Project Paper Data Sheet CROATIA Science and Technology Project

Source Borrower IBRD/IDA Total

Date: July 2, 2009 Country: Republic o f CROATIA Project Name: Science and Technology Project Project ID: PO80258

Local Foreign Total 2.7 3.0 5.7 21.9 8.0 29.9 24.6 11.0 35.6

Task Team Leader: Paul0 G. Correa Sector ManagedDirector: Lal i t Raina / Fernando Montes-Negret Acting Country Director: Theodore Ahlers Environmental category: C

Borrower: the Republic o f Croatia Responsible agencies: Ministry o f Science, Education and Sports (MSES), Business Innovation Center o f Croatia (BICRO), Rudjer Boskovic Institute/Rudjer Innovations, Brodarski Institute, University o f Zagreb and University o f Rijeka

Revised estimated disbursements (Bank FY/€ million) FY 2007 2008 2009 2010 201 1 Annual 1.7 5.6 4.9 8.8 8.9 Cumulative 1.7 7.3 12.2 21.0 29.9

Current closing date: November 30, 2009 Revised closing date: proposed to extend until May 3 1,20 1 1

The restructuring i s Board approved. Does the restructured project require any exceptions to Bank policies? I s approval for any policy exception sought from the Board?

The revised project development obj ectives/outcomes are:

Yes No No

(a) to enable research and development institutions to commercialize research outputs; and (b) to increase the ability o f enterprises, particularly small and medium sized companies, to invest in research and development (R&D) activities.

Does the restructured uroiect trigger anv new safeguard uolicies? N o

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PROJECT PAPER

PROPOSAL TO RESTRUCTURE CROATIA SCIENCE AND TECHNOLOGY PROJECT

(Loan No. 7320-HR)

Introductory Statement 1. T h i s Project Paper seeks the approval o f the Executive Directors for the introduction o f changes in the Croatia Science and Technology Project (STP), Loan 7320-HR (P080258), to the Republic o f Croatia (the Borrower) and any accompanying project legal documents. It follows a formal request by the representative o f Borrower, Ministry o f Finance o f June 16, 2009 and each o f the Project entities (Business Innovation Center o f Croatia (BICRO) and Brodarski Institute (BI)), which resulted from the discussion o f the findings o f the Joint Portfolio Review and an initial request for the extension o f the project by the Ministry o f Science, Education and Sports o f October 1,2008.

2. The key proposed changes are:

(a) revised Project Development Objective (PDO) and associated outcome indicators, removing the objective o f restructuring research and development institutions and therefore focusing on the objectives o f enabling the commercialization o f public research and fostering private sector R&D; and

(b) the extension o f the closing date o f the project from November 30, 2009 to May 3 1, 201 1 and the reallocation o f Loan h d s between disbursement categories, cancelling the sub-component related to the creation o f a venture capital fund (VENCRO) and increasing the allocation to programs that directly and indirectly support business R&D (RAZUM Program and Unity Through Knowledge Fund Component).

3. The revision o f the PIX) aims to reflect more accurately what can be achieved with the available funds and given the prevailing institutional conditions in the country and the level o f ownership for this specific objective. As concluded during the mid-term review o f the project, progress achieved towards the objective o f restructuring public research and development institutions was very limited while results achieved in terms o f the commercialization of publicly-funded research and research capacity surpass original expectations.

4. The reallocation o f loan funds and the extension o f the project closing date aims to, within the original scope, adjust the project to country’s needs given the current global financial crisis. With the reduction o f access to credit by enterprises and the downturn o f the economic activity, the Government o f Croatia i s eager to ensure that sufficient public funding i s made available for the support o f private R&D, thereby mitigating the impact o f the global crisis on private investments in R&D.

5. As a recent World Bank report shows, Croatia i s one o f the countries o f South East Europe where larger R&D expenditures and better commercialization o f knowledge would generate higher development impacts.’ By focusing on achievable objectives and adjusting the

For a detailed discussion on this topic, including estimates o f the impact o f higher R&D expenditures on economic growth in Croatia see Croatia’s EU Convergence Report: Reaching and Sustaining Higher Rates o f Economic Growth. Wor ld Bank Report, 2009. Washington DC.

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use o f proceeds to the country’s needs, the restructured project i s more l ikely to contribute to the achievement o f these impacts.

Background and Reasons for Restructuring

6. The STP consisted originally o f a € 31 mill ion loan distributed among four components: (i) restructuring research and development institutions (RDIs) and supporting knowledge commercialization by public research institutions; (ii) strengthening private R&D and innovation; (iii) engaging Croatian scientific Diaspora in joint projects and other initiatives, to transfer their knowledge and ski l ls for the benefit o f Croatian economy; and (iv) capacity building o f the National Innovation System. The Project was approved in July 2005, became effective in May 2006 and has a closing date o f November 30,2009.

7. During i ts f i rst two years, STP achievements were lower than the targets agreed in the established results framework and the project performance was rated “moderately satisfactory”. In essence, the project performance was hindered by the lack o f readiness o f local counterparts at the start o f the project.2 With the conclusion o f this capacity building phase in 2008, the STP started to generate effective results reflected in patents applications; new research contracts with the business sector, and a strong pipeline in most sub-financing component^.^ 8. Despite this positive trend, the mid-term review o f the project showed two major structural deficiencies in project implementation: (a) the very limited achievements in terms o f restructuring RDIs, one o f the goals stated in the PDO and (b) the failure to develop the venture capital component (VENCRO) totaling € 4.5 mi l l ion or almost 15% o f the total loan.

9. After using more than hal f o f i t s original allocation, BI failed to achieve sel f - sufficiency ratios that would convincingly indicate a successful advancement o f the restructuring process. Despite the opening of new sources o f revenues, BI’s long-term sustainability i s s t i l l jeopardized by high and growing costs, especially salaries and maintanance, particularly heating costs, which in turn are associated to the costs o f maintainance o f the hydrodynamic laboratory, i t s major asset.4 T h i s in turn reflected the lack o f ownership towards a complete restructuring, as originally envisaged in the project document.

10. Moreover, the participation o f Rudjer Boskovic Institute (RBI), originally envisaged as the second institution to be restructured, became de facto restricted to the support o f activities related to the management and commercialization o f the institute’s intellectual property. As an institute involved in applied as wel l as basic research, the extent and nature o f such restructuring was indeed unclear. At the same time, political resistance to a shi f t in the financing sources o f one o f the most prestigious research institutions in the country was mounting.

For instance, delays in achieving two major covenants postponed the project launch. The covenants were the adoption o f a Science and Technology Policy and the inclusion o f Rudjer Boskovic Institute as one o f RDIs to be restructured. Several institutions required to implement the project had to be established - from staffing and training, to procedural rules and analytical frameworks for the program implementation that had to be built f rom scratch.

See Project Implementation Status and Results Report (ISR) o f January 2009. Another structural factor is an incentive regime inadequate to attract and retain young and wel l qualif ied researchers. As a

result, BI is not in compliance wi th the two legal covenants, namley the self-sufficiency targets and the required contributions to the Institutional Renewal Account (IRA). A detailed analysis o f the financial and economic situation o f BI, as w e l l as its milestones for a successful restructuring process is available in the Aide Memoire o f the October 2008 Mid -Term Review Mission.

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11. In the meantime, STP had successfully launched several activities that enabled the commercialization o f research results and research capacity. For instance, it accepted the requests o f support to the creation o f technology transfer offices from two major Croatian Universities; Rudjer Innovations (RI), the technology transfer office for RBI had already generated two spillovers Rudjer Medikol Cyclotron; and Rudjer Medikol Diagnostics*, filed several patent applications and licensed a handful o f licenses to the business sector.

12. In sum, while the goal o f restructuring at least two R D I s with the purpose o f guaranteeing their long-term sustainability appeared highly unlikely to be achieved at mid-term review, the objective o f supporting the commercialization o f research had shown to be highly promising. Overall, the risk for the implementation o f the restructuring o f research institutions had been assessed as “significant” during the project appraisal phase. Under those circumstances, the Government o f Croatia and the Bank agreed that STP should remove the goal o f restructuring R D I s and focus on the objective o f enabling the commercialization o f research results and research capacity o f those institutions.

13. The several attempts to establish the venture capital fund during 2008 failed as the companies selected to manage the initial capital provided by STP were unable to mobilize the necessary co-financing from the private investors. While aspects o f the financial regulation in the country may have contributed to this result, factors related to the size and maturity o f Croatian financial market were originally known to represent a “high” risk to the implementation of this component at project appraisal. The subsequent deterioration o f global financial markets further increased this risk.

14. Moreover, with the global economic crisis, the conditions under which credit i s available for Croatian f i r m s worsened significantly. The economic downturn also reduced the amount o f internal resources available for the business sector to finance their own R&D expenditures. In this context, the Government o f Croatia and the Bank agreed that the proceeds originally allocated to the establishment o f the venture capital fund should be reallocated to the programs supporting R&D expenditures by the private sector and that project duration should be extended thereby allowing for the full absorption o f these funds.

Proposed Changes 15.

i.

A revised Project Development Objective:

Original PDO: (a) to strengthen and restructure research and development institutions and to promote commercialization o f the research outputs and (b) to upgrade technological capabilities o f enterprises.

ii. Revised PDO: (a) to enable research and development institutions to commercialize research outputs; and (b) to increase the ability o f enterprises, particularly small and medium sized companies, to invest in research and development (R&D) activities.

Rudjer Medikol Diagnostics i s a jo int venture (JV) with R B I ’ s department for molecular medicine, which runs genetic testing o f hereditary breast cancer (and has been certified wi th the European protocol for breast cancer screening) in the field o f preventive medicine care. Rudjer Medikol Cyclotron i s a joint venture o f RBI and private health-care provider, which provides highly sophisticated nuclear medicine services (radionuclides) for diagnostics o f cancer (PETICT), not available in Croatia so far, and w i l l also work on R&D o f new radionuclides and other research connected to cyclotron in general.

This i s the PDO as stated in the Loan Agreement (p. 16). The objective as stated in the PAD (p. 4) i s as follows: (a) to strengthen and restructure selected research & development institutions to promote applied research, while maintaining their scientific excellence; and (b) to increase the ability o f enterprises to develop, use, adapt and commercialize technology. These differences w i l l also be correct for by the proposed project restructuring.

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16. The new results framework and project outcome indicators, as described in Table 1. A comparison between original PDO and results framework and the newly proposed one i s presented in Annex 1.

17. The elimination o f the venture capital sub-component (originally € 4.5 million).

18. A reallocation o f the loan funds among the different project agencies, realigning the use o f loan proceeds and the new project objective; including the increase in the percentage o f expenditure from loan proceeds for RAZUM program to 100 percent (originally 80 percent), to help alleviate the shortage o f counterpart hnding due to financial crisis, as well as cancelling a total of €1 .O mil l ion o f the original loan amount o f € 3 1 mi l l ion as described in Table 2.

19. The extension o f the closing date from November 30,2009 to May 3 1,201 1.

20. The following additional changes: a) the cancellation o f the BI’s implementation covenant requiring maintaining an Institutional Renewal Account (IRA)7; and (b) the cancellation o f the BI’s sustainability clause (Project agreement with BI, Article IV, Section 4.02 (a)). Amendments during project implementation, as well as measures adopted to s impl i fy Bank’s approval o f sub-financing programs and procedures, will also be integrated to the legal project documents.* Revised project cost/disbursement estimates and financing plan are presented in the Annex 2.

Analysis

21. Envisaged to become the backbone o f Croatia’s innovation policy, STP represented part o f the Government’s efforts to strengthen the competitiveness o f Croatia. In the context o f raising labor costs and living standards in light o f the upcoming EU accession, the project was envisaged to enable the country’s transition towards a knowledge economy. With that purpose in mind, and given Croatia’s untapped stock o f scientific knowledge, the commercialization o f research results and research capacity seems to have a larger economic impact than the restructuring o f selected R D I s , which would have helped to guarantee their long-term sustainability. Having overcome the resistance o f large part o f the scientific community to the commercialization o f research outputs, project results a more l ikely to be achieved.

22. In this sense, the proposed change in the PDO does not significantly alter the original economic, social and institutional aspects of the project. Rather, with the elimination o f the objective o f restructuring RDIs , the loan will no more finance the severance pay for eventual lay-off o f redundant workers. The proposed changes in the project do not involve any exception to Bank policies. The proposed changes do not raise the environmental category o f the project or trigger any new safeguard policies.

~~

’ The BI i s required to set up an internal revolving fund account (the IRA) (completed) and to make quarterly replenishments from i t s revenues to the account totaling € 1.5 million by 2010 (not done) and to use the amounts on deposit in said institutional renewal account for the purpose of financing its institutional renewal requirements, under terms and conditions acceptable to the Bank.

Actions undertaken to streamline the project implementation include: (i) the Bank provides one no-objection to the Business plan, Procurement plan and Training plan package of each RDI once a year (as compared to previous multiple submissions at different times), whereas the procurement and training plans may be revised on as needed basis to address project implementation status and developments; (ii) the task team leader (TTL) has delegated authority to s ign o f f on procurement actions to the field-based procurement expert pursuant to Office Memorandum dated October 7, 2005 from Armando Araujo, Director OPCPR, and consistent with AMs 1.30 (c) and any regional requirements; (iii) the Bank’s prior review to UKF projects that exceed the value o f €200,000. With current strong commitment in the Ministry of Science, Education and Sports (MSES), the Bank i s also considering delegating more authority to MSES in approving certain select activities instead o f the Bank.

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Expected Outcomes 23. The expected project outcomes include: a) mure research outputs and research capacity commercialized by RDls, as measured by the number o f contracts concluded with the business sector raising from 2 to around 30 between 2006 and 201 1 ; the number o f spill-over companies increasing to approximately 8; and the volume o f licensing agreements signed between R D I s and the business sector reaching a sum o f €1 million; and b) more innovation andprivate R&D, as measured by the share o f small and medium size companies introducing products new to the market maintained at the pre-crisis level o f roughly 7 percent in 2 0 1 1 and a volume o f R&D expenditures by SMEs in € 9.2 mi l l ion in the period.

Benefits and R i s k s

24. With the project becoming the backbone o f Croatia’s S&T Pol icy and disbursements picking-up, the proposed changes will (i) increase the likelihood and the magnitude o f commercialization o f research and private sector innovation, thereby contributing to Croatia’s transition towards a knowledge economy and (ii) extend the availability o f funds for private R&D in a context o f illiquid financial markets. Th is wil l help mitigate the effects o f the global economic crisis in the country. In addition, the extension o f the project would allow more time for the full consolidation o f newly created policies and institutions.

25. Two main factors present risk to the achievement o f the expected outcomes: (a) a renewed resistance to the commercialization o f research outputs, in light o f the increased global resistance to market-oriented reforms and for which we attribute a “medium” r isk level; and (b) the lack o f counterpart funding, that could result from the tightening o f the fiscal policy, for which we attribute a “high” risk level (as compared to “medium” r i sk level during project appraisal).

26. The following are mitigating factors:

(a) Despite the project’s orientation towards market-reforms, i t s implementation has and will continue to seek synergies with EU programs and policies, aiming to have the EU accession agenda as an institutional anchor for STP related activities. In addition, newly appointed administrations to the University o f Rijeka and RBI have explicitly manifested their support to the project. Finally, the goal o f restructuring RDIs , a source o f major resistance, was removed;

(b) With respect to an eventual reduction in counterpart funding, the Government and the Bank agreed to increase the financing ratio from loan proceeds, as allowed by the Country Financing Parameters, and should the need arise. T h i s in particular refers to selected sub- financing categoriesg. Furthermore, as a result o f the Joint Portfolio Review o f February 2009, the Government recommended, through i ts Conclusion adopted on March 25, 2009, more intensive disbursement of loan and grant funds financed by the Bank. Finally, the proposed restructuring raised the value o f the project to the government as i t better addresses i t s needs, and particularly in the context o f the current global crisis, as demonstrated during the Joint Portfolio Review.

Currently, the increase in the financing ratio has only been proposed for the RAZUM program (p.6 o f the Project Paper).

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27. Evaluations during the mid-term review and discussions held with the project counterparts on the restructuring o f STP suggest that the overall risk associated to the implementation o f STP may be moderately reduced due to the above described mitigating measures.

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Tabb 1: Proposed Results Framework Table 1.a: New Project Outcomes

DescriDtion ' Baseline Actual Target Project Objective

1.. Enabling RDIs to commercialize research outputs as measured by:

Increased number and value o f research contracts with the industry (€ million)

............ ._ Increased commercialization o f R&D results, as measured by:

a) Number and value of spillovers (including j oint-ventures)

b) Number and value o f licensing agreements signed with the business sector

2. Increased development, use and adaption o f technology by the enterprise sector as

SMEs that have new or significantly improved products new to the market maintained (as

.............................................................. ....................................... .......................

............................................................................................................................................. ...............

. . . . . . . . . . . . . . . . . . . . measYred.!?Y:. . . . . . . . . . .

share o f total enterpcises)" Volume o f private R&D mobilized (through programs supported by STP - in € million)

(Primarisource) I 2006 ' 2008 May 2011 i

BI's contracts wi th pnvate 1 2 I 10 30 companies, UKF contracts co- , financed by the business sector , 0 5 ' , € 1.8 ' €8.0 and research contracts signed '

by TTO's and not dlrectly 1 i

~

- . f inpced bl_STP . -. i - ~_ - - ___ _ I

As signed by RI and other TTOs , None , 3 , 8

As signed by R i &d other None , 6 8 , € 5,000 €2,860,000

, €323,000 €1,000,000

2 . -1 _ _ - - -

. . TTOs

- . _ _ _ - 1 __I

I

Source: Community Innovation , 7.22% ' N.A 7% Survey

__ " ...................... i" At least 30% o f R A Z U M ' €6.0 I €6.8 , €9.2

uroiects; 20% o f UKF ~ j c o h & with industry and 1 50% o f SPREAD projects

Table 1.b: New _ _ Proposed Intermediate Outcomes Intermediate Objective Baseline Actual , Target- , Contribution to

PDO

(a)

2008 ' May2011 - - * I- i 2006

I Component A - Encouragmg the co&nerciahzationof- publicly-funded R&D

BI's share of revenues from private companies 22% ' 31% ' 35% I to enable t 1 research and

IP taken to protection from RBI and third parties None - - . 55 60 , development 2 6 institutions

i Number of patents granted to RI None

' to commercialize IP transferred to Zagreb and Rijeka's TTOs None , , None ~ 2o I researchoutputs

i . ,

... .............................................................. ........................................................... : ....................................... & ...................... ^ ............... i ................

....... ............. ............................................................................................................................................................................................. :.. ........................................... ). ........ ............................. ........................ ............................................................................ Number of patents filed by the TTOs i None j None ~ 8 i

......... I , to increase the ability

RAZUMprogram(€million) ~ 18.03 j 28.54 ~ 33.68 ~ ParticularlYSMEs~to

Component B - R&D financing program for enterprises ~ (b) ....... ... ...... i i ........ i

Number of SMEs directly supported by BICRO programs ~ 37 i 60 ~ 78 ~ of enterprises,

. . . ~ invest in R&D

.. ~ L ........................................ ! ................. i ........ !

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , - - ' TECHCRO program (number o f projects) 1 ' ' ' "None 7 I 12 ''I activities

........................................... ....................... ............................................ I.. L . .+. i SPREADprogram(€million) None I 0.08 ~ 1.5 j

j (a) to enable research and

Component C: UKF Number ofprojects (total) None i 38 i 50" ,la. ml *-ma..+

UG V C ; l V p U k G U L

ProjectswithCroatians limngabroad ' None ' 18 i 30 ' institutions ' to commercialize - . : research outputs

Projects wkh young scientists None 18 , 15 (b) to increase the

' 15 i ..

Projects involving cooperation with the industryi2 ' None ' 8 . r

1 ._ ........ i . . . . . ... 2 . . . . .: Projects successfully completed (as evaluated by UKF j None 2 , 30 Of

i particularly SMEs, to / invest in R&D evaluation committee)

I .................................... .. .......................................................................................... .. " " ....

lo Preliminary results o f BICRO sub-financing programs indicate that mobilization of the private investment from SMEs could be expected; hence the proposal to benchmark the share o f f i rms performing R&D as per the results of Community Innovation Survey, carried out by the EU. '' T h i s target has been decreased due to increased share o f projects of higher value as compared to medium-value projects. l2 Includes the projects primarily oriented to industry sector and other UKF projects where industry invested matching funds.

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Table 2: Proposal for Reallocation o f Loan Proceeds by Components (€ million)

~ I 1 Project Component /_Act iv iy Original _ql!ocation ; projosed Al lowkon , __ Difference- ,

I 1 Component A I 10,500,000 , 10,600,000 100,000 BI I 4,000,000 3,000,000 ' -1,000,000

-900,000 . 800~000 - _ _ i - __ - . - - - - - - - -_ - -_ 4~0007000 i - - 6,000,000 -__ - > _ ' . . 2,000,000 ~

~

--I - _- RBI / RI Unyersity o f Zagreb- i . 2,500,000

- . - - 1' ----

I I - - I . - - - .- _. . _- - ,_ - - - - . 8!0,000 Uniyers!tyOf Rijeka . i -

BICRO Institutional Buildng - . 700,000 1 0 Component B 14,000,000 11,868,124 ; -2,131,876

RAZUM Program 3,000,000 ' 5,143,124 2,143,124 Venture-Capital Technology Centers 4,300,000 4,525,000 , 225,000 ~

MARIB IC R&D Center 1,600,000 ; 1,600,000 ~

New and . - Existing TCs 1,100,000 1,325,000 225,000 SPREAD Program 1,500,000 9 1,500,000 I

Component C . . 3,700,000 ! . 4,550,000 850,000 150,000 Operational Support i 300,000 . 450,000 700,000 4,100,000 UKF Fund - 1 - -3,400,000

Project Implementation 1,640,000 , 1,900,000 , 260,000 ~

0 ' -_ -4,500,000 . . _ _ 4,500,000 - - - ~

I t

-1 . I

Technology-Incubators , _ . 1,600,000 . 1 1,600,000 _ _ - -

3 .

- - > - - r

. - 1,450,000 I 250,000 , Implementation Unit, Other 1,200,000 , i Croatian Innovation System & I Croatian Accredtation Council , 440,000 , 450,000 ~ - . 10,000 ,

1 Unallocated -- __ 1,000,000 1,000,000 i _.

1 I Other (Unallocated Fees) 1,160,000 , 1,077,500 -82,500

0 ~ Fees 160,000 8 77,500 . -82,500 ' Total Project Expeqditure 31,000,000 29,995,624 -1,004,376

* * * * * *

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