The Production and Innovation Networks of Estonian Companies

Introduction

As a consequence of the geopolitical location and small size of Estonia, the country’s economic development has been based on the open economy model. Immediately after the restoration of independence, a liberalisation of foreign trade began, opening the Estonian market for imported products and thus bringing about strong competition in the domestic market. This in turn forced businesses to look for suitable foreign markets and the economy was soon oriented towards export. Simultaneously with the start of the privatisation of state-owned companies in the mid-1990s, a very liberal investment environment for foreign investors was developed. Rapidly, Estonia became a country where the relative importance of foreign investment was one of the highest in Europe. From the late 1990s onwards, Estonian businesses themselves also started to invest abroad, first into the neighbouring countries of Latvia and Lithuania, and after that, the purchasing of companies from Finland and Western European countries began (e.g. Tallink, Nortal) and new businesses are now being established as far away as Asia (e.g. Fortumo OÜ).

As a result of all these steps, the general business activities of Estonia have become connected with various international networks, real as well as virtual. The Estonian companies owned by foreign investors have become integral parts of the networks of multinational enterprises. Another group of Estonian companies, owned by locals, has built international networks of their own and thus become multinational enterprises (e.g. BLRT Group). A third group of Estonian-owned Estonian companies have not invested abroad themselves, but are still a part of international networks through export, import or subcontracting activities. A fourth group consists of companies that were ‘born global’ (Skype, TransferWise, Click and Grow), i.e. were established to be part of foreign markets from the very start.

Thus, a considerable share of Estonian businesses are connected to transnational (aka multinational) networks as an economic phenomenon. This is manifested through participation in international supply chains, which are essentially huge multinational networks with participants in various countries contributing distinct components of the product, which is then assembled into the end product with various services attached to it (a global supply chain). On the other hand, these networks can also be seen as global value chains where the participants receive a part of the new value created by the chain as a whole (Gereffi 2014).

The increasing transnationalism of companies and persons poses a principal challenge to entrepreneurs as well as policymakers: how to unite the separate tracks of the virtual and real economic dimensions? A virtual network can function in a variety of ways, for example through competition within the supply chain where production units participate in a global competition for the same supply contracts, through sharing-economy platforms like Airbnb, through social networks like LinkedIn, but also with the help of compatriots living and working abroad. Real economy networks are related to the characteristics of the physical location of a company, like a sufficient supply of workforce, the presence and quality of knowledge institutions (universities) and financing opportunities. Virtual networks are flexible, extensive and open, while real networks are finite, slow to change and often characterised by unique traits. Entrepreneurs as well as policymakers must more and more often deal with the question of how these parallel networks and their diversity can be unified in order to maximise revenue.

The topic has been tackled in this chapter with an attempt to analyse it meaningfully within the context of Estonia, showing the increasing openness, transnationalism and diversification of Estonian business from the early 1990s up to the present. Estonia has a very open economy, attested, for example, by its high standings in various indices measuring globalisation. The object of our analysis is thus the impact of openness on the development of economic networks and what can be done to facilitate the development of networks. From the point of view of Estonia, it is important that our businesses be connected to as many supply chains as possible. It would also be good to increase our part in the new value constantly created in that chain, which would make it possible to pay higher salaries and companies would have more profit to invest into development. The manufacturing industry plays a very important role in increasing the complexity and knowledge-based nature of the Estonian economy, and therefore this chapter focuses particularly on this sector.

Estonian Business in the Global Economic Network

An important development direction in the modern global economy is the rapidly-increasing mutual dependency of economies, demonstrated through many real economic and virtual networks. Abolishing the restrictions imposed on international trade and direct foreign investments in the late 1980s played a crucial part in starting this process. In addition, the process was also supported very strongly by rapidly evolving information technology and especially the extensive widening of its scope of application beginning in the 1990s. Companies participating in global trade were now seen within the framework of global value chains.

The importance of networks was also emphasised in connection with the innovation processes. The most widely-accepted treatment of innovation at present - the innovation systems approach - stresses the importance of various types of networks (e.g. company-company, company-university, company-state, employees within their own networks) (Lundvall 2013; Asheim & Gertler 2005). Networks have become especially important in studies of innovation in recent years, mostly in relation to the increasing impact of globalisation on economic development and the growing importance of the rapidly evolving business and information technology models in the global economy.

Globalisation has especially influenced international production networks where different parts of the value chain are located in different countries. Value created by business models based on the sharing and processing of information (e.g. Amazon, Uber, and Airbnb) is constantly growing in importance in the total volume of global trade (Mckinsey 2016). Value chains and their production and innovation networks are becoming increasingly virtual and international, i.e. the transnationalism of these networks is increasing.

Estonia took advantage of the opportunities that appeared with the opening up of the global economy in the early 1990s and quickly started to liberalise its own foreign trade as well, opening the Estonian market for imported products and thus bringing about strong competition on the domestic market. This in turn forced Estonian businesses to look for suitable foreign markets and the economy was soon oriented toward exports, which surpassed 70% of the gross domestic product already in 1995. In privatising state-owned enterprises, Estonia chose the model of involving foreign investors and managed quickly to design a very open and free investment environment for foreign investors. Estonia quickly became a country where the relative importance of foreign investments was one of the highest in Europe. Estonia’s openness to foreign investors as well as the very large share of companies owned by foreign investors in the processing industry is shown in Table 2.3.1.

Table 2.3.1. Share of companies with foreign participation in the processing industry of Estonia 1996-2014

Sources: Various data collections of Statistics Estonia.

Table 2.3.1 shows how the relative importance of foreign-owned companies grew quickly in 1996 and 2008 in terms of employment, creation of added value and exports. The activities of foreign investors had a huge impact in directing the industry towards exporting. We can also see the learning ability of Estonian businesses, expressed quintessentially in the continual convergence of the parameter characterising workforce productivity - added value created per employee (Masso et al. 2012). In 1996, 33.7% more added value was created per employee in a foreign-owned company than in an Estonian-owned one, whereas by 2014, this number had decreased to 17.3%.

The generalisation can be made here that the structural changes brought along by the opening up of the economy in Eastern Europe, including the economy of Estonia, were very rapid in the 1990s and helped reach the productivity levels of the developed industrial countries of Western Europe. Figure 2.3.1 illustrates the growth of workforce productivity in Estonia compared to the productivity in Finland, Germany and South Korea. It can be seen that during the late 1980s, Estonia’s underdevelopment compared to these countries escalated, but in the second half of the new decade, productivity grew quickly in Estonia, up to the year 2008.

Figure 2.3.1. Productivity of the workforce per employed individuals, 2015, US dollars, as percentage of Estonia compared to the country

Source: The Conference Board Total Economy database, author’s calculations.

Simultaneously with this rapid growth, the debt burden of the private sector and the current account deficit were also increasing fast: both of them started growing in the second half of the 1990s and stopped in 2008 with the global economic crisis that hit Estonia very painfully. These changes led to the formation of the present structure of Estonia’s economy, characterised by an orientation to foreign markets and industrial enterprises with large foreign participation. The same sectors dominate in Estonian industry as in the Scandinavian countries: wood, heavy machinery, electronics, chemistry and furniture production. Specialising in similar fields as Scandinavia has created for Estonian industry an image of ‘Subcontractor’, which only partly corresponded to the truth back in 2000, and has clearly changed by now: “There is already a significant number of companies among Estonia’s industrial enterprises that are doing product development and providing production services with a high level of specialisation. This means that the products and processes are complex, but also that there are niche products and consequently small production volumes with inevitable cyclical-ness.” (Karo et al. 2014).

On the basis of the position of the companies in the global value chain of the parent companies, two ideal types of companies can be discerned (generalising vastly) among Estonian industrial enterprises with a foreign participation. First, there are the A-type companies who started as subcontractors for large companies producing well-known brands, and evolved into providers of specialised production services, but import almost all of the production input. These companies have very close ties to their parent companies, but they don’t have many significant connections to other companies and educational establishments in Estonia. Elcoteq can be named as an example from earlier times. But there are also other companies with a main production task received from the parent company, like the plywood producer UPM Kymmene in Otepää, the machinery construction company Clyde Bergemann or the electronics firm Enics in Elva.

Secondly, already we have also the so-called B-type companies. The parent company has given them an additional opportunity to build their own cooperation network of local businesses and to move on from production towards development activities as well, involving research and development workers from Estonia. A good example of this group of companies is ABB, which is foreign-owned, but acts in Estonia under its own brand; the company has one of its six central global hubs in Tallinn and they cooperate with close to 100 companies in Estonia, employing 10,000 people. These B-type companies are able to bring their virtual networks to Estonia, turning them into real cooperation networks operating here and thus contributing significantly to economic development.

In the last decade, more and more Estonian-owned companies have appeared (the C-type) that have managed to build an international concern and the companies themselves have become leaders of international service provision and production networks. Examples from the services sector include Tallink, Nortal and Fortumo, and from the production sector BLRT, TMB and Harju Elekter.

The most detailed information on the networking of Estonian companies can be found in the study ‘Global Value Chains and International Procurement’, published by Statistics Estonia in 2011, which includes information on all 514 companies active in Estonia with more than 100 employees. Results of the study show that 419 companies, i.e. 81.5% of the respondents, were part of a concern. Consequently, networking was very widespread already in 2011, although most of the concerns were domestic and the networks Estonian. Still, 16.1% of the companies had subsidiaries abroad, with 7,766 employees, 1,351 of them in industry and the rest in the service sector. These companies are representatives of locally owned transnational companies within Estonia’s economy who have established international networks.

Estonian businesses have made significant progress in creating real networks, but using them for gaining and spreading new knowledge is still on a modest level. Although progress has been made, the mainstream of industry in Estonia is still far from the development trajectory characteristic of ABB. Naturally the small size of Estonian companies and the experience of entrepreneurs pose limits here. While the ‘subcontractor’ image of our companies has diminished, moving to higher levels in the value chain will take some time.

There have been three stages in the movement of Estonian as well as East European companies on the ‘ladder of knowledge’. First, a rapid growth in productivity in the 1990s, for which no growth in the use of intellectual property was required. Second, a rapid growth in the use of intellectual property in the 2000s. Third, the slowing down of both of these trends in the 2010’s.

Thus, it may be said as a huge generalisation that the source of the growth of productivity of Estonian companies has not been so much the development of a knowledge base, but rather investments into fixed assets and increasing sales abilities.

Trying to understand the impact of the processes described above on the innovation networks in Estonia, two trends stand out. First, the research and development activities of companies are strongly concentrated in Harjumaa and Tartu, representing 65% and 20% respectively of the corresponding expenses of companies (Mürk & Kalvet 2014). Second, the specialisation of companies in sectors of research and development activities (where the corresponding investments are made) differs significantly from the specialisation of the public sector (Ukrainski et al. 2014; Karo et al. 2014).

The CIS surveys (Community Innovation Survey) carried out regularly show that although industrial enterprises are the main vehicles of export and also innovation in Estonia, their ability to analyse and interpret the market signals of the global frontlines of technology and innovation is limited (e.g. in the usage of domestic raw materials), and the domestic and international networks of these companies are limited in the same way – in terms of who (and to what extent) their innovation partners are (Kaarna et al. 2015).

Foreign owners of industrial companies also play an important part: on the one hand, it is much easier to reach foreign markets through them, but on the other hand, they do not have established networks in Estonia. In such cases, mediating organisations like professional associations and clusters play an important role. There are considerable differences here between industry sectors: the electronics and wood industries have strong professional associations and clusters that bring the leading companies of the sectors together, while this cannot be said for the machinery industry. Cooperation between companies improves most significantly when products become more complex.

Transnational Companies in Production and Innovation Networks

The production and innovation networks of Estonia’s processing industry companies are becoming increasingly transnational by nature. Although it could be said from a historical perspective that Estonian industry was very closely integrated into pan-Soviet-Union supply chains already before 1990, and it was possible to talk about production networks already then, but there was only one type of transnationalism - in the eastern direction. The links of businesses with the world economy are much more versatile today. Through foreign investors from the Nordic countries, Germany, Holland and a number of other states, our businesses participate in global value chains. This channel of transnationalism is very important for Estonia, as a third of all people employed in the processing industry in Estonia worked in foreign-owned companies in 2014, and they accounted for more than half of the revenue, two-thirds of the exports, etc.

The contribution of transnational companies to the development of Estonia’s economy depends largely on which networks their subsidiaries participate in and what freedom of decision they have in various activity areas. Studies of foreign investors conducted by the research group at the Faculty of Economics at the University of Tartu show that the decision-making freedom of the Estonian subsidiaries of transnational companies is most notable in the fields of human resources and logistics (see Figure 2.3.2), followed by production and advertising in the local market. The field where foreign owners exercise most control is investment and financing decisions, but also the export regions of Estonian companies and planned foreign investments.

Figure 2.3.2. Average estimates on the distribution of decision-making processes between a foreign investor and an Estonian subsidiary, 1 - decision made fully by foreign investor, 5 - decision made fully by the Estonian subsidiary

Source: Roolaht, Vissak, Varblane (2010) p 114.

Price formation, choice of distribution channels and marketing measures are usually also strongly controlled by the foreign investor. There are production companies who don’t do any marketing or sales, concentrating on a production task in the larger supply chain of the concern (e.g. Saint Gobain Glass, Estonia SE or UPM Kymmene). Decisions concerning production, logistics, staff and procurement activities are mostly taken by the Estonian subsidiaries. In supplying materials, the subsidiaries participate in global procurements for the concern, which give them better input prices because of the large purchase quantities. In such cases, the decision-making parameters of the heads of the local companies are restricted to an efficient and evolving organisation of production.

The autonomy of research and development activities and product development also depends on the activity profile of the local company. When providing products or services for the local market, the local employees participate intensively in the development processes or even offer development ideas for the entire international concern (Fortum). However, there are also activity sectors where the development activity is restricted to implementing the product specimens obtained from the foreign owner into production. Independence, however, should not be seen as a non-changing phenomenon. The decision-making autonomy of a local company also depends on the capabilities and development abilities of the local management, which may increase the autonomy to a certain extent as local competence grows. The independence of a company located in Estonia as well as increasing management rights may be a decisive preliminary step to increasing the company’s market position. If the limitations on independence remain the same or increase, on the other hand, this may increase the probability of shutting down activities in Estonia and moving elsewhere.

From the point of view of network relations, taking into account the needs of the customer is important for the heads of foreign-owned companies, and so is cooperation with other companies with the same owner in Estonia or abroad, and with supply partners (see Figure 2.3.3). Intensive exchange of knowledge, joint trainings and the transfer of experience are very common and regular in the internal networks of transnational concerns (Lasertool & Clyde Baergemann). However, cross-border exchanges of knowledge and training visits are quite common also in smaller foreign-owned companies (UPM Kymmene & Scan Holz). Even if no official and regulated cooperation methods have been established in an organisation, the training and development opportunities that are afforded by the owners of foreign-owned firms are usually still important and regarded as such by the managers.

Figure 2.3.3. Average estimates of the importance of cooperation partners in foreign-owned companies, 1 - completely unimportant, 5 - very important

Source: Roolaht, Vissak & Varblane (2010) p 116.

Based on their experience, the managers of foreign-owned companies generally tend to be sceptical about the role and contribution of professional associations, finding that their usefulness is rather limited. Network relations with consulting firms, research institutions, universities and other higher educational establishments are not very important for foreign-owned companies. The same conclusion was reached in a study comparing 14 European countries, where a negative relation was found between foreign ownership of companies and cooperation with local universities (Rõigas et al. 2016). Foreign investors operating in Estonia named the theoretical nature of academic education and its limited application to the company’s practical development needs as the main problems. Still, positive examples of effective cooperation relations with the Tallinn University of Technology or University of Tartu as sources for management know-how were also mentioned. Companies see opportunities for exchanging experiences with universities, whether in the form of lectures by visiting entrepreneurs, for example, or a contribution by researchers to the development of the company, but a lot depends on the initiative of individuals or a lack thereof.

A certain general idea of the connections of foreign companies with Estonian and foreign production networks can be obtained by looking at the relative importance of using Estonian subcontractors, which Varblane et al. (2012) discovered reached 54%. Two-thirds of the respondents said that the level of using Estonian subcontractors will remain the same in the future, while one-fifth are still planning to increase the share of local subcontractors. Thus, it can be said that there is quite a bit of room for growth in connecting foreign-owned companies with the local economy in more diversified ways. It should include a considerably tighter connection between the Government and foreign investors, for example by establishing a round-table meeting of the Prime Minister with foreign investors, a series of meetings between Estonian universities and foreign investors, etc. Even such simple but dynamically active networks would let us take better advantage of transnationalism to develop our economy.

Summary

An important development direction in the modern global economy is the rapidly increasing mutual dependency of economies. This is actualised through international supply chains, which are essentially huge multinational networks with producers in various countries producing distinct components, which are then assembled into the end-product with services attached (a global supply chain). On the other hand, these networks are also global value chains where the participants receive a part of the new value created by the chain as a whole. From the point of view of Estonia, it is thus important that our businesses should be connected to as many supply chains as possible. The larger our part in the new value created within this chain, the higher the salaries and the higher the profits that can be invested into company development.

The connections of Estonian businesses with international real and virtual networks has been increasing steadily over the last decades. Thus, the transnationalism of our economy has been growing and diversifying. During the era of classic transnationalism in the mid-1990s, there were subsidiary companies owned by foreign investors operating in Estonia, but since the end of the 1990s, new types of transnationalism have evolved. There is a significant number of companies operating in Estonia whose managers have built international networks of their own and thus become multinational enterprises. In the last decade, many ‘born global’ companies have appeared, especially in the information technology sector, established for acting only in foreign markets from the very start.

Estonian businesses have made significant progress in creating real networks, but using them for gaining and spreading new knowledge is still on a modest level. Although progress has been made, the mainstream of industry in Estonia is still far from the development prowess exemplified by the Estonian subsidiary of ABB, where the parent company has given the subsidiary an additional opportunity to build its own cooperation network of local businesses and to move on from production towards development activities as well, involving research and development workers from Estonia.

The contribution of transnational companies to the development of Estonia’s economy depends largely on which networks their subsidiaries participate in and what freedom of decision they have in various activity areas. The more transnational companies that seek and find partners for research and development activities and product development are established here, the more effectively the intellectual fruits of innovation will be transferred through their networks into Estonia and vice versa, from us to the world. Studies of foreign investors show that when providing products or services for the local market, the local employees participate intensively in the development processes or even offer development ideas for the entire international concern (AS Fortum Tartu). Still, there are more sectors where the development activity is restricted to a high-quality fabrication of the product specimens obtained from the foreign owner.

It is important to note with regard to the future that the autonomy of the decision-making processes of subsidiaries of transnational companies should not be seen as an unchanging phenomenon. The decision-making authority of a local company also depends on the capabilities and development abilities of the local management, which may increase independence as local competence grows. The stronger the independence of an Estonian subsidiary of a transnational company, outside of pure production, the more likely it is that cooperation in research/development and innovation with other Estonian companies and research institutions will begin.

There is quite a bit of room for growth in connecting foreign-owned companies with the local economy in more diversified ways. It should mean a considerably tighter connection between the Government and foreign investors, for example by establishing round-table meetings of the Prime Minister with foreign investors, serial meetings between Estonian universities and foreign investors, etc. Even such simple but dynamic networks would let us take better advantage of transnationalism to develop our economy.

Acknowledgements

We would like to thank Tea Danilov, Tarmo Kalvet, Olga Mikheeva and Imre Mürk for their help in compiling this paper. We also thank the participants in the focus group interview: Märt Helmja, Juhan Kaalep, Toomas Kästik, Julius Stokas, and Ruth Vahtras from the foreign investments area of Enterprise Estonia (EAS).

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