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2. SOCIO-ECONOMIC BACKGROUND

The report provides an evidence base to inform the development of the new European Regional Development Fund ( ERDF) Programme in Highlands & Islands for the period 2007-13. The analysis examines the underlying challenges in the economy in contributing to the achievement of the EU's ambitious targets for jobs and economic growth under the Lisbon Agenda. Key issues facing the region's economic development through the programming period are identified, but inevitably, these may alter over so long a time period. However, the trends identified are part of more fundamental features of the Highlands & Islands economy which have shaped domestic policy as well as the issues highlighted in the Community Strategic Guidelines as central to improving regional competitiveness. Crucially, these broader perspectives have been set in a Highlands & Islands context to establish priorities and identify optimal arrangements for delivery.

The analysis is not meant to be a comprehensive review of the regional economy, but a focus on a specific set of market features which Structural Funds can help to address. Some important elements of wider economic development have not been examined in detail because Structural Funds cannot provide significant support to address the issues adequately. The analysis focuses on aspects of socio-economic development where limited Structural Funds support can make significant differences. In addition, the analysis takes into consideration the areas of eligible activity set out in the Structural Funds regulations and prioritised in the Community Strategic Guidelines (as discussed in more detail in Chapter 3).

Similarly, there are other analyses that have informed the development of the Programme, not least the Strategic Environmental Assessment, which provides the key baseline environmental data for the Programme area and recommendations for addressing environmental sustainability issues. Consequently, the following analysis does not cover environmental sustainability issues in detail.

The socio-economic analysis begins with a context-setting section covering key development characteristics of the region, especially demography, employment and productivity. It then concentrates on three particular areas, reflecting both the importance to factors specific the region's underlying competitiveness as well as the policy themes highlighted in the Structural Funds regulations:

• enterprise sector: general issues relating to enterprise development, particularly the overall health and trends in the enterprise base of the region and key obstacles to growth, and barriers to growth, as well as innovation and RTD;
• communities, especially the challenges of socio-economic deprivation in fragile areas, access to services and the challenges this brings to overall regional competitiveness; and
• regional economic infrastructure, covering key infrastructure areas where limitations or deficiencies are having a significant detrimental effect on economic development.

Where specialised sources of data/research are used, these are cited in the text with the references listed in the annex. General sources of statistics used in the analysis include: the Scottish Economic Statistics series, the Scottish Economic Report and the General Register Office for Scotland ( GROS).

2.1 General Background

Population

General

The population of the Highlands & Islands area in 2001 rose to 361,625, a slight increase from 1991, compared to a 0.4% decline in Scotland as a whole. However, this hid a degree of variation, with more fragile areas losing population while areas around relatively prosperous towns and settlements gaining population.

Table 1: Population change by area in the Highlands & Islands (1991-2001)

Source: Census results from GROS and ONS. Original 1991 data revisions.

Using ward data, Figure 1 below illustrates that the general pattern of change during the 1990s was one of concentration of population around the larger settlements, while the more remote and fragile areas continued to suffer from out-migration. This pattern is most evident around the Inverness area, which has drawn people in from the surrounding rural areas, but it is also clearly replicated in Orkney, Shetland, the Western Isles and Argyll. The Western Isles experienced significant population loss over this period, with some 18 of the 31 wards witnessing a loss of more than 10%. The changes in the East Ross area are dominated by neighbouring Inverness, while in Lochaber the lack of available land for housing around Fort William may have influenced the general decline in population.

Figure 1: Population change in the Highlands & Islands (1991-2001)

Source: Census 2001 wards, GROS.

One of the key challenges for the region is its settlement pattern. The Highlands & Islands area population of 361,625 gives a population density of 9.3 people per km ² (based on a geographic area of 39,050 km). Excluding the city of Inverness, the population density for the region falls to 7.8 people per km ², comparing to the Scottish average of 64.8 and the UK figure of 242.4. Low population density has produced a settlement pattern of small communities, often distant from key markets and services, resulting in additional costs in the provision of goods and services due to a lack of economies of scale and a corresponding enterprise base - an important development constraint recognised in previous Cohesion policy vis-à-vis the former Objective 6.

Peripherality is further exacerbated in the Highlands & Islands by the extent of the island-based population. In 2001, the inhabited islands had a combined population of 99,494 people living on 90 islands, some 23% of the total Highlands & Islands population. The rate of population decline has been more significant on the islands with smaller populations. Thus, while islands with a population of more than 5,000 in 2001 experienced an overall population increase of 3% since 1961, islands with populations of less than 500 experienced an overall fall of 20% in population over the same period. Depopulation, particularly in fragile areas, has been shown to have an adverse effect on community confidence and service sustainability, increasing the vulnerability of communities already experiencing acutely the problems of high-cost service provision and market access.

Age Structure

The population of the Highlands & Islands area is slightly older than the Scottish average, with a trend towards an aging population. The percentage of the population aged 44 years or less has decreased in the Highlands & Islands from 61.7% in 1991 to 56% in 2001. This is slightly lower than the rate for Scotland, which was 59.7% in 2001 (62.3% in 1991).

The percentage of the population aged 65 years or older in the Highlands & Islands has increased from 15.9% in 1991 to 17.2% in 2001. This compares to 16% for Scotland in 2001 (15.4% in 1991). The pattern of demographic change across the Highlands & Islands, coupled with a trend towards an aging population, is bringing fresh challenges to the Highlands & Islands area. Out-migration is also a constraint on economic growth with the Highlands & Islands witnessing an under representation of people aged 18-30 years and out-migrants tending to have higher levels of training/qualifications.

Migration

Despite the levels of out-migration, some areas of the Highlands & Islands have experienced growth in the number of in-migrants. Given the relevance of population change to economic, social and cultural development, it is very important to understand the demographics, characteristics and motivations of the migrant population.

Highlands & Islands Enterprise commissioned research to look at the in-migration patterns in remote parts of Highlands & Islands that experienced population growth during the 1980s and 1990s. Of the 600 in-migrants questioned, some 80% had moved from outwith the Highlands and Islands, 48% from England or Wales and 5% originated from outside the UK. The vast majority had strong personal connections to the area, their move driven by quality of life features and a long term aspiration to undertake the move.

Inward migration to the Highlands & Islands from the rest of Scotland shows that on average, some 4,393 people moved each year (2002-04) from the rest of Scotland to the region. Some 65% of these in-migrants were below 35 years and were most likely to be university leavers returning to the area to take up their first job and young families looking for a better quality of life. Analysis of out-migration from the region to the rest of Scotland over this period shows that 72% of out-migrants were aged under 35 years, with a significant number falling in the 15-19 age category, mainly school leavers attending university outwith the area.

Migratory patterns between Local Authorities indicates a high level of movement between the Highland mainland and neighbouring Local Authorities with net gains in the Western Isles, Orkney and Shetland - although they have seen overall demographic decline - and net losses in Perth and Kinross, Aberdeenshire and Moray. In general there was a net outflow to urban authorities, perhaps due to young people attending university and not returning to the area having completed their studies.

The number of overseas inward migrants rose from 225 in 2001/02 to 1,630 in 2004/05, a much greater rate of increase than for the rest of Scotland and the UK overall. The distribution of migrants in the Highland area has been consistent over this time, with the city of Inverness accounting for some 40% of the total.

Most registrations were in the 18-24 (45%) and 25-34 (37%) age groups with slightly more men than women moving to the area. The number of unemployed people in Highland fell steadily during this period at the rate of about 300 per year, providing a possible link that inward migration is meeting shortages in the labour market. Evidence across the Highlands & Islands indicates that overseas in-migrants have flourished in manufacturing jobs, working in fish processing factories and tourism related industries.

Employment and unemployment

With the labour market tightening in recent years, employment levels in the Highlands & Islands are high. The Highlands & Islands has an employment rate of 73%, slightly above the Scotland level of 72% and significantly above the rates for the EU-15 and EU-25. The Highlands & Islands has a higher economic activity rate, at 76%, than the EU-15 and EU-25 which are at around 70%. Between 2001 and 2004, the Highlands & Islands' economic activity rate has seen a small decrease while the Scottish and EU rates have increased by 1% in the same time frame. Lastly, the Highlands & Islands' unemployment rate (4.8%) is well below the levels for EU-15 and EU-25. While unemployment across the EU increased between 2001 and 2004, it decreased in both the Highlands & Islands and Scotland.

Table 2: Headline statistics on employment and unemployment

'-' is not available

Source: Eurostat.

Productivity

Earnings

Absolute earnings in the Highlands & Islands have risen hugely over the last 25 years as a result of the general growth and diversification of the economy. However, in relative terms, the region's position has not changed significantly against national averages - incomes levels for 2004 were around 91% of the Scottish average and 85% of the UK average (as illustrated in Table 3).

Table 3: Earnings in the Highlands & Islands

Source: Annual Survey of Hours and Earnings, ONS, 2005.

Lower earnings are as a result of a range of factors including a low share of national employment in high-paying sectors, a lack of private sector head offices and the out-migration of young people. The large number of people employed in the tourism sector, typified by low wages, is also a major contributor.

Gross Value Added

GVA per full-time employee is also lower in the Highlands & Islands than in Scotland, indicating lower levels of productivity. Figures are influenced by small firms dominating the economy, higher costs of production and corresponding lower value outputs. Table 4 below highlights the decline in Gross Value Added per head in the Highlands & Islands and Scotland relative to the UK average over the six-year period from 1997-2003.

Table 4: Trends in GVA: the Highlands & Islands in context (1997-2003)

Source: ONS, 2005.

As highlighted in the Table 5, the GVA level for Shetland and Orkney continued to decline significantly relative to the UK between 1997 and 2003, reflecting changes in the oil industry. Orkney experienced a 17% decrease in the GVA per head over the six-year period. Lochaber, Skye & Lochalsh and Argyll & the Islands area also experienced a decline relative to the UK average.

Table 5: Trends in GVA : variation within the Highlands & Islands (1997-2003)

Source: ONS, 2005.

Gross Domestic Product

Relatively low GDP/ GVA across the Highlands & Islands is due to a range of factors, some of which are highlighted below:

• high share of employment in relatively poorly-paying sectors (including tourism, retailing, food and fish processing);
• low share of employment in highly-paying sectors (including higher education, financial and professional services);
• limited research institutes and business spin-outs from higher education facilities, which are a source of highly-paid jobs;
• lack of head offices (which provide well paid managerial and other senior jobs and are a source of profits);
• incidence of low income generating farms and crofts;
• self-employment, generating low incomes in tourism accommodation and local services;
• economies with traditionally low-pay structures (eg. Orkney);
• high seasonality in employment (increasing the unemployment rate in the winter); and
• factors relating to peripherality, sparsity of population, high building costs and transport costs.

High infrastructure and construction costs in remote areas are inputted into the GDP calculation, resulting in a likely inflation of GDP estimates - there is no methodology to compensate for these higher costs factors and the corresponding reduction in income available. These additional costs contribute to GDP without adding value or increasing quality of life.

Key messages

• While population increased in the region as a whole, there have been significant variations, with some communities having experienced substantial declines (particularly in the islands). There is also a trend towards an aging population, more so than in other parts of Scotland and the out-migration of young people from the region.
• Low population density and a dispersed settlement pattern underlines the peripheral and rural nature of much of the region.
• Unemployment and economic activity rates in the region compare relatively well with Scotland, UK and EU averages.
• In terms of earnings, while levels have improved over time, the Highlands & Islands continues to perform below Scottish and UK averages.
• Overall, the region has relatively lower productivity than Scotland and the UK, with some parts of the region displaying particularly low rates.

2.2 Enterprise Sector

Enterprise development

With almost 18,000 enterprises registered for VAT, the Highlands & Islands has a significantly higher enterprise stock relative to its population size than Scotland and the UK, though both have a small stock in a European context.

• In 2004 there were 389 enterprises per 10,000 population in the Highlands & Islands, well above the Scotland and UK average stock of 250 and 306 respectively. This fits with the Countryside Agency's finding that, in England, there are 8% more enterprises per head of population in rural areas than in urban areas.
• Between 2000 and 2004, the Highlands & Islands has seen a small decline in its enterprise stock, while Scotland (1%) and the UK (3%) have both seen increases.
• By NUTS 3 area, Orkney and Shetland have the highest enterprise stock relative to population. However, the two areas and Eilean Siar have seen the greatest decrease in enterprise stock between 2000 and 2004.

The health of the enterprise stock is dependent on the extent to which it is replenished by new businesses. There are around 33,000 self-employed in the Highlands & Islands, 12.4% of all those in employment.

• This is lower than the EU-25, EU-15 and UK figures, but above the Scottish average.
• Between 2001 and 2004, self-employment in the Highlands & Islands decreased by 11.5%. This is a substantial fall relative to the increase in self-employment in the EU, UK and Scotland.

On the basis of VAT registrations, almost 1,280 new enterprises set up in the Highlands & Islands in 2004.

• The enterprise birth rate at 27.8 per 10,000 population is above the Scotland figure of 23.3 but below the UK average of 30.7.
• Orkney, Shetland and the Inverness-centred Highland Council area have the highest enterprise birth rates at close to 30. Moray Council area consistently has the lowest at 19.

The enterprise closure rate in the Highlands & Islands mirrors the enterprise birth rate. At 31.4 per 10,000 population it is well above the Scotland figure (23.6).

Research and innovation and enterprises

Compared to much of Europe, the absolute level of innovation in the UK and particularly Scotland, is relatively low. Highlands & Islands differs little from the rest of Scotland in this regard.

• In terms of existing enterprises, the proportion of companies introducing product and process innovation is low. On the other hand, the firms which do innovate obtain a much higher proportion of income from their new or improved products than most of Europe.
• Patent applications, while only a partial and indirect measure, are lower in Scotland as a whole at 95 per million population than the EU-25 average at 135.

Gross expenditure on RTD in Scotland in 2003 amounted to 1.5% of GDP. This is below the UK average and the figure for the EU-25. Per capita expenditure in Scotland lags both the UK and EU-25 figures. However, there have been substantial increases in Scotland's expenditure (25%) between 2000 and 2003. This is accounted for by growth in both enterprise and higher education RTD.

For RTD, data is available on total employment in RTD-intensive industries, namely computer and related activities, research and experimental development in natural sciences and engineering, and technical testing and analysis. In 2004, less than 1% of the Highlands & Islands employment is in the selected RTD-intensive industries, around half the proportion for Scotland and Great Britain.

Barriers and constraints

Enterprise Development

Although relatively strong compared to Scotland as a whole, the small enterprise stock in the Highlands & Islands as a whole continues to present development challenges for the region. This derives in large part from the poor new firm formation rate for the region which could present longer-term challenges to the region's enterprise base. Evidence suggests that - at least, for Scotland as a whole - there remains a potential pool of 'would-be' entrepreneurs. A survey by the Small Business Service (2003) found that 10% of the Scottish adult population (compared to 13% in England) are, or have recently been, thinking about setting up their own enterprise. However, the 'problem' is that would-be entrepreneurs are less likely to take action in Scotland than in England. Consequently, if the new firm formation rate is to be improved, the key requirements are to stimulate action and to ensure the population has the skills and resources to convert their interest into action rather than to generate interest per se.

There are many inter-dependent factors which stimulate or constrain the willingness and ability of individuals set up their own enterprise. At the level of the individual, the main perceived constraints traditionally relate to finance. This has several dimensions:

• Most enterprises are set up using the founders' personal finance. Many do not have the necessary savings to enable them to set up in enterprise.
• Raising external finance (ie. from the banks) also requires that 'would be' founders have access to personal savings or wealth to offer as security or meet bank 'gearing ratio' requirements.
• There is a some fear of taking on debt (presumably aggravated by the need to provide security from personal assets) and concerns about security (eg. leaving a job and concerns over potential enterprise failure).

Access to finance, rather than marginal variations in its cost, has been seen as a widespread barrier especially amongst those with few savings such as the young. Fraser (2005) found that the main source of start-up finance was personal savings - used by two-thirds of start-ups. Other sources of finance commonly used are loans from friends and family (used by 13% of start-ups) and bank loans (used by 10%). Just 2% used equity finance. This suggests that access to external start-up finance is limited, with most people using personal savings, mortgaging their home or borrowing from friends or family.

However, it is not clear to what extent finance exists as a clearly-defined market failure. According to the Annual Survey of Small Businesses in Scotland (2004) report, only 18% of individuals faced obstacles in accessing finance. Over the past year, 11% of enterprises had sought finance in the past year - of those, 76% did not have any problem obtaining finance from the first source they approached, while 13% were unable to obtain any finance from their first source. In only 1% of cases was the business being considered 'too risky', the reason behind finance being refused. More common reasons for finance being turned down were a lack of security (26%) and poor business performance (23%). The most commonly-cited impact of not acquiring financing was that it slowed down business plans (18%). Although no studies on venture capital investment in Highlands & Islands could be sourced, it is likely that the number of enterprises in the region financed by venture capital is relatively low given the trends described above.

In addition, the survival rate of businesses in the region needs to be improved, with a relative high business closure rate for the Highlands & Islands. Businesses are likely to face distinctive pressures in the region, including:

• relative lack of access to export markets, arising from the peripheral nature of the region and higher transport costs;
• very limited business community and support infrastructure for business development in rural areas, especially with regards to finance; and
• limited business skills capacity, arising from the weak training and learning infrastructure, as highlighted in the analysis of further and higher education below.

RTD and Innovation and Enterprises

An important determinant of innovation is business RTD. Consequently, the relatively low level of corporate RTD in Scotland - and in the Highlands & Islands in particular - is an important factor constraining innovation. The low level of RTD reflects inter alia:

• Scotland's industrial structure with medium/high-tech manufacturing and high-tech services under-represented (relative to both the UK and EU-15 averages) - this imbalance is even more marked in Highlands & Islands; and
• the limited presence of two of the UK's most RTD-intensive industries (ie. aerospace and automotive sectors), again even more marked in Highlands & Islands.

Beyond this, many of the barriers to increased RTD are similar to the barriers to innovation.

Scottish and UK companies tend to cite the same constraints on innovation. The most frequently quoted factors, both by innovators and non-innovators, are the cost and risk of investing in innovation, combined with the cost and availability of finance. Given that much innovation is financed from retained earnings, the cost and availability of finance is influenced by both past company performance (ie. profitability) and problems of raising external finance.

Innovation requires expenditure (ie. investment) ahead of the generation of income arising from successful innovation. As such, it creates risk via its initial negative impact on cash flow. The payback period, especially from investment in RTD, can be long term. The risks are most severe for small companies while small, young companies are also more dependent, almost by definition, on raising external finance for innovation (ie. they have fewer retained earnings). Nevertheless, there is a substantial minority of 'potential innovators'. For these, access to finance is a constraint. For those already involved in innovation, access to finance constrains the level of investment in RTD and innovation. These constraints are most severe for small and young enterprises ( DTZ Pieda, 2004).

A second widely-perceived barrier amongst innovators is the recruitment of appropriately-qualified personnel. Nevertheless:

• the Scottish companies in the Community Innovation Survey employ more science and technology graduates and more graduates in other subjects as a percentage of their total workforce than the UK average; and
• an above average proportion of the entire Scottish workforce have degrees (including an above average proportion with science and technology degrees).

Human capital, at least as measured by qualifications, is another significant factor in the Highlands & Islands, where the out-migration of young graduates and the absence of a university-status body to address the research skills need of the region hinders its overall RTD capacity.

These are Scottish-wide problems and while data on RTD capacity in the Highlands & Islands is limited, the region experiences other problems that exacerbate these more common issues. They include the absence of significant research and innovation centres, particularly in the academic sector, which traditionally have acted as catalysts for new technology spin-outs and the wider dissemination of new technologies and innovation. As described in more detail below, the region has only started to develop a set of higher education and integrated further education bodies which can become the focus for industry-specific research and innovation. Similarly, the diffused nature of the enterprise sector and the absence of large firms has reduced the critical mass of businesses that can form industrial clusters or drive industrial research and development.

Key messages

• The region has a relatively high enterprise stock, but one that is still small on absolute terms, particularly in the more remote areas. Existing businesses in the region face a combination of distinctive challenges owing to their peripheral location, cost of access to major markets and limited access to business skills training.
• A relatively low new firm formation rate also points to long-term issues on the sustainable growth of the enterprise base, although the region does have a healthy supply of self-employed individuals. Finance and entrepreneurial skills are key bottlenecks for the development of new businesses.
• The Highlands & Islands has notable deficiencies in its RTD and innovation capacity, exacerbated by the small enterprise base, the few number of key research centres, lack of finance and the limited research skills training infrastructure in the region.

2.4 Communities

Statistics to compare community disadvantage across European regions are not readily available. Analysis in Scotland is primarily confined to the Scottish Index of Multiple Deprivation ( SIMD). The index is a combination of six stand-alone indicators: current income; employment; education, skills and training; health; housing; and access to local services. However, while effective at identifying urban disadvantaged communities, including those in the Highlands & Islands, the SIMD does not adequately identify rural disadvantaged communities because:

• rural disadvantage is less visible due to low population densities; and
• the SIMD is dominated by the levels of disadvantage in Scotland's urban areas.

The table below gives the Highlands & Islands overview of the six SIMD indicators. The percentages represent the number of the region's 623 data zones that fall within Scotland's most deprived data zones. The benchmark is the 9.6% of all Scotland's data zones that are within the Highlands & Islands.

• Only the access to services indicator would appear to show levels of rural disadvantage. The indicator measures drive time to key services, such as GPs, primary schools and supermarkets. 43% of the Highlands & Islands' data zones are in Scotland's 15% least accessible. Distance and peripherality is a key issue for Highlands & Islands' communities.
• The five other indicators and the overall SIMD show that disadvantage in the Highlands & Islands cannot be identified using conventional measures. Only 3% of the region's data zones fall in Scotland's 15% most deprived.

Table 6: Deprivation in the Highlands & Islands data zones (2004)

Source: Scottish Index of Multiple Deprivation.

Rural disadvantaged communities face many of the same barriers to employment as those living in deprived urban areas but there are some important differences.

• Deprivation is not as geographically concentrated as in urban areas and, as a consequence, is often less visible.
• Employment rates are often higher in rural areas but the type of jobs in rural areas can lead to a higher incidence of under-employment where more jobs tend to be:
• low-paid
• part-time
• seasonal
• limited in their opportunities for progression.
• Distance and isolation from services and employers, allied to the cost and availability of transport, are key issues.
• The take-up of benefits tends to be lower in rural areas.
• As earlier sections have shown, some communities have also experienced significant population decreases as well as low levels of productivity, suggesting that there are significant demographic and economic sustainability threats.

Supporting the access to services indicator, the vast majority of Highlands & Islands residents live in small towns or rural locations.

• The three island NUTS 3 areas have close to 70% of their residents living in 'remote rural' locations.
• Even in the Highland Council area, 37% of the population live in 'remote rural' locations and only 31% in urban areas or 'accessible small towns'

Overall, rural areas such as the Highlands & Islands are strongly characterised by self-employment, part-time employment and under-employment.

• Self-employment is much more prevalent in rural areas (Scottish Executive, 2003). This reflects the importance of micro/small enterprises in sectors such as agriculture and tourism and is often associated with low average wages.
• Part-time employment is much more common in remote rural areas than in Scotland as a whole, and in comparison with accessible rural communities. This reflects the thinner economic base in more sparsely populated, remote communities and the difficulties in sustaining full-time employment.

The greater prevalence of part-time and self-employment implies lower earnings from employment. Seasonality of employment can also add to under-employment and lower earnings. Futureskills Scotland (2005) found that 28% of workplaces in rural Scotland had a workforce fluctuating seasonally, compared to 23% in the rest of Scotland. Temporary contracting was also much more common in rural areas. It also found that:

• employees in rural Scotland are more likely to work in agriculture, forestry and fishing, energy, water and construction, hotels and restaurants, and health and social work than those in the rest of Scotland; and
• rural Scotland is significantly underrepresented in financial intermediation and real estate, and is slightly underrepresented in transport, storage and communications; public administration and education; and other services.

Similarly, with respect to the distribution of employees by occupation in rural Scotland, rural areas do not perform as well as the rest of Scotland:

• Employees in rural Scotland are less likely to be in managerial or professional occupations than those in the rest of Scotland…
• …and more likely to be in personal service, operative and elementary occupations.

Whilst this partly reflects the industrial make-up of rural areas, it is a concerning finding and may go some way to explain the migration of young people away from rural areas when they leave school and university.

Evidence of the importance of smaller employers in the rural economy shows that 24% of employees in rural Scotland continue to work in workplaces with less than 10 employees, compared to just 16% of employees in the rest of Scotland (Futureskills Scotland, 2005). In contrast, 27% of employees in the rest of Scotland work in workplaces with 250 or more employees, compared to just 11% of employees in rural Scotland.

Research has shown that disadvantaged communities struggle to attract and sustain SME activity. This is not easily shown statistically, as areas of deprivation are often highly localised while SME-related data are limited to local authority areas. Additionally, the relative lack of high geographical concentration of disadvantage in the Highlands & Islands makes it even harder to research this issue. SMEs located within rural locations face a number of critical issues (Smallbone et al., 2002), including:

• small local markets and distance to major urban centres;
• few chances to do business with and communicate with local firms due to the small number of local companies in actual numbers rather than densities;
• skills shortages caused by restricted local labour markets and a lack of affordable housing;
• a shortage of accessible training schemes/courses; and
• high levels of specialisation.

Barriers and constraints

The key barriers and constraints for the Highlands & Islands with respect to community sustainability are:

• In the Highlands & Islands, peripherality and distance to key services are key barriers to sustaining viable communities, not just in terms of their enterprise base, but with respect to retaining population overall.
• As has been noted, the region has a very low population density, highly-dispersed settlement patterns and an aging population though, in recent years, the population size has stabilised. These features are particularly acute in some parts of the region.
• Overall, there has been net migration into the Highlands & Islands with the major exception of 16-24 year olds, many of whom move out of the region to further their education and often do not return. However, some parts of the region have experienced significant depopulation.
• SME activity and self-employment levels are high in some parts of the region, but the small enterprise base in some communities - combined with distance to key sources of finance and skills as well as from major markets - raise issues of long-term sustainability.

Key messages

• The region has strong levels of rural disadvantage, particularly with respect to access to key services. Peripherality and distance from major population centres exacerbates the problems some communities have in economic and population sustainability.
• Although employment rates appear to be relatively high, there are significant issues for some rural areas arising from part-time and under-employment.
• The economic sustainability of some communities will be weakened by the small enterprise base and the low rates of new firm formation experienced across the region. Enterprises based in small rural communities can lack access to key services underpinning their development as well as to major markets that would support expansion.

2.5 Economic Infrastructure

The Highlands & Islands has been identified through its designation under the Convergence Objective as a region whose economic development is significantly hampered by deficiencies in its economic infrastructure. There are a number of infrastructure areas where the need for improvements could add significantly to regional competitiveness:

• further and higher education;
• renewable energy;
• tourism; and
• transport.

Further and higher education

The Highlands & Islands area is different from the rest of Scotland in relation to its higher education infrastructure. The University of the Highlands & Islands Millennium Institute ( UHI) is the only higher education institution ( HEI) in the region, in comparison to 20 HEIs in the rest of Scotland. There is a wider college network addressing further education needs in the region: Scotland has 46 further education colleges, and six of these are based in the Highlands & Islands.

A report by DTZ Pieda (2005), which examined the supply and demand for post-school education, revealed that many areas of the Highlands & Islands have a high proportion of school-leavers entering full time higher education. Eilean Siar and the Orkney Islands have the highest participation rates at 41% and 38%, respectively, compared to a national average of 31%. Yet, for many young people, studying locally has not been a possibility and they have had to leave the region to pursue their education. However, the creation of the UHI is a significant move towards providing the Highlands & Islands residents with local access to higher education.

UHI was designated as an HEI in 2001 and HIE have set out the achievement of university status by 2007 as a key target in their operating plan ( HIE, 2006). The University is able to provide higher education through a partnership of fifteen colleges and research institutions, based in different locations throughout the Highlands & Islands. A flexible learning environment is offered to UHI students through the use of an advanced high-speed electronic network. Most students study at a college or learning centre but there is also the option of using web-based learning materials where, for example, video-conference technology can be used for tutorials.

Table 7: Proportion of school leavers entering FE/ HE Full Time (2002/03)

Source: DTZ Pieda (2005).

There is a big contrast between the types of students UHI attracts compared to other Scottish HEIs.

• 58% of UHI's students study part-time compared with the Scottish average of 30%.
• 30% of the young full-time undergraduate entrants were from low-participation neighbourhoods, compared to Scotland and UK averages of 20% and 14%, respectively.

Renewable energy

Renewable energy technologies are key to achieving the Scottish Executive's (2005) Sustainable Development Strategy goal of sustainable development through an innovative and productive economy that delivers high levels of employment and protects while enhancing the physical and natural environment. A thriving renewables sector has the potential to enhance Scotland's manufacturing capacity, to develop new indigenous industries, particularly in the Highlands & Islands, and to provide significant export opportunities. The Scottish Executive has set the target of 18% of electricity generated within Scotland by renewable means by 2010. There is also the aspiration of generating 40% of its electricity from renewable sources by 2020.

Marine

The Scottish Executive (2002) Opportunities for Marine Energy in Scotland report concluded that Scotland already possesses many of the skills and capabilities required to develop a marine energy industry. The Highlands & Islands leads Scotland in the industry through the European Marine Energy Centre which has a commercial wave energy scheme in Islay and a Marine Energy Test Centre in Orkney.

Biomass

Biomass projects hold significant potential for the Highlands & Islands as not only do they provide a flexible and predictable generation source but also provide opportunities for rural regeneration, job creation and the development of sustainable communities.

Micro-Renewables

The Scottish Community Regeneration Initiative provides local support through a 'one-stop shop' to encourage local participation in, and awareness of, micro-renewables. The Highlands & Islands Community Energy Company supports community developed and owned renewable energy projects.

Tourism

Tourism is a key sector in the Highlands & Islands as it includes accommodation, visitor attractions, transport, retail, food & drink, and leisure activities. The area's scenery and cultural heritage attracts visitors, providing economic benefits to the region ( HIE, 2004).

• In 2001, around four million visits were made to the Highlands & Islands by UK residents, accounting for an estimated £792 million spend.
• Around 500,000 trips were made to the Highlands & Islands by overseas visitors, spending an estimated £110 million.
• The total output and GVA generated at basic prices from tourism for hotels and restaurants is roughly £410 million and £228 million, respectively. This is equivalent to £12,000 GVA per employee in the hotel and restaurant sector.

Tourism is a significant employer in the Highlands & Islands at 11% of all employees, representing a slightly higher proportion of total employment in this region compared to Scotland as a whole. Tourism also supports a higher proportion of part-time employees and female employees than any other sector in the Highlands & Islands ( HIE, 2004).

Table 8: Headline tourism indicators (2004)

Source: Annual Business Inquiry.

The Countryside Agency (2003) highlights tourism as a key opportunity for the diversification of rural economies and, in particular, for farm diversification. This can encompass a range of options.

• Farmers can provide tourism facilities, including accommodation, visitor attractions, etc.
• Farmers can sell food and other products to tourists either directly (through farm shops, farmers markets, etc.) or through specialist retailers.
• Farmers can be paid to conserve landscapes and biodiversity, which will in turn encourage tourism in the area.

One particularly important opportunity relates to more effective use of local produce. 46% of visitor spending relates to food and drink, and two-thirds say that they would be prepared to pay more for quality food and drink. This suggests there are opportunities to promote local produce through farm visits and shops, local markets and retailers, visitor centres linked to food and drink processing, restaurants and mail order business.

Transport

Transport is a key issue in the Highlands & Islands as the table below shows in relation to the difference in transport provision between the Highlands & Islands and Scotland.

• Car dependency is higher across the Highlands & Islands with around 50% of people aged 17 or over driving every day, well above the Scottish average of 42%.
• Around 75% of households in the Highlands & Islands have at least one car available for private use - often of necessity due to poor public transport.
• Bus services are far less frequent in the region.

Table 9: Access to transport (2003/04)

Source: Scottish Executive (2006) Transport Across Scotland in 2003 and 2004.

Scotland's Transport Strategy, which has promoting social inclusion as a key objective, identified the following issues facing people in rural areas:

• for drivers, a high proportion of their income is spent on driving costs;
• for non-drivers, the higher levels of car use mean there is less demand for public transport - those without a car, such as older people, disabled people, women and young people, become more socially excluded; and
• poor access to key services.

Much of the region is also dependent on other forms of key transport, not least the island communities, where ferry services (and supporting port infrastructure) as well as air links (and supporting airport infrastructure) are critical access issues.

Similar issues relate to telecoms infrastructure. The region has benefited from strong investment in upgrading the region's communications infrastructure to improve coverage to national averages, especially with respect to ISDN. Indeed, this has been one of the major achievements of previous Structural Funds programmes. However, to take full advantage of the investment, critical in an area where distance from major sources of information (eg. RTD and innovation) and markets restricts development, more could be done to improve broadband speed and connectivity and the extent of e-commerce take-up by businesses and individuals.

Key messages

• Further and higher education infrastructure in the region has traditionally been weak in the region, contributing to the weaknesses identified in other parts of the socio-economic analysis. UHI and the related college network in the region presents a strong opportunity for the Highlands & Islands to address this gap.
• The region's natural resources provides a strong basis for the development of renewable energy technologies and commercial developments.
• Tourism is a significant employer for the region. The natural and cultural heritage of the Highlands & Islands presents an opportunity for the sector's longer-term sustainable growth.
• Transport bottlenecks - particularly for road and ferry - continue to affect the peripherality of much of the region in terms of access.

2.6 Summary of Key Challenges

As has been stated, this socio-economic analysis has not set out to be a comprehensive analysis of the strengths and weaknesses of the region's economy. Instead, it has sought to identify the issues that are most pertinent to intervention by the ERDF, as defined within the Community Strategic Guidelines and the Structural Funds regulations. In summarising this chapter, several key challenges have been set out for the 2007-13 programming period in the following broad areas of potential intervention: enterprise development; community sustainability and economic infrastructure.

In this final section, on the basis of the statistical evidence presented above, a summary of the key issues to be addressed in the Programme is presented: first, an analysis of the main strengths, weaknesses, opportunities and threats for the region's labour market; and second, a more detailed identification of the key challenges for the Programme.

SWOT analysis

Regional Strengths

• Employment and economic activity rates across the region are strong with relative low levels of unemployment.
• Overall, the region's population loss has been limited, with relatively strong levels of in-migration, though there continue to be significant demographic losses for particular parts of the region and among young people.
• Although small in absolute terms, particularly in some parts of the region, there is a relatively high enterprise stock across the region as a whole.
• A high-quality environment and cultural heritage which are the basis for much of the economic activity in the region, including tourism and renewable energy.

Regional Weaknesses

• Economic growth and gross value added (as a measure of productivity) continues to lag Scottish and UK averages.
• A rural-based economy, where geographical peripherality, sparsity of population and dispersed settlement patterns are major constraints on long-term economic development.
• The small size of the Highlands & Islands business base - combined by difficulties in accessing key markets outside the region - suggest that the business base continues to be limited in its ability to expand.
• New firm formation rates remain relatively low in the region with access to skills training and finance as key bottlenecks.
• The levels of research and innovation in the region continue to be low in both relative and absolute terms, arising from a combination of lack of business innovation and the absence of key research centres driving industrial and technological RTD.
• Some communities in the Highlands & Islands are particularly vulnerable to the small enterprise base and suffer from lack of access to key services and markets.
• The historical absence of a strong local further and higher education infrastructure has limited the region's capacity to generate research and innovation centres and supply key skills for the development of the business base and contributed to out-migration of young people.
• Despite continuing investment across the years, the transport infrastructure of the region continues to provide limited and costly access for much of the Highlands & Islands population because of the region's geography, the dispersion of population and the number of island-based communities.

Regional Opportunities

• The development of UHI and the college network presents a strong opportunity for the region to gain a local skills and educational anchor for the region as well as provide a core of industrial research expertise.
• The emerging renewable energy sector in the Highlands & Islands - and the region's natural resources to enable a wide range of renewable technologies to be developed - is one of the region's future strengths, particularly with respect to marine, wind, biomass and micro-renewables.
• The strong natural and cultural heritage of the region provides a set of resources which could underpin a competitive, growing tourism sector and improvements to the overall productivity and earnings levels of the tourism workforce.
• The investments in the region's broadband infrastructure provides a good basis for exploiting e-commerce opportunities and addressing the development bottlenecks arising from distance to major markets.

Regional Threats

• Historic population decline has resulted in limited levels of unemployment but presented challenges to the sustainability of particular communities, particularly in the islands.
• The aging of the population and continued out-migration of young people could present longer-term labour and skills supply problems, given the current tightness of the labour market.
• Lack of investment in key aspects of the region's RTD and innovation capacity could result - particularly in developing local nodes of expertise for research and skills generation - could result in the region losing competitive advantage in emerging technologies and industries.
• Continuing decline in agricultural and rural industries could reduce earnings levels and the employment opportunities for rural workforces throughout the region, exacerbating population loss - particularly among young people - and consequently, the vulnerability of fragile communities in the region.
• Although improved significantly in recent years, the telecoms infrastructure in the region is limited by the speed, connectivity and extent of usage by businesses and individuals.

Key programme challenges

The SWOT analysis - and the key messages highlighted in the foregoing sections - suggest that there are a number of key strategic challenges which the Programme should address.

1. Improving the sources of commercial RTD and innovation in the region. The region lacks key local centres of research and innovation in the industries and technologies in which it could develop a competitive advantage. To help establish a viable RTD base and support environment for maximising the economic benefits of the region's research capacity, the challenge if for the region to increase the connectivity between the research base and local enterprises. This also extends to research and innovation networks between enterprises and the level of collaborative RTD in the enterprise sector.

2. Removing the barriers and lack of incentives to entrepreneurs and growing enterprises. To improve the new firm formation and business survival rate, the bottlenecks on new and growing enterprises need to be addressed, particularly the lack of finance and skills. This is closely linked to the ability of the region's enterprise sector to make full use of any improvements in the levels of RTD and innovation addressed in the first key challenge.

3. Improving access to basic services and sustainable community infrastructure in vulnerable areas. Limited access to key services weakens the sustainability of some communities in the area by contributing to population loss. Although ERDF funding is limited in its scope for providing basic services, the challenge is clear with respect to key communal infrastructure that underpins the economic and social development of fragile communities.

4. Increasing SME development in vulnerable communities. Increases in the capacity of disadvantaged communities to attract and sustain SME activity, more effective mechanisms for encouraging investment in, and service delivery to, Scotland's poorest communities by the enterprise sector need to be developed.

5. Improving the quality and coverage of further and higher education infrastructure in the region. The existing investment in the UHI Millennium Institute network has provided a strong basis for addressing the research and teaching deficiencies in the region contributing to out-migration and the weak RTD performance of the Highlands & Islands. However, the challenge is to make full use of that investment by addressing any remaining gaps in the network's capacity and ensuring that it is fully exploited for the economic development of the region.

6. Developing full commercial exploitation of renewable energies technologies. The opportunity to develop a wide range of renewable energy technologies, and to maximise their economic, social and environmental value, could make important contributions to the region's economic development.

7. Enhancing the sustainable use of the existing cultural and natural assets of the region. To maximise the economic and social benefits of tourism and the region's environmental and cultural heritage, it is important to create a tourism product with higher added value. This will generate more sustainable enterprises and better quality job opportunities.

8. Addressing the remaining bottlenecks in 'access' infrastructure across the region. Despite the legacy of extensive investment, the region's acute peripherality means that there remains considerable scope for improvements in transport and telecommunications infrastructure - critical in enabling access by communities, enterprises and individuals to market, educational and other opportunities.

These challenges will form the basis for the development of the Programme strategy and individual priorities set out in Chapter 4.

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