The EU has warned that Ireland faces a huge challenge to modernise its economy in a report that shows R&D spending as a proportion of GDP fell between 1998-2004.

The European Innovation Scorecard 2005 published yesterday ranks the Republic 11th out of 25 EU states - the second year in a row that Ireland has slipped backwards on innovation.

The report highlights that Government investment in public R&D programmes in the six-year period was not matched by an increase from the Irish business sector.

"Most worryingly, business R&D shows both an absolute and relative decline over time, falling from 0.90 per cent of GDP in 1998 to 0.77 per cent in 2004. This decline is not matched by an increase in public R&D, which has grown only modestly, from 0.35 per cent of GDP in 1998 to 0.40 per cent in 2004," says the report, which is part of the EU's ongoing Lisbon Agenda programme to promote R&D, growth and jobs.

The report says that Ireland must make the transition from an economy where foreign investment played a large role, particularly in the ICT sector in order to serve the EU market, to an economy based on innovation.

"Many indicators point to serious difficulties in making this transition," it says.

Ireland is still a strong performer in the field of high technology exports, where it ranks 68 per cent above the EU average. This is due to an excellent performance on the supply of new S&E graduates and above average results for tertiary education.

However, the report notes that the share of exports from high technology products fell by 25 per cent between 2001 and 2003.

It also highlights a drop off in the venture capital supply in Ireland, which fell from 136 per cent of the EU average in 2000 to 92 per cent of the average in 2003.