The risks and rewards of public investments

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What is the role of the state in investing in innovation? Is it purely about fixing market failure or can the state play a more entrepreneurial role?

At a glance

A paper in Research Policy: X develops a framework to analyse the role of the state as a risk taker and co-investor in innovation. This is aligned with a market co-creation role rather than a market fixing perspective. Policies that incorporate the risk-taking entrepreneurial role of the state can positively affect the distribution of rewards. Sharing rewards enables a more portfolio mindset and signals the value and legitimacy of the state’s role.

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A market failure perspective

The last 50 years have seen the emergence of disruptive technological innovations from ICT to biotech to renewable energy. This has required both public and private investments across the innovation chain. While private risk-taking has been recognised through entrepreneurship, public investments are framed as fixing market failures. Innovation policy has centred on the idea that innovation is led by private entrepreneurs who benefit from market fixing funding in infrastructure, skills and grants.

The market failure view of government funding has a particular understanding of returns. While private enterprises deserve the ‘profit’ created, public organisations can gain by focusing on spillovers that emerge from wealth creation. This occurs through the creation of ‘social returns’ such as:

• knowledge spillovers and public goods
• better quality and cheaper goods and services
• job creation.

All result in economic growth and positive fiscal impact.

Market co-creating and shaping

Three ideas lay the foundation for a new approach to policy:

1. The developmental state

• Policies are not ‘interventions’ – markets are embedded in social and political institutions and largely influenced by them.
• An active state can lead profound transformations and can act as a capital provider.

2. Legal institutionalism

• Legal arrangements frame and influence the organisation of the economy and the state.
• The process of setting up systems of substantive rules, contracts, procedures and practices can institutionalise policy goals.

3. The entrepreneurial state

• The concept of the entrepreneurial state refers to the public sector’s willingness to invest in new high-risk areas before the private sector does.
• The state is a leading financier in contemporary market economies, acting both as a capitalist (risk-taker) and an entrepreneur (opportunity-driven).
• The role of the state is better understood as co-creating and shaping markets, and not only fixing them.

A portfolio approach

The allocation of risks and rewards in public–private partnerships is a lens through which to examine perceptions about the ‘failure’ and ‘success’ of public investments and expected returns. It makes it possible to investigate actual mechanisms where the state, on behalf of citizens, seeks to reap a share of the financial rewards

Because innovation is inherently uncertain and investments have no guaranteed return, enhancing public control over any rewards is a necessary condition to legitimise the state’s role in creating and shaping markets. There is an expectation that outcomes of successful public finance will serve the taxpayers if public agencies absorb high technological and market risks.

Market failure theory assumes that the state already recoups rewards via job creation, knowledge spillovers, increased living standards and tax revenues. This approach has no explanation for the instruments that public agencies consider in seeking to link risks and financial rewards. Examples include public procurement for R&D and innovation, profit-sharing mechanisms and institutional designs that contribute to a productive environment for innovation.

A market co-creating and shaping approach takes the view that government initiatives are an intrinsic dimension of investment process and strategy. Rewards can be understood as an attempt to balance financial returns and broader economic and social benefits.

What this means

Public investments are at the centre of the innovation process because of their role in co-creating and shaping markets with business. A broader understanding of the role of the state in market co-creation can increase overall efficiency in the economy while seeking broader societal benefits.

Recognition of the risk-taking entrepreneurial role of the state provides justification for public agencies to recoup some of the financial rewards beyond taxation. Sharing rewards with private actors enables a more ‘portfolio’ mindset where the upside is used to cover the downside.

There is a need to promote the development of capabilities in the public sector. Empowering governments to design, implement and assess practices for dealing with the risk–reward nexus is key. Only appropriate capacity-building can invigorate hopes for inclusive, innovation-led growth.

Want to read more?

Socializing the risks and rewards of public investments: Economic, policy, and legal issues – Andrea Laplane and Mariana Mazzucato, Research Policy: X, Volume 2 2020

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