in the EU in 2015.

Then comes the growth-stage trap, when established companies need financing to scale up, to broaden their outreach, to go global. In 2015, more than 20 times as much was spent in later-stage venture capital investments in the US compared to the EU.

Despite a tradition of excellence in academic research, Europe is falling behind in starting up and scaling up business ventures. Can we afford to let businesses and entrepreneurs leave Europe to seek risk financing elsewhere?

2. Fragmentation

Brussels is often blamed for imposing bureaucracy and unnecessary standards for businesses. If anything, the different rules and regulations, taxes and standards across the 28 member countries that hamper cross-border investments and business expansion is something the EU could help improve.

Fragmentation also occurs at other levels. The disparity across Europe when it comes to investment in innovation is one such example. According to Eurostat, Sweden and Austria spent above 3% of GDP on R&D in 2016, while there were nine countries that reported R&D spending below 1%. This legislative mosaic, alongside diverging national policies and priorities, is doing no justice to the efforts to take on other global superpowers.

3. Frame of Mind

Many of the issues Europe is currently facing on the innovation development front could also be put down to the European frame of mind towards risk-taking. This is reflected in the approach to venture capital and its limited availability here. In the absence of such support, European entrepreneurs find themselves relying mainly on risk-averse bank lending.

Furthermore, European companies and organisations are hesitant to buy new products from innovative young firms and often go for established logos. A recent EIB Investment Report shows that EU firms are twice as likely to focus on adopting existing innovations, while only 8% can introduce new products to their markets. The result is that young firms turn to the US, where established companies are more willing to test new products and experiment with new technologies.

Image: Eurostat/OECD/DG Research and Innovation - Unit for Analysis and Monitoring of National Research and Innovation Policies

Smart policies for smart growth

1. Scale up patient and venture capital

But it’s not all bad news. European venture capital has grown threefold over the past five years to €18 billion. Public support has been pivotal in sustaining risk capital financing across the EU in the post crisis period. EU-backed financial instruments like the European Fund for Strategic Investments (EFSI) and InnovFin have totally transformed the innovation finance landscape in Europe by de-risking investments for others and attracting private investments on a large scale. Such instruments stimulate private investment and kickstart venture capital ecosystems all over the continent.

Public finance has been and will remain a key funding source for basic research and for backing private risk capital in Europe. The European Commission has made interesting proposals for the next budgetary period, including significant increase of its core instrument for investments in R&D – Horizon Europe, a dedicated fund for digital skills, cybersecurity, high-performance computing and artificial intelligence, and a €38 billion budget guarantee under InvestEU to ensure a continuation of EFSI’s success. But is this enough?

Ultimately, the EU needs to make a quantum leap in its support of European venture capital if it is to remain competitive on the global stage. We need to generate support for European entrepreneurs that will develop strategic sectors of the European economy, build the innovation leaders of the future and take strategic long-term equity holdings in European corporates in strategic sectors. We need to offer patient capital on a different scale if we are to contemplate a global leadership position.

2. National policymaking is key

On the policy side, the EU is promoting unification of standards across member states. Its strategies for capital markets union and a digital single market aim to address many of the challenges related to fragmentation of the European single market. The abolition of roaming charges in June 2017 was an important step towards the creation of the digital single market in the EU. The General Data Protection Regulation (GDPR) and Payment Services Directive (PSD2) are other exemplary policy initiatives aiming at a more uniform digital business environment that also protect citizens.

However, ultimately, national policymakers are in charge of implementing the necessary reforms to reduce red tape and unify standards to allow for rapid advances in the digital economy. One thing is clear – the single market is key to the EU’s competitiveness. No European country alone has the critical mass to compete on the global stage. With supply chains and value chains cutting across countries, closer coordination and progress on a toolbox of financial instruments to support policy priorities and industrial excellence could still give Europe the edge.

3. Embrace the changes coming from technological developments

Frame of mind does not change overnight. However, technological developments and digitalization have changed the way we live, work, shop, communicate and even the way we date. Much like how Europeans are embracing these changes, policymakers need to embrace the dynamics that generate them.

It may be difficult to talk about adapting education policy, but there are many initiatives that can help change the European frame of mind. In many parts of Europe, public interventions to boost the investment ecosystem can have a lasting effect, kickstarting venture capital investments, mobilizing capital and encouraging support for innovative projects with a strong catalytic effect.

We have recently seen a significant boom in venture capital activity in Bulgaria, the Baltic states and Greece, spurred on by cornerstone investments from the public sector – all areas with very limited prior activity in the field of risk capital. Public actions to overcome the initial inertia in the venture-capital ecosystem can have very positive lasting effects in this respect.

Europe has to do more

The fundamental building blocks are there: Europe has a strong academic base, some of the best universities and research institutions in the world, a skilled workforce, policies to support entrepreneurship and some very innovative companies. To keep up with relentless global competition and avoid falling behind in key industries that rely heavily on innovation, Europe has to do more.

The EU has proven that it is able to design effective and successful instruments that have the ability to mobilize private capital and boost innovation. Such instruments will need to be reinforced and scaled-up, and designed in such a way as to reduce fragmentation, maximize the catalytic effect and attract private capital. With the new budgetary period on the horizon and negotiations in full swing, this is the time to take European innovation policy to the next level.