Speeches & Presentations

The Campaign Against Innovation


Sidney Taurel

Chairman and Chief Executive Officer - Eli Lilly and Company

March 18, 2003

American Enterprise Institute - Washington, D.C.

Thank you, Chris (DeMuth), not just for that kind introduction but for all the extraordinary contributions you and your colleagues at AEI have made to health care policy discussions over the years.

AEI represents a very articulate voice in a very complex wilderness. And I just want to take the opportunity to say how much we at Lilly appreciate hearing it.

But I'm delighted to have the opportunity to participate today in what I know will be a rich conversation with this distinguished group of thought leaders. The issues I'll address will be familiar to you - basically, the tension between society's desire for better medicine and its aversion to higher health care costs. But I hope to offer an angle of view on these issues that may not be so familiar. I want you to look over my shoulder and see how the various choices in the policy environment affect the choices available to a CEO in my industry.

Let me start with a question: Do you believe we already have all the medical innovation we need?

That may sound like a purely rhetorical question, but it's not. For one thing, there are some influential commentators who are on record saying, in essence, "yes."

Moreover, if actions can be taken as answers, I have to assume that many policymakers, here and in other nations, must agree with that view.

The two most important preconditions for innovation in my industry are market-based pricing and intellectual property protection. But when I look at health care systems around the world, I see that policies that support innovation are dwindling, while policies that discourage it are proliferating. A third-party observer trying to make sense of this, without access to other data on the motives involved, might reasonably conclude that this amounts to a worldwide campaign against pharmaceutical innovation.

These measures are almost always advocated and adopted in the name of cost control. I don't really believe that there is some global conspiracy or even that the proponents of any single measure actually intend to stop medical progress.

Nonetheless, that may turn out to be their end effect. I have a real concern that, if these trends continue, especially here in the United States, we could see the collapse of true innovation in biomedicine.

Leaders in my industry have made this point before, as you all know. But apparently we have not been able to make the case for it successfully. Today, I want to attempt to make the case by sharing with you the business logic that anchors it.

First, let me give you a very quick tour of what a company like Lilly faces as an innovation-driven business in a global pharmaceutical market.

The market restrictions in Germany and Japan that we've heard about this morning are unique only in their particulars. In general, they reflect a global pattern.

Throughout Europe, the pharmaceutical industry labors under various kinds of price controls, of which the simplest and most onerous is a price set by government fiat. This is the practice in all of southern Europe, including France. Canada also has price controls.

The U.K. substitutes profit controls for direct price controls and also has a number of mechanisms to restrict access and limit demand.

In the developing world, intellectual property protection is the burning issue. After years of slow, steady progress in improving intellectual property protection, the recent trade negotiations have put the whole patent system into jeopardy. Participants in the on-going TRIPS negotiations are now contemplating proposed revisions, which would essentially allow developing countries to abrogate pharmaceutical patents almost at will.

Despite the way this issue has been featured in the press, the drug companies aren't worried about a poor country overriding patents to meet an internal public health emergency. The concern is over the potential to legalize intellectual property theft in places like India and Brazil, where low-cost manufacturers would exploit wider latitude to produce knock-off drugs for export.

When all is said and done, there is only one market in the world that supports pharmaceutical innovation - the United States. We still speak of it as the "last free market," and indeed, though hardly "free" of government intervention, it is the one market where global innovators find the incentive they need to keep pushing the boundaries.

But those incentives are now threatened on a number of fronts, as various kinds of cost-control legislation find new proponents - notwithstanding Dr. Lichtenberg's work showing that the benefits of new drugs greatly exceed their costs.

Congress has actually passed legislation to allow U.S. pharmacies to import U.S.-made drugs from Canadian wholesalers, essentially importing Canada's price controls as well. The only thing holding it back from implementation is FDA concerns about potential safety problems.

We see many states adopting a variety of price measures and access controls to reduce their Medicaid drug costs. In some cases, they are trying to extend Medicaid drug rebates to a larger segment of their population.

The debate over Medicare reform and especially over the addition of an outpatient drug benefit is in many ways a debate over a market-based model versus the current central planning approach, with its attendant price controls.

Finally, we've seen a variety of measures that would weaken intellectual property laws in the U.S. A bill was passed in the Senate last year that would tilt the playing field heavily in favor of generic companies and very much against the research-oriented innovators.

Given the discouraging climate for innovation already established around the world, I believe that any of these more drastic proposals would, if implemented in the U.S., lead to a "death spiral" in our ability to find and develop new treatments.

When I make this point to elected officials, I realize that many don't believe me. Perhaps they hear it as a threat and think it's really a bluff. Perhaps they think it's just a gross exaggeration. Perhaps what they won't quite say out loud is roughly this: "Are you saying you'll stop doing R&D? You won't. That's what you do. You don't have any other business to be in."

While it's true we would not turn out the lights in our labs - we would continue to do some form of R&D - but it would be very different than what we are doing today. My key point is that, under a regime of weaker IP protection or harsher market controls, our R&D would no longer be able to deliver true innovation.

To understand why, you need to take a look inside the machinery of pharmaceutical innovation and understand the genesis of medical breakthroughs.

Major pharmaceutical companies are built upon and driven by blockbuster drugs. At this point, that's defined as a product with sales of above a billion dollars a year. All the "Big Pharma" companies have some of these very big drugs anchoring their portfolios, and most have grown by developing or acquiring a series of them over the years.

Blockbusters tend to be highly innovative drugs, often breakthroughs. They are big because they represent the first or best treatment for a major medical need.

At the same time, they are very elusive, very rare. No company has ever found a way to produce big, innovative drugs efficiently, economically, or even predictably. For all its technological sophistication, the business model centered on innovation is pretty primitive.

Think of a funnel, with the wide end representing the discovery stage and the narrow end representing the launch point of a new product. Thousands of compounds enter the top of the funnel and begin to undergo testing. A large percentage fail very early. More fail at each stage of development. But ultimately a few do make it through. You've probably seen the attrition statistics before - for every 5,000 entering the top, one comes out the bottom. This is part of the reason why it costs $800 million to $1 billion to produce a new drug.

Of those that make it to market, not all are big drugs by any means. In fact, only one in three makes back its cost of development. So the true blockbusters are a fraction of the fraction that survives the journey.

And yet these few throw off enough value to make the innovation model work. Among other benefits, they pay for all the failures, but also for the lesser innovation that occurs along the way. These discoveries may have smaller markets and thus represent lower return to the companies. But they are critically important to those who suffer from these diseases, and, as long as we can continue to find some big new drugs, we can afford to bring these lesser ones to market as well.

Most importantly, blockbusters finance the search for more breakthroughs, which makes our innovation engine run something like a breeder reactor, the nuclear energy system that produces fuel even as it consumes fuel.

This is not simply a matter of having the resources to reload the top of the funnel. Rather the key resources are those required to keep moving a "critical mass" of compounds through the R&D funnel. It's the "D" that's rate limiting, not the "R."

This is a key to understanding where innovation comes from, so let me take it one layer deeper.

Think of the funnel again. Superimposed over the funnel of scientific attrition, there is an inverse funnel of cash outlays, a stream that gets wider and wider as the molecules move forward. It's well known that the greatest expense occurs in the third and final phase of clinical trials and so this is the part of the innovation process that most people associate with the capabilities of the big companies. But there is an earlier, less visible stage of development that I would say really defines the engine room in the innovation machine.

This is the period between candidate selection, where one molecule is selected for further development from a "family" of kindred compounds, and the stage where a surviving drug candidate is tested for efficacy in patients, which is the beginning of Phase II clinical trials. In between, the candidate is tested for toxicity and for all sorts of other properties that determine whether it can be moved into human beings and, ultimately, commercialized as a marketable product.

The key thing about this part of drug development is that it combines high costs with high technological risk. Moving a compound from candidate selection through first human dose involves a lot of people putting in a lot of hours in many disciplines. By the time you reach the end of Phase I, you may have $100 million invested in that compound when you include the cost of all failures and the cost of capital. Yet 70 percent of the molecules that make it this far will never make it to market, and none of this work tells you what you most want to know - will it work?

But you have to be willing and able to place your bets despite the uncertainty. Your chances of succeeding are improved by having a lot of candidates to move forward. But bringing a lot of candidates forward means proportionally greater expenditures. Unless you have one or more big drugs on the market to give you these resources, you just can't afford the risks that go with a sustained pursuit of innovation.

Incidentally, this explains why the vast majority of new drugs come from pharmaceutical companies and not from university or government labs. That claim has been advanced in several recent attacks on the industry, but it is simply not true. These scientists can do the early part of the "R," and in fact they do contribute a lot of new ideas for the top of the funnel. But they are simply not staffed, funded, or organized to do the "D." The capabilities really don't exist outside the industry.

Even smaller pharmaceutical companies and most biotechs typically partner with the major companies to bring their molecules through the development process.

Obviously, this business of finding significant new pharmaceutical treatments is a very high risk proposition. The only thing that induces people to put their money and their time and talents into it is the prospect of a return commensurate with the risks.

Nobody, under any circumstances, is ever guaranteed that such a return will be achieved. But what guarantees that such a return is possible are the two key principles I noted in my opening: intellectual property protection and market-based pricing.

The patent system gives inventors a period of exclusivity in which to try to get their return. Market-based pricing allows successful innovators to actually achieve the level of return their investors require.

The question our policymakers need to ponder is what happens to biomedical research and development if those two principles are compromised to any significant degree? What changes in the model I've described, if we get price controls in "the last free market"?

I believe pharmaceutical companies would focus first on how to survive and later on how to succeed in the new environment.

I think the first thing they'd do is to focus much more attention and resources on maximizing sales of existing products. That means much greater marketing spend to try to gain market share, and the only place that money can come from is the research budget.

As the importance of marketing grows, the number of marketers would shrink in an intense wave of consolidation. Many would have no choice but to combine operations and cut costs. But even relatively successful companies would see consolidation as a key strategy for gaining leverage to counter the greater power of the government buyers.

The net result would be that the industry's total R&D effort would shrink tremendously. Instead of 20 or so medium-to-large companies spending $30 billion a year on research, you might have 4 or 5 huge conglomerates spending half or one-quarter of that amount.

Furthermore, whatever the total amount spent on R&D, it would be allocated much differently than it is today.

In the aftermath of new controls, companies would shift resources away from early stage R&D and focus them on developing new indications or line extensions for existing products and on trying to accelerate development of late-stage molecules. Those are the potential new products that you know the most about and that can come to market soonest. They may be the last new products you'll ever see so you'd better get everything out of them you possibly can.

Then, over time, I think a number of other strategies would emerge to try to offset the lower potential returns by pursuing lower risk ventures.

I suspect the dominant strategy would center on deliberate imitation and incremental improvements to existing products. The pharmaceutical market would become a world of "me-toos." There are already quite a few companies that haven't been successful at innovation and so already depend heavily on this kind of incrementalism. Ironically, they might actually have an advantage in the new world.

To the extent that some new research still continues, I think it would be very much more concentrated, in terms of disease targets, than it now is.

In the current innovation model, where blockbusters are so rare but so valuable, most companies will follow a promising lead even into a therapeutic territory where they have no presence. And in fact over the last 20 years, 50 percent of pharmaceutical innovations have come in areas where the inventors had no prior experience.

That exploration of the "white space" will disappear. Companies will try to leverage their existing knowledge base. What are physicians in this specialty really looking for? What are the critical success factors for a clinical trial in this class? And thus stick closely to the therapeutic areas they know best.

Another very likely adaptation will be an effort to diversify beyond pharmaceuticals. To escape oppressive regulation, companies may move toward the over-the-counter market or nutritional supplements or any other similar opportunity that consumers pay for out of pocket.

It's hard to see where the industry might go in a new wave of diversification. But if marketing indeed turned out to be the key competency in the price-controlled environment, companies would probably try to leverage that skill in new areas of comparatively low risk, perhaps in areas like home health care or nursing homes or other areas of health care delivery.

Finally, we have to assume that, for some companies, none of these adaptations will work. They will fail and disappear.

Those most vulnerable in a price-controlled future would logically be those which, today, are most committed to innovation.

I think the biotech industry in particular would see terrible attrition. It's no coincidence that 70 percent of the world's biotech capability is located in the U.S. That concentration is directly tied to the potential for profits in the U.S. pharmaceutical industry. Take away that incentive and the investors will pull out and biotech will wither away.

That will only accelerate the downward spiral in innovation, because, collectively, biotech companies are a very important source of new ideas, new technology, and new molecules for the broader pharmaceutical industry.

Look at the cumulative impact of all these effects and I think you can see the result. The innovation engine runs out of fuel. True medical breakthroughs will be few and far between, if they come at all.

My scenario of the choices pharmaceutical companies might make in the face of price controls or patent erosion is what the economic logic suggests to me. But it is not merely hypothetical. We have plenty of empirical evidence from the experience of other nations and from our own experience in the U.S. which suggests that the pursuit of innovation would no longer be a choice.

This morning, we've already heard two powerful examples of what has happened to the pharmaceutical industry in Japan and Germany. Just in case anyone thinks those are somehow anomalies, let me briefly point to a couple of others.

France is one I know from direct experience. It may be the "poster child" for the campaign against innovation.

Here's an amazing fact: In the second half of the 1960s, French pharmaceutical companies matched U.S. firms in producing new drug substances - 92 for France, 93 for the U.S. This was double the innovation output for German firms in the same period, which in turn was double the output of the U.K.

Over the next three decades, U.S. innovation continued to outpace all others. Production of new drugs held steady in the U.K., declined sharply in Germany, and all but collapsed in France. In the five-year period 1990 through 1994, U.S. firms produced 85 new drugs. French firms produced 14.

What are the forces behind such an extraordinary decline? A great part of the answer has to be the impact of price controls. The French system aims to force the lowest possible unit price for pharmaceuticals, and, in pursuit of this, it takes very deliberate aim at innovation. When a genuinely new product is approved, its price is set based, in part, on its expected sales volume. If the sales exceed expectations, the maker is required to cut the price to offset the incremental costs to the government.

In other words, innovation is punished if it is successful.

Ultimately, the industry that has emerged in France is just what our hypothesis would predict. Their industry has seen huge consolidation over the last 20 years, as French companies became less and less able to generate the innovation desired in the developed world.

Two of the surviving companies have acquired the critical mass necessary to try to discover and develop drugs for the U.S. market. But the majority have concentrated on their home market and on exports to developing nations. They have fitted themselves to these markets by pursing a strategy of low-cost, minimal innovation, and heavy promotional spending.

Finally, this kind of reaction to the threat of controls, this flight from innovation, has happened before in the U.S. - twice, in fact.

Back in the '60s in the aftermath of the notorious Kefauver hearings, we saw pharmaceutical companies rapidly diversifying into all sorts of business lines - agricultural chemicals, animal health products, cosmetics, medical devices and diagnostics. That's how Lilly came to be, for a number of years, the owner of Elizabeth Arden cosmetics.

The same thing happened in the early '90s in reaction to the Clinton administration's proposed health care reforms, which many thought would end market pricing in U.S. health care.

There was a very rapid response within the industry. Internal R&D spending began to decelerate very rapidly. Industry investments in research had been increasing at more than 10 percent per year. All at once that rate fell to under 3 percent per year.

Wall Street had a similar response. Venture capital for biotech companies all but dried up. And investors bailed out of pharmaceutical stocks, wiping out billions of dollars of market capitalization in a very short span of time.

In that climate, pharmaceutical companies were following the logic I've laid out, shifting budgets to the late-stage pipeline and redirecting investment into other business lines.

In that period, Lilly and the other majors began to invest in things like disease management and pharmaceutical benefits management and even entered the generics business. Because the threat arose and disappeared so quickly, we promptly shed these new branches and resumed our core pursuit of innovation. But there is no doubt in my mind that the industry would be forced down that same path if the incentives to innovate were dismantled by new legislation.

In short, pharmaceutical innovation for the entire world hinges on the policy choices of the American people and their elected representatives.

So again, I put it to you - do you believe we already have all the innovation we need? In the very near future you are going to have a chance to give your answer, and your answer is going to count.

As health care costs continue to rise, as our society tries to cope with the retirement of 76 million baby boomers, I'm sure there will be some voices willing to argue in the affirmative.

For the other side, we must imagine the voices of all who suffer from illnesses we cannot yet defeat: the millions who suffer from heart failure, from Alzheimer's, from a dozen deadly cancers, from the complications of diabetes, and on and on. How do they vote?

The terrible irony of the campaign against innovation is that it is coming at precisely the moment in history that medicine is poised for a great leap forward.

For all our amazing advances in the last 50 years, we are still working with the tools of the first pharmaceutical revolution. That is, we are still mostly using advanced chemistry to treat disease symptoms. In the new age we are now entering, we will increasingly use advanced biology to actually cure or even prevent disease from occurring.

The fruits of genomics and other new disciplines in biomedicine will clearly take some time, longer than we first thought, to transform therapeutics. But that transformation will come if we do not interdict it with short-sighted controls.

To do that would forsake millions of sufferers and yet never deliver effective cost control. It would leave us stranded part way along the curve of progress - advanced enough to do some good at great cost but not enough to really begin to shrink the massive cost of disease.

We need to understand, once and for all, that innovation is not the problem. It is the solution.

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