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Empowering Innovation: Real-Life Examples
European Straits #240
Hi, it’s Nicolas 🤗 I have recommitted to publishing this newsletter on a weekly basis. As a reminder, its purpose is to provide a European perspective on analyzing the global economy, with a particular focus on entrepreneurship, finance, strategy, and policy.
Last week's edition focused on the metaphorical door closing on Silicon Valley-style startups, inspired by Peter Zeihan's recent take on innovation. In this issue, I delve into the concept of empowering innovation, along with the six industries or sectors Zeihan highlighted as the most interesting from an innovator’s perspective.
1/ When contemplating innovation, it helps to revisit the most straightforward definition I've ever come across (by Scott D. Anthony):
Doing things differently, with an impact.
The idea that innovation means doing things in a new way is pretty easy to grasp. However, the significance of the “impact” component is frequently underestimated. Simply doing something differently does not qualify as innovation if it cannot be scaled up. When a novel approach remains confined to a lab setting or falls short of expanding in the market, it can’t be deemed innovation. There’s no innovation without widespread adoption and making a difference at scale.
Consider this example: we frequently encounter news of groups of scientists uncovering a potential cancer cure. But with time, and a bit of experience, we can all discern that these are typically no more than lab experiments or, at best, promising clinical trials. While these endeavors may represent excellent science, they do not qualify as innovation until the potential cure, on top of delivering on its promise, transforms into an approved medication, receives reimbursement from insurance companies, garners prescriptions from healthcare professionals, and gains acceptance from society as a whole.
2/ Innovation takes various shapes and results in various outcomes. Towards the end of his life, Harvard Professor Clayton Christensen was developing a theory of innovation as a contributor to economic growth. He categorized it into three groups:
Efficiency innovation revolves around achieving the same level of output with reduced input, whether capital or labor. It's the driving force behind a company’s ability to slash costs without compromising the volume and quality of its supply chain output. The primary outcome of efficiency innovation is the liberation of invested capital, enabling generous dividends and share buybacks for corporate shareholders. It also contributes to a sustained boost in labor productivity that usually leads to substantial job displacement.
Sustaining innovation involves the refinement of an existing product, typically targeting customers who are willing to pay for improved quality and performance. Such innovation enables businesses to leverage their existing operational processes and cost structures, typically maintaining their profit margins. It has a neutral impact on invested capital and employment, with companies generally retaining their previous levels of capital and labor.
Finally, there is empowering (or disruptive) innovation, which focuses on establishing a novel platform that entirely redefines how value is created within one or more industries. A prime example is Apple's introduction of the iPhone and the App Store in 2007-2008, which had a massive and groundbreaking transformative impact. In general, empowering innovation requires a significant infusion of capital but then leads to creating many new jobs.
As you see, there is a mutual reliance among Christensen’s three categories of innovation. According to him (and I agree), a national economy achieves balanced progress only when there's a sufficient amount of empowering innovation (which requires capital and generates jobs) to offset the consistent corporate inclination toward efficiency innovation (which releases capital and destroys jobs).
The third category, empowering innovation, aligns with the focus of geopolitical strategist Peter Zeihan in the video I discussed last week. Today, I aim to delve deeper into the six sectors Zeihan covered. In each case, it's not just about breakthrough technology; it's about how this technology can lead to significant changes in how value is generated and distributed within a given industry.
3/ At the bottom of Zeihan's list of innovations is the deployment of small nuclear reactors. The anticipated role of those from an innovation perspective is quite clear: they are expected to facilitate a more decentralized and resilient electricity grid while mitigating carbon emissions (notably through the substitution of coal power plants with small nuclear facilities).
However, Zeihan believes that this innovation is unlikely to have a significant impact due to its distance from the market. The current macroeconomic and geopolitical circumstances are reducing the availability of capital. In addition, the Western world exhibits significant resistance to nuclear energy, a sentiment typified by the Green movement (which Zeihan contends are gas-rich Russia’s useful idiots).
Coming from France, a Western nation heavily reliant on nuclear power plants, I believe I can shed light on the numerous obstacles when it comes to relying more on nuclear energy.
For starters, building a nuclear power facility, however small, is an immensely intricate task, necessitating a robust industry with top-tier engineers and technicians capable of transferring cutting-edge process knowledge from one generation to another—a capability that only a handful of countries possess. (Regrettably, it appears that France's nuclear industry is experiencing a steep decline in this regard.)
Then, the construction of a nuclear reactor, however small, necessitates government involvement for at least two reasons: (i) the need to guarantee safety, which demands intrusive regulatory oversight, and (ii) the substantial costs involved and uncertain returns on invested capital, which make government financial support essential. And what tends to occur within sectors heavily influenced by government intervention? Well, they not only hinder progress, but also instill distrust in external parties, further impeding innovation.
Finally, there’s the management of nuclear waste. Can we guarantee the safety of such hazardous waste over time frames as extensive as thousands of years? We’d have to establish a perpetual guardianship akin to a Knight Order, bound by a strict code of honor to safeguard those waste materials in perpetuity. In the past, the prestigious Corps des mines fulfilled this role on behalf of the French government, but its capacity to oversee the nuclear sector has diminished due to a decline in prestige, disgrace brought by some individuals, and the shift of electricity market regulation to the EU level rather than national governments.
These are typical obstacles to those working on small nuclear reactors. To overcome them, aspiring innovators would need sheer persistence, as well as a massive allocation of capital. If this didn't happen when capital was cheap, it's unlikely to occur soon—esp. because the US, with its size and resources, is not prioritizing nuclear energy due to its energy independence through shale oil and gas (see below).
4/ Next, consider artificial intelligence. Zeihan believes its impact will be limited because, as a geopolitical strategist, he doesn't see how we can produce AI-tailored microchips quickly enough for widespread adoption of new AI tools in today's world.
Zeihan’s is a difficult call to make. I find it especially challenging to assert that we'll face hardware shortages when Nvidia is thriving, ARM seems to be succeeding with its IPO, and China is rapidly advancing in microchip production, posing a potential challenge to the once-dominant US chip industry.
So clearly, I'll need to delve deeper into this topic in a future edition. For now, as always, I like to spot continuities as much as disruptions, and I view AI as the next step in enhancing human capabilities with computing power and connecting individuals across networks. Consequently, as previously happened with open source software, cloud computing, smartphones, and social media, AI could fuel spectacular productivity gains without fundamentally changing our current paradigm.
In other words, I don’t see AI as the dawn of a new technological revolution. Rather, it parallels what Japanese automakers represented in the 1970s for the automotive industry: visible users of new tools and methods that drove everyone to enhance their processes and led to producing (i) superior, (ii) more cost-effective products at (iii) a faster rate. AI itself is an empowering force indeed, but its numerous applications will primarily focus on what Christensen termed “efficiency innovation”—more about enhancing overall economic productivity than disrupting value creation altogether.
See also Tyler Cowen’s AI Won’t Supercharge the US Economy (Bloomberg).
5/ As we go up on Zeihan’s list, it’s now about expanding the presence of satellites in Earth's orbit. This opens the door to a wide range of exciting and beneficial possibilities across various domains: global internet access (= Starlink), Earth observation, navigation and GPS systems, support for space exploration, agriculture, communication networks, scientific research, national security, environmental conservation, disaster management, urban planning, and resource optimization.
As per my contacts within the industry, the reason why this is not happening at a large scale yet is a discrepancy between two things: on one hand, our growing capacity to build cost-effective, high-performance satellites; on the other hand, the challenges and expenses tied to their launch those ever-improving satellites into space. In short: we're good at building satellites with promising applications in mind, but we struggle at launching them so that they can have an impact.
Progress is being made, however, with one standout player: SpaceX. Elon Musk's aerospace company has dedicated significant resources to achieving reusability for its rockets. To veterans in the industry, this approach appears unorthodox: reentry into the Earth's atmosphere requires additional fuel and intricacies, which in turn heighten the risks and costs associated with individual launches.
However, by persisting and sticking to its vision, SpaceX has found a way to launch more often, and this change has been shaking up the industry to its core. More launches mean each one costs less. Cheaper satellite launches make it possible to customize them for different needs, like choosing your own ride instead of taking a bus. And this is exactly what empowers an entire ecosystem of innovators eager to send satellites into space for a wide range of new applications.
6/ Zeihan then proceeds to talk about advances in new medical treatments and personalized medicine, a field that has made significant strides following the global COVID-19 pandemic and the widespread distribution of mRNA vaccines.
Similar to his perspective, I believe that the healthcare industry is primed for empowering innovation. However, it's important to emphasize that insurers, who essentially fund the entire system, can pose obstacles to such innovations making a significant impact. This is especially pronounced in the presence of government-backed public insurance systems. In our current macroeconomic context, governments tend to prioritize austerity and cost reduction over harnessing the benefits of healthcare innovation—not a good thing for aspiring innovators.
To go further on healthcare, read this prior edition of European Straits I authored during the initial 2020 lockdown, Toward Better, Cheaper Healthcare:
Deploying more technology in healthcare contributes to reallocating costs, moving the burden from paying physicians and nurses in costly hospitals to paying companies that design, sell, and operate systems and devices that can diagnose and treat diseases in a more efficient and effective way. As the market grows, a larger share of the value added tends to be located in tech-driven segments rather than the traditional healthcare industry centered around in-person, paper-supported medical practices.
7/ Then there's the incredible story of fracking, and how it has spawned an entirely novel source of fossil energy: shale oil and gas. This has disrupted the geopolitical landscape by significantly reducing the US's dependence on fossil fuel imports, all while fostering the emergence of a flourishing (although not yet financially sustainable) industry—funded almost entirely by cheap Wall Street-allocated capital.
Fracking is truly an American saga, one that Europeans may not be fully acquainted with, except from an environmental standpoint (the practice has been banned in more than one European country, including France and Germany). Have a look at this educational video about fracking if you’d like to know more about the technology itself and its hazardous environmental impact: How does fracking work? 👀
Between 2006 and 2015, the energy world was turned upside-down by an epic development in the oil industry few had foreseen. From the low point, in 2006, when it imported 60% of its oil, the US became an oil powerhouse – eclipsing both Saudi Arabia and Russia – and by the end of 2015, was the world’s largest producer of natural gas.
This remarkable transformation was brought about by American entrepreneurs who figured out how to literally force open rocks often more than a mile below the surface of the earth, to produce gas, and then oil….
But the shale success story nearly became a disaster. While to date, most of the complaints about fracking have focused on environmental concerns, there’s a bigger and far less well known reason to doubt the most breathless predictions about America’s future as an oil and gas giant. The fracking of oil, in particular, rests on a financial foundation that is far less secure than most people realize. Because so few fracking companies actually make money, the most vital ingredient in fracking isn’t chemicals, but capital, with companies relying on Wall Street’s willingness to fund them. If it weren’t for historically low interest rates, it’s not clear there would even have been a fracking boom at all.
Despite what McLean wrote in 2018, Zeihan is bullish on shale oil and gas because he (rightfully) estimates that the industry has achieved operational viability. The shale industry managed to expand significantly and to become strategically important during a period of unusually low capital costs. As a result, despite its current lack of financial sustainability, it has firmly established itself and is likely to remain a permanent fixture. In time, financiers and the US government will most likely work out solutions to achieve the fracking industry’s stability and continue bolstering the US's self-reliance from an oil and gas imports perspective.
8/ Lastly, there's the entire array of technologies that enhance agricultural productivity. I once invested significant effort in this field, particularly during our involvement with Agricool, a now-defunct portfolio company of ours, as they grappled with improving the economic framework for cultivating fruits and vegetables in cities.
For further insights on this topic, I recommend reading Agriculture Lost, Then Found by the company’s co-founder and then-CEO, Guillaume Fourdinier (2017):
[We] take advantage of numerous possibilities: vertical farming, environmental controls, networked information, and small footprints. We optimize growing conditions for temperature, lighting, pH, and humidity. Our monitoring systems ensure quality control throughout our network while also helping anyone to grow and maintain Agricool produce. We can produce more crops on less surface area, with only 1.2 km2 of [shipping containers] able to take the place of the 186 km2 currently needed to grow the fruits and vegetables for a city the size of Paris. We do it all using 100% renewable energy sources, and we do it more often — why wait for summer strawberries when we can produce them year-round thanks to the design of our containers?
Unfortunately, Agricool hasn't thrived—and in his video, Peter Zeihan indeed suggests that gene editing, not Agricool-style urban farming methods, is the key contributor to empowering innovation in agriculture.
By coincidence, I’m considering this topic (innovation in agriculture) as I revisit Joe Studwell's work on Southeast Asian economic development. In his landmark book How Asia Works, Studwell emphasizes the significance of land reform, leading to high yields on family farms through what he calls “glorified gardening.” This labor-intensive approach results in a singular outcome, achieving a balance between low labor productivity and high yield per acre, which is crucial for triggering economic development. In contrast, Western-style large-scale agriculture faces diminishing returns (lower yields) due to limited labor allocation per unit of land.
To Zeihan’s point, could technology potentially compensate for such diminishing returns, enabling the high yields characteristic of Studwell's “glorified gardening”, but at a large scale? This aligns with the direction many agricultural innovators, as suggested by Zeihan, are currently heading. If they effectively deliver such progress, the outcome will be life-changing and fascinating to watch.
9/ What do all these empowering innovations, whether they have been validated or are still emerging, have in common? I would identify four key elements:
They originate from advanced technology, spanning from compact nuclear reactors and sophisticated language models to reusable rockets, fracking and gene editing. However, having access to such technology alone is insufficient to bring about empowering innovation. Recall Bill Janeway's statement from his book Doing Capitalism in the Innovation Economy: “At any point in time, there is more technology available than anyone knows what to do with.”
Some innovations were driven by readily available and affordable capital, as is evident in the case of fracking. Conversely, others were hindered from achieving significant scale due to a scarcity of resources, as I believe is occurring in the healthcare sector. Here, insurers and governments exercise stringent control over the allocation of funds for drugs, devices, and other innovative products (unless it’s about widespread vaccination during a global pandemic, of course).
The significant impact empowering innovations have at a broad scale disrupts the conventional methods of value creation and distribution within the affected industry. This is precisely how empowering innovation fosters progress: it not only initiates improvements in productivity, but also plays a role in reorganizing economic dynamics, constantly challenging the status quo, empowering job creators, and displacing those who lag behind.
Ultimately, we often remember a single prominent figure who appears to epitomize the entire innovation effort, such as Steve Jobs for the iPhone, Elon Musk for SpaceX's reusable rockets, or Aubrey McClendon, the late fracking pioneer in Oklahoma. While these stories are inspiring, they sometimes overshadow the fact that empowering innovation requires a supportive ecosystem of numerous players and substantial capital investment over very long periods of time.
10/ What about startups, then? That was the focus of last week's edition, and I remain steadfast in my view: the era of startups is winding down; it's time to reconsider the extensive use of the term “startup.”
Sure, It's understandable why entrepreneurs aspire to be likened to Steve Jobs, Elon Musk, or Jeff Bezos. Furthermore, adopting the startup label enables them to approach venture capitalists who, in comparison to private equity firms or traditional banks, may be less stringent in their requirements for a comprehensive business plan and more patient regarding profitability.
However, as we transition into this consolidation, 1970s-like phase I discussed last week, it's essential to categorize the realm of investor-backed entrepreneurs in a more accurate way:
One category relies explicitly on groundbreaking technology, which is the realm where venture capital initially specialized. As suggested by the real-life examples above, this category is often the breeding ground for empowering innovations. VC firms labeling themselves as "deep tech investors" usually engage in this demanding sphere, while others who adopt the title often don't fully embrace its mindset.
Another category encompasses businesses riding the wave of the shift from the age of the automobile and mass production to the new age of computing and networks. While these may seem innovative because they introduce a new approach to traditional industries, they don’t really pass the test of innovation. Indeed, most industries have now completed the transition, rendering the use of computing and networks less novel and more banal. Furthermore, the playbook for converting to the new paradigm has become so well-established and extensively documented, it brings down the inherent uncertainty that typically fuels innovation. All in all, many entrepreneurs in this category still like to perceive themselves as innovators, when in reality, they are often building B2B SaaS companies—following a well-trodden path without innovating much in the process. This segment is increasingly suited to private equity funding rather than venture capital.
Finally, the third category, as I mentioned earlier, encompasses companies that do not fit into either of the aforementioned groups and should refrain from using the term “startup” at all. It’s just too much confusion and embarrassment 😉
That concludes today's discussion. In the next installment, my aim is to explore the concept of uncertainty and how it underscores the significance of readily available and affordable capital in the development of innovative companies. If you have any suggestions, remarks, or comments, please feel free to email me or share your thoughts in the comment section!
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From Munich, Germany 🇩🇪