Imbalanced Innovation: The High Cost of Europe's "Free Ride"

By keeping pharmaceutical prices and utilization artificially low, Europe is losing more economically than it gains, says consulting group Bain & Co. Here's why—and what the drug industry should do about it

The once-balanced scales holding the gold of pharmaceutical innovation have tipped precariously toward the US and away from Europe. Figures for the decade to 2002 paint a gloomy picture: US R&D investment nearly tripled to $26 billion, far outpacing that in Europe, which less than doubled to $21 billion. If current trends continue, US innovation spending will be twice that of Europe by 2012. At the same time, Europe has dramatically curtailed the growth of pharmaceutical spending, cutting per capita outlays to 60% of what the US spends. That number will plunge to 25% by 2012 if today's trends don't change. Moreover, pharmaceutical industry investment and associated innovation has "followed the money" as the proportion of the industry's global returns generated in the US has increased by 15% at Europe's expense. Today, the US generates 62% of the industry's global returns compared with 18% for Europe. (See Exhibit 1.)

These imbalances are hurting everyone, and need to be redressed.

But neither side of an increasingly contentious policy debate sees it this way. In Europe, many leaders believe that lower per capita drug spending is good for their countries. Meanwhile US critics, led by the former FDA Commissioner Mark McClellan, MD, claim that Europeans are getting a "free ride" on the labcoat-tails of US innovators, as US insurers and consumers unfairly pay the lion's share of innovation costs through higher drug prices. (See "Transatlantic Tit for Tat," In Vivo Europe Rx, December 2003 (Also see "Transatlantic Tit For Tat" - In Vivo, 1 Dec, 2003.).)

The conventional wisdom that underlies this debate—Europe profits, the US pays—is wrong. Our analysis shows that the social and economic costs of the innovation imbalance to Europe, in the form of delayed access to drugs, poorer health outcomes for some drug-sensitive diseases and competitive decline of the Europe-based pharmaceutical industry, make the model anything but free.

A Scorecard of Costs and Benefits

At first glance, Europe seems to be in an enviable position. It spends 60% less per capita on pharmaceuticals than the US does—a gap that has roughly doubled since 1992. (See Exhibit 2.) That trend has translated into major European savings: if Europe's pharmaceutical spending per capita had matched that in the US, Europe would have spent an additional $160 billion in 2002 and $840 billion cumulatively over the preceding decade. European governments are largely responsible for these differences. Fixed reimbursement prices in France, set reference prices in Germany and profit limits in the UK have contributed to prices 25-35% lower in these countries than US prices for comparable drugs.

Clearly, the current system creates direct, visible benefits for Europe in the form of lower pharmaceutical spending per capita. Yet the costs of the model to Europe—though less readily apparent—are equally real.

Most obviously, the center of gravity for pharmaceutical research has shifted from Europe toward the US. In 1992, Europe invested $10 billion in R&D, while the US invested $9 billion. Over the next decade, however, US R&D investment increased 11% annually, to $26 billion, while European R&D investment climbed just 8% annually, to $21 billion. The consequences for Europe: fewer high value-added jobs than in the US and thus fewer new drug patents that translated into commercial products.

The slower rate of European spending also led to fewer first drug launches in Europe. From 1993 to 1997, 81 new molecular entities (NMEs) were launched first in Europe compared with 48 launched first in the US. Over the next five years the situation reversed: from 1998 to 2002 there were only 44 NMEs launched first in Europe versus 85 in the US. (See Exhibit 3.)

The location of new drug launches has significant bearing on how quickly doctors and patients can access the most advanced treatments. The reason: lengthy reimbursement negotiations that follow government approval of any new drug. (See "Can the EC Boost Europe's Competitiveness?" IN VIVO, September 2001 (Also see "Can the EC Boost Europe's Competitiveness?" - In Vivo, 1 Sep, 2001.).) One study by Wharton's Pat Danzon and AstraZeneca's Richard Wang shows that the US has become the focal point for new drug launches, with delays between approval and launch averaging four months in the US, while in Europe launch delays range from seven to 19 months (the UK is shortest, while Greece is longest).

Taken together, these data suggest that the considerable costs of the "free-rider" model could outweigh its benefits. The key question for Europe, therefore, is whether the current model actually benefits European citizens in terms of its total economic and social impact.

Adding Up the Cost to Germany

To answer this question, we chose to examine Germany. It's the largest pharmaceutical market in Europe, it's currently considering significant reforms to its health care system, and it boasts a long history of drug innovation led by companies such as Bayer AG and Hoechst (since subsumed into Aventis SA [See Deal]).

In 1992, Germany and the US spent virtually the same amount per capita on pharmaceuticals: $275 versus $288. Over the next decade, however, a large gap developed, driven largely by the German government's imposition of set reference prices. In 2002, Germany spent just $421 per capita—nearly 40% less than the US, which spent $685.

So Germany appears to be benefiting from the innovation imbalance. But is it really, when all the economic and societal impacts are considered? To calculate Germany's "net score," we created a scorecard. It assessed the positive or negative value to the German economy of all the relevant indicators: savings in spending on pharmaceutical products; impact on industry competitiveness, including spending on pharmaceutical R&D the number of high value-added jobs gained or lost; the gain or loss of corporate centers; and lastly the relevant changes in health outcomes. Wherever possible, we included all relevant economic multiplier impacts of both "costs" and "benefits."

Our scorecard calculates the difference between Germany's actual 2002 performance and how the country would have performed with a US-like system where the government exerts less control over drug prices. In effect, it shows whether Germany enjoys a net gain or suffers a net loss under the current system. (See Exhibit 4.)

Erosion in Competitiveness

From the perspective of pharmaceutical spending, Germany did well. In 2002, the country saved $19 billion because it spent significantly less per capita on pharmaceuticals than the US did. But the cumulative effect of achieving this savings over the last few decades has been to erode the competitive position of the German pharmaceutical industry. In R&D, Germany lost $3 billion that would have been invested in a free-market system for pharmaceuticals. In fact, between 1992 and 2002, Germany's R&D investment increased by just 52% while investment in the US increased by 184%.

But Germany lost more than just the absolute value of $3 billion of R&D spending. Investment in R&D stimulates additional innovation spending—often within a local cluster of research institutions. Based on benchmarks, we estimate this loss at 30% of the R&D investment. Germany also lost the patent value that occurs based on the transfer price profit from the country of IP ownership to other markets. Assuming a 5% transfer price royalty to the country of IP ownership, this would translate into $200 million of German economic loss.

In 2002, Germany also lost $3 billion in wages from high value-added jobs. Even accounting for the fact that some small percentage of these highly trained scientists took jobs in other German industries, we estimate that from 1990 to 2001, the number of high value-added employees in Germany's pharmaceutical industry fell by 26% while the US number increased by 52%. We assume that the high value-added jobs that were lost represent about 15% of the total pharmaceutical industry employment.

What did Germany lose along with these jobs? First, the government lost $1 billion in taxes that weren't paid by these high value-added workers. Second, it lost approximately $200 million that the German government spent educating and training highly skilled employees who couldn't find jobs in Germany and left for research opportunities in the US. This brain drain diminished Germany's academic and commercial viability. Finally, Germany lost a nearly $4 billion job-creation benefit that accrues when high value-added jobs create additional employment in supplier and service industries (e.g., lawyers and accountants).

If Germany's pharmaceutical industry had kept pace with its US counterpart, it could have avoided losing $3 billion of profits in 2002. In 1980, two German firms–Bayer and Hoechst–ranked among the world's top 10 drugmakers. They've now disappeared from the top-10 list. (Bayer is still based in Germany, but it's now number 19. Hoechst combined with Rhone-Poulenc Rorer and is now Aventis, based in France legally and the US operationally). Along with these corporate centers, Germany lost $1 billion in taxes from these companies. It also lost a $1 billion "company formation" benefit, a figure predicated on the fact that corporate centers commonly spawn local startup companies and outsourcing firms.

Worsening Health Outcomes

Finally, and perhaps most importantly, it's critical to consider the impact of the free-rider model on health outcomes. Comparing health outcomes across countries is a complex proposition. Many factors bear on the health of a population, from the quality of hospital care and diagnostic screening to a people's diet and exercise habits. Sorting out cause and effect can be a daunting statistical undertaking, and our analysis is only directional in its findings. Nevertheless, we estimate that in 2002, Germany lost nearly $5 billion from poorer health outcomes driven by lowered access to the most innovative drugs.

One index of access to innovative drugs is their use in specific diseases for which highly effective new pharmaceuticals have recently been developed. Troubling signs have appeared in Germany regarding drug usage and mortality rates for such diseases.

Consider heart disease. Seventy-four percent of eligible German patients are not receiving statins, a key preventive treatment for coronary artery disease. In the US, the figure is 44%. German cardiac mortality declined 8% from 1990 to 2000, while in the US it dropped by 13%.

Breast cancer is another case in point. Forty-one percent of German physicians are treating early-stage breast cancer patients with taxanes—key drugs that target tumor cells for death and are often considered standard-of-care. Compare that rate to the US, where 60% of doctors use the drugs in early-stage patients. German breast cancer mortality decreased by 9% from 1990 to 1998, while in the US, mortality dropped more than twice as much, by 19%. (See Exhibit 5.) In fact, there is compelling evidence suggesting that mortality rates correlate strongly with the total rate of introduction of NMEs, country by country. Given the dramatic shift of NME introduction to the US from Europe, we would expect that the full health cost of Germany's innovation decline in pharmaceuticals is likely to be far higher.

Of course, there are counter-arguments to several of these points. For example, in the US a lot of money has been spent on expensive drugs—like allergy and impotence medicines—that did little to fundamentally improve mortality and morbidity. Still, Germany's lagging outcomes in heart disease and breast cancer can be taken as a warning sign. When doctors and patients don't have timely access to the most innovative drugs, society does pay a price.

We conservatively estimate that Germany lost $3 billion in 2002 as a result of the innovation imbalance, even without being able to fully quantify the health impacts of lesser and slower rates of introduction of truly innovative medicines. The calculus will differ for other European countries. But in most if not all cases, European countries are bound to score a loss, particularly when the full health impacts are taken into account.

Taking Action

Clearly, addressing the costs of the EU's "free ride" is strongly in Europe's self-interest. But it's also fundamental to the health of the drug industry, to reduce its increasing dependence on the US market. The industry can't afford to rely on the current sporadic, individual actions of a few major drug firms however. It needs a collaborative, far-thinking response to a big economic threat. Much as they have in the US, drug companies need to push for change across a range of areas that could help re-balance innovation.

Activist approaches, which tend to excite interest in US pharmaceutical executives, may seem naïve to European executives, who know the political challenge of trying to change a system that has lowered drug costs to governments and consumers. But as the costs of the "free-rider" model--in reducing the robustness of the European based industry and in diminishing access to innovative drugs--begin to come home to the European public, the skeptics may soon see a sea change in popular attitudes--and pharmaceutical companies may find their efforts bearing unexpected fruit.

Drug makers should collectively target European government ministers for dialogue–not with an eye to arm-twisting the health ministers who control the pharma lines in their national budgets, but with the goal of persuading the economics ministers who stand to lose most by the flight of local investment, high-value added jobs, and corporate centers. It's these ministers, more often than not, who can see the big picture and move to change the system with measures like R&D tax incentives; broadening or extending patent coverage; boosting public spending on biomedical research; and funding university-business linkages, or so-called "research innovation clusters."

Consumers present another promising target for concerted corporate action. In particular, pharmaceutical companies should focus on the physicians and patient advocacy groups who are frustrated daily by lack of access to innovative drugs, and whose voices carry increasing weight in these national debates. Scientists, too, are bound to be open to arguments that they use their collective pulpit to press their governments for the policy changes that would prevent brain drain and its attendant costs.

It would be disingenuous to pretend that drug companies wouldn't benefit directly and immediately from such changes in pharmaceutical patient access and pricing. But European leaders, for their part, can reduce the system costs of the free-rider model without busting budgets if they focus on actions that gain the most innovation benefit per Euro of added spending. European officials could expand access to the most innovative drugs, averting a likely backlash by physicians and patients while keeping down spending on me-too drugs. They could also increase R&D incentives, with the goal of reversing the talent flight of scientists and academics. There are several means to this end, including instituting tax breaks for firms' R&D expenditures. They could likewise increase government support for academic research, with greater incentives for technology transfer from the university to the private sector.

Europe's "free ride" is a myth. The sooner that myth is exploded, the sooner governments and companies can begin working together to re-balance innovation and expand the benefits of a vibrant global pharmaceutical industry.

--by Jim Gilbert and Paul Rosenberg

Jim Gilbert and Paul Rosenberg are partners at Bain & Co.'s Health Care Practice.