The cost of R&D: How much money is needed to address the current

need?Andrew FarlowDepartment of Economics, and Oriel College

University of OxfordMédecins Sans Frontières (MSF) Campaign for Access to

Essential Medicines International Conference on Ensuring Innovation for

Neglected DiseasesLondon, United Kingdom

8 June 2005www.economics.ox.ac.uk/members/andrew.farlow

It’s not just R&D…

• 42 % of Africa’s population – 300 million people – have no access to safe water.

• Without clean water, anti-retroviral treatment for AIDS sufferers is not as effective, and formula milk cannot safely be used to prevent transmission of HIV from mother to child.

• Better water management can greatly reduce malaria

mosquito breeding sites.

It’s not just R&D…

• Two-thirds of all the African children who die under the age of five could be saved by low-cost treatments such as vitamin A supplements, oral rehydration salts and insecticide-treated bed-nets to combat malaria.

• A tenth of all the diseases suffered by African children are caused by intestinal worms– These can be treated for 25 US cents per child

• Research on virus resistant maize for Africa• LOADS OF EXISTING UNDERUSED

TECHNOLOGIES

But R&D is vital…• Huge range of issues…

– Better drugs, e.g. artemisinin combination therapies (ACTs) for malaria

– Better diagnostics – Better prevention – Better delivery systems– More heat-stable products– Better…– Gates “Grand Challenges”

– Why should the poor not benefit from technological advances too?

– A matter of equity.

A mix of R&D cost studies

• Tufts (DiMasi, Hansen, and Grabowski):– “The Price of Innovation: New Estimates of Drug

Development Costs” 2003– “Assessing Claims about the cost of new drug development:

A Critique of the Public Citizen and TB Alliance Reports” 2004

• Public Citizen– “Rx R&D Myths: The Case Against the Drug Industry’s

R&D Scare Card” 2001• The Global Alliance for TB Drug Development

– “The Economics of TB Drug Development” 2001

Views of one side…• (Referring to Public Citizen Report) “fundamental

economic principles were ignored…their estimates using published data are deeply flawed and substantially understate R&D cost….grossly technically inappropriate …fallacious economic reasoning about the nature of investment in R&D and an erroneous view of the corporate income tax” Tufts 2004

• “For numerous reasons, the projections in the [TB Alliance] Report cannot be appropriately compared to our $802 million result…Our R&D estimates are costs per approved drug, not costs per approved indication” Tufts 2004

And the other side…

• “But this R&D scare card – or canard – is built on myths, falsehoods and misunderstandings…an unfounded or false, deliberately misleading story.”

Public Citizen referring to TUFTS

Average cost of a drug?

• Tufts $802m… now $1.2bn in some versions.• TB Alliance $115m-$240m.

[Another angle… if divide total global pharmaceutical spending by output of NCEs = $50bn per NCE]

Role of CIPIH and others…• Most of the above are studies of drug development costs.• We need more data on non-drug R&D too.

– Vaccines – Innovative interventions of all sorts too

• CIPIH: – Flip side to CIPIH work is costs of R&D. Better ways

(including IP) to do R&D => lower R&D costs.– We “need to gather information on R&D costs and

other factors needed for economic analysis.” (CIPIH Open Forum 1 June 2005, Overview slide 40)

All studies have ‘issues’: TUFTS• Just a few issues• 1) Sampling issues:

– Those approached to join sample were not themselves a random sample.

– Failed to check that the voluntary nature of response did not create further sample bias toward more costly firms (Tufts found anecdotal evidence of this).

– Mergers may also have helped bias the sample, by self-selecting firms to take part in the direction of high cost firms.

– Trial size issues…especially that they are measured as high size and high cost in Tufts compared to other approaches to working out costs of development.

– Secrecy of the underlying data.. Can’t independently replicate the ‘R&D cost experiment’… a standard scientific requirement.

All studies have issues: TUFTS

• 2) Skewed cost distributions, with mean greater than median, but the mean used in calculations. – Since successful trials were used to price the unsuccesful

trials, and since we know that firms strategically spend more on trials that are ‘likely to succeed’, we record a higher cost for failed trials than those trials did on average actually cost.

– Ideally we would like the size-distribution of surviving and non-surviving trials at each phase and calculate out of pocket cost on that basis.

– Another problem of the secrecy.

All studies have issues: TUFTS• 3) Covers self-originated new molecular entities (NMEs).

Adequate for the described task.– But the ‘self-originated’ makes them a more expensive

sample than ‘average’.– May be inadequate for many of the issues raised by current

neglected drug projects.– Hard to read into Tufts cost data what it might mean for,

say, current neglected diseases work.– Date a poor proxy for e.g. AIDS drugs (c.f. South African

Competition case)– Inadequate for debating in an informed fashion the relative

roles of private/PPP v public sectors.

All studies have issues: Public Citizen

• Just a few issues:• 1) If the point is to work out what the real resource costs are of developing a

drug/vaccine, then should not adjust down to remove ‘tax breaks’. Should leave pre-tax.– If want to have a debate about profitability of the industry, gov. subsidies,

excessive pricing, etc. then we want to adjust for some of these things. – Meanwhile ‘real resource cost’ is a pre-tax issue.

• 2) Wrong to remove capital costs.– ‘Who’ pays capital costs, and where ‘risk’ ends up is part of the

problem… and helps choose between R&D systems. Capital costs need to be factored in.

• 3) Not enough time spent on worrying about TUFTS methodology.

General points…

• Claim of an ‘average’ cost to develop a drug/vaccine is nice but misleading… – It’s not an exact science. – It depends what you are looking for (cryptic

comment… sorry!).– A wide range is to be expected.– Mechanisms highly dependent on knowing this

supposed “average cost” are to be avoided.

Some general themes instead…

• 1) Opportunity Cost

• 2) Rent seeking behaviour

• 3) Risk and the cost of risk

• 4) Emerging economy costs of R&D

1) There is always a budget constraint

• Massive level and range of needs – there is always a budget constraint.

• “Opportunity cost” is not a dirty phrase– The alternative you were prevented from doing because you

spent on this project– For any given budget for developing

drugs/vaccines/diagnostic devices/delivery devices you could have achieved MORE drugs/vaccines/ diagnostic devices/delivery devices and access by avoiding high cost approaches.

• It should guide intertemporal policy decisions:– The overall R&D cost matters (i.e. efficiency of underlying

R&D approach taken) and not the timing of the flow of funding per se.

Commission for Africa costings

There is always a budget constraint

“Opportunity cost”

the alternative you were prevented from doing because you spent on this project

2) Minimize ‘rent seeking’ to keep R&D costs down

A CASE-STUDY: COST OF DRUG R&D IN GENERAL

• Say, in a ‘perfectly functioning’ R&D ‘scheme’, it would cost an expected $1bn to discover the drug/vaccine for a disease in a way that maximizes the ‘social surplus’ at $5bn.

• You wish to get as close to the ‘optimal scheme’ as possible (you never make it – the world is imperfect)

• You want to leave ‘consumers’ themselves with as much of the ‘social surplus’ as possible and not have it ‘taxed’ or ‘priced’ away from them – especially if they are poor and the opportunity cost of resources is high.

2) Minimize ‘rent seeking’…

• What happens if instead you offer all the $5bn of surplus to ‘cover the R&D’? …

2) Minimize ‘rent seeking’…• ‘Rent seeking’: Even very inefficient projects that would not survive

under the ‘perfect’ scheme will survive. – Although their probabilities of success are poor, they will still attract

financial backers, since on average they generate positive expected profit.• In markets with a lot of ‘economic rent’ possibilities, a large part of the

social surplus is dissipated:• ‘Excessive’ marketing (though we need to allow for useful marketing).• ‘Excessive’ ‘me toos’ (again allow for ‘useful’ me toos).• High cost forms of R&D, including large sample sizes to prove small

differences in therapeutic value, trials that include marketing reasons (big industry literature on this), etc.

• Inefficient use of IP.• Inefficiency is compounded by the deadweight loss of having to raise the

$5bn if it is raised through, say, taxation.

2) Minimize ‘rent seeking’…• ‘Fair’ return on industry capital entirely consistent with

inefficiencies in end product and/or intermediate product markets.– (Scherer example) If for example, patents turn out to be inefficiently long,

rather than perennial excess returns being earned, most of the potential private benefit is dissipated in rent seeking behaviour transforming these rents into costs even if there is little or no social benefit.

– This drives profits to the point where price equals average costs, where fair return is achieved.

• High measured R&D cost figures are endogenous to ‘market power’ and industry structure as much as being dependent on any ‘fundamental’ notion of “R&D” costs.

2) Minimize ‘rent seeking’…lessons• Other thoughts on this: We want reward to be linked

as much as possible to the true costs and difficulty of developing products for each disease as well as therapeutic value, epidemiology, etc.

• So the ‘optimal’ ‘R&D’ cost of any project should depend on a range of variables (all expected too!!!):– Complexity of underlying science;– Costs of doing R&D (also depending on types of firms

encouraged);– Epidemiology;– Production costs of the eventual product, etc. – NOTE: Not just information on the medical condition

itself.– Note not necessarily linear tradeoffs.

2) Rent seeking and neglected disease? • The tight budget constraints of neglected disease research

suggest that rent-seeking and forms of wasteful activity are likely much lower than for developed economy disease R&D:– R&D for neglected diseases especially cost effective.– At the margin a $ spent on neglected disease R&D is likely

to be especially productive.– R&D cost studies based on developed economy markets

are likely to ill-fit R&D costs of neglected disease markets.– Need for more separate neglected disease specific R&D

cost studies.

2) Rent seeking and neglected disease?

• The distortion away from neglected diseases is linked to rent seeking activity in developed economy markets:– Developed economy health R&D problems and

neglected disease R&D problems are linked.– Change incentives/reforms in one… what happens in

the other?

2) A lesson: avoid rent seeking in any new R&D mechanisms

• OBSERVE: When considering new mechanisms to support neglected disease R&D, R&D costs are lower by avoiding mechanisms that create rent seeking (or by thinking of ways to modify them to avoid rent seeking):– E.g. An APC two-stage game.

• If lots of discretion and need to ex post adjust, then APC has firms competing twice - at the R&D stage, and again, at the committee stage.. The second stage competition is rent seeking

• Or rent seeking happens at start of mechanism to reduce the number of potential players at the second stage.

• Any mechanism with committees (including Treaties) and discretion, and large sunk costs still to be paid at the end will encourage rent seeking and higher per unit R&D costs.

2) A lesson…

• OBSERVE: not just emphasis on therapeutic value – Eg. Prize-based models could not just reward by

therapeutic outcome.• It would ignore the differential underlying cost space

– Choice of prize-based scheme over alternatives (front loaded, open source, directed research, etc.) would boil down to relative efficiencies at achieving close to the optimal $1bn scheme.

• Similarly models that just target costs, miss out on the therapeutic profile.

3) RISK and cost of R&D finance• Tufts: half the R&D cost of developing a new drug is ‘cost of capital’

i.e. reward to risk taking.• Wrong to exclude capital/risk costs from commercial R&D cost figures.• Wrong to exclude capital/risk costs of non-commercial R&D models

too… someone bears the risk… • But it is also wrong to exclude the value of risk-saving of such R&D

models!– If PPPs/NIH activity takes away risk from later players, should that

not be properly valued and ascribed too (currently it is not in R&D cost data)?

• Debate about relevant level of capital costs and who bears the risk, should be part of the choice about how and where to do R&D.

3) RISK and cost of R&D finance• Is R&D high risk? Well, yes and no.• Degree of individual variance of an R&D project or of a pharmaceutical

firm is not what matters• What matters is the degree of covariance of that firm with the overall

market.• If financial markets are efficient, risk can be spread, with investors

holding well-diversified portfolios and bearing little or no idiosyncratic risk.

• This is in the capital (CAPM) cost methodology used But this is lost from the rhetoric and PR – The talk is always about individual financial gambles on technology,

and never the covariance of these financial gambles with other financial gambles.

3) RISK and cost of R&D finance• Most of the TUFTS capital cost is the market rate.• Big increase in capital costs component in Tufts study

was not because R&D got riskier per se (that is a separate issue) but because the stock market bubbled in the late 1990s– Pulled up average cost of capital rate up– This got applied on earlier sunk R&D costs too

3) Equity/non-equity based R&D finance

• Traditional model of drug development has been equity-based R&D.

• PPP and others have changed this.• What are the implications of this for the R&D cost

question?• This is an under-considered point.• But all mechanisms of R&D, including all proposed

new mechanisms, have different presumed financial mechanisms underlying them…and this has implications for R&D costs.

3) Equity/non-equity based R&D finance

• Some thoughts on the role of equity finance in drug/vaccine R&D.

• Fundamental financial problem = ‘separation of ownership and control’ of firms engaged in research. Two affects:

• A: managers/scientists have a preference to invest in things that benefit them (a larger firm size, nicer offices, more staff under their control, higher pay, prestige projects, etc.)

• B: being risk averse they wish to avoid risky R&D. • Normally, one would think to use more debt than equity

finance (“leveraging”) to mitigate problem A.

3) But ‘leverage’ is of limited use in the case of R&D-intensive firms:

• 1) The knowledge asset created by R&D investments is intangible, often contains a lot of ‘know-how’, is partly, if not largely, embedded in human capital, and is often very specific to the firms –. for debt-holders there is no physical asset to secure loans (i.e.. debt).

• 2) Servicing debt requires a stable cash flow. Often R&D must be sustained at a certain stable level to be productive and it would make R&D even more expensive if it had to compete with this cash flow requirement.

• 3) If bankruptcy is a possibility, managers may avoid variance-increasing R&D projects that have value and that shareholders would want, leading to fewer long term projects.

3) Role of equity finance in R&D

• So, the apparent solution to the first problem doesn’t work.

• So, most pharmaceutical R&D instead takes place in:– firms based on equity-based, external, finance;– older firms with already established cash flow

records;– or newer firms with access to venture capital...(but

venture capital is also expensive).

3) Role of equity finance in R&D• But this leads to a new set of problems:

– One reason firms do not do certain kinds of research is because it is hard to communicate to equity-based markets the value of research (even if they want to be truthful… since they will not be ‘believed’) and hence to raise the finance for it.

– asymmetric information and moral hazard => extra gap between the private rate of return and the cost of capital when the innovator-investor and financier are different.

– Firms therefore do not invest in innovations that would pass the private returns hurdle.

– Short termism too: Jon Horton, GSK, says firms “like to see a return on investment by the end of year 3.”

3) Role of equity finance in R&D– Also by its very nature drug R&D is very long term.

The ‘lemons premium’ is higher for R&D than for ordinary investment because the difficulty of separating good from bad projects when projects are long-term R&D investments is much greater than with short-term low-risk projects.

– The problem is made worse by the fact that many firms are also reluctant to release information to financial markets, afraid of revealing information to competitors.

– Paradox: Need secrecy to secure the ‘end payment’, but this enforces lack of sharing and higher cost forms of finance.

3) Where is this argument going?• Are PPPs, breaking some of these information problems?

Or not?• Are PPPs reducing risks and enabling ‘cheaper’ forms of

finance or not?• Are pay-as-you go ways to finance R&D lower (or higher)

cost approaches to neglected drug R&D compared to end-to-end (i.e. all reward at the end)?

• How do PPPs diversify their portfolio if they are less equity based?

• This should instruct our choice of R&D mechanism?• E.g. 10-15 malaria vaccines entering clinical trials in Africa

in next few years – ten of them European. Who to direct funding to… these developers or “big industry” players?

3) Costs of finance matter: case of HIV

• HIV vaccines likely to take a minimum of 15 years to develop.

• If we take (at face value) $1.2bn per year of out-of-pocket research and trial costs needed (IAVA 2004).

• Replacing this flow for 15 years with a payment at the end, and relying heavily on biotechs and venture capital at the start and large pharmaceutical firms later. How much would it cost?

• Required rate of return to investment needs to capture many risks above and beyond required market return:– Uncertainty about ever getting a vaccine;– Uncertainty about internalizing value of research in a highly open

iterative discovery process such as that required for HIV;– Risk that the mechanism collapses at any point between now and

end;– High level of time-inconsistency risk (all-at-the-end APCs still

contain a great deal of time inconsistency risk);– High cost of venture capital for early discoveries (30%-40% is

typical VC rate… we need to average that into the 15 year rate), with later rates lower;

– High ‘reputational risk’ for the last big firm in the chain.

3) Costs of finance matter: case of HIV

3) Costs of finance matter: case of HIV

• How much above normal required market rate of return?• And how much to pay at the end?• $65bn, if required nominal rate of return 15%, real = 12%);• $105bn, if required nominal rate of return 20%, real = 17%);• $165bn, if required nominal rate of return = 25%, real = 22%);• This excludes the (still likely very high) costs after 15 years

since APC would not pay out all in first year so as to allow follow-on vaccines.

• These are low rates of return compared to speculative investments that venture capital normally makes.

• But are they too high for this case? Or too low?• What are the exact sizes of the risks in the case of HIV and how

high are capital costs going to be?

HIV…looking from the other side…

• Average expected horizon until repayment:• 10 year horizon: each $1billion pays for about £100m-

$150m of early out-of-pocket HIV research costs • 15 year horizon: each $1billion pays for about $35-

$66m of early out-of-pocket research costs.• All in expected terms… and all very, very rough…

HIV…the other way..

• Add in ‘crowding out’– say, half (maybe push payments prove hard to remove

from ‘winners’, and Russia, India and China cannot be barred from ‘spoiling’ markets for products later)

• $1billion of promised HIV payment paying for about:– $50-$80m of genuinely additional new early out-of-

pocket private R&D at 10 year horizon

– $15m-£30m at 15 year horizon

HIV…the other way..

• Maybe this is why current levels of private funding are so low?– It is claimed there is ‘no market’. – Maybe it is the very high risk, high capital costs

and high risks of ‘crowding out’?– Does a $3bn fund have any impact at all?– If it, at most, creates a few months’ worth of

what IAVI says is needed, will firms bother? It would be too risky?

HIV…. The dangers. • “Unfortunately, as public budget deficits prevail across

OECD countries, there seems little prospect of major new public initiatives on a scale to make a significant difference.” Harvey Bale, CIPIH posting CIPIH Forum, 7 Mar 2005.

• Strong pressures to trim current levels of funding for HIV vaccine research due to the size of budget deficits. – Proposed U.S. budget, includes only 0.5 percent increase in overall

funding for the NIH– Substantially less than the rate of inflation during the past few years – Way below the rates of funding increase of the past decade.

HIV… The dangers…• “Our belt is being tightened for us...the previous largess that

was associated with all research, particularly HIV, is now not going to be a reality for the future." Dr. Anthony Fauci, head of the National Institute of Allergy and Infectious Diseases, NIAID,

• Fauci says that this tightening may well hit HIV vaccine research “especially hard”

• So, lots of hype about power of HIV APCs for HIV…combined with pressures to cut back funding for vaccine research…

• …But we saw just how weak an HIV APC would be..• What are the consequences for HIV vaccine R&D and that

chances of ever getting a HIV vaccine?

4) The role of emerging countries

The Global Alliance for TB Drug Development “The Economics of TB Drug Development,” 2001, p58.

4) The role of emerging countries…

The Global Alliance for TB Drug Development “The Economics of TB Drug Development,” 2001, p59

Concluding Thoughts…• Not driven by “what is the cost of R&D”... More

important is to work out the most efficient way to do R&D…including nature of financial instruments used to pay for research… and then see what that costs…

• Then use that to work out how much is needed…