Implausible Denial:

Why the Drug Giants’ Arguments on Patents Don’t Stack Up

Oxfam’s Cut the Cost Campaign was launched in February 2001. It is a response to the global health crisis where 11 million people die needlessly each year from infectious diseases. The campaign seeks to make more life-saving medicines available to poor people in developing countries. While there are many factors involved, our campaign focuses on the need to change the WTO patent rules, and the strategies of the pharmaceutical giants, both of which combine to put life-saving medicines beyond the reach of the poor. In response to Oxfam’s basic demand that patent protection should take into account national economic and health circumstances, a number of counter-arguments have been put forward by the major pharmaceutical companies, including:

• The advantages to the industry of enforcing a global and uniform system of patent rights.
• The risk that any diminution of the minimum 20-year patent terms imposed under the WTO Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) would undermine incentives for research & development (R&D), to the detriment of developing countries.
• The claim that the industry is already – via Public Private Partnerships (PPPs) and voluntary donation schemes - doing what it can to address the public health needs of developing countries.

This paper sets out these core arguments and explains why Oxfam believes they are, at best, unconvincing.

Argument 1:

Given that the pharmaceuticals industry operates in a global market, a uniform global patent system and pricing policy are needed to protect the value of companies’ intellectual property world-wide. Without a uniform patent system providing twenty-year protection the industry would lack incentives for undertaking research into major diseases.

Oxfam’s view: Patents do play an important role in generating incentives for R&D. However, the super-profits which patents generate are concentrated in industrialised countries, which have a greater capacity to absorb the higher prices associated with patenting. Developing country economies are too small and purchasing power too limited to absorb higher prices. Applying stringent patent protection in developing countries will not generate more revenue for companies, but it will significantly limit poor peoples’ access to vital medicines.

The pharmaceuticals industry is amongst the most profitable in the world .The United States dominates the global pharmaceutical market, alone accounting for 40% of sales in the world’s top ten markets. Developed countries as a whole – North America, Europe and Japan – account for roughly 80% of global sales. The incentives provided by these markets have led leading pharmaceutical companies consistently to enjoy above-average price/earnings ratios, reflecting the perception of investors that they will continue to deliver above-average earnings and dividends growth.

The incentives offered by developing countries, on the other hand, are extremely limited, because of the small market potential they offer – the whole of Sub Saharan Africa, for example, accounts for under US$1bn (of a US$343bn industry) in annual global sales, and South Asia little more. The application of more stringent patent protection will not increase the capacity of governments or individuals – who buy 80% of medicines from their own pockets – in developing countries to buy medicines and thus increase incentives.

Argument 2:

Strong patent protection will not damage public health in developing countries if it is accompanied by Public Private Partnerships (PPPs) that provide heavily discounted and/or donated drugs, and if the industry develops ‘tiered pricing’ policies.

Oxfam’s view: PPPs may be part of the solution, but are inadequate in isolation. They are ad hoc and reversible, frequently conditional, and provide no guarantee that the best attainable prices are achieved.

Public Private Partnerships may be useful…

PPPs, in which companies participate in efforts to increase access to medicines, have an important contribution to make. PPPs have played a striking role in preventative health – most notably in vaccinations – but should not be seen as an alternative to efforts by governments to adopt systematic policies on pricing and patenting, and to reform of international patent rules, particularly with a view to promoting market-based solutions to affordability through generic competition.

… but can have significant weaknesses …

PPPs often bear little relation to the scale of the problem they are set up to address. Despite considerable publicity surrounding it, even the co-ordinated efforts of the five companies participating in the UNAIDS Accelerating Access Initiative fail to offer solutions that are commensurate with the problem. For example, in Uganda it is estimated that the programme will reach between 20,000 and 50,000 people at best, while the number of HIV positive Ugandans is 1.4 million. There is also a danger that in concentrating on negotiating private initiatives, public health bodies – both national and multilateral – fail to evaluate whether such initiatives are in fact a sustainable alternative to generic competition in bringing down and sustaining low prices.

…and are not an alternative to systematic cheap medicine policies.

Despite significant and ever-growing company offers of substantial price cuts, such offers are an ad hoc disease-specific approach to the problem rather than a systematic solution to the issue of price. Oxfam is concerned that they leave developing countries reliant on the charity of companies, that they are reversible and their scope is under the control of the companies, which is a particular concern if the main motivation is merely PR management of a topical media issue.

As evidenced by the recent price cuts offered by the Indian firm Cipla on generic HIV/AIDS drugs which undercut multinational companies offers, and Merck’s further price cuts in the face of global campaigning, PPPs such as the Accelerating Access Initiative provide no guarantee that prices will be set at or below generic levels. Unless companies are more transparent in their costing and pricing, their claims that they are selling at or below cost cannot be corroborated.

Argument 3:

Differing periods of patent protection or substantial price cuts in poor countries would result in rich countries’ pharmaceuticals markets being flooded with cheap generics or parallel imports, seriously undermining the industry’s profitability.

Oxfam’s view: The risk of low-price generics or parallel imports of patented products leaking from developing to developed countries is overstated (indeed, the US market has been able to sustain substantially higher prices than most countries around the world, including its immediate neighbours Mexico and Canada). Given that these threats appear in practice to be manageable, it is perfectly possible to have a differentiated patent regime and/or pricing policies tailored to the differing health and economic circumstances of individual countries.

The evidence shows that parallel importing is in practice manageable …

Existing restrictions on parallel importing – the importation into a more expensive market of a branded product from a market in which it is sold more cheaply - allow prices of patent-protected products to vary substantially amongst developed countries. In the US, for example, (according to a November 1999 USA Today investigation), prices of the top 10 best-selling drugs were around 40% higher than in Canada and around 20% higher than in the UK, a situation which can persist because of the US prohibition on parallel importing (other than for personal use). It would obviously be even more difficult to import products into the US from countries that are further afield. In the European Union, parallel importing is permitted, but only from other member states (and therefore not from developing countries).

With ingenuity – e.g. distinctive labelling, perhaps modifying the appearance of the product, careful monitoring of distribution, vigorous customs enforcement etc – it is clear that leakage of low-price products back from developing countries to high-price developed markets could be minimised. Indeed, the fact that a number of global pharmaceuticals companies already offer significant discounts on HIV/AIDS medicines in Africa clearly implies that they believe it possible to manage the threat of parallel imports back into Europe or the US. This is particularly true given that discounted medicines are distributed to the public health system and not to private traders. Contraceptive medicines have for some time been sold at significantly lower prices in developing than developed countries, without major re-export to industrialised markets.

… and patent terms do not need to be the same everywhere (or enforced uniformly).

A valid patent in one country rules out the importation of generics into that market. Historically it has been possible to operate a system in which countries balance IP protection and social and economic needs of their citizens without undermining patent protection regimes in other markets. Generic medicines produced, for example in India, are unable to enter markets in which patented versions of the same product are available. However, there is nothing to stop a company acting responsibly by issuing a voluntary license or waiving patent protection, as shown by the recent decision by Bristol-Myers Squibb to waive patent rights on the HIV/AIDS drug Zerit in South Africa.

Furthermore, prior to TRIPS many countries (e.g. India) provided only for process patents thus allowing local manufacturers to develop equivalents using alternative processes. This system did not significantly deter innovation into new medicines for northern markets, and offered a means for governments in poor countries to provide cheaper medicines and support local firms.

Given the role that generic competition plays in public health in developing countries and the need for patent reward to be commensurate with the social benefits it provides, Oxfam sees no convincing reason in practice for patent terms to be the same everywhere.

Argument 4:

Without effective patent protection there would be no research & development (R&D) into ‘Third World’ diseases.

Oxfam’s view: There is chronic under-resourcing of R&D into tropical diseases due to the limited market potential offered by the poor countries in which these diseases are most prevalent. Strong patent protection will not materially increase either the market potential in these disease areas, or the incentive for R&D (as it is profits, not patents per se, which are the incentive for R&D). There are better ways of ensuring the necessary R&D. Meanwhile, strong patent protection in rich countries is enough incentive to yield results on medicines common to rich and poor countries.

Very little R&D is spent on diseases of developing countries …

According to the latest figures from the WHO, only 0.2% of all health-related research is spent on acute respiratory infections (such as pneumonia), diarrhoea and tuberculosis – ailments which account for 18% of the global disease burden. Some analysts argue that research into drug resistant tuberculosis, for example, is ten years away from bearing fruit, because of the concentration of the disease in poor countries. Malaria, which accounts for 3% of the global disease burden – 10% in Sub-Saharan Africa – accounts for only about 0.1% of research funds. Most of the estimated US$26.4bn spent on R&D by US firms in 2000, by contrast, was directed at products for ‘rich country diseases’ - cancer and diseases of the cardiovascular, central nervous, endocrine and metabolic systems.

… because the potential market is simply not big enough …

The lack of R&D into diseases of poverty is a function of the limited market potential offered by the people and countries in which these diseases are most prevalent. In 2000, for example, Latin America – often heralded as offering important markets – accounted for only 4% of total global pharmaceutical sales and Sub-Saharan Africa probably well under 1%. In 1997 per capita sales for pharmaceutical products in the UK was US$233 per person, for the US it was US$319. In Bangladesh per capita total health expenditure –including staffing and infrastructure, as well as drugs – was US$13 per person. The figure for Uganda was US$ 14.

Statistics for Sub-Saharan Africa clearly illustrate the problem. The combined GNP of the 20 biggest Sub-Saharan African economies was US$271bn in 1999 (US$577 per head), compared with US$1,338bn (US$22,640 per head) in the UK, which itself accounts for just 4% of the world pharmaceuticals market. According to the 2000 World Health Report, in most of these 20 countries total health expenditure is less than 5% of national income. Even if all 20 of them spent 10% of their GNP on health and 20% of that on pharmaceuticals, the market would still be less than 2% of the world total, and a breakthrough drug with the potential to capture 5% of the entire Sub-Saharan African drugs market would produce sales of just US$270m per year. By contrast, Viagra - Pfizer’s drug for erectile dysfunction - had worldwide sales last year of US$1.3bn. In fact, Pfizer had 8 products with sales of more than US$1bn, including 3 with sales of more than US$3bn and one – the cholesterol reducing agent Lipitor – with sales of more than US$5bn.

… and stronger patent protection would not materially change the picture because it is profits, not patents per se, which are the incentive for R&D …

Patents create the ability to charge high prices for drugs, but sustaining the high price of medicines does not create or enhance the capacity of people – or their governments – to buy them.

... nor would extending patent protection to developing country governments do much to stimulate local R&D and innovation

When it comes to pharmaceutical products developing countries tend to be net importers of technology as most lack the industrial or research base to take advantage of patent protection. For these countries the main constraint on innovation is low levels of development. The TRIPs agreement will restrict the scope such countries have for copying and technology transfer, while simultaneously raising the cost of protected technologies and products owned by others.

There are other ways of ensuring the necessary R&D, though …

Significant innovation such as the Green Revolution, the Human Genome project and the internet, have been premised on public funding, co-operation and information-sharing rather than patenting, illustrating that there may be more subtle and effective ways of securing R&D into tropical diseases. These include substantially increased publicly funded research. Incentives to the private sector could include targeted tax relief in developed countries for R&D into tropical diseases; differential tax treatment of profits on sales made in different parts of the world; and purchase funds that guarantee an eventual market or prize funds for cures for particular diseases. Medicines developed with significant public funding should go onto the market with limited, if any, patent protection to ensure that returns to companies are not excessive, thereby maximising the benefits to the poor.

… and strong patent protection in rich countries is a sufficient incentive for R&D into diseases that occur in developed and developing countries, such as HIV/AIDS …

Patents in developed countries are a sufficient incentive for R&D into drugs for diseases which are common to developing and developed countries. The absence of blanket, global intellectual property protection such as that now offered under TRIPS did not prevent the development of numerous anti-retrovirals, antibiotics, cancer drugs etc.

… and, anyway, the problem for many people is not that the medicines do not exist but that they are too expensive

For millions of people per year in developing countries, the problem is not that drugs to save their lives do not exist, but that they cannot afford them. Public health improvements could be made in certain therapy areas even if nothing more was ever spent on R&D, although treatment for drug resistant strains of diseases are needed.

Argument 5:

Companies, like individuals, have the right to protect their property – including intellectual property – against theft, which is why they are seeking protection through the WTO.

Oxfam’s view: Governments have to balance different and sometimes competing rights of citizens. Attempts by governments to defend the right to health care by flexible patent enforcement are under threat by company bullying, even when such flexibility is apparently consistent with the TRIPS agreement. Companies should respect the spirit and letter of the legal limitations on their patent rights. Where they fail to do so, and insist on a rigid approach to patent enforcement at the expense of poor people’s health, they are discovering that they risk public condemnation.

A patent is a contract between governments and private actors through which the government agrees to intervene in the market to allow patent-holders to keep prices artificially high, thereby generating profit margins high enough to act as an incentive for future R&D and to reward the risks involved in investment. For governments to award such rights they should strike a balance between social benefits the product offers and the need for incentives. Patents should be defined by what national laws and international agreements say, rather than by what multinational companies would like. Developing country governments are right to carefully assess the scope and duration of the patent protection they offer in order to ensure that the costs do not outweigh the benefits. The "right" to intellectual property has to be balanced – and particularly in developing countries with acute health needs – with the obligations held by governments to meet other rights of their citizens – such as those to health and education. In the case of diseases such as HIV/AIDS where medicines prolong lives, the right to life must surely trump the right to intellectual property.

Under TRIPS, patent laws can contain public health safeguards such as compulsory licensing provisions. Companies must respect these and abstain from manoeuvres –such as taking legal action or advocating trade sanctions – aimed at frustrating efforts by governments such as those of Brazil and South Africa to make use of such safeguards.

Furthermore, although patents confer on companies the right to enforce market exclusivity, they do not impose on them the obligation to do so. A responsible management will take account of all relevant factors – immediate profit implications, damage to its reputation, risk of consumer boycotts and government displeasure etc. - in deciding how vigorously to enforce intellectual property rights in any given situation.

Argument 6:

The global pharmaceuticals industry is not a charity and it’s not a national health service. As in any industry, profits and returns to investment in research and development matter. It takes US$500m to bring a new drug to market, and the rewards for innovation have to be sufficient to justify the risks involved. A 20-year patent term is justified by the cost and risk associated with R&D into new drugs.

Oxfam’s view: Oxfam fully accepts the need for profits and returns to investment in R&D. We believe, however, that the industry is not as risky – and R&D not as costly – as is often claimed. The industry’s claim that it costs US$500m to bring a new drug to market is misleading, and the significant contribution of public funding is often glossed over. In addition, Oxfam recognises as legitimate the question raised by many government and public health groups as to whether the full twenty years of patent protection is necessary, even in rich markets, especially given the significant decline in average drug development times from which the industry has benefited in recent years. Oxfam’s position is that patents are important, but it is not very important for patents to be long, and not at all important for patents to be long everywhere.

The industry is not as risky as claimed.

Despite claims that the industry is particularly risky, examples of significant drug companies facing financial difficulties are extremely rare. The pharmaceuticals industry is, in fact, amongst the most profitable in the world. Leading pharmaceutical companies consistently enjoy above-average price/earnings ratios, reflecting the perception of investors that they will continue to deliver above-average earnings and dividends growth. Drug companies do spend heavily on R&D, but they typically spend twice as much on sales & marketing, and production costs are so low relative to the prices they charge that profit margins of 25-30% are typical. In 2000, Pfizer’s production costs were 17% of sales, R&D 15%, and selling and other costs 39%, leaving a profit margin of 30%. GlaxoSmithKline’s production costs were 21% of sales, R&D 14%, other costs 37%, and the profit margin 28%.

Headline ‘cost per new drug’ figures can be misleading

Most frequently-cited figures for the average cost of discovering and bringing to the market a new drug – e.g., the US$500m estimate used by the industry’s US lobbying organisation PhRMA – are essentially tweaked and updated versions of DiMasi et al’s 1991 estimate of US$231m at 1987 prices. The following are good reasons to treat such high figures with caution:

• Definitions of ‘R&D’ and ‘new drug’. Significant amounts of R&D are typically incurred in conducting trials which are not necessary for regulatory approval, but which are aimed at bolstering a product’s marketing claims. And most studies look only at the number of ‘new entities’ launched (i.e., drugs with a new active ingredient) and ignore the much larger number of approvals for new formulations, combinations etc. In both cases, the effect is to inflate the ‘R&D cost per new drug’.
• High discount rate. Virtually all studies inflate R&D expenditure to reflect the time between the money being spent and the product being launched. Discount rates used, however, to ‘capitalise’ R&D in this way typically reflect not just price inflation or interest forgone between the time the money is spent and the date a product is launched but also the ‘opportunity cost’ of the expenditure (i.e., what the money might have earned had it been productively invested elsewhere). The result is – via compounding - very substantially to inflate the ‘cost per new drug’. The DiMasi study used a 9% real annual discount rate, with the result that the opportunity cost component was more than half of the final US$231m figure. Other studies have used discount rates of up to 14%.
• Dangers of extrapolation. The R&D cost per drug will be very sensitive to small changes in development and approval times and to success rates in R&D. Extrapolating from historic data risks substantially overestimating likely future costs. In particular, development and approval times have fallen significantly in recent years (e.g., since the early 1990s, average US clinical development times have fallen by more than 2 years and approval times by 18 months). Moreover, many industry experts expect new technologies (notably genomics) to cut substantially the R&D failure rate. Lehman Brothers, for example, has postulated a fall of more than 25% in the cost per new drug between 1996 and 2005.
• Tax-deductibility of R&D. The headline figures used by PhRMA etc. ignore the tax-deductibility of R&D. Applying a marginal corporation tax rate of, say, 35% to a pre-tax cost figure of US$500m gives a post-tax cost of US$325m.

Much R&D is publicly funded.

The US NIH (National Institutes of Health) has estimated that in 1995 the contribution of private industry to overall US health R&D was just 52% and the NIH alone accounted for 30%. The private industry percentage has probably fallen since - the NIH’s 2000 budget was US$17.8bn (compared with the US drugs industry’s domestic R&D expenditure of US$22.4bn estimated by PhRMA) and has jumped a further 14% to US$20.3bn this year.

Some specific examples of the contribution of US public funding of R&D:

• A 1998 investigation by the Boston Globe concluded that 45 of 50 top-selling drugs approved in the US between 1992-7 had received government funding at some stage of development.
• A May 2000 report of the Congressional Joint Economic Committee found that 7 of the 21 most important drugs introduced in the US between 1965 and 1992 (including tamoxifen, AZT/zidovudine, Taxol, Prozac and Capoten) were developed with the help of federal funds
• The National Cancer Institute (one of the institutes of the NIH) has played a significant role in the discovery and development of cancer drugs. Nader & Love (‘Federally Funded Pharmaceutical Inventions’, 1993) reported that of 37 cancer drugs approved since 1955, 34 had received US government support during development. A later study showed that 50 of 77 cancer drugs on the US market as at January 1 1996 had been sponsored by the NCI.
• There has also been substantial federal involvement in the development of AIDS drugs. For example, AZT was originally synthesised in 1964 by the Michigan Cancer Foundation under an NCI grant and - although GlaxoSmithKline eventually secured the anti-HIV use patent - the award of this patent was hotly disputed by the NIH, which claimed an involvement in discovering AZT’s anti-HIV utility. Videx (ddI) was discovered by the NIH and licensed to BMS. And NIH involvement – much of it via the National Institute of Allergy and Infectious Diseases (NIAID) - was also important in the development of 3TC, Invirase, Ziagen, Zerit and Viramune, amongst others.

The twenty-year patent protection offered under TRIPS is arbitrary and could be reduced without prejudice to R&D. Because of ‘discounting’, R&D investment decisions depend heavily on projected revenues in the early years after launch …

In making R&D investment decisions a company will compare the ‘present values’ of estimated future income and expenditure by applying a ‘discount rate’. The earlier revenue comes on stream, the more valuable it is in accounting terms. Conversely, the later revenue comes on stream, the less valuable it is, since it is more heavily discounted. In the pharmaceutical industry, R&D costs are relatively immediate and predictable, but revenues lie in the speculative future. The ‘discount rate’ applied to them to calculate their present value will reflect not just ‘time value’ but also the risk that the drug candidate fails in R&D or flops on the market. Thus a typical discount rate applied to any proposal to research and develop a drug would be around 25%.

What are the implications of applying such a discount rate in the context of the debate on patents? Firstly, it suggests that, while patent terms must exceed the five years needed for R&D to have any purpose, it is not very important for patents to be as long as 20 years. Estimated revenues in the early years after launch are far more important in R&D allocation decisions than revenues in later years. It follows that cutting patents to 15 years globally (which would get closer to the average level of effective protection offered in the 1980s) would have few adverse effects on R&D decisions, since the discounted value of revenue in the final five years will be small.

For developing countries, the advantage of shorter patent periods is earlier access to inexpensive generic medicines and an earlier fall in the price of branded products as a result of competition. And as argued earlier in this paper, the small size of developing-country markets means that even having little or no patent protection would barely reduce the overall R&D incentive in the case of a global disease. It would, however, greatly reduce the period during which people in poor countries were forced to pay high prices for their medicines.

Conclusion

Oxfam believes a strong and profitable pharmaceutical industry is important to advances in human welfare. But the combination of unfair WTO patent rules and ruthless corporate strategies to maximise profit are contributing to the global health crisis where hundreds of millions of poor people suffer the misery of chronic ill-health and early death.

So far, the counter-arguments of the pharmaceutical giants have been weak. The major companies know they face a serious crisis in their public relations and yet they appear unable to respond currently to the scale of the challenge facing them. Oxfam hopes that soon, one or two companies in the industry will learn from forward-looking companies in other sectors, such as oil, and start to provide leadership towards a profitable but also more responsible business strategy to respond to the global health crisis.

Date of original publication: April 2001