On the Economics of R&D, Sustainability, and Planting Trees in Whose Shade You’ll Never Sit
The appearance of sustainability and greenness is important to businesses. From petrochemicals to probiotics, modern publicity campaigns seem incomplete without a diverse gallery of smiling people. All living in the moment, surrounded by nature, and blessed with eternal sunshine.
It’s no coincidence either. We’re suckers for emotional arguments, and that’s part of what makes us human. Whichever way you slice it, we are far less rational than we like to think — and the green‑washers know it.
But being green is inherently greater than just appearing green, and research and development (R&D) tax reliefs are designed to reward those companies who are helping to improve the way in which we co-exist with the natural world. Activities that contribute to improving the efficiency and sustainability of existing processes can qualify for tax relief under the research and development scheme. We’ve put some examples at the bottom of this blog post, but to understand why and to properly deconstruct the blog’s title for its aphoristic value, we want to introduce you to an interesting economic concept: the externality.
Cool, so what is an externality?
In a nutshell, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit. ‘Costs’ to the third party are called negative externalities, and benefits are termed positive externalities.
Imagine you’re a crop farmer, and your neighbour invests in an apiary. You don’t pay for the bees, and you don’t pay for their upkeep, but you benefit because the neighbour’s bees pollinate your crops and increase your crop yields. Ka-ching! That’s a positive externality.
Alternatively, imagine you’re embarking on a much-needed mini-break. You’ve bagged yourself a bargain on Skyscanner and you’re flying Malaga-return for £50, good for you! Also, the airline is covering its fixed costs on a seat that would otherwise have gone empty, so that’s great for them too.
Both parties directly involved in the transaction are happy. You do feel a little guilty that the carbon-footprint of your jet-setting lifestyle contributes to the developing climate crisis — but why should you pass up this opportunity that you’ve been gifted? Anyway, the scientists of tomorrow will come up with a solution when we really need it, and you’ll probably be long gone by then anyway. Just like that, you’ve imposed a significant negative externality on people who don’t even exist yet.
This is an example of what economists call a market failure, in which individuals pursue the outcome that is best for themselves individually, but which leads to suboptimal, bad, or even disastrous outcomes from a societal perspective. Adam Smith’s metaphor of the invisible hand explains how individuals’ selfish pursuit of their own interest can lead to societal benefit. This is the great wonder of capitalism. Smith knew however, that the invisible hand’s anthropogenic nature made it characteristic of some distinctly human foibles. That’s a fancy way of saying that human imperfections make the invisible hand clumsy.
OK, that’s all well and good. But what does any of this have to do with sustainability?
Well, when it comes to incentivising more positive practices and fewer negative ones, forcing the costs or benefits of the externality to be reflected in the initial transactions is one solution. This internalisation means that the cost or benefit of the externality is considered in the original transaction.
Maybe there’d be fewer flights if flying was taxed more heavily, and maybe the tax revenue could be used to incentivise research on greener flight technology? Maybe your neighbours in the first example would have installed the apiary sooner if they knew you’d be willing to subsidise some of the cost, if there was a fund to support such communally beneficial activities, or if keeping bees attracted tax-benefits. See where we’re going with this?
There is a problem with all of these interventions though, which is that every newfangled measure has the potential to introduce more administrative complexity. Before you know it, you’re operating in an acronym-laden tax and policy environment that’s about as viscous, opaque, and sensical as a bowlful of alphabetti spaghetti. The pace of innovation is inevitably slowed if firms competing to survive are forced to invest significant amounts of time in a bureaucratically complex arms race, rather than innovating, for a strategic advantage. Where you draw the line on what constitutes the right level of market-modulation is subjective by definition (it’s where you draw the line), but it’s hard to argue that incentivising societally beneficial practices isn’t of virtue.
Enter: Research and Development Tax Reliefs
Companies undertaking research and development generate positive externalities which they are not themselves going to capture the value of. These externalities are general advances in understanding or ability, which have a general tendency to be combined and built on by others in unforeseen ways. From a scientific and technological perspective, this principle has been understood for centuries. Isaac Newton claimed to have seen further if only because he was “standing on the shoulders of giants”, and the iPhone owes its existence to billions of dollars’ worth of state-funded military research. It’s a well-established societal perk of R&D activity, but one that doesn’t inform the investment decision from a corporate finance perspective; Apple probably wouldn’t have invested in pressing the smartphone revolution if the smartphone’s technological foundations weren’t already in existence. The research and development schemes are designed to link the wider societal benefits of undertaking R&D to the initial financial investment decision, so optimising the level of investment in scientific and technological advancement.
We’ve touched on this already, but there is huge value in preserving the ecological health of our local and global communities. There are also huge costs to getting it wrong. That’s why the costs incurred in advancing science or technology, specifically where these relate to the sustainable refinement or alteration of existing processes to make them more efficient and ecologically friendly, are included in the scheme. If you’re innovating to find new ways of reducing the negative externalities imposed on the planet, HMRC will internalise some of that benefit to you in the form of tax reliefs or credits. Examples of qualifying activities include:
- Developing alternative packaging that is more ecologically sustainable. This might include research to develop new bioplastics or the technical development of new bioplastic products.
- Finding new ways to reduce the amount of water or energy used in a process.
- Finding ways to reduce pollution and environmental contamination with new capture methods for hazardous chemicals or processes that use fewer or less ecologically harmful chemicals.
- Developing new recycling processes and technologies, such as AI-enabled recycling sorters.
- Expanding what we know about bees, practical apiculture, and combating colony collapse disorder.
It’s clear that R&D tax reliefs are important, and there is great societal value to their existence. Whilst they are an often-misunderstood part of the tax system, we’ve witnessed significant advances in the industry in recent years which make it easier for companies to understand how they can benefit from such schemes. But we wanted to do more, and that’s why we created Novel — a digital platform designed to help people claim R&D relief as simply as possible. This means you can start claiming relief on your qualifying costs right away and plough more back into the work that really matters.
You won’t need an R&D consultant to use Novel, although our team is always on hand for support or advice should you need it.