Hooked on rebates?: CNBC UK Exchange newsletter

This report is from this week’s CNBC’s UK Exchange newsletter. Each Wednesday, Ian King brings you expert insights on the most important business stories from the U.K. and other key developments you won’t want to miss. Like what you see? You can subscribe here.

In AstraZeneca and GSK, the country boasts two of the world’s 15 largest pharmaceutical companies — only the United States and Switzerland can match that — and, in Cambridge, Oxford and Imperial College London, three of the world’s top 10 universities for life sciences. It is also one of the top five global investment destinations for life sciences research.

Beneath the surface, though, all is not well. Relations between the government and the U.K. pharmaceuticals industry — whose trade body, as well as AZ and GSK, includes the domestic arms of multinationals like Pfizer, Sanofi, Merck, Eli Lilly and Bristol-Myers Squibb — have frayed over the issue of drug pricing.

Most branded medicines in the U.K. are bought by the state-run National Health Service (NHS). Thanks to its size — it accounts for roughly 85% of healthcare spending — the NHS enjoys huge buying power.

This has for decades been underpinned by voluntary pricing agreements — voluntary in the sense that non-voluntary terms would have been worse — between the industry and the NHS. The latest of these, the Voluntary Scheme for Branded Medicines Pricing, Access and Growth (VPAG), came into effect in January last year.

Under the scheme, agreed between the government, NHS England and the industry body, the Association of the British Pharmaceutical Industry (ABPI), a cap is set on how much the NHS spends annually on branded medicines. This cap is currently allowed to increase by 2% per year, rising to 4% a year by 2027. To enforce the cap, pharmaceutical companies agree to repay a percentage of drug sales to the NHS via a rebate or “clawback.” Over the last 11 years, this rebate has averaged just over 10%, but in December last year Wes Streeting, the current secretary of state for health, shocked the industry by setting a rate of 23% — significantly ahead of the expected 15%.

The ABPI immediately warned this would put “a very real strain on companies” and put at risk U.K. industry growth and investment.

It pointed out that, at 9% of U.K.’s healthcare spending, the NHS deploys a smaller share of overall healthcare costs on medicines than any comparable country, with France spending 15% and Germany and Italy 17%.

Negotiations have since rumbled on but, 12 days ago, Streeting abandoned talks after the ABPI rejected an offer from him which had included lower rebate rates in all future years of the scheme and a rise in both the price of new medicines and net spending on them.

He told newspapers: “I won’t allow big pharma to rip off our patients or taxpayers.”

It has already soured relations between the government and AZ, whose chief executive, Pascal Soriot, in July announced plans to invest some $50 billion in the U.S (which last year accounted for 43% of the company’s global sales) by 2030 and who followed this up on an earnings call by calling AZ a “very American company”. The significance of this was that, according to reports in The Times, Soriot had privately discussed moving the primary listing of AZ, the biggest company in the FTSE-100, to New York.

While he is the biggest name in U.K. pharma, Soriot is not the only industry leader unhappy at the level of the rebate.

John McGinley, U.K. country president for Pfizer, said in an ABPI report published in March that the unexpected hike in the rebate was “incompatible with the U.K. government’s ambitions to be a global life sciences leader.”

In the same report, Doina Ionescu, Merck’s general manager for the U.K. and Ireland, called the new rate “unaffordable,” adding that it would hamper “our ability to discover innovative medicines and deliver them to patients.”

The latest critic is Johan Kahlström, U.K. managing director of Novartis, who last week told the BBC the U.K. had “become largely uninvestable” for drugmakers.

Lurking in the background is U.S. President Donald Trump. The president has demanded pharma companies cut drug prices in the U.S. to bring them in line with those in Europe and Canada. This price differential largely reflects how the U.S. healthcare system is structured but, nonetheless, has allowed Trump to argue that American patients subsidize their counterparts elsewhere.

Companies like Eli Lilly have said that, for drug prices to fall in the U.S., the price paid for drugs by healthcare systems elsewhere may need to rise. It last week temporarily suspended U.K. shipments of Mounjaro, its weight-loss drug, ahead of a big price increase this month.

So, Trump’s demands intensify the need for drugmakers to extract better terms from the U.K. government. Compounding the problem, they may not want to agree these terms until they know more about Trump’s proposed tariffs on pharmaceutical imports, which are likely to have an inflationary impact on U.S. selling prices and thus put even more pressure on them to raise prices elsewhere.

The row over the rebate may have other unwanted side-effects. It gives drugmakers like AZ an excuse to divert research and development spending to the U.S. as Trump is demanding.

They are also less likely to launch new medicines in the U.K. — something already happening because of another running sore for the industry, namely the criteria used by the National Institute for Health and Care Excellence (NICE), the body accountable to the Department of Health that decides whether new drugs represent good value for money to the NHS.

It all leaves the U.K. government, which has pledged to make the country a “life sciences superpower,” in a bind.

U.K. assets have been suffering in recent days as concerns about the country’s fiscal outlook and debt sustainability returned to the fore. Sterling dropped more than 1% against the U.S. dollar on Tuesday as borrowing costs rose across the board, with the 30-year gilt yield reaching its highest level since 1998.

The FTSE 100 meanwhile continued to fall away from August’s run of record highs. The blue chip index dropped 1.44% last week and has lost another 0.44% since the start of September. That’s amid broader risk aversion in global equities, with steep declines in European stocks as well as on Wall Street.