Innovation for Growth i4g

Policy Brief N2

Public Procurement of Innovation

Lena Tsipouri

A powerful tool to foster innovation is targeted and specifically designed public procurement (PPI). Therefore, public procurement shall be utilised to stimulate innovation and to create new markets. Awareness rising and changing the minds of procurers is essential to overcome the slow and timid application of PPIs in Europe and to fight barriers and risks associated with the change of procurement culture. Actions required are: o o o Building up the necessary human resources and skills for operating PPI; Structural Funds envisaging enabling measures in their guidelines; A Minister responsible for both procurement and innovation and/or the establishment of special agencies.

Moderate innovator countries and catching up countries would benefit most of PPI as intervention needs are moderate and Structural Funds would be most instrumental.

This report does not necessarily reflect the views of the European Commission. These comments are based on a number of previous presentations including expert group reports for the EC.

Public Procurement of Innovation

Some definitions (What is meant by PPI?) Public Procurement of Innovation (PPI) is a demand-side policy instrument influencing innovation. It has been defined as the process by which public organisations place an order for the fulfilment of certain functions by a new product (good, service, system) that does not yet exist, and whose development and diffusion will influence the direction and rate of technological change and other innovation processes. Scholars consider it as a promising (though very challenging) and important demand-side innovation policy instrument (Dalp, 1994; Edler and Georghiou, 2007; Geroski, 1990; Rothwell and Zegveld, 1981). This policy sees the government as an intelligent customer able to combine the coverage of its needs with its development policy. PPI is a kind of public-private partnership, which, if properly implemented, can offer the best of both worlds: the government specifies a desired output, taking its immediate needs and/or future need and social challenges into consideration the private businesses creativity and efficiency are mobilised to meet the requirements with the best available technologies or with technologies developed specifically to provide the desired output.

It is suggested since decades that PPI is one of the most effective demand side measures (Geroski, 1990; p. 183). More recently in a survey of more than 1000 firms and 125 industry federations, over 50% of respondents indicated that new requirements and demand are the main source of innovations, while new technological developments within companies are the major driver for innovations in only 12% of firms (BDL, 2003 in Edquist 2012). The most recent evidence is from the UK, where in a survey of 800 responding suppliers 2/3 of firms said public procurement has had positive influence on innovation and 25% of firms attribute all R&D to demand by public buyers (Underpinn project)1. PPI can be classified according to (at least) two dimensions2: 1. The character of the procurer: Direct PPI is the simplest form, when the procuring organisation is also the end-user of the product resulting from the procurement but there is (or may be) another (public or private) market for the resulting product, which then is diffused. Catalytic PPI occurs when the procuring agency serves as a catalyst, coordinator and technical resource for the benefit of other end-users, not itself. 2. The novelty of the product and its position in the innovation cycle: The most promising but also more risky PPI is developmental PPI, which is the case when the procurer buys completely new-to-the-world products and/or systems are created as a result of the procurement process. It can be regarded as creation oriented PPI and involves radical innovation. Conversely adaptive or diffusion-oriented PPI is when the product or system procured is incremental and new only to the country (or region) of procurement. Hence, innovation is required in order to adapt the product to specific national or local
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http://underpin.portals.mbs.ac.uk These dimensions rely on definitions used in the papers of Edquist (2012), FhG (2005), EC (2009)

conditions. It may also be labelled diffusion oriented or absorption oriented PPI (Edquist 2012, EC 2005). Adaptive PPI may occur either intentionally (as a result of the procurers intention to support suppliers to adapt technologies) or unintentionally (in case the procurer is unaware of the adaptations needed and the benefits occurring because of that). Pre-commercial procurement (PCP), which has been extensively addressed in the EU3 refers to the procurement of (expected) research results and is a matter of direct public R&D investments, but with no actual product development. While it may eventually help producers to create innovative products and launch them into the market, at the PCP stage it is rather contract research and may include development of a product prototype; hence it is a supply side measure that neither creates nor stimulates a new market (Edquist 2012). Direct, developmental PPI has been practiced more extensively in the US defence sector and in the past in the Scandinavian countries. Adaptive PPI is increasingly used in the case of environmental protection and energy saving (alternative energies and waste management). Catalytic PPI is mostly encountered in countries with centralised public procurement authorities. Innovation leading countries and companies are more likely to generate developmental PPI, whereas diffusion can be encountered in all types of countries and companies.

The economic rationale (Why does it matter?) The underlying rationale for all demand-side policies is that the most effective way to stimulate innovation is by creating markets for innovative products, which improve business expectations. Public procurement is one way of market creation. In economic terms the rationale for intervention is based on fundamental arguments: Market failures lead to sub-optimal investment in R&D and innovation because of risks and appropriability: Hence the basic Arrow (1962) rationale applying to all R&D incentives apply to PPI as well. Economies of scale: New products need significant scale to amortise not only the investment necessary for R&D, but also investments and commercialisation costs, in particular for specialised and co-specialised assets (Teece, 1986). Innovation expenditure is usually much higher than R&D itself; hence an initial client, who can be relied upon for large quantities and be used for demonstration to trigger large scale global demand, may constitute a major milestone in the go/stop decision. Increasing competitiveness in new technologies in general and lead markets in particular. Conditions of domestic demand are one of the main dimensions that build up competitive advantages (Porter, 1990). Edler and Georghiou (2007) see the rationale of PPI in its role in supporting local demand (subsequently creating a lead market), which constitutes a major factor in the location decisions of companies and in the inclination to generate innovations in a given location. To some extent this reminds of industrial policy infant industry arguments and has thus been rejected by policy makers as a tool of protectionism in the past. However, PPI is not limited to

Communication

national boundaries and is hence not incompatible with EU competition rules. If anything, it is leverage to speed up creative destruction. An additional market failure refers to PPI as policy tool to satisfy social needs that are not met by markets. In the case of social challenges, the rationale of intervention takes public goods (like climate change) into consideration. The overall logic of intervention then is that, although PPI is not sufficient to turn innovative production into a profitable activity, it can have a major leverage effect, by intervening so that risks are reduced and anticipated private returns on investment become more attractive for the suppliers. At the same time the intervention envisages important social returns on investment, either by directly meeting social needs or by stimulating economic growth. Long-term social benefits justify support to make up for short-term reduced profitability.

Conversely, the risk of PPI is the creation of lock ins and the longer-term dependence of the public sector on specific technologies, which may prove outdated or too expensive. In addition PPI, in its form described here, may be seen as a classic demand-oriented tool that displace new ways of innovation produced directly by public services or by the codevelopment of innovations through public-private partnerships. The cases of urban public transportation and health services are reported as prominent such sources of innovation.

Experiences of PPI (Who does what) Both the OECD (OECD 2010) and the EU (Aho Report, Innovation Union, OMC PCP) promote PPI as an effective policy instrument. In their last amendment4 the EC Directives specify five different procedures that can be used for public procurement: the open procedure, the restricted procedure, the competitive dialogue, the negotiated procedure and the design contest. The competitive dialogue is especially relevant for complex public procurement projects, particularly those requiring significant technological innovation. With these amendments the Directives are no longer a legal barrier for PPI, although it is still a difficult procedure that public procurers prefer avoiding for convenience. Despite convergence of academic and policy recommendations PPI remains a rarely used instrument. At the level of rhetoric most EU member states recognise the relevance of such demand-side instruments for achieving the Lisbon objectives in their recent policy documents. In several cases discussions are launched and implementations are expected to start in the near future. But only few countries are adopting specific measures. (Germany, Sweden, UK, Flanders, the Netherlands and the UK are the best-known examples). However, even there, critical observers see progress as slow and timid (House of Lords 2010). In fact it is suggested that even in the Scandinavian countries, who were the champions of PPI (Edquist 2012) the number of PPIs is reducing rather than increasing. The US SBIR programme is one model that some EU member states have adopted (UK, the Netherlands) and others are discussing as a special adaptation of PPI. SBIR is, however, often (depending on its specific features) more a case of PCP than PPI. In other cases a special share of the public procurement budget is earmarked for PPI, such as in the case of the
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This refers to the formal adoption, there are new amendments planned but not yet adopted

Spanish Government passing a law fixing at 3% the objective of public procurement of innovation in 2013 for the budget of the General State Administration 5. Cyprus reports a similar internal discussion with no specific initiatives yet. In a similar but more refined approach in France the law of modernisation of the economy 2008 allows public purchasers to reserve a part of their public procurement for high tech, R&D and technological studies for innovative SMEs or by giving them preferential treatment for this procurement. Another option is a more systematic information tool towards the private sector by the creation of an Action Plan for the implementation of a demand- and user-driven innovation policy, as in the case of Finland. In addition in Finland public procurement actors can apply to TEKES for PPI funding in the dialogue phase/development of criteria etc. Similarly, the Flanders Action Plan on PPI, has adopted a horizontally integrated approach in order to help government to identify public demand and define purchasing needs and increase the public commitment to procurement of innovative solutions from the private sector (use of innovation platforms). (OECD, 2009). In Italy pilot cases are reported where two regional administrations launched pilot schemes investing research funds instead of procurement money to help regional supply (Bonnacorsi et al.) Selection of case studies in different papers and studies (TC 2012, OECD 2009, FhG 2006, EV 2009) indicate that the sectors of ICT and energy-environment (energy-saving construction and waste management) are probably the most often encountered cases of PPI, almost exclusively taking the form of adaptive PPI.

Problems and barriers (Why does it not work fast enough?) The slow and timid adoption of PPIs in Europe is attributed to a large number of barriers and risks associated with the change of culture necessary to massively change the state of mind of procurers. The barriers are of different kinds: 1. The dominant patterns of procurement and the resistance to change (inertia): Procurement processes developed over decades show that only competition, as understood by auction theory (Edquist et al., 1999) and price matter. The lack of interaction safeguards competition and the lowest possible price reduces public spending. The careers of procurers are traditionally built on these two criteria. Hence, their reluctance or hesitation to intervene in markets with insufficient information availability should not come as a surprise. With significant efforts the life-cycle cost idea could be adopted but further risky assumptions meet resistance. These dominant patterns prevent interaction, articulation of innovation needs and early communication of future needs. 2. The significant skills needed for operating PPI: Off-the-shelf public procurement is a relatively simple and straight forward process, requesting procurement specific
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http://www.micinn.es/portal/site/MICINN/menuitem.edc7f2029a2be27d7010721001432ea0/?vgnextoid=94af08541a901310V gnVCM1000001d04140aRCRD&vgnextchannel=4346846085f90210VgnVCM1000001034e20aRCRDc

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technical skills and basic management skills. Turning from simple procurement to PPIs means that more demanding and complex conceptual, operational and managerial skills will be needed to tackle information asymmetries and complex, multilateral negotiations. Technical skills and insight are more demanding the more PPI refers to radical innovations. These capabilities may be difficult to find and possibly even more difficult to reward appropriately in the public sector. The risks of the PPI process, which are by definition high constitute an additional barrier. Policy risks are even higher because, in addition to the technological risk, policy makers need to anticipate the response of actors. A risk analysis (EC 2009) decomposed the PPI risks into technological risks related to non-completion, underperformance or false performance of the procured good and service; organisational and societal risks of the procurement failing or under-delivering for reasons situated within the organisation that procures or to a lack of acceptance and uptake by the users; market risks are to be found on the demand and supply side and financial risks related to potential cost overruns and/or the inability to secure the funds needed. In addition to that uncertainties associated with large scale-projects, longer time-horizon projects can hamper the completion of a PPI. An additional risk, occasionally mentioned refers to market distortions. One is the danger of lock-ins mentioned above. Another one refers to the risk of large players dominating the global market. Finally there is a risk of de facto (hidden) protectionism, since it is argued that, even if competitive dialogue is open at the European level, procurers cannot avoid an inherent preference to negotiate with suppliers in close distance and similar culture. In certain cases the lack of an enabling environment can also be a factor that inhibits even the generation of ideas for PPI. The lack of sophisticated demand (in Porters sense) or incumbent national industries dominating the domestic market means that there are no potential suppliers interested to boost PPI. Finally the institutional framework, namely the EU directives, although not forbidding anymore, may discourage procurers, because of the caution they request.

Suggested interventions (What to do next?) It seems that there is no special need for more rhetoric or policy documents but actions/incentives to eliminate the barriers identified above, which have prevented the rise of PPI. To scale up this type of procurement interventions can take three different forms, analysed in order of increasing difficulty below. All three of them can be addressed with different degrees of ambition and intensity: The PPI culture and climate Policies Governance.

The PPI culture and climate: EU and national policy papers have paved the way towards raising awareness. The next step is to engage into changing career prospects and helping build up the necessary skills to successfully implement PPIs. The former is a matter of national public policy sanctions and rewards: internal procedures need to be formalised on how procurers who attempt PPIs are rewarded and reassured that potential failures will not be held against them (provided they have 6

adopted sound processes). This calls for innovative human resources policies in the public administration. The latter can only be addressed by extensive training for understanding the EU Directive, the options they offer and the way to address them. More importantly training is needed on how to deal with the different stages of the procurement process, when adopting PPIs: Identifying the requirements and user readiness; market intelligence; tendering process; assessing tenders and awarding contracts and managing contract delivery (FhG, 2005). Such training may be more effective if undertaken in networks of procurers rather than individual organisations.

It seems that the neither specific percentages earmarked for PPI, nor the action plans have as yet been able to trigger a change. What might be a next step would be a request to procurers to submit a short annual report indicating the list of procurements they undertook and for which, among them, they considered the option of PPI (when dealing with societal challenges) and why they adopted or rejected it. This can help build up a new way of thinking and combat inertia. Policy intervention: The most important barriers are associated with the risks that procurers face and their ability to overcome them. In addition to the training mentioned above, what is necessary are additional resources mobilised from outside the procurement budgets. These can take different forms, each one associated with its own challenges and benefits: 1. The adoption of SBIR-types of intervention is the most often discussed and adopted one. However, as with PCP, SBIR may or may not end up in successful PPIs. If, unlike the US, R&D support is offered under the condition that the outcome will be procured by a public organisation, this will be a clear PPI form. 2. Supporting procurers with innovation grants in the initial, preparatory stages of a PPI (based on the TEKES model mentioned above) is one way of facilitating the process and helping reduce information asymmetries. The problem with this type of policy intervention is that it offers limited resources that may not be sufficient to prevail over inertia. 3. Another form, if ambitions are to be increased is the mobilisation of innovation grants for the procurement process itself to complement the standard procurement budget. Procurers adopting PPI solutions could, under such facilities, request additional resources in order to decide on a PPI instead of of-the-shelf procurement for the same need. The synergies of the combined budgets would reduce financial risks but would trigger coordination problems that need to be addressed in new governance modes. 4. Finally, probably the most ambitious and challenging intervention would be a special insurance mechanisms for PPIs, in particular as an effective way to stimulate innovative procurement from SMEs. Korea has tried a programme of this kind established in 1996, which was not binding. The ultimate problem was the weak legal grounds for enforcing public procurement. A change of provisions led to a significant upscale and from 2000 to 2005 new SME technology products passed from 3% to 9.3%. The organisation and cost of such an intervention is a significant challenge. The first type of intervention described above only makes sense at the national level, the second and the third can be implemented at the national or at the EU (Commission) level, whereas the third might be best suited for EIB-EC cooperation. Structural funds can adopt

such interventions in their guidelines and pilot joint standard procurement and innovation policy support. In addition to such interventions that support procurers/suppliers directly, indirect interventions for the creation of platforms or lead market initiatives can be helpful, if adequately organised. This, however, only makes sense in innovation leaders and followers 6, where sophisticated demand and interested suppliers co-exist or at the EU level. Governance changes: The missions or needs of procuring agencies do not include an innovation rationale. PPI is in that sense a policy serving two masters. It may well be argued then that the current governance of public procurement is not well suited for PPI and there is a need for new governance models to address this double-aim by combined/coordinated instruments. In particular PPI raises important issues of governance and coherence between its primary goals and its goal as an innovation policy instrument. A simple change of governance is to adopt the idea of the Forward Commitment Procurement, which involves providing the market with advance information on future needs in outcome terms, early engagement with potential suppliers and the incentive of a forward commitment (House of Lords). This, combined with the idea of an annual report, mentioned above, can pave the way to a broader, more frequent procedure for subsequent PPIs. Another change of governance is the idea to create special agencies to manage PPI (Netherlands and UK), which will have the necessary human resources and expertise to deal with the procurement of functional requirements rather than products or services. They can act as support mechanisms to standard procurement agencies. Still another, more radical option, is the proposal of the House of Lord in the UK, which calls for a single Minister being made responsible for both procurement and innovation across government and that, further, a Minister should be appointed in each government department with specific responsibility for procurement and innovation within their departments. In addition departmental Chief Scientific Advisers should have a greater role in ensuring the procurement of innovative ideas by their departments, encouraging engagement with industry and academic communities and assisting departments in the formulation of their long-term planning through horizon-scanning activities. Finally, an option combined with the policy measure suggested for shared budgets above, would be for an ad hoc coordination committee or innovation policy makers and procurers to follow up throughout the individual PPIs.

Conclusions It is suggested that PPI needs to be adopted to stimulate innovation and competitiveness in Europe and mobilise additional resources to meet the Lisbon objectives. Despite recent policy documents this has not sufficiently taken off the ground. Hence, a number of possible interventions are suggested to scale it up. These need reorganisation, cost and persistence. They are more likely to be adopted by innovation leaders but direct, diffusion PPI is likely to

In the jargon of the IU Scoreboard

come up in moderate innovators and catching up countries are well. The following matrix suggests how the risks and interventions needs can be illustrated: Development PPI High risks, high rewards (potential lead market development), need for coordinated, ambitious interventions High risks, high rewards (potential lead market development), need for ambitious interventions and multi-level coordination Diffusion PPI Easiest and most often encountered type; intervention needs are moderate; use of Structural funds can play a major role Relatively easy process with coordination problems; use of Structural funds can play a major role

Direct

Catalytic

It is, however, important to note that PPI should not be interpreted as panacea. On the contrary it is loaded with justified barriers and reluctance that need to be carefully addressed at the level of implementation. In addition, at the level of policy design it needs to be carefully addressed to avoid the creation of lock-ins and/or the displacement of innovations produced directly in the public service.

REFERENCES Edquist, C., Zabala-Iturriagagoitia, J. M. (2012), Public Procurement for Innovation (PPI) as Mission-oriented Innovation Policy, Version of April 7, 2012. Accepted for publication in Research Policy. Forthcoming during 2012. Edquist C., Hommen L., Tsipouri L. (eds.) (2000), Public Technology Procurement and InnovatioN, Kluwer Academic Publishers Group. Edler, J. and Georghiou, L. (2007), Public procurement and innovation -Resurrecting the demand side. Research Policy, 36(9), 949-963. Fraunhofer Institute Systems and Innovation Research (2005) Innovation and Public Procurement. Review of Issues at Stake, Study for the European Commission (No ENTR/03/24) Georghiou, L, (2007), Demanding Innovation Lead Markets, Public Procurement and Innovation, NESTA Provocation 02: February 2007, London: NESTA.