David Stallibrass and John Fingleton have contributed to The Entrepreneurs Network's 'Operation Innovation' - a collection of short essays, each addressing a key way in which the UK can improve its growth prospects, with innovation as a central theme.

Our piece - 'Innovative by design' - looks at how regulation can best support entrepreneurs and innovation. It builds on John's Zeeman Lecture at the RPI, and asks if the answer might increase regulatory predictability, rather than increase flexibility and discretion.

Innovative by design

Uncertain or discretionary regulation is a common vector for rent-seeking. A firm will spend up to the total of the advantage it gets from a particular way a regulation might be interpreted in lobbying and other rent-seeking effort to attain that interpretation. Firms are good at this. Almost every opportunity to lobby and influence government and regulators to a firm’s benefit will be taken advantage of.

Not all lobbying is duplicitous. Much of it can be constructively aimed at ensuring regulators and policymakers understand the industries and issues they grapple with. But it does destroy value. It misallocates resources, undermines a firm’s culture, and poisons the well of entrepreneurial spirit; of innovating for consumers and firms competing on their merits.

The greater the discretion, and the higher the stakes, the more rent-seeking will take over. Whatsmore, the harm that rent-seeking imposes on productivity growth in each sector is likely to grow over time:

“...rent-seeking activities exhibit very natural increasing returns. That is, an increase in rent-seeking activity may make rent-seeking more (rather than less) attractive relative to productive activity. This can lead to [...] very high levels of rent-seeking and low levels of output.”

Perhaps the clearest example is in big-tech, where a significant set of smaller firms seem to spend almost as much effort taking regulatory chunks out of the incumbents as they do actually trying to compete on the merits.

There is a clear risk of similar substitution of competition for regulatory engagement in financial services where the highly discretionary Consumer Duty imposed by the Financial Conduct Authority (FCA) encourages firms to benchmark performance, pricing, and behaviour against each other while engaging in extensive ongoing compliance conversations with the regulator, albeit with the regulator urging firms to be innovative in the way they do so.

Regulators are often asked to show more flexibility and discretion in the name of supporting innovation: both in the regulations they write and in the way they interpret the ones that currently exist. Where this creates a shift from rigid pro-incumbent regulation then it is sensible, but a constant state of flexibility triggers risks.

The 2022 report by the Regulatory Horizons Council (RHC), ‘Closing the gap: getting from principles to practices for innovation friendly regulation’, suggests a “less codified, more outcomes-focused approach” to regulation. The Taskforce on Innovation, Growth and Regulatory Reform (TIGGR) also extolled “a framework based on risk and outcomes, not ‘tick-box’ compliance” in their 2021 report on a similar subject.

Both reports contain a broad range of sensible suggestions, and correctly highlight some of the benefits of more flexible regulatory approaches in accommodating new and innovative technologies and business models. However, neither report considers the very real costs of increased regulatory discretion and decreased regulatory certainty.

This is the paradox at the centre of increased regulatory flexibility: while it may make space for more innovative business methods and products, it also creates a vector for rent-seeking and lobbying that can undermine the entrepreneurial spirit of entire sectors.

The solution is to adopt the objectives and methods advocated by reports such as those from TIGGR and the RHC, but doing so while targeting and designing regulatory discretion so that any benefits clearly exceed the costs. By making regulations and regulators pro-innovation by design.

It is true that the process of changing regulations to be more innovation focused is itself an opportunity for lobbying and rent-seeking. However, if done well it replaces repeated discretionary decisions with one-shot reform which, due to its size and public and political nature, will also likely be more resilient to accidental regulatory capture. Examples of such pro-innovation reform include:

• Ensuring the objectives of outcome-focussed regulation are clear and unambiguous. Good ‘outcome regulation’ includes, for example, replacing the requirement that a heat-pump be 1m away from a boundary wall in order for the noise to not interfere, with a requirement that the measured noise output at the boundary be less than a given number. This precisely captures the underlying issue – noise reduction – but allows firms maximum flexibility in how to address it. Less helpful ‘outcome regulation’ might include the FCA consumer duty that stipulates that consumers must get ‘good outcomes’ across a range of potentially conflicting measures;

• Reducing the number of regulators’ objectives. The more objectives that a regulator has to balance in their prioritisation and policy decisions, the less predictability and the greater the discretion. The objectives of Ofcom, for example, have ballooned from two primary and six secondary objectives in 1984 to two principle objectives, ten other duties, and six principles of community obligation, many of which are in tension with each other and require delicate discretionary balancing;

• Increased use of sandboxes to inject bounded and targeted discretion into otherwise rigid regulatory regimes. Regulatory sandboxes, where rigid regulatory systems are replaced with more discretion and closer outcome-monitoring for particular innovative firms or products, was pioneered by the FCA and supported by both the TIGGR and RHC reports. They are a powerful mechanism to provide targeted regulatory flexibility to more entrepreneurial firms without undermining broader regulatory stability. Perhaps an economy wide regulatory sandbox could be introduced?;

• Increased use of block-exemptions to inject clarity into more discretionary regulatory regimes. Block exemptions, as used extensively in European Union competition law and, thankfully, likely to continue to be implemented in domestic British law, allow particular categories of firm or industry exemption from compliance with otherwise complex and discretionary competition law. They are usually targeted at smaller firms, or industries where there is a low risk of harm. Extension of the block-exemption principle to other areas of complex or discretionary regulations would complement the use of sandboxes for more rigid regulatory systems.

It is tempting for policy makers to just tell regulators to be more sensitive to innovation, to be more flexible, to just ‘make it so’. But to truly make regulation more supportive of entrepreneurs and innovation, regulation needs to be pro-innovation by design. This requires hard work from regulators and government, but without that work, pro-innovation meddling in regulatory regimes may well do more harm than good.

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