A recent white paper published by the European School of Management and Technology (ESMT), carried out “An Economic Assessment of the Relationship between Price Regulation and Incentives to Innovate in the Pharmaceutical Industry.” The project, which was sponsored by the Swiss pharmaceutical company Novartis, explored the possible consequences that pricing and reimbursement regulation may have on pharmaceutical innovation.
Specifically, the paper examined how pharmaceutical products are increasingly becoming subject to strict pricing and reimbursement conditions in many European countries, which the U.S. is believed to be following. One major cause of this shift has come in the context of governments trying to contain costs from healthcare expenses.
But as the authors point out, the U.S. and Europe have not paid much attention to the adverse consequences that pricing and reimbursement regulation may have on pharmaceutical innovation, by reducing the value of pharmaceutical projects and by curtailing the resources available to carry them out. These countries have also forgotten the impact such regulation can have on the number and characteristics of the drugs that will be launched in the market in the future.
As a result of their analysis, the report concluded that there are a number of price control and reimbursement regulation options for countries that can severely impact innovation in the pharmaceutical industry. To prevent this from happening, the authors asserted that “in designing optimal pharmaceutical pricing and reimbursement regulation, the benefits of more affordable or cost-effective drugs must be traded against the costs of less pharmaceutical innovation.”
Specifically, the report acknowledged that governments must not choose strict pricing and reimbursement regulations because they can hinder innovation and can lead to “fewer projects being developed in general and in particular in low-margin therapeutic areas and with little potential of being considered highly innovative at the time of market launch.”
The process of creating drugs is extremely complex, and takes years of research and development (R&D) as well as funding. In the past, R&D budgets were primarily financed by current cash flows. Once a budget was allocated, a variety of decisions is then taken regarding which projects to accelerate, which projects to delay, and for what therapeutic indications to perform clinical trials. While these decisions in the past were based primarily on scientific and technological grounds, “in the recent years—and arguably because of the stricter cost-containment policies implemented—there has been an increase in the importance assigned to commercial factors, including considerations about potential pricing and reimbursement regulation outcomes.”
Another consequence of a stricter and more complex regulatory environment is that pharmaceutical firms will be forced to devote more efforts and resources to comply with such regulations. As a result, the report found that “all forms of pricing regulation—compared to a counterfactual of market based pricing—are likely to reduce the value of projects and the resources available for R&D activities.” This decline in resources for R&D then has the potential to delay the launch of a product in the countries with low willingness to pay or the focusing of R&D efforts of products that address the specific needs of high willingness- to-pay countries.
Pricing and Reimbursement Regulatory Schemes
The report then discussed Internal Reference Pricing, which is setting the amount the government will reimburse for a specific drug in reference to a set of comparable drugs that it deems to have the same or similar therapeutic effect. In evaluating this scheme and others, the report found that the more stringent form of Internal Reference Pricing, the more likely pharmaceutical firms would direct their R&D investment toward indications where there is a lower probability that a drug will end up being “later in class” and therefore have its price referenced against a generic drug in the later years of its patent protection. These may be either products in therapeutic indications that affect a smaller number of patients (such as rare diseases) or projects with a lower expectation of success—for instance, because the mechanism of action still needs to be validated.
A related response to Internal Reference Pricing is that pharmaceutical firms investing in indications with high expected demand are also more likely to cancel projects at later stages of the development process when they discover that there is a higher than expected probability that another firm will launch a product to treat the same therapeutic indication before them. This is because the realization that the firm will be later in class significantly lowers the expected return to further investment.
Another response to Internal Reference Pricing is that rather than innovation leading to a range of differentiated products in a particular indication, each of which treats different patients with varying degrees of effectiveness, there is likely to be less innovation in drugs to treat indications with high expected demand and more innovation in drugs to treat areas with low expected demand.
The consequence of setting prices that are not efficient for their context is that a pharmaceutical firm may have insufficient incentive to launch its product in the country. If the prices do not allow the firm to recover its launch costs then it will not launch. Alternatively, for instance, under external price benchmarking it may launch the product only at a late stage in its life cycle. This reduces or eliminates the benefits that the government health insurer (and the patients it represents) would obtain from the product. It also reduces the incentives to the pharmaceutical firm to invest in future R&D, and thereby develop new products.
Moreover, because this realization typically does not happen until later in the R&D process (for instance, at the time of entering Phase III clinical trials), it means that otherwise worthwhile projects are more likely to be abandoned and the sunk investment wasted under Internal Reference Pricing. This fact is consistent with the increase in attrition rates observed over the last decade, in particular between Phase II and Phase III clinical trials.
The effect of pricing regulation on pharmaceutical innovation is further complicated by the fact that different pricing regulatory schemes in different countries are in place at the same time, and it is their combination that affects global pharmaceutical innovation.
One consequence that has already occurred because of scientific and regulatory factors is the rise in tailored drugs. Decreasing returns of the pharmaceutical discovery effort have led the pharmaceutical industry to shift its innovation model from a more symptomatic large-population concept to a more causal “personalized” concept. This has happened largely because it has become more and more difficult to identify new drug targets that can be safely and effectively “hit” in large and heterogeneous populations.
These personalized drugs are drugs that either treat rarer diseases or treat only a part of the population that is afflicted by a disease. The subpopulation that is targeted can be identified with the aid of diagnostic tools on the basis of biomarkers or genetic markers. Personalizing a drug for a smaller but homogeneous population offers potentially significant therapeutic advantages in terms of safety and efficacy.
Another factor that has changed pharmaceutical innovation is demographic trends—including the rise in the fraction of the world’s population that is old. The elderly are disproportionately affected by chronic diseases such as certain forms of cancer and neurodegenerative diseases, and the pharmaceutical industry has taken on the challenge of addressing these unmet medical needs, despite pressures from governments worried about the financial sustainability of their old-age health-insurance programs, such as Medicare in the U.S. Effectively treating the elderly is also significantly benefiting from the rise in tailored medicines: indeed, it is often the case that in their old age individuals are affected by multiple diseases, requiring personalized care.
Faced with these challenges in pricing and reimbursement schemes, the report analyzed how recent evidence suggests that economic and/or commercial considerations are becoming an increasingly important factor in the development decision-making process, and how they are being made at earlier stages.
In particular, the report discovered that commercial considerations (i.e., future prices/economic value) play a significant role already in determining whether to advance a product candidate into preclinical development. The problem with this trend is that there is no value for commercial considerations to play a role in earlier research stages because the commercial success of drug candidates is still many years away from potential market launch. Moreover, the therapeutic indications and effectiveness are still to be established, and several R&D stories show that many times successful drugs are the result of serendipitous discoveries that would have not occurred had the discovery process been guided by commercial considerations.
With that in mind, the report explained that two mechanisms of pricing and reimbursement regulation may already have an effect on drug development:
- To the extent to which, the R&D budget is determined on the basis of current sales, and to the extent to which pricing and reimbursement regulation affects current sales, the resources available for drug development are also affected; and
- Because pricing and reimbursement regulation is likely to affect the profitability of one sort of drugs more than another, holding the budget constant, the set of drug candidates that are advanced is also affected.
In discussing a variety of reimbursement and regulatory schemes, the report asserted that although the “across-the-board price cutting may be effective at cost containment,” it does not take into account that in an environment, as the current one, in which pharmaceutical firms are rational and forward-looking in their decision making—this scheme curbs the incentives to innovate.”
It was also noted that “as long this type of scheme affects current sales and, as it is traditionally the case, research and development is financed out of current profits, fewer resources will be available for innovation.”
With respect to bilateral negotiating schemes, the report noted that because negotiating prices involves transaction costs, it will reduce the funds that can be spent on the products themselves. This in turn will lower the pharmaceutical firm’s Return on Investment (ROI) from drug development and means that some projects/potential products that would have exceeded the threshold ROI for financing under market-based pricing will maybe now fall below. As a result, they found that bilateral negotiation is likely to lead to a reduction in the number of projects that are financed and thereby the overall level of R&D investment. And if there are more profitable products available to be financed than there is money available (i.e., the size of the R&D budget is a binding constraint) a price cut on current products will further reduce the level of R&D investment.
In addition, where price cuts take place and therefore reduce the revenue from current sales, while also reducing the R&D budget available for investment, an across-the-board reduction in prices may also affect the nature of the products that are financed. In particular, the ROI of a low-margin/high-volume project is much more vulnerable to a price cut than a high-margin/low-volume product. This means that, on top of reducing the overall level of R&D investment, a price cut will skew investment into high-margin/low-volume projects, which are likely to occur in niche areas.
Another scheme, known as external price benchmarking, can also have a negative effect on innovation because it will lower the overall incentive to invest in developing new products. Under this scheme, firms will earn lower overall returns relative to what it would have earned under market-based pricing because they are not able to make sales at a lower price in low-willingness-to-pay countries and/or not be able to recoup higher returns in high-willingness-to-pay countries over the full life of the product. Combined with the additional resources on product differentiation, which will raise the costs of and lower the returns to innovation, the lower return on investment in the long run will reduce the firm’s incentive to invest in R&D and is likely to result in less overall innovation.
At the same time, external price benchmarking may affect the nature of products that are brought to market. If firms respond to external price benchmarking by launching first or only in high-willingness-to-pay countries, they will try to focus their R&D investments on products that address the specific needs of those countries. For instance, they may focus on treatments for diseases that are more prevalent in high income countries or on rare diseases that are only profitable in countries with a higher willingness to pay. At the same time, because of the restriction that external price benchmarking places on the volumes they can achieve, they may choose not to develop and launch low-margin/high-volume products that require a large population to be profitable. This may push firms further towards niche products.
Firms may also introduce a different version of the drug, not because they are more appropriate for patients in the particular countries but simply because they are different. If a firm differentiates its product to avoid price benchmarking rather than therapeutic reasons, it is not likely to make patients any better off and may make them worse off.
Another effect would be if a firm sells a differentiated product in each country, there will be less useful information on which to evaluate the performance and/or therapeutic benefits of a specific drug, and therefore may lead to less accurate prescribing of drugs by physicians.
Pharmaceutical innovation on average can last 10 years because of the time required to find a drug candidate, enroll the individuals participating in clinical trials, and receive marketing authorization. In fact, it is estimated in the literature that only 1 in 5,000 to 10,000 drug candidates is successfully developed and authorized for marketing.
Furthermore, the drug discovery and development process is risky, because during clinical trials a drug candidate may prove unsafe or ineffective, or because the marketing authorization may consider the evidence gathered in support of a new drug application insufficient. Such risks are significant considering the costs of developing one drug are above $800 million according to estimates.
With such a difficult and complicated path for the pharmaceutical industry to follow, it is clear that “innovation is and must be a crucial priority of the pharmaceutical industry, as pharmaceutical firms’ aim to address unmet medical needs.” Consequently, for firms to address these unmet medical needs, they need the freedom and fair regulatory environment that allows them to discover and develop a drug that utilizes a novel mechanism of action to treat a disease (a so-called “breakthrough” drug).
Accordingly, the report asserts that “pricing and reimbursement schemes must strike a balance between promoting innovation in the pharmaceutical industry and keeping the price of drugs low,” so that we can continue to make these discoveries that help patients stay healthier and live longer.
It would be in the best interest of policymakers in the U.S. to take into consideration the findings in this report, and to seriously consider the effects reducing Medicare reimbursement on drugs, devices and services will have on the ability of pharmaceutical and device firms from continuing to innovate in our country. Without engaging these firms in an open and transparent matter regarding ways to maintain levels of progress and innovation, it is likely that companies will leave the U.S., taking their jobs, revenue, and technologies elsewhere, something American medicine cannot afford.