Reviving European innovation | McKinsey

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Europe a century ago was a global powerhouse of innovation, but it has started to lose its edge: today, despite some notable exceptions, many innovative companies are found elsewhere. Europe is falling behind in growing sectors as well as in areas of innovation such as genomics, quantum computing, and artificial intelligence, where it is being outpaced by the United States and China.

A discussion paper from the McKinsey Global Institute (MGI), suggests five paths that could help the continent regain its competitive edge. The paper, Innovation in Europe: Changing the game to regain a competitive edge (PDF—352KB), focuses on ways that Europe could seek to build on its strengths rather than trying to play catch-up, given that it is hindered by fragmentation and lack of scale. This article is a condensed version of the original paper, which draws from MGI research as well as from a recent collaboration with the World Economic Forum.

Section 1

Europe’s innovation challenge

Given Europe’s relatively high wage costs and low reliance on natural resources, innovation remains of fundamental importance for the continent’s economic and social system. European companies still account for one-quarter of total industrial R&D in the world, but over the past ten years US companies have continued to increase their share, reinforcing their leadership position. China and South Korea have also been catching up. Such competition challenges the ability of Europe to sustain its growth model over the long term.

A survey we conducted of large firms shows that innovators who are first to introduce new products and services to the market experience significantly higher revenue growth. Yet the share of European companies that consider themselves true innovators is notably lower than in the United States (Exhibit 1).

The European economy needs a productivity boost from innovation and new frontier technologies to support growth

The European economy has regained momentum recently after years of sluggish growth, but the short- to medium-term outlook remains fragile, and the continent’s productivity growth has declined sharply over the past two decades. Increasingly, Europe’s economic prospects depend on innovation in general, and especially digital and new frontier technologies, including artificial intelligence, Internet of Things, blockchain, high-power computing, and the integration of biology and engineering. These technologies have the potential to deliver the breakthrough in productivity that Europe needs. We calculate that more than one percentage point of productivity growth could result from exploiting digital opportunities alone.

Innovating in products and services that require new and high-demand skills is an important way to reduce the risk of wage and employment pressure resulting from automation.

We estimate that if European companies were to develop and diffuse AI according to the continent’s current assets and relative position in digital technology in the world, Europe could add €2.7 trillion to its economic output by 2030. Closing the gap with the United States in innovating at the digital frontier and in facilitating faster adoption of AI could add €900 billion, bringing the total potential boost to about €3.6 trillion.

Innovation will also be needed to counter frictions and adjustment challenges in the labor market from automation. According to our analysis, 62 million full-time employee equivalents and more than $1.9 trillion in wages might be associated with technically automatable activities in the five largest European economies. Innovating in new products and services that require new and high-demand skills is an important way to reduce the risk of wage and employment pressure. We find that firms anticipating innovative models out of AI have the largest propensity to expand their workforce; companies have a relatively large incentive to upgrade skills in order not to miss out on opportunities.

Europe is falling behind in adopting and investing in general and digital innovation

Europe’s startup scene is thriving: the number of AI startups has tripled in the past three years and is now relatively comparable to the figure for the United States on a per GDP basis. Early-stage startups are better financed than ever before. Investment in European tech is at a record high, with $23 billion invested last year, a five-year increase of 360 percent and an increase of 21 percent compared to 2017.

Europe invests significantly less than the United States in intangibles like software and databases, intellectual property, and economic competencies like organizational capital and training, which represent major factors for innovation capacity.

When it comes to talent, too, Europe has long been a research powerhouse. Its research community is larger, but also more diffused, than that in the United States or in China. The tech workforce employed by startups is growing; it expanded by about 4 percent in 2018. The number of European software developers, a key resource for many innovative technologies, has grown at a rate of 4 to 5 percent in the past two years, culminating in a total of 5.7 million professionals today, well ahead of the United States, with 4.4 million professional software developers.

Yet in some key innovation areas, Europe is falling behind. Equity finance as a key driver for innovation and digital investment remains underdeveloped, with 90 percent of the European Union’s venture capital funding concentrated in only eight member states. This creates a challenge for European companies that seek funding for fast growth. More broadly, Europe invests significantly less than the United States in intangibles like software and databases, intellectual property, and economic competencies like organizational capital and training, which represent major factors for innovation capacity.

Digital adoption has also been slower in Europe than in competing regions. Both digital attacker and incumbent shares of revenue are significantly smaller than in the United States. Consequently, Europe’s gap in digitization remains at about one-third the level in the United States and has not changed much in recent years. European companies are less mature in their state of diffusion of digital technologies and in their use of these technologies for innovation, namely new services, processes, or business models.

One challenge appears to be Europe’s ability to scale startups into major companies. For example, it has transformed digital promises into success with “unicorns”—privately held startups valued at more than $1 billion—at only about half the rate seen in the United States or even Tel Aviv.

The rise of global platforms and ‘superstars’ drives the need to change the rules of the game

With intangible investment eclipsing the tangible kind, the rise of platforms and the ability to scale and to do so quickly seem to matter more for a significant part of the innovation ecosystem. Despite efforts to establish a Single Market, Europe remains fragmented, with many national legislations and systems of regulations and VAT, which are all hard to change, and many mostly domestic companies.

Today’s superstar firms earn 1.6 times more economic profit on average than superstar firms 20 years ago.

“Superstars,” which we define as the top 10 percent of companies with more than $1 billion in annual revenue, as measured by economic profit, are gaining importance. Our research finds that today’s superstar firms earn 1.6 times more economic profit on average than superstar firms 20 years ago. They are seven times larger by revenue than median firms and have returns on investments that are twice as high. In addition to capturing a greater share of income, they exhibit relatively higher levels of digitization, greater input of skilled labor and a higher innovation intensity, more intangible assets, and deeper integration into global flows of trade, finance, and services than their peers.

Yet Europe has started falling back in its share of superstars. Over the past 20 years, Europe’s share of superstars globally dropped by about 50 percent, while it remained constant for the United States and Canada and increased significantly for the Asia–Pacific region (Exhibit 2).

R&D also is becoming increasingly concentrated, and Europe is losing share, particularly in digital sectors. Just 250 companies generate close to two-thirds of global business R&D investment. In this group, while European automotive players dominate, European companies’ R&D spending by software and computer services firms was only about 8 percent of the global total, well below 11 percent for Chinese companies and far behind the 77 percent for US-based companies in 2018 (Exhibit 3).

Furthermore, the trend is negative. Over the past five years, the global share of European companies’ total R&D spending has declined by more than two percentage points, while the share of US companies climbed by more than two percentage points and the share of Chinese companies by six percentage points. The share of European companies among those newly joining the ranks of the 2,500 largest R&D investors decreased to about 12 percent, only about half the share of Chinese firms and one-third the share of US companies.

Large US and Chinese tech and platform companies, in turn, are gaining importance. US-based tech companies invest more in R&D than their US peers in the S&P 500, with the six largest—Amazon, Apple, Facebook, Google, Microsoft, and Netflix—spending about €43 billion on R&D in 2018, and €31.6 billion on acquisitions in 2017 alone. Google, the most active among them, spent $12.6 billion on acquiring more than 300 startups between 2013 and 2018. In contrast, Europe was almost inactive in tech R&D and possesses only half as many unicorns as the United States, and none of the large internet platform companies.

Naturally, this impact can be felt in Europe: The largest US tech companies are consistently able to offer higher-than-average salaries in Europe, for example 1.5 times the market average in London in 2017.

Section 2

Five pathways to change the rules of the game

While no silver bullet exists for Europe to address its structural scale disadvantages, we see five ways that play to Europe’s strengths, capitalize on key trends, and change the rules of the game rather than (or in addition to) playing eternal catch-up on the well-known ingredients of innovation (Exhibit 4).

The five themes are by no means exhaustive; we intend them to add a specific perspective to the many ongoing initiatives as well as to a large and growing body of research on how innovation policies need to change in a more digital context. A common feature of the five themes is that they can help Europe scale up, to meet the challenges of more pervasive innovation.

1. Europe can benefit from its industrial scale

The next playing field of innovation will be more oriented to business-to-business (B2B) than business-to-consumer (B2C) enterprises, with many technological applications centered on diffusion across industries and supply chains. While Europe has fewer superstar firms, the continent can build on its industrial prowess; European manufacturers are among the largest global innovators and the continent also has an edge in B2B and digital in other large sectors such as healthcare and the financial industries. Stakeholders in Europe also have a history of collaborating and navigating the complexities of coordination and standard setting, as for example the automotive industry does with issues related to safety and connected driving.

European manufacturers are among the largest global innovators and the continent also has an edge in B2B and digital in large sectors such as healthcare and the financial industries.

Europe could build on its strong industrial companies and this track record of collaboration to foster cooperation across industry boundaries and even among competing companies in the same industrial sectors. Examples set by the European Automotive Telecom Alliance, which includes telecom operators, vendors, car and truck manufacturers, and suppliers, may be only the beginning, as competitors in the automobile industry combine their research efforts and service offerings to achieve more scale in customer and data access. Similar efforts in other sectors could enable medium-size companies as well as small entrepreneurial firms and startups to pilot innovation at a large scale within existing industrial supply chains.

Second, Europe could create dedicated, coordinated testing areas—so-called sandboxes—for key technologies. Local geographies could pick technologies and create safe spaces in which businesses can test innovations on a temporary and geographically limited basis. Sandboxes could help innovative firms cope with regulatory obligations in real-life situations and enter a dialogue with regulators. This has been demonstrated, for example, in the United Kingdom, where the Financial Conduct Authority, the country’s financial regulator, established a safe environment for fintech startups to test products and services—including online platforms, biometrics, and distributed ledger technology (blockchain)—before widely launching them on the market. Subsequently, 90 percent of firms that participated progressed to a wider market launch.

More controversially, the European Union could enable the formation of large European players in many sectors. Clearly, efforts to complete the Single Market will be welcome and will help in that regard, notably in sectors like telecommunications and banking that are still relatively fragmented geographically. Europe could also review market access, subsidies, and investment policies globally where foreign players may have an edge. Less clear are relaxations of antitrust policies or even active formation of European champions like Airbus, which may seem like an obvious response but may come with many undesired consequences for competition and competitiveness.

2. Europe can rethink data and user access and standards

Demands to raise standards for data protection and privacy are increasing, as large internet platforms continue to push into more industries and leverage their network scale. Europe is already considered a leading actor on data governance and privacy protection, with the 2018 General Data Privacy Regulation (GDPR) and, most recently, legislation on the free flow of data.

Such initiatives could not only give companies and research institutions access to anonymized data, but also enable citizens to increase control over what data are captured and how they can or cannot be used, when, and by whom.

Europe could aim to enable secure access for innovators to data pools they do not own and create scale around common standards. Among the options could be to open access to government data in certain strategic sectors, for example transportation, where relevant to smart cities and transport, or in healthcare, where tangible benefits such as increased drug effectiveness could result. Implemented in a smart way, such initiatives could not only give companies and research institutions access to anonymized data, but also enable citizens to increase control over what data are captured and how they can or cannot be used, when, and by whom. The Berlin-based privately funded cross-industry platform Verimi could serve as an example for a data alliance: a digital identity provides easy access for users to visit websites and use other services without the need to enter personal data every time. Instead, they can decide which data they share with whom and manage it transparently. Government-driven examples exist as well, for example in Belgium, Estonia, Finland, and Spain.

More radical options could include standardized interfaces and potential regulations to access private firm-held data, changing the way ownership and location of data are treated. This could help smaller companies use data for the creation of innovative services and thus benefit citizens. At the same time, it could also have severe consequences, including reduced transparency about the kind of data that are used and combined. Such a move would require further testing and experimentation.

Finally, Europe should continue to promote open technology standards, building on a legacy of successful standard setting, for example in GSM.

3. Europe can use its public-sector procurement scale to propel innovation

Europe’s procurement spending on public services and products amounts to 14 percent of its GDP annually, equal to about €2 trillion. If leveraged well, smart intervention, coupled with large budgets turned toward innovation, could have significant impact.

To that end, Europe could scale up digital government, as Estonia has done with e-Estonia, and drive European convergence on standards and open interfaces. This would require a mind-set shift away from national steering and toward a coordinated European and open innovation–focused approach. In some ways, transformation of European governments has already begun: Five of the ten leading countries in e-government are from Europe, according to the United Nations. Examples already under way that could provide some of the technical basis needed for digital innovation in cross-border services include the European electronic Identification, Authentication and Trust Services (eIDAS) initiative, which aims to enable secure transactions between citizens, government agencies, and businesses. In the Netherlands, it has already triggered a large-scale cross-border digital ID project, connecting 200 public services in about 100 municipalities that can be accessed with nationally issued e-IDs from 32 countries. As a result, private businesses are beginning to offer digital IDs to simplify log-in and transactions for customers.

Second, European public procurement spending could create significant scale of innovation demand if coupled with innovation components, for example in sectors such as healthcare, education, and public works. In some instances, this is already happening: Many governments are starting to mandate use of Building Information Modelling for public construction projects.

Third, enhancing public investment in research, innovation, and other intangible assets could help bridge Europe’s current investment gap compared to other economies. This may require rethinking the funding of breakthrough innovation. In addition to paving the way for institutional investors, such as pension funds, the option of creating a publicly financed European innovation scale-up fund to provide financing at scale for key competitive sectors could be explored, with the aim of eliminating the 2018 overall research gap of about €75 billion with the United States.

4. Europe can compensate for its fragmentation with openness and connectedness

Demographic change and a lack of high-skill labor have created a situation in which European businesses struggle to find people with the skills they need. High-skill labor may be a particular challenge. Just over one in four (25.4 percent) immigrants coming to the European Union has a high-level education, compared to 35.6 percent of the immigrants to other Organisation for Economic Co-operation and Development (OECD) countries.

The “triple helix model” asserts that innovation can be amplified if intermediaries connect and organize universities, industries, and governments to achieve a common goal.

Europe has a history of collaboration across borders, including in EU framework research. Moreover, almost half of the workforce in tech hubs like Berlin and London has come from abroad, and European startup founders reporting on employee candidates’ willingness to relocate to a new country indicate that Europe is gaining in attractiveness. Location decisions are often driven by factors such as wages and public spending, but also by visa requirements, overall quality of life, and political factors, where Europe holds a competitive edge.

Europe could try to further strengthen collaborative and open innovation. Approaches include networks like Innovate UK, cluster formation like Cap Digital in France, and collaborative research and innovation centers like the EU Science Hub. To further connect different clusters and leverage the strengths of networking, the European Strategic Cluster Partnerships (ESCP) recommends leveraging a “triple helix model” of innovation. This model asserts that innovation can be amplified if intermediaries connect and organize universities, industries, and governments to achieve a common goal. Facilitating the connections among these three stakeholders can open innovation within Europe. An example is TasLabin Trento, Northern Italy, where the local and regional government developed a cooperation cluster strategy with the goal of creating advanced innovation infrastructure. They also created four large-scale open data projects, opened e-government portals, and invested in infrastructure for businesses and citizens (primarily information and communications technology). The TasLab cluster has attracted more than 800 world-class researchers and leading businesses such as IBM, Nokia, and Siemens.

In regard to talent, specifically, Europe could try to leverage its strengths, as well as the geopolitical climate currently geared toward preventing immigration to change flows of high-skill migrants in its favor. This could include encouraging the return of Europeans who work abroad.

International talent could be attracted by creating better pathways for high-skill professionals. For example, opportunities in Europe could be better promoted by leveraging social media. EURES, the European portal for job mobility, already runs a website that lists job vacancies and is active on social media platforms. It could be expanded to target non-European citizens.

Third, the EU could address compensation practices for startups by changing taxation on stock options. Currently, startup employees in the United States have twice as much upside exposure as their European peers. Europe could enable workers to participate more fully in the success of their companies by simplifying the rules and taxation framework for stock option remuneration through a common framework, thereby improving the risk-reward profile for startup employees. Startups in countries such as Germany and Spain report that current taxation schemes make it difficult to set up stock option schemes.

5. Europe can leverage the scale of global firms to its benefit

Regardless of whether Europe succeeds in changing the terms in its favor in a scale-matters world, it could ensure that it derives as much value and benefits from large non-European firms as possible.

One of Europe’s priorities could be to ensure not only that its citizens continue to enjoy the benefits of services delivered by non-European companies, but that these companies also create more Europe-based employment, innovation, customer value, and tax income.

To this end, Europe could engage in identifying key challenges that keep companies from shifting more value creation to Europe and respond with corresponding measures or incentive programs. Benefits would need to be carefully weighed against risks, beginning with potential loss of intellectual property.

Europe possesses many ingredients for successful innovation and adoption of innovation. In a superstar world in which it lacks scale, it needs to find its own innovation model and play to its strengths rather than trying to catch up with the strengths of others. Industry ecosystems, public-sector digitization and demand, data access and governance, talent migration, and attraction of foreign activity could all be parts of a solution. We encourage critical feedback and reactions as well as further research on how Europe can restore its luster as an entrepreneurial and innovative leader.

Download Innovation in Europe: Changing the game to regain a competitive edge, the discussion paper on which this article is based (PDF—352KB).

Jacques Bughin is a director of the McKinsey Global Institute, where Jan Mischke is a partner. Eckart Windhagen is a senior partner in McKinsey’s Frankfurt office. Pål Erik Sjåtil is the regional managing partner for Europe, based in Paris. Bernhard Gürich is a consultant in the Hamburg office.