Enterprise and Industry Directorate General

1. European Commission Enterprise and Industry Directorate General EU’s economic reform challenges - European Competitiveness Report 2006 Gert Jan Koopman, Director for Industrial Policy and Economic Reforms Brussels, 1 December 2006

2. The Competitiveness Report • The European Competitiveness report is an annual publication produced since 1997, at the request of the Council (Resolution of 21 November 1994). This is its 9th edition. • It is an analytical paper. It examines key developments and factors that explain competitiveness -and are relevant to policy- from the point of view of economic theory and empirical research. European Competitiveness Report 2006

3. The Competitiveness Report • The 2006 Report has been redesigned to serve the analytical foundations of the microeconomic pillar of Lisbon strategy. This brought it closer to the policy agenda. • It reviewed a number of reforms: • Liberalisation of energy markets; • Business environment and better regulation; • Financing of innovation; • Designing innovation policies taking into account the lead markets concept. • and the competitive position of two industrial sectors: • the producers of Information and Communication Technology goods and services; and • The pharmaceutical industry. European Competitiveness Report 2006

4. Structure of presentation I. Facts on EU growth and productivity performance II. Key policy challenges: innovation, energy, business environment III. Competitiveness of EU manufacturing sectors European Competitiveness Report 2006

5. I. Recent economic performance: GDP and productivity growth European Competitiveness Report 2006

6. EU-25 growth: contributions of employment and labour productivity Note: The two components sum up to the average annual GDP growth rate in the respective periods. Data source: European Commission (AMECO). European Competitiveness Report 2006

7. Productivity levels by Member State Note: Labour productivity defined as GDP per employed person. Data source: European Commission (AMECO). European Competitiveness Report 2006

8. Average growth of labour productivity by country, 2000-2005 Note: Labour productivity defined as GDP per employed person. Data source: European Commission (AMECO). European Competitiveness Report 2006

9. II. Key policy challenges: energy European Competitiveness Report 2006

10. Electricity markets in the Member States European Competitiveness Report 2006 Source: European Commission report to the Economic Policy Committee, October 2006.

11. Liberalisation of European energy marketsChallenges and policy options • The European energy markets have been going through a process of liberalisation since the early 1990s. • Based on existing economic literature discussing both EU and non-EU experience, the Report presents an assessment of some of the effects of liberalising the European electricity and gas markets. European Competitiveness Report 2006

12. Liberalisation of European energy marketsChallenges and policy options Liberalisation and efficiency • Liberalisation of energy markets will generate efficiency gains if competition is increased. • As competition in energy markets is still limited, we have not yet reaped the full benefits from liberalisation. • Competition in energy markets will entice firms to shift their R&D efforts towards efficiency-enhancing technologies. European Competitiveness Report 2006

13. Liberalisation of European energy marketsChallenges and policy options Liberalisation and security of supply • Before liberalisation, security of supply was achieved by high level of overcapacity for which consumers paid the price. • Less overcapacity will lower energy prices but could also lead to larger price volatility. • Consumers can protect themselves through long-term fixed price contracts. • The internal energy market will promote reliability of networks, provided that interconnections are sufficient. European Competitiveness Report 2006

14. Liberalisation of European energy marketsChallenges and policy options Liberalisation and environment • Impact of liberalisation on environment ambiguous as aggregate effect can be positive or negative, depending also on initial conditions. • Liberalisation can strengthen the effect of market based environmental instruments such as the European Emissions Trading Scheme. European Competitiveness Report 2006

15. II. Key policy challenges: business environment European Competitiveness Report 2006

16. The Regulatory Environment in the context of the strategy for Growth and Jobs: findings from empirical research Effects of product market reforms (PMR): • Product market reforms in OECD countries over the period 1985–1995 contributed to an increase of 0.2 – 0.3 percentage points in total factor productivity growth in the long run; • Moving to US levels of regulation in the EU would lead to a labour productivity growth rate increase of 0.15 percentage points in the long run; • Regulatory reforms aligning the overall regulatory stance with that of the most liberal OECD country could increase the annual rate of total factor productivity growth in continental EU by between 0.4 and 1.1% over 10 years. PMR facilitating firm entry • Entry liberalisation in service would boost annual multi-factor productivity growth in the overall business sector by about 0.1 to 0.2 percentage points in certain countries. Indirect effects would boost manufacturing annual productivity growth by 0.1 to 0.2 percentage points in certain European countries, most notably Germany, France, Italy and Greece. • Increasing the current firm entry rate by one percent lead to an increase in labour productivity by 0.60% and an increase in employment growth of 2.67%. • A 1% increase in the entry rate leads to an increase in output, employment and labour productivity growth rate of 2.2%, 2.7% and 0.6% respectively A 1% increase in exit rate reduces output growth rate of 0.8% (one year lag), while increases labour productivity growth by 0.7% (2-year lag) • Reducing the level of state control and entry barriers to entry to the best OECD practice would Increase long-term employment rates by between 1.3 and 2.5 percentage points (lower-bound estimate). European Competitiveness Report 2006

17. The Regulatory Environment in the context of the strategy for Growth and Jobs: findings from empirical research -2 PMR enhancing competition • Product markets reform aiming at increasing competition would lead to a GDP increase of about 2% in the medium run (acceleration of output growth by almost a quarter of a percentage point annually over a period of 7 to 8 years). • Competition-friendly product market reforms reducing the price-mark-up in the euro area by 10 percentage points would produce a long term increase in the GDP level in the euro area of 4.3%. • Product market reforms reducing the price mark-up in the euro area to US levels would bring a GDP level increase in the euro area of 8.6% (relative to its baseline level) in the long run. Reduction in administrative costs • A reduction of 25% in administrative burdens in the EU would lead to a real GDP level increase of 1% in the short run and a real GDP level increase of 1.4% in the long run. European Competitiveness Report 2006

18. The Regulatory Environment in the context of the strategy for Growth and Jobs: findings from empirical research –an example The Ease of Starting a Business and Per Capita GDP Source: European Commission calculations on the basis of data from the World Bank “doing business” database. European Competitiveness Report 2006

19. The Regulatory Environment in the context of the strategy for Growth and Jobs: findings from empirical research –an example Cumulative GDP effects by 2025 of a 25% reduction in administrative costs(DG ENTR and CPB, 2006) European Competitiveness Report 2006

20. The Regulatory Environment in the context of the strategy for Growth and Jobs Situation in Member States: • Different sets if indicators: OECD, WB, ID, Fraser Institute/World Economic Forum; • The group of countries with less restrictive regulatory environments: Cyprus, Denmark, Estonia, Finland, Ireland, Luxemburg, the Netherlands and the UK; • The group of countries with a more restrictive regulatory environment comprises the Czech Republic, Greece, Italy, Lithuania, Poland, Portugal and Spain. European Competitiveness Report 2006

21. The Regulatory Environment in the context of the strategy for Growth and Jobs National efforts, in terms of setting up: • explicit Better Regulation strategies; • Impact assessment systems • Simplification programmes; • Systematic consultation of stakeholders; • Programmes for measuring and reducing administrative costs. • Conclusion: we are at the beginning of a long process. Those starting from a less favourable position should do more. European Competitiveness Report 2006

22. II. Key policy challenges: innovation European Competitiveness Report 2006

23. The Financing of Innovation The rationale for public intervention: • Limited appropriability of innovation • Response: direct subsidies and fiscal incentives • Imperfections of the capital markets: (information asymmetries, adverse selection and moral hazard). • Response: business angels, venture capital, loans and guarantees. • The chapter looks at what MS propose to do (in their NRPs) and draws conclusions on possible policy gaps. European Competitiveness Report 2006

24. The Financing of Innovation – the findings • Wide variation on delivery mechanisms for grants and tax incentives; • New measures favour tax incentives more; • Particular attention to seed and early stage venture capital; • Schemes change frequently and often are complex. No. of Member States European Competitiveness Report 2006

25. The Financing of Innovation Policy gaps: • Need to facilitate venture capital mobility; • More consideration should be given to facilitate debt finance of innovation; • There is scope for mutual learning and exchange of best practice; • Need for more systematic evaluation of existing measures. • Not to forget: finance is an important but small part of the innovation process. European Competitiveness Report 2006

26. The Lead Markets approach in Innovation policy • Objective: What is a lead market? Is there a case for policy intervention? If yes, through which mechanisms? • Varied meanings of the term in economic literature. • Most common definition: the market where an innovation is first widely used that later becomes successful internationally regardless of where that innovation was invented European Competitiveness Report 2006

27. Lead Markets: stylised international diffusion pattern of an innovation design (source: ZEW) European Competitiveness Report 2006

28. Lead Markets: diffusion of Internet in selected countries (source: ITU) European Competitiveness Report 2006

29. The Lead Markets approach in Innovation policy: conclusions • The conclusion of the Report is that innovation and technology policies should incorporate those factors that contribute to a successful lead market strategy: • incorporation of foreign market needs, preferences of global customers, global trends; • emphasis on lowering costs of production; • allowing competition among different innovation designs. • There is little empirical evidence in support of policies to administratively create lead markets for specific “champion” products and technologies. European Competitiveness Report 2006

30. III. Competitiveness of manufacturing sectors European Competitiveness Report 2006

31. Manufacturing sectors in EU-25 with highest production growth in 2001-2005 European Competitiveness Report 2006

32. Manufacturing sectors in EU-25 with steepest decline in production in 2001-2005 European Competitiveness Report 2006

33. Sectors in EU-25 with highest productivity growth in 2001-2005 European Competitiveness Report 2006

34. Sectors in EU-25 with slowest productivity growth in 2001-2005 European Competitiveness Report 2006

35. Sectors in EU-25 with strongest Revealed Comparative Advantage in 2004 European Competitiveness Report 2006

36. Sectors in EU-25 with weakest Revealed Comparative Advantage in 2004 European Competitiveness Report 2006

37. The competitiveness of the EU ICT sector The importance of ICT, direct: • In 2003, the ICT sector represented 3% of total EU25 employment and 4% of GDP. • In 2003, ICT services accounted for 70% of total EU25 ICT sector employment, 80% of value added and for about 90% of its enterprises. • In 2003, the EU15 ICT sector contributed to 45% of total EU15 market economy labour productivity growth. • The importance of ICT, indirect: • ICT impacts on the rest of the economy through ICT investment, ICT production and ICT use. ICT uptake is one of the major drivers enabling firms in the rest of the economy to increase their productivity and competitiveness. • ICT capital contribution in EU15 amounted to 32% of total EU15 GDP growth between 1995 and 2004. European Competitiveness Report 2006

38. The competitiveness of the EU ICT sector Strengths… • The EU ICT sector is successful in producing sophisticated and high-quality ICT products (scientific instruments, electronic components and telecommunication equipment). • It is particularly strong in chip design, software development and ICT services. • One of the key strengths of the EU ICT sector is its human capital. • Strategic R&D is performed in the EU while less knowledge-intensive market oriented R&D is located in South-East Asia. European Competitiveness Report 2006

39. The competitiveness of the EU ICT sector:export shares in ICT manufacturing industries 1995 and 2004 (percent). EU EU EU EU EU European Competitiveness Report 2006

40. The competitiveness of the EU ICT sector …andweaknesses • The ICT manufacturing trade deficit was 55 billion euros in 2004. • Large parts of ICT hardware production software coding have been relocated to South-East Asia. • The ICT uptake in other parts of the economy is slower than in USA and Japan. • Lower investment growth than in emerging economies threatens lower value added activities in the EU. • Lower R&D intensity than US or Japan, R&D concentrated in larger companies. European Competitiveness Report 2006

41. The competitiveness of the EU ICT sector Conclusions • The answer to the challenge from low-cost producers lies in further climbing up the quality ladder. • Raising R&D investments of the EU ICT sector and ensuring the availability of skilled labour will be crucial for the EU ICT sector’s future competitiveness. • Policies that matter most for the EU ICT sector’s competitiveness include those fostering R&D and innovation, entrepreneurship, IPR, e-skills, ICT uptake and completing the Single Market (i.e. Growth and Jobs strategy). European Competitiveness Report 2006

42. Pharmaceuticals • A fast growing global market of around 450bn€ in 2005. Two major players: • US market: a little less than 50% • EU: around 30% • In both markets, production, employment and productivity are rising. • Moreover, the EU has a positive and growing trade balance while the US turned negative, especially with the EU. • US investments in the EU explain these trends. European Competitiveness Report 2006

43. Pharmaceuticals The bad news • the pharmaceutical innovation system becomes global and is increasingly dominated by the US: • Increasing share of US held patents; • Increasing value of US patents (on basis of citations); • Central US position in collaborative R&D projects. European Competitiveness Report 2006

44. Pharmaceuticals The bad news (continued) • The central role of smaller, dedicated biotechnology firms in the innovation system: Much more present in the US, both as initiator and developer, of collaborative R&D projects. • The fast rise of China, Brazil, India in pharma R&D. European Competitiveness Report 2006

45. Pharmaceuticals Different market dynamisms • US market more concentrated and more contested than EU: new drugs command much higher prices, when patents elapse –or more innovative drugs appear- prices drop abruptly; • Product turnover much slower in Europe; • European markets remain fragmented by different regulatory regimes; but, • A visible price convergence exists in the EU. European Competitiveness Report 2006

46. Pharmaceuticals Factors: • Parallel trade; • regulation at national level; • External reference pricing. • Lower price group: SP, PT, EL, EU-10. European Competitiveness Report 2006

47. Pharmaceuticals Policyimplications • Sector level: Pharmaceutical Forum • Cost-containment policies and innovation; • Unifying effectiveness testing of drugs. • Horizontal level: Strategy for Jobs and growth: • R&D; • Innovative entrepreneurship. European Competitiveness Report 2006