Viewpoint: Inflation is an obstacle to innovation in Europe

The inflation rate may average around 10% across the whole of Europe but the impact is not the same for all sectors, and policies designed to combat its effects need to reflect this.

Considering these differences is particularly important when weighing the effect on companies that invest heavily in innovation, especially small and medium-sized enterprises (SMEs) working on frontier technologies and in environments that are high risk and competitive,

With government budgets under strain, it is also necessary to remember that public funding is a critical component of innovation and when well directed, is the basis of a true industrial policy. As Mariana Mazzucato, professor in the Economics of Innovation and Public Value at University College London points out in her book, ‘The Entrepreneurial State’, many current developments in renewable energy and digital technologies – including practically everything that makes the iPhone an iPhone – rest on prior and high risk public investment.

That makes it essential innovation funding and incentive programmes continue to function effectively, even in the midst of rampant inflation.

Since 1983, the EU has funded framework programmes in research and innovation, which have become an established lever for innovation, an area where Europe lags behind other regions of the world, as seen in international rankings.

The current framework programme, Horizon Europe, has the specific aim of regaining technological leadership and promoting a central industrial policy of the EU, building open strategic autonomy.

Inflation threatens to undermine this objective, because projects are funded through competitive processes based on excellence, with winning projects receiving a grant for a percentage of the total cost.

Because of the way the system works, project costs must be agreed well in advance of implementation and are considered among the selection criteria. Rapid increases in the price of materials or other inputs, such as we are currently experiencing, can hinder or seriously compromise projects, a situation many researchers and SMEs are now facing.

This led me to put a parliamentary question to the European Commission, asking if any price revision measure is being considered to mitigate the effects of inflation on science and innovation projects already underway. Despite being aware of the increases in costs, in its response, the Commission says it does not envisage the inclusion of price revision formulas in the subsidy procedures it manages, and that it is the applicants’ responsibility to take into account, in future calls, the current inflationary pressure on the costs included in their proposals.

Seeing into the future

Taking the example of a project designed in 2016, submitted in 2017 and awarded in 2018 as part of the Horizon 2020 research programme, the Commission’s reply assumes that the institution, SME or research group applying for funding should have foreseen the COVID-19 pandemic; the decoupling of the US and China that has deeply altered the global supply chains; a concentration of business processes that has increased the market power and ability to impose price rises by the companies that supply them; and the war in Ukraine that has raised the price of energy and other raw materials.

Neither the Commission with all its resources, nor the European Central Bank, with its capacity to forecast the course of the economy – and also to intervene in it -  anticipated at any time between 2016 - 2021, that an inflation rate of 10% would become a reality in 2022. So why is the Commission implying that innovative entities and SMEs should be able to forecast such a major macroeconomic change?

This attitude is a big problem, given inflation does not affect all sectors in the same way, nor can all sectors transfer price increases to customers in the same way. The consequences are disastrous, especially for those sectors with a high innovation content that are central to achieving open strategic autonomy and facilitating the green and digital transitions, either because they need high levels of public funding, or because they have lengthy design and production cycles.

A clear example of this is in the European space industry, which is key to both guaranteeing connectivity and secure communications and to providing data needed in mitigating and reversing climate change. In this industry, contracts are valid for ten years, at prices fixed in line with the EU budget. With the Commission not in a position to review current contracts, will the sector continue to invest in innovation, or will it address the problem of rising prices in a way that undermines innovation?

This example should make us think about ways to alleviate the negative impact of inflation in sectors of high interest for the future of the EU. If we do not act in time, innovation will be stifled, increasing the existing gap with other regions, and making the EU fall even further behind in the digital and technology race. SMEs and start-ups which are the heart of innovation in Europe will be forced to stop working on European projects and look for other options or more favourable environments.

It is especially important for Europe to support innovative companies and sectors at a time when others are building their industrial policies around innovation. In the US, for instance, an $80 billion investment plan has been launched to support North American companies or foreign firms that set up in the US. This may result in a diversion of the European talent, effort and investment required for our digital and green transitions, to the US.

Europe cannot afford to lose its industrial leadership and innovation potential at such a sensitive time, when globalisation as we know it has stalled and we are moving towards a more segmented model, in which the location where goods are produced does matter.

We must work together to improve our ability to adapt to the new circumstances and to achieve the much-needed open strategic autonomy, making us less dependent on third parties, while increasing the innovation capacity of the EU and all its territories.

We must act without ideological blinkers, in an ambitious and transformational way, to develop the means to complete the green and digital transitions to the benefit of all EU citizens. This calls for a move from a logic of profit to a logic of resilience – which is the only possible approach, given current global challenges and the intensification of uncertainty.

Lina Gálvez Muñoz is a Spanish MEP and vice chair of ITRE, the Committee on Industry, Research and Energy, European Parliament.