Nature Biotechnology “UK strong arms industry over drug pricing” reports that the National Health Service (NHS) is seeking an immediate price freeze with a 5% price reduction for all drugs commencing January 2009. British drug prices were controlled by the Pharmaceutical Price Regulation Scheme (PPRS). The drug companies can set their own prices when products are launched, but price increases are limited. PPRS also sets a cap on profits; the excess must be refunded to the NHS. You can imagine the cost shifting games being played.

GlaxoSmithKline (GSK) sued when the NHS demanded a 4.5% price cut on Zantac. GSK was victorious in its claim of being unfairly treated, so the NHS terminated PPRS and moved to “value-based pricing”. In June, the industry “voluntarily” agreed to the 5% price cut.

The National Institute for Health and Clinical Excellence (NICE) is the mechanism for value-based pricing. Famous NICE fights include Genentech’s (DNA) Avastin and Eisai’s and Pfizer’s (PFE) Aricept for cancer and Alzheimer’s. But I believe the biggest impact the Brits are having is on product life management.

Nick Scott-Ram (biotech industry consultant) complains about NICE: “Developing a new drug is very expensive, even if it is only a minor improvement on existing products, but if NICE compares its price with an earlier drug in the class it will often come out uneconomic. It’s even worse if the first-in-class product has become generic and thus much cheaper.”

Pharmaceuticals is the only industry that expects to be paid as much for product life cycle management as true innovation. Controlled or extended release versions of drugs often launch just before patent expirations. Doctors are then converted to the “new and improved”, higher priced extended release versions, and the first generation drug is removed from the market. NICE puts the brakes on pay for convenience and life cycle management.

Pharma claims they want to operate in the free market. Let’s compare the drug industry with the rest of the free market. How much extra would you pay for the annual release of the new and improved version of Tide laundry detergent? Governments must make value judgments precisely because consumers cannot buy drugs the way they buy laundry detergent. Consumers should not be forced to pay up for meaningless innovation.

Remember the doctor chooses medications, and the consumer or their insurer pays the bill. Pharma has to convince doctors of the value of innovation in order to make the sales. The doctor does not care about product prices.

Real innovations are totally new products, significantly reducing patient suffering and significantly extending patient life. The drug industry is only entitled to operate in a free market if they bring forth true innovation. Don’t forget the US National Institutes of Health (NIH) has been responsible for a substantial portion of pharmaceutical innovation.

I would like to conclude with a few words about biotechnology. Monoclonal antibodies (or mAb), the primary technology of Genentech (DNA), Medimune (AZN) and other large biotechs is becoming commonplace. The public will soon resist paying premium prices for commonplace technology. Investors should consider moving from “old biotech” to the leaders in RNA based drugs, such as ISIS.

Disclosure: Author is long ISIS and PFE.