Innovation is certainly in the headlines, not just in Canada but around the world, as countries struggle to create good jobs, generate wealth and raise living standards in an increasingly competitive global economy. One of Barack Obama’s first acts as US president was to unveil an innovation strategy. Britain’s coalition government has boosted innovation spending despite massive cuts elsewhere. The European Union has embarked on a new innovation strategy. China, in its latest five-year plan, is heavily focused on making the transition to an innovative, high-value economy while India and Brazil are unveiling manufacturing strategies.

Innovation is how the world will meet challenges such as climate change, a low-carbon economy, improved agricultural production and an aging society. Innovation is especially important for Canada since innovation drives productivity, which is the key source of sustained improvements in living standards, yet Canada’s productivity performance has seriously lagged that of many other competitor nations for the past two decades. The aging of our population adds to the urgency. Statistics Canada recently forecast that by 2031, there will be fewer than three people in the labour force for every retiree, compared to just under five today. To sustain our quality of life we will need major improvements in innovation and productivity to compensate.

If anything, the pace of innovation has accelerated, as we can see with the ever-changing array of mobile electronic devices such as smartphones, e-readers and various versions of the iPad where RIM, Apple, Samsung, Microsoft, Nokia and others are in a fast-moving race to advance technologies and introduce new products. Likewise, the automotive industry is undergoing its own fast-moving technological revolution. The competitive environment is becoming increasingly intense.

Understanding what we mean by innovation is important. Innovation is clearly about creating new products and services, and new ways of making and delivering them. But it is also about developing new markets, creating new business models, restructuring the workplace and improving skills. And while much innovation comes from investing in new machinery and equipment, including information and communications technologies, it is also, increasingly, about investing in intangibles such as research and development, design and engineering, software and systems, marketing and brand building, employee training and management.

But if Canada is to improve its productivity through innovation, the key focus must be on the business sector. It is in individual companies that customer needs and opportunities are identified and pursued. Bombardier’s development of the Q400 aircraft, Magna International’s development of hydroforming technology, Research in Motion’s BlackBerry, McCain Foods’ success in processed foods, SNC-Lavalin’s engineering capabilities, the Cirque du Soleil’s entertainment success and CAE’s flight simulators are all based on identifying customer need.

Universities and colleges are crucial in graduating well-educated and innovative students, conducting fundamental research and helping companies overcome technical or other problems. Public policy can remove barriers and provide incentives for innovation. But the decision to pursue a new product or service starts in a business. The decision to pursue a strategic innovation strategy to deliver new or improved products or services that customers will buy is the critical first step, by either an established business or an innovative entrepreneur. Once that decision is made, then the role of universities, public policies, partnerships with suppliers and other factors in the innovation process kick in. So the biggest challenge is to spur Canada’s business community to take innovation much more seriously and make innovation its core strategy.

Universities and colleges are crucial in graduating well-educated and innovative students, conducting fundamental research and helping companies overcome technical or other problems. Public policy can remove barriers and provide incentives for innovation. But the decision to pursue a new product or service starts in a business.

This concern over innovation is far from new. Canada’s poor productivity performance has been the subject of study for a long time, and with it the recognition that innovation is the key driver of productivity. Canada’s business sector productivity fell from 93 percent of the US level in 1984 to 76 percent in 2007. This compares with 92.1 percent in France, 89.8 percent in Germany, 83.7 percent in Sweden and 78.5 percent in Britain.

Successive governments have tried to address the innovation gap. The Mulroney government set up the National Advisory Board on Science and Technology, which produced excellent reports on boosting Canadian innovation and productivity and pursued its Prosperity Initiative. It also launched the Networks of Centres of Excellence to link business and universities in precommercial R&D. In 1991, Michael Porter and the Monitor Group produced an important assessment of Canada’s weak innovation capacity, in their report Canada at the Crossroads.

The Chrétien government, in turn, launched its own science and technology review and pursued its own innovation agenda. This included the establishment of the Sustainable Development Technology Fund, Technology Partnerships Canada (abolished by the current government in 2007) and various programs to boost university research, such as the Canada Foundation for Innovation and the Canada Research Chairs. As well, in 2006, its Expert Panel on Commercialization published a report, People and Excellence: The Heart of Successful Commercialization, which highlighted “the low level of commitment by many Canadian businesses towards research and many other facets of innovation, especially in comparison to these levels of commitment among Canada’s major competitors.”

The Harper government spawned three new studies: the Competition Policy Review Panel’s report, Compete to Win; the report of the Council of Canadian Academies, Innovation and Business Strategy: Why Canada Falls Short; along and the report of the Expert Review Panel on Research and Development which should appear in the near future. The current government is pursuing its own innovation strategy, Mobilizing Science and Technology to Canada’s Advantage, which includes the Canada Excellence Research Chairs, the Centres of Excellence for commercialization, the Automotive Innovation Fund and the Strategic Aerospace and Defence Initiative.

Yet while progress has been made and the policy framework improved, the underlying problem persists. The consultation paper of the Expert Review Panel on Research and Development questions whether our businesses can become as innovative as they must to respond to big changes in technology and markets around the world. “There is some evidence to suggest that Canada is not well positioned to become an innovation leader” and prosper in a fast-changing world, it said. “In-depth analyses of the Canadian economy’s weak performance in business innovation and productivity growth indicate that Canada’s BERD [business spending on R&D as a share of GDP] — a key indicator of innovation activity — is lagging significantly behind competitor countries.” According to the OECD, Canadian business spending on R&D in 2009 was 0.913 percent of GDP, compared to 2.022 percent for the US, 2.527 percent for Japan, 2.553 percent for Korea, 1.878 percent for Germany, 2.545 percent for Sweden and 1.248 percent for China.

This warning is not much different from the 1991 Porter report. Porter was blunt in his assessment. Canada, his report said, was too dependent on the export of relatively unprocessed natural resources produced with imported technologies, lacked an innovation mindset, was especially weak in the design and production of machinery and equipment, had too few companies looking to markets beyond the US, suffered from too few Canadian multinationals and too many foreign branch plants, had too few supplier industries for advanced parts and components, and had an abysmal productivity performance.

Canada’s “most serious weakness,” it said, was its low productivity growth; since the early 1970s Canada had ranked near the bottom of all major industrial countries in productivity growth. Canada was “in many respects ill-equipped to respond to a rapidly changing competitive environment.”

In essential areas such as science and technology and education and training, combined with a poor economic environment of high budget deficits and high taxes, Canadian industry was hard-pressed to do the critical upgrading it urgently needed. Moreover, the report said, “owing to Canada’s extensive trading relationship with the United States and its unusually high degree of foreign ownership, the shifting character of international competition poses particularly daunting challenges for Canadian firms and public policymakers.”

A key priority for Canada was to attract more “home bases” — ideally Canadian-controlled, Canadian-headquartered companies or foreign subsidiaries with global or North American product mandates. “Typically, a company’s home base is where the best jobs reside, where core research and development is undertaken, and where strategic control lies. Home bases are important to an economy because they support high productivity and productivity growth.

In the context of the changing global economy, we believe that Canada is in danger of losing much of its capacity to attract and retain home bases.” Foreign subsidiaries, it said, tended to source from abroad.

With a high level of foreign ownership, the Porter report said, “many of the strategic decisions in important Canadian sectors are made, based on the overall global strategies of parent companies. How the choices made by these parent companies with respect to the location of home base activities for all or segments of their businesses will evolve in response to changes in international competition is a critical issue for Canada.” Pratt & Whitney operations in Canada are a good example of a “home base” activity since the Canadian subsidiary has the world mandate for turbo-prop aircraft engines — and consequently has a large engineering workforce and is an important investor in R&D in Canada. But with much faster growth potential and rising educational levels in countries such as China, Brazil, India and Mexico, Canada will have to compete much harder for multinational “home base” investments.

Most foreign investment in Canada had been made to access natural resources or located here to gain access to the Canadian market when tariffs were higher. But the most beneficial form of foreign investment, the report said, is that which establishes a “home base” for a particular business or business unit, since this signals that Canada possesses true international competitive advantage in that industry.

Statistics Canada recently forecast that by 2031, there will be fewer than three people in the labour force for every retiree, compared to just under five today. To sustain our quality of life we will need major improvements in innovation and productivity to compensate.

The Porter report was especially concerned over the lack of a significant machinery and equipment industry in Canada since development of advanced machinery and equipment in partnership with core user industries gives those industries quicker access to fast-changing process technologies. Canada, it found, imported much of its machinery and equipment, which meant many Canadian companies lagged in the adoption of new technologies — and hence were less innovative. Canada’s “weakness in related and supporting industries is both a cause and a result of Canada’s lack of a vibrant domestic machinery and equipment industry,” Porter said. It’s estimated that Canadian industry imports about 70 percent of its machinery and equipment.

Canada, Porter concluded, needed to become an innovation-driven economy. “Canadian enterprises in all sectors must move to develop innovation-based advantages” while “governments must align their policies to support this strategic objective.” While natural resources will remain important for the Canadian economy, Canada must develop more specialized technologies and upgrade its resources to more sophisticated and differentiated products.

Paul Romer, the Royal Bank research fellow at the Canadian Institute for Advanced Research and a key figure in the development of what is known as endogenous growth theory, which links economic progress to investments in innovation, argued in a 1994 article in Policy Options that “the most important job for economic policy is to create an institutional environment that supports technological change.” Government, he said, must support a high level of research and discovery, and market incentives must guide the process of discovery.

Statistics Canada recently forecast that by 2031, there will be fewer than three people in the labour force for every retiree, compared to just under five today. To sustain our quality of life we will need major improvements in innovation and productivity to compensate.

Government, he added, must also support a high level of interaction between business and universities. “Nations that can sustain a policy stance that tolerates, or perhaps even fosters, the process of creative destruction can count on sustained economic growth,” Romer wrote, adding that “those that are most successful in creating institutions that foster discovery and innovation will be the worldwide technological leaders.”

Fast-forward almost 20 years to 2009 and the report of the Council of Canadian Academies on innovation and business strategy. Not much had changed since Porter’s report. Innovation and poor productivity were still the defining issues. “The persistently lagging growth of labour productivity in Canada is due primarily to the weak innovation performance of the business sector,” its report said. And, it continued, “the weak innovation performance of Canadian business is due to the fact that relatively few Canadian companies adopt innovation-based business strategies.”

The purpose of the task force was to determine why Canadian businesses invested so little in innovation. To do this it focused on identifying how companies actually made the decision on whether to compete on the basis of innovation or on some other strategy such as cost-cutting. The factors that influenced a business decision, it said, included structural characteristics (what sector or whether it was foreign-controlled); the competitive intensity of the industry it was in; the environment for new ventures (for example, the availability of financing); public policies that encouraged or inhibited innovation; and business ambition (was the company ambitious and focused on growth). The council found two features of the Canadian economy that it said were especially significant. One was the high level of foreign ownership in several major Canadian businesses, such as automotive and chemicals, which meant that many of Canada’s larger companies had little direct contact with final customers — instead they were integrated into parent-company value chains. Yet contact with final customers is one of the most important drivers of innovation. This helped explain why Canada was a commodity supplier and technology adopter. “Canada’s failure to develop a greater number of innovative Canadian-based multinationals has been a key contributor to the country’s overall R&D weakness,” it said.

The other factor was the relatively small size and geographic fragmentation of the Canadian market. Small markets, the report said, “are less conducive to innovation” than larger markets like the US. Why is this so? Smaller markets offer lower potential reward for undertaking the risk of innovation; and smaller markets tend to attract fewer competitors and therefore provide less incentive for companies to innovate.

Yet other countries with much smaller domestic markets, such as Sweden and Taiwan, have shown that the disadvantages of a small market can be overcome if there is a strong emphasis on innovation-intensive exports. So business strategy is critical. While resources make Canada wealthier we have relied too much on exports of unprocessed natural resources.

Like the Porter report 20 years earlier, the council report underlined the fact that “Canada has a serious productivity growth problem,” and stressed that “Canadians should be concerned about the productivity of our export-oriented economy as competition from China and other emerging economies intensifies.” But, the council report said, “Canada’s productivity problem is actually a business innovation problem.” There was no single cause and no one-size-fits-all solution, the report said, calling for a sectoral approach in analyzing, for public policy purposes, how businesses made decisions in each important business sector.

The task force, which was asked by the federal government to analyze the reasons for the weak innovation performance by business rather than to make recommendations, nonetheless made some broad proposals. These included measures to boost investment in advanced machinery and equipment, especially ICT; promotion of a stronger export orientation by Canadian companies, especially those that deal directly with final customers (these tend to be Canadian-controlled); improving the climate for innovative entrepreneurs so as to transform university research into successful commercial results; and supporting key areas of Canadian strength through focused sector strategies.

Canada has not been standing still. Major tax changes have been made, including elimination of the capital tax, reduction in corporate tax rates and tariffs on imports of machinery, and tax incentives for investment in machinery and equipment. The macroeconomic environment has been much improved since the mid-1990s when the government of the day moved to eliminate the federal deficit, cut taxes and significantly increase spending on the science base, including new institutions such as the Canada Foundation for Innovation, Genome Canada, the Canada Research Chairs and the Canadian Institutes of Health Research. In the 2008-09 economic downturn an important part of the federal stimulus package went to support the country’s research infrastructure at universities, colleges and research hospitals. Yet vital challenges remain, in particular to build up an innovative business sector and improve Canada’s productivity performance.

The high level of foreign ownership in Canada and the ease which deep-pocketed multinationals can buy up promising Canadian companies are one challenge we face. Tundra Semiconductor in Ottawa and DALSA in Waterloo are just two recent examples. Acquired Canadian companies often become what have been called “R&D branch plants” where the acquiring company purchases the company for its intellectual property and research capability rather than growing it to a fullscale business. Yet Canada has effectively eliminated its powers to block or negotiate conditions for foreign takeovers of all but the largest firms, except for national security reasons. Moreover, with the misguided sell-off of Nortel and its rich patent pool there was no attempt made to find a Canadian solution that would have led to various segments of Nortel being used to create new Canadian businesses.

Canada, in fact, has proportionally far fewer large businesses that have the scale and scope for innovation and global competition than the US has. According to research findings of the Bank of Canada, “Firm size differences play a significant role in explaining the productivity gap between Canada and the United States.” In 1997, 62.3 percent of US manufacturing firms and 48.7 percent of Canadian manufacturing firms had 500 or more employees.

But 29.7 percent of Canadian firms, and 22.1 percent of American firms had fewer than 100 employees. Among all business enterprises, 36.9 percent of Canadian firms and 51.2 percent of American firms had 500 or more employees, while 47.2 percent of Canadian firms and 34.4 percent of American firms had fewer than 100 employees.

Larger firms, the research showed, were more likely to invest in product and process innovation. The larger the firm size, the greater the output over which to spread the cost of innovation, while larger firms also enjoyed a lower cost of capital. Firms with more than 100 employees are 27 percent more productive than those with fewer than 100. According to Statistics Canada, of the $16.1 billion spent by Canadian business on R&D in 2009, 43.4 percent was spent by a small number of R&D-performing companies with annual revenues of $400 million or more and another 15.3 percent by companies with revenues of $100 million to $399 million.

So growing larger firms — future Canadian multinationals — is a key challenge rather than simply increasing the number of start-ups, most of which will never grow beyond a small size. As Andy Grove, co-founder of Intel, has argued, “Start-ups are a wonderful thing, but they cannot by themselves increase tech employment. Equally important is what comes up after that mythical moment of creation in the garage, as technology goes from prototype to mass production.” This is the challenge of scaling up businesses so they have the scale and scope for ongoing growth and competitiveness.

Canada’s challenge is to increase the number of innovative entrepreneurs or gazelles — the roughly 5 percent of small businesses that are doing something new, have proprietary technology and are on a rapid growth path. As the Competition Policy Review Panel recommended in its 2008 report, “Federal and provincial governments’ small and medium-sized enterprise policies should focus on those firms that demonstrate the desire and capacity to grow to become large enterprises.” This kind of policy may be more effective than across-the-board measures for all small businesses. An Industry Canada study found that between 1985 and 1999, of the 1.8 million net new jobs created, some 1 million were created by just 7 percent of companies — fast-growing firms or gazelles.

While Canadians are good at starting innovative companies, we don’t do that well at growing them to global scale. The lion’s share of public support for business innovation comes though the Scientific Research and Experimental development tax incentive, which was worth about $7 billion to companies in 2009. But the Canada Revenue Agency seems to have an adversarial relationship with business and imposes highly burdensome reporting requirements that are often beyond the capabilities of small and mid-size businesses. Moreover, only small private Canadian-controlled companies can get a refundable tax credit so that if a smaller company goes public or brings in an outside foreign partner, it loses access to the refundable credit and has no other way to monetize its unused tax credits despite its urgent need for cash flow; mining companies can sell off their unused tax credits through flow-through shares but innovative tech firms can’t. This restriction may explain why tech-based firms often are sold to larger companies that can use the tax credits. Moreover, while tax incentives encourage close-to-market R&D, they are much less attractive for longer-term, higher-risk R&D that is farther from market. There, direct grants are more useful.

Yet Canada provides less direct support to companies for high-risk innovation than most other comparable countries. According to the OECD, Canada ranks far behind the US, France, Korea, Sweden, Germany and Britain in the proportion of GDP in direct grants that is provided by government to support business R&D — in fact, Canada ranked 27th out of 31 nations surveyed. Canada also ranked 16th in the availability of venture capital as a share of GDP.

Canada’s principal program to directly support innovation through grants is the Industrial Research Assistance Program or IRAP, and it has played a significant role in helping companies advance new technologies. Yet IRAP is significantly underfunded — it frequently runs out of money in the middle of the fiscal year. It also operates as a division of the National Research Council where it is constrained by NRC policies. To boost innovation, IRAP should be spun off as an arm’s-length agency independent from government, with its own board of directors and a significant boost in base funding, as was done with the Natural Sciences and Engineering Research Council in 1978.

At the same time, there is strong emphasis in public policy on innovation as the commercialization of new knowledge from university research. Certainly that can be important and there are good examples, for example at the University of British Columbia. Westport Innovations is a global company in proprietary technology for burning natural gas, hydrogen or bioethane in motor vehicle engines; QLT Inc. is a leading pharmaceutical company specializing in diseases of the eye; and Zite is a Vancouver company that developed a special news app for the iPad and was recently acquired by CNN. In all three cases, the underlying technologies that launched the firms came from UBC. The capacity for universities to spin off companies deserves public support. But most innovation originates in companies that are not connected to universities, so much more attention should be focused here. In supporting more growth-oriented businesses, some of which will become future Canadian multinationals, there would be a greater receptor capacity for research emanating from our universities.

Yet Canada provides less direct support to companies for high-risk innovation than most other comparable countries. According to the OECD, Canada ranks far behind the US, France, Korea, Sweden, Germany and Britain in the proportion of GDP in direct grants that is provided by government to support business R&D — in fact, Canada ranked 27th out of 31 nations surveyed. Canada also ranked 16th in the availability of venture capital as a share of GDP.

Canada also remains fixated on resource development. Indeed, promotion of the Alberta oil sands, with pipelines to Texas and to the Pacific coast to export raw crude, is a top priority of the government, as part of the “Canada as an energy superpower” strategy. Yet we may be repeating the same mistakes highlighted in the 1991 Porter report — exporting unprocessed raw materials instead of value-added upgrading. The Keystone pipeline is designed to take crude oil sands oil from Alberta to be refined in Texas. US suppliers are also providing much of the technology for oil sands development. According to Gary Doer, our ambassador in Washington, more than 900 US companies are providing equipment and supplies for our oil sands projects. Our nonrenewable natural resources can give us an edge but that depends on the innovative technologies we develop to exploit them in a sustainable way and our ability to capture more of their value by creating upgraded and differentiated products from these resources.

Clearly, lecturing business leaders to be more innovative won’t get results. That has been tried for the past couple of decades. If Canada is to become an innovative nation we must become more innovative in innovation policy. This means that policy-making must focus much more on fostering Canadian companies that can acquire the scale and scope to compete in a world of rapid technological change and increasing global competition. We need a Canada Inc. mentality, and the leadership in our most successful companies should be the ones to build the public case. This was felt to be urgent in 1991. Some 20 years later, it is even more urgent. Foreign multinationals can be helpful partners. But leadership must come from Canadian business.

The World Economic Forum notes in its most recent rankings of competitiveness (Canada slips from 10th to 12th place this year) that while Canada has efficient labour, goods and financial markets, well-functioning institutions, quality education and health care and decent infrastructure, it ranks a lowly 24th when it comes to business sophistication. “As we have noted in recent years,” the 2011-12 Global Competitiveness Report says, “improving the sophistication and innovation potential of the private sector, with greater R&D spending and producing goods and services higher on the value chain, would enhance Canada’s competitiveness and productive potential going into the future.”

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