Foreword

Good policy requires sound evidence. The field of innovation is no exception. Robust measures of innovation and the benefits it brings to the UK economy will help guide and improve innovation policy, and make the UK a more prosperous place.

The Innovation Index was designed to meet this challenge. It measures a broad range of innovative activity, from the R&D that lies behind innovative technologies to the service design and organisational innovations that power the UK's service industries. And by linking investment in innovation clearly to productivity improvement, it underscores the central importance of innovation to economic growth.

This report presents the pilot version of the Innovation Index, and is the result of 18 months of work with a group of leading innovation experts, practitioners, policymakers and economists. Over the next year, we will be refining the methodology and extending the scope and detail of the Index.

As always, we welcome your comments.

Jonathan Kestenbaum Chief Executive, NESTA November, 2009

NESTA is the National Endowment for Science, Technology and the Arts. Our aim is to transform the UK's capacity for innovation. We invest in early-stage companies, inform innovation policy and encourage a culture that helps innovation to flourish.

Executive summary

This report presents the pilot version of NESTA'S Innovation Index. The aim of the Innovation Index project is to provide a basis for better policymaking about innovation by developing and deploying significantly improved measures of innovation in the UK.

Until now, public debate on the UK's innovation performance has disproportionately focused on the science base and investment in scientific research and development. These factors will remain important to the UK's economy in the future. But the UK's economic success will depend on its ability to commercialise and profit from research and ideas, and to innovate in the service sector and the creative industries. The investments needed to make this happen range from product and service design to developing innovative skills and organisational innovation.

At the heart of the Index is a wider and more complete measure of how much the UK invests in innovation, and what the benefits of this are to national productivity. This headline indicator is supported by two complementary tools: a company-level measure of innovation, which can be used as a measure of the innovation activity of individual sectors; and an assessment of how favourable a climate the UK provides for innovation based upon available internationally comparable data.

The pilot findings of the Index show the scale of innovation investment in the UK: the private sector invested £133 billion in innovation in 2007 (the most recent year for which data are available), or around 14 per cent of private sector Gross Value Added. Over three-quarters of this was in 'hidden innovation' - investment in areas other than traditional research and development. Although international estimates are, in some cases not totally comparable, it seems that the UK invests more in innovation than many developed economies.

This investment in innovation made a significant contribution to the UK's economy. Our interpretation of these results is that innovation was responsible for two-thirds of the UK's private-sector labour productivity growth between 2000 and 2007, increasing productivity by an average of 1.8 percentage points per year. Again, a significant part of this productivity increase came not from traditional research and development but from other types of investments in innovation, such as design, the development of innovative skills, brand equity and organisational innovation.

The pilot Index also examines the innovative performance of individual firms and sectors, demonstrating a link between innovation and firm growth, and showing how firms in several 'low innovation' sectors as measured by R&D spending in fact undertake significant amounts of innovation. The pilot surveyed 1,500 firms across nine sectors, and provides a methodology to expand this measurement more widely.

Finally, the analysis of the wider conditions for innovation shows that the UK is a relatively good place to innovate, but identifies shortcomings in a few key areas, in particular access to finance, the role of demand (and in particular government procurement) in stimulating innovation, and the availability of appropriate skills. This component of the Index draws together a suite of indicators that can be used to track seven vital conditions for innovation over time. These seven conditions are linked to one another through a straightforward model of how the innovation process occurs, and compared to six other leading economies. (In some areas, available internationally comparable data are more complete than in others.)

The development of the Index is a two-year project; the publication of this pilot version represents a half-way point. The next 12 months will be used for the gathering of more detailed data, the exploration of a number of new analyses and conceptual questions, the incorporation of feedback received on the pilot, and the extension of the Index to incorporate public sector innovation. It is envisaged that the Index will then be refreshed with new data each year, providing an ongoing account of the UK's innovation performance.

Better measurement shows the importance of innovation – and helps guide policy

Innovation sits at the heart of debates over economic growth, and encouraging an innovative economy is high on the wish-lists of many governments. NESTA's Innovation Index, the pilot form of which is presented in this report, is a major project to demonstrate the contribution of innovation to economic growth in the UK, and to complement this with a measure of growth at a company level and an assessment of the wider national conditions for innovation.

Measuring innovation effectively is important because policy is affected by how we measure results. Lord Kelvin's adage "if you cannot measure it, you cannot improve it" has an important implication: if something needs to be improved, it must first be measured correctly.

There is a particularly pressing need for good measures in the field of innovation. The most familiar and most widely accepted metrics of innovation still relate to a linear model of innovation based on science and technology and tailored to manufacturing industries. Despite the inclusion of aspects of non-technological innovation in surveys such as the EU's Community Innovation Survey, internationally agreed indicators such as expenditure on research and development (R&D), patent production, and numbers of science and technology graduates still loom large in public debate.[^1]

This measurement bias has shaped innovation policy. After several decades of measurement of R&D,[^2] many countries have formulated policies to encourage more of it. The Lisbon European Council set a target that EU member states should spend the equivalent of 3 per cent of GDP on R&D.[^3] Having identified innovation as one of the five levers of productivity,[^4] and thus part of a key PSA target, the UK government introduced R&D tax credits as a means of increasing it.

NESTA's Innovation Index is an attempt to provide a measurement of innovation that reflects how innovation really happens, and one that can both quantify the importance of innovation and act as a guide to better policy.[^5]

The Index - key findings

The improved measures of innovation deployed in the pilot Index have highlighted a number of important phenomena:

The UK invests more heavily in innovation than R&D measures would suggest. Private sector businesses invested £133 billion in innovation in 2007 (the most recent year covered by the Index), representing 14 per cent of private sector output. Although international estimates are not totally consistent, this compares favourably with the data available for countries like France and Germany, and is similar to the US. This may be one reason why the UK has enjoyed higher productivity growth in recent years than France or Germany despite concerns over its investment in R&D.[^6]

Most of this investment takes other forms than traditional scientific R&D. Traditionally, R&D expenditure has been used as proxy for innovation investment. However, R&D represents only 11 per cent of the investment in innovation measured by the Index, which includes a range of complementary investments needed to commercialise ideas, including product design, training in new skills, organisational innovation, developing new customer offering and brands, and copyright.

The findings of the Index to date show that innovation may be responsible for the lion's share of the UK's productivity growth from 1990-2007. Two-thirds of UK private sector productivity growth between 2000 and 2007 (1.8 percentage points of productivity growth per year) was a result of innovation.[^8] These first three findings on innovation investment and productivity constitute the headline messages of the Index.

Innovation is strongly linked to business growth across a range of sectors. It may come as no surprise that innovative software firms enjoyed a much faster growth rate than non-innovative ones (13 per cent average revenue growth per year compared to just over zero per cent). But this relationship held true even in sectors like legal services, where innovative firms enjoyed average revenue growth of over 10 per cent, while non-innovative firms' revenues shrank on average.

The UK is a relatively good place to innovate, but has some important shortcomings. On the basis of available internationally comparable data, the UK appears to be a mid-table performer when it comes to the wider conditions for innovation compared to other leading economies (including the US, France, Germany, Japan, South Korea, and Finland). Although there is scope to develop these data further, they suggest that the UK performed less well on three important indicators: access to finance, demand for innovation (in particular the use of government procurement to encourage innovation), and skills for innovation.

The Index builds on a range of existing attempts to measure innovation

NESTA is not alone in its desire to improve the measurement of innovation. The Index builds on a wide variety of research that has sought to measure national investment in innovation, how innovative firms are, and the innovation-friendliness of different countries.[^9]

The task of defining innovation has been the subject of detailed work, in particular by the OECD in successive versions of the Oslo Manual.[^10] These definitions have expanded over time from a narrow focus on technological product and process innovation to include a much wider range of activities, including marketing and organisational innovations, and to take account of innovation in services and low-technology sectors. A recent definition proposed by the US Advisory Committee on Measuring Innovation in the Twenty-First Century Economy is indicative of this broader definition; it describes innovation as "the design, invention, development and/or implementation of new or altered products, services, processes, systems, organizational structures, or business models for the purpose of creating new value for customers and financial returns for the firm".[^11]

The OECD's definition has played a central role in framing the Community Innovation Survey (CIS). This business-level survey, which has been conducted since 1991 by EU member states and Eurostat, asks businesses across the EU about their innovation activities. Six waves of the CIS have now been completed, providing an increasingly comprehensive view of innovation at the firm level, including product, process, organisational and marketing innovations.

The European Innovation Scoreboard (EIS)[^12] further evaluates conditions for innovation at the national level. It is a composite of a large number of indicators used to rank EU countries (and a number of others, including the US) in order of innovation-friendliness. Similar collections of indicators have been developed elsewhere, for example for the State of Massachusetts.[^13]

Research has also taken place to address the wider question of the impact of innovation on economic growth, as reflected in GDP. Particularly important to this have been macroeconomists' attempts to measure investment in intangible assets and their impact on economic growth. Intangible assets have been described as investments in knowledge capital, as distinct from physical capital or labour, the two factors of production at the heart of the traditional growth accounting approach which is consistent with national accounts. A way of measuring these investments was set out in 2006.[^14] Some early estimates have been made of the levels of intangible investment in developed countries.[^15] The exponents of the original research have argued that it offered a way of calculating the effect of innovation on the economy.[^16] These approaches are now being developed by the US Bureau of Economic Analysis.[^17]

The initial idea for a UK index to measure innovation was proposed by the DTI Innovation Unit in 1994, but was not implemented. The Innovation Nation White Paper of 2008 tasked NESTA with designing an Innovation Index, taking into account a broad definition of innovation. This pilot Index represents the first substantive output of that work.

The pilot Index has three components

The overall aim of the Innovation Index is to offer a significantly better basis for government policy that affects innovation. The pilot Index does this in the following ways:

1. Its most important component is a measure of the amount of investment in innovation in the UK economy, and the effect that this has on economic growth and productivity.
2. Its second component is a tool to understand innovation at the firm level that captures hidden innovation and reflects the different ways that innovation occurs in different sectors.
3. Its third component is a set of metrics that can be tracked to assess how favourable a climate the UK is for innovation.

Finally, it is intended to provide a measure of innovation in the public sector. The measurement of public sector innovation has not been carried out as part of the pilot Index, but will be included in the 2010 version of the Index.

The remainder of this report considers these three components in turn. In each case, the report identifies the work that has been done, the findings of the Index, and what will be done to develop the revised version of the Index.

Component 1: A measure of how much the UK invests in innovation and the economic impact of this

This is the most important and ambitious aim of the Index. The impact of innovation investment on economic growth, and specifically productivity, is of central concern to the Government. It is captured in the productivity Public Service Agreement Target shared by HM Treasury and the Department for Business, Innovation and Skills, the aim of which is to close the UK's productivity gap with the US, Germany and France. Innovation has been identified as one of the five levers to close this gap, but existing innovation metrics do not relate directly to productivity.

The pilot Index has generated a good working figure for the size of UK investment in innovation from 1990 to 2007, and the contribution this makes to GDP. The next phase of work between now and November 2010 will refine the precise types of investment included, improve the underlying data – partly through primary data collection through a new intangible investments business survey – and provide a further year of data and a replicable process for generating future years' figures.[^18]

A. What was done

A working definition of innovation investment as investment in new knowledge assets was adopted

The first challenge is defining what investments to count as investments in 'innovation'. Despite the work of the OECD and others to define innovation, existing definitions do not provide a simple distinction between 'innovation-related' and 'non-innovation-related' investments suitable for applying at the level of the national accounts;[^19] moreover, with the exception of spending on software, the national accounts do not treat spending on innovation as an investment.

For the purposes of the pilot Index, it was decided to define innovation investments as investments in knowledge, or, as macroeconomists would put it, intangible assets. This means that the Index measures not only scientific research and developments, but the downstream co-investments needed to commercialise and profit from new ideas.

This definition has two advantages:

First, it follows the approach for measuring innovation being considered by the US statistical authorities,[^20] and therefore increases the chances of obtaining directly comparable data from other innovation measurement exercises. Other developed countries have also undertaken some work to estimate the investment in intangibles, providing initial early points of comparison.

Second, it includes a number of investments that relate to important aspects of 'hidden innovation',[^21] such as organisational innovation, the investment in skills needed to provide new services, investment in product design, and investment in branding necessary to take an innovative product or service to market. Many of these, such as training and skills development and organisational improvement, are particularly relevant for innovative services businesses, and constitute the bulk of their investment in innovative offerings. Table 1 provides a number of examples of the practical importance of these types of investments to innovative firms and sets out the seven categories into which knowledge investment was divided.

Box 1 gives an example of how these different types of investment come together in practice in the real world to produce a recognisable innovation.

The next phase of the development of the Index will re-examine this definition of innovation and if necessary improve on it. In particular, NESTA will consider (and invite comments on) whether some measure of innovative tangible capital (such as cutting-edge computers or high-tech machines[^22]) should be included, how to include knowledge investments by the public sector (such as state-funded training), and whether some aspects of intangible investment should be excluded (in particular, some aspects of training and skills development, and some aspects of brand investment).

The measurement of these has been significantly improved compared with previous estimates

Previous attempts have been made to measure the amount of intangible investment in the UK[^23] and in other countries.[^24] The pilot Index builds on them but goes further by improving the UK data in several ways. First, it developed new estimates of investment in design for the UK, which capture both the design services bought from external providers but also that developed in-house by firms themselves. The latter was achieved by counting the hours spent by employees in a wide range of in-house design activities, from new engineering designs to the development of new financial instruments. Second, we collected new primary data[^27] that were used to test the robustness of the estimates for the different types of investment in innovation, with the result that the measures produced are more reliable.[^28] And last, but not least, we updated all the measures up to 2007, the latest year for which national accounts data are available.[^29]

The quality of data will be further improved in time for the revised Index report in 2010 through the use of a detailed survey on investment into innovative assets by UK firms.