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Expert Panel Consultation Paper: Section 2

Public Policy and Business Innovation

The rationale for public support of business R&D

Public support for business R&D has been justified on the basis that the benefits of such activities often extend beyond individual firms, generating positive outcomes for the entire economy.

This justification is most compelling in instances where the activity is not likely to yield immediate profits or other benefits that can be limited to the individual R&D-performing firm, yet holds potential for longer-term benefits for society at large. Thus, the justification for government intervention is strongest in the case of basic research activities. The strength of the justification declines as research activities progress through the various stages leading to commercialization — i.e., from basic research through to applied research, experimental development, and commercialization. The benefits of these successive activities are progressively more likely to be captured by the R&D performer, and there is correspondingly less likelihood of "spill-over" to the larger economy.

Defining innovation

The Oslo Manual (2005) is the basis for the OECD definition of innovation: "the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organizational method in business practices, workplace organization or external relations" (p. 46).

Business innovation

Examining the effectiveness of federal support for business R&D activity requires an understanding of the wider context in which business innovation occurs. The CCA's model on business and innovation strategy is very helpful in this regard.7 Figure 2, below, is a modified version of that model. It illustrates that a range of factors influence a company's choice to adopt innovation as a competitive strategy — a choice that compels it to seek inputs in support of its innovation activity.

Figure 2: Business Innovation

Figure 2: Business Innovation
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Factors influencing business strategies for innovation

The CCA outlines five principal factors that influence a business's decision to compete on the basis of innovation — factors whose relative importance varies from sector to sector and according to the specific circumstances of each individual firm. As depicted in the above illustration, they are the following:

  • Structural characteristics. For example, is the firm in a sector that is traditionally innovation-oriented or is it involved in the provision of a more standard product or service? Is the firm a subsidiary of a foreign company that conducts most R&D abroad?
  • Competitive intensity. For example, must the firm continuously innovate to survive because it provides a product or service driven by evolving customer tastes? Is the firm active in a foreign market, where global competition might be intense? Is the firm subject to foreign competition in Canada?
  • Climate for new ventures. For example, is the firm part of an innovation cluster in which there is a readily available supply of sophisticated venture financing, cutting-edge knowledge, highly skilled graduates, and other firms with complementary expertise and synergistic characteristics?
  • Public policies. For example, are legal and regulatory frameworks and policies — e.g., in areas such competition, corporate taxation, bankruptcy, and intellectual property — conducive to business innovation?
  • Business ambition. For example, what is the "corporate culture" of the firm? Is it risk-averse? Is it dedicated to expansion?

While this Review is focused on federal support to business and commercially oriented R&D, these factors help explain the overall innovation context and can have a bearing on the effectiveness of federal R&D support. This is because a business's investment in R&D will depend, first and foremost, on its prior commitment to an innovation-oriented strategy for which R&D is an important enabler — i.e., the "demand" for R&D originates in business strategy.

On the other hand, the extent of R&D undertaken by a company will also depend on its cost. Consequently, if government policies and programs reduce the "supply" cost of R&D for a business, it will likely undertake more R&D than would otherwise be the case, with presumably greater spill-over benefits for the economy at large. R&D incentives may even be sufficiently attractive to induce a shift in a business's strategy, moving it toward a much greater focus on innovation. Perhaps more likely, R&D incentives may induce an innovation-focused company to reallocate activity — for example, by expanding its innovation-related expenditures — to take advantage of the incentives.

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Inputs to business innovation

The foregoing factors, in various combinations, generate the pressures and opportunities for innovation. Once a company chooses to adopt innovation as a competitive strategy, it seeks out the necessary enabling inputs: (1) ideas and knowledge; (2) talented, educated, and entrepreneurial people; (3) networks, collaborations, and linkages; and (4) capital and financing. Federal support for business R&D takes the form of specific initiatives that help businesses develop or access each of those four inputs. As such, understanding the larger Canadian context for each input is essential to examining the role and effectiveness of the initiatives at the core of this Review.

Ideas and knowledge

Ideas and knowledge are key inputs to business innovation. Companies can acquire ideas and knowledge — for instance, by purchasing or licensing intellectual property. They can also develop ideas and knowledge in support of their innovation strategies by performing in-house R&D. Canada's business sector lags behind comparator countries in the amount of R&D it performs relative to the size of its economy (as seen in Figure 1, above).

That said, BERD intensity varies considerably across firms, regions, and industry sectors. In absolute terms, private sector R&D spending is weighted toward a relatively small number of large firms in a limited number of sectors. However, while the vast majority of smaller businesses do not perform R&D, those that do tend to be more research-intensive than larger firms — i.e., they spend more on R&D as a percentage of company revenue. Specifically, Statistics Canada's preliminary data for 2007 indicates that R&D expenditures among the largest R&D-performing companies (revenues exceeding $400 million) represent one percent of their revenues. In contrast, for the smallest R&D-performing companies (revenues of less than $1 million), the figure stands at almost 40 percent.8

The R&D commercialization ecosystem

Inventions are not considered to be business "innovations" until they achieve significant commercial penetration. Commercialization is a multifaceted, complex, and non-linear process that involves any or all of the following activities: business planning, identifying customer needs, basic and applied research, experimental development, market engagement and testing, and financing.

The roles of the various players in Canada's commercialization ecosystem are equally complex. Government laboratories conduct science in support of public policy mandates and, in cases like the National Research Council, contribute to commercially-oriented R&D. Universities, colleges, and polytechnics provide a high-quality supply of graduates to renew and enrich the labour force.15 Supported by the federal granting councils and other funders, these institutions also perform R&D, with universities undertaking a significant amount of basic research, though basic and applied research activities are increasingly intertwined. As for R&D-performing colleges and polytechnics, research is often focused on helping companies address commercialization challenges by turning those challenges into student-led applied research problems. With respect to private sector R&D activities, most research performed by firms is applied and explicitly developed for business purposes, primarily commercialization.

From a regional perspective, there are also significant differences in BERD intensity, with the two most BERD intensive provinces (Ontario and Québec) accounting for roughly 80 percent of Canada's business R&D spending.9 Moreover, BERD intensities vary considerably across industry sectors, with approximately 80 percent of R&D focused in sectors that account for approximately 25 percent of GDP.10 Some of the most BERD intensive manufacturing sectors include: office accounting and computing machinery; radio, television, and communication equipment; and pharmaceuticals.

Given the integration of Canada's economy with that of the US, the evolution of the Canada-US BERD gap is of particular interest (see Figure 3, below, for a sectoral breakdown of the gap in the most recent year for which comparable data is available). The CCA conducted a sector-by-sector analysis of the gap over the 16-year period beginning in 1987. The analysis concluded the following:

The most significant drivers of the long-run trend have been (i) a sharp reduction in the contribution of the manufacturing sector to the Canada-US gap, implying that Canada has been making some progress in manufacturing innovation; and (ii) an offsetting increasing gap in business services R&D (particularly in wholesale and retail trade). The broad shift of output and employment toward services and the application of ICT in service sectors have been occurring more rapidly in the United States than in Canada.11

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The analysis also considered the effect of two key factors in contributing to the gap: variations in the sectoral composition of the Canadian and US economies, and differing R&D intensities within the same sectors. It concluded that "generally lower Canadian R&D spending within the same sectors in both the United States and Canada accounts for a greater portion of the gap… than does Canada's adverse sector mix — i.e., the greater weight in Canada's economy of resource-related and other activities that have inherently low R&D spending."12 In other words, relative to the US, there is a pervasive weakness in BERD intensity across many sectors in Canada.

Figure 3: BERD Intensity Gap by Sector, US and Canada, 200313
  Sector share of business GDP (%) BERD intensity (%) Contribution to gap
Canada US Canada US Gap

* Excludes agriculture, primary forestry and fishing and real estate services. (Return to Table reference 1)

Gap is defined as the "sector share of BERD intensity times sector share of GDP." (Return to Table Reference 2)

n.e.c = not elsewhere classified. (Return to Table Reference 3)

§ An omnibus group of subsectors (including medical precision instruments, among others) that is not further broken down in the source database. (Return to Table Reference 4)

Business Sector* 100.0 100.0 1.86 2.90 1.045
Manufacturing 25.4 21.4 4.51 8.20 0.611
Motor vehicles and parts 3.3 2.0 2.07 13.31 0.199
Phamaceuticals 0.6 1.1 25.10 21.12 0.081
Aircraft and spacecraft 0.7 0.7 16.95 28.05 0.070
Chemicals, excluding pharmaceuticals 1.4 1.5 2.24 6.68 0.068
Machinery and equipment, n.e.c 1.6 1.4 3.86 6.69 0.028
Rubber and plastics products 1.3 0.9 0.43 2.75 0.020
Food products, beverages, and tobacco 3.2 2.4 0.62 1.29 0.011
Electrical machinery and apparatus, n.e.c 0.4 0.7 5.63 4.25 0.010
Other non-metallic mineral products 0.7 0.7 0.84 1.05 0.001
Coke, refined petroleum products, and nuclear fuel 0.5 0.6 3.59 3.35 0.000
Fabricated metal products, except machinery and equipment 1.8 1.5 1.25 1.29 -0.003
Textiles, textile products, leather, and footwear 0.8 0.6 1.17 0.75 -0.005
Radio, TV, and communication equipment 0.8 1.0 43.68 33.60 -0.008
Office accounting and computing machinery 0.1 0.3 55.91 13.93 -0.016
Basic metals 1.4 0.6 2.54 1.38 -0.028
Wood, paper, printing, and publishing 5.3 3.6 2.45 1.49 -0.075
Other manufacturing§ 1.3 2.0 4.16 16.10 0.259
Business Services 52.9 66.2 1.21 1.72 0.496
Wholesale and retail trade 17.3 20.1 0.52 1.91 0.294
Other services 14.6 24.1 2.90 2.92 0.279
Financial intermediation 10.9 12.5 0.36 0.17 -0.018
Transport, storage, and communications 10.1 9.5 0.86 0.29 -0.059
Mining & Quarrying 9.5 2.1 0.51 0.08 -0.046
Utilities 4.1 3.2 0.43 0.07 -0.015
Construction 8.1 7.2 0.07 0.07 -0.001

In a forthcoming report on business innovation policies, the OECD underlines a renewed focus in many OECD countries around the use of procurement as a tool to create demand for business innovation.14

Talented, educated and entrepreneurial people

A fundamental role of Canadian universities, polytechnics, and community colleges is to educate the individuals whose skills and talents are required to support business innovation, which depends on workers with a wide range of creative, entrepreneurial, commercial, managerial, technical, and scientific skills.15 As such, Canadian businesses need people with knowledge and expertise in disciplines ranging from science, technology, engineering and math ("STEM" disciplines), through to commerce, management, the social sciences, humanities, professions, and the arts.

Canada's record in this regard is mixed. Canada ranks first in the OECD in graduation rates at the college level and places around the OECD average in graduation rates at the bachelor's level. However, it is below the OECD average in graduation rates for master's and PhD degrees.16 This seems to be related, in part, to a weak demand for individuals with these degrees. In comparison to the US, a lower proportion of the Canadian labour force has advanced degrees in most industry sectors.17 Moreover, relative to high school graduates, the earnings advantage of individuals with advanced degrees is less pronounced in Canada than in the US.18 This would be consistent with other evidence that Canadian firms, on average, may not be as committed to investing in — and retaining — the high-quality talent of Canadian graduates for the advancement of their own innovation strategies.

A strong foundation of entrepreneurial and commercial skills is another vital aspect of business innovation. There is evidence that Canada faces some challenges in this respect. For instance, as noted in STIC's State of the Nation report, "Canada has far fewer degrees in business both at the undergraduate and graduate level than the US. Overall, managers in Canada generally have lower educational attainment than those in the US, and CEOs of our largest companies tend to have less formal business education at the graduate level."19

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Networks, collaborations, and linkages

The successful introduction of new products and processes can benefit from collaboration among firms, governments, and the higher education sector. Businesses develop strategic partnerships to connect to global knowledge flows, share research results and R&D risks, pool skilled staff, commercialize inventions, and help access new markets. As a result, social and physical infrastructure linking collaborators and networks — and, on a larger scale, clusters — are important for innovation and commercialization.

In the case of effective collaborations between the business and higher education sectors, they depend on linking the "supply-push" of research and discoveries with the "market-pull" of firms seeking to exploit their commercial potential. In its overview of public-private collaborations, the STIC explains:

While the overall picture is mixed, the balance of evidence suggests that many Canadian universities are first-rate scientific institutions. But in the context of the knowledge-based economy, it is not considered sufficient for a country's universities to produce groundbreaking scientific research in isolation. A growing body of research suggests that effective links between the three principal innovation funding/performing sectors [business, post-secondary education, and government] are an important contributor to a successful national innovation system, especially as a mechanism for transfer of S&T into the commercial sphere.20

One of the positive indicators of the state of public-private partnerships in Canada is that the country ranks above the OECD average in respect of the percentage of higher education expenditures financed by industry.21 This suggests that universities and colleges are playing an important role as a resource for business innovation for certain activities and sectors. On the other hand, STIC underlines that "the OECD placed Canada near the bottom of OECD countries in terms of the proportion of businesses collaborating with universities for R&D."22

Although commercialization is a key aspect of public-private collaborations, networks, and linkages, it is important to note that there are many other benefits stemming from such partnerships. These include: open scientific communication and consultation; industry access to specialized equipment, facilities, and personnel (including, in particular, potential future employees); and stimulation of new research questions and directions arising from problems faced by innovative firms.

Capital and financing

Innovative start-up firms can only become sustainable businesses if they have access to risk capital enabling them to build a bridge between their innovative ideas and commercial viability. Risk capital can originate from internal earnings or from external sources of capital. With respect to the latter, risk capital can take the following forms:

  • Seed capital. In the early or seed stages of firms' development, entrepreneurs must finance activities such as proof-of-concept, product development, and initial marketing. To do so, they often depend on informal investments provided by family, friends or "angels." The latter, who are external to the firms themselves, are typically wealthy individuals with knowledge of the business sector and relevant technologies.
  • Venture capital (VC). In the post-seed stage of commercial validation, entrepreneurs depend on VC, which is generally provided through professionally managed funds combining the resources of a group of investors. Together with seed capital, VC is vital to the survival and growth of innovative start-up firms, which typically do not have access to traditional institutional funding, given that their projects are difficult to assess by non-specialists, that they entail greater risk than other investment classes, and that they require long lead times to commercialization.
  • Support from traditional institutions. When firms move beyond the first stages of commercialization and seek to rapidly expand their small businesses into medium-sized or larger enterprises, there is a need to employ greater amounts of capital. In most economies, this is the role of the public markets. However, there can also be institutions — i.e., private equity, pension funds, and banks — that target this gap and provide risk capital at the expansion stage.

Without an active presence in Canada of adequate sources of capital — including the associated and critically important knowledge, experience, and mentorship of investors — there is a chance that the commercial benefits of innovations originating in Canada are exploited by firms in other countries with greater capital capacity.

In its analysis of the state of risk capital in Canada, the CCA concludes that "the limited data available on 'informal' investment sources in Canada suggest that they are much less extensive, in relative terms, than comparable sources in the United States."23 It underlines that this has repercussions extending beyond the availability of financing, since investors, as noted, are an invaluable source of advice, mentorship, and expertise.

As for VC firms, the CCA analysis also points to a number of challenges facing Canada. For instance, it underlines the lower rates of return of Canadian VC funds relative to the US. It concludes that "the generally weak performance of Canada's VC industry is due to the fact that the industry is still relatively young, and thus has not yet developed sufficient depth of experience to select and mentor the best potential investment candidates."24

Capital investments in physical machinery and equipment may also spur innovation within firms, as they embody the latest ideas, technologies, and innovations developed by others. In its most recent Report on Canada, the Institute for Competitiveness & Prosperity shows that the Canadian business sector has persistently lagged behind its US counterpart in ICT machinery, ICT equipment, and software investments per worker. In 2009, the Canada-US gap in ICT investment per worker stood at roughly $1,500 — or almost 40 percent. The Institute underlines two main challenges that have, in the past, inhibited businesses' willingness to ramp up investments in technology: relatively high tax rates on capital investment and a lack of competitive intensity. It notes, however, that significant progress has been made on the tax front.25 With respect to competitive intensity in Canada, it may be weakened by relatively small Canadian markets and differences across sectors in the extent of openness to international competition.26

For further information about the topics covered in Section 2, please refer to the Reference Documents that will posted on the Panel's website from time to time, starting in January 2011 (

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Consultation questions

  1. In addition to the R&D activity defined by the OECD, should government be funding other business activities related to the commercialization of R&D? If so, what and why?
  2. Does Figure 2, the model of business innovation presented above, capture the key structural factors and inputs to innovation? If not, what is missing?
  3. Regarding capital, is there an adequate supply of risk capital for Canadian firms at each stage of their growth (start-up, small, medium, large)? If not, why not? Where returns on investments are low, what are the reasons and potential solutions?
  4. Regarding ideas and knowledge, do you believe it is important for Canadian firms to perform their own R&D and, if so, what do you believe are the key factors that have been limiting business R&D activity in Canada?
  5. Regarding networks, collaborations and linkages, what are the main impediments to successful business-university or business-college partnerships? Does the postsecondary education system have the right capacity, approaches, and policies for effective partnerships with business?
  6. Regarding the creation of demand for business innovation, what role, if any, do you believe that government should play in being a "first customer" for R&D investments in Canada?
  7. Regarding talent, is Canada producing sufficient numbers of graduates with the right skills to drive business innovation and productivity growth? If not, what changes are needed? Where demand for advanced skills is low, what are the reasons and what changes, if any, are needed?
  8. Can you describe whether and how your firm employs students currently enrolled in community colleges, polytechnics and universities, and what government measures could make it easier to work with students during their academic programs and to recruit them after their graduation?