Valuation of Regulatory Risk on Pharmaceutical R&D

Abstract

Geopolitical tensions, supply-chain concerns and policy risk have moved to the forefront of the pharmaceutical industry. This paper develops a real options valuation model of drug R&D that captures sequential clinical investment with technical failure, stochastic costs, uncertain cash flows, and optimal abandonment. We incorporate two regulatory shocks: a reduction in effective exclusivity period and a price-control shock that reduces net cash flows. Calibrating to an incremental CNS program, we find that project value at initiation is highly right-skewed: the mean is USD 69.6m but the median is negative, so expected value is driven by rare high-upside outcomes. Regulatory risk mainly compresses this upside. Both reductions in effective exclusivity and price-based interventions substantially weaken investment incentives, even when they occur with moderate probability. Value is strongly convex in exclusivity length, with the final years carrying the highest marginal value. We introduce iso-value maps that summarize how time-based and price-based policies substitute in their impact on project valuation, to clarifythe trade-offs inherent in regulatory design: losing two years of exclusivity is comparable to roughly a 30% cash-flow contraction. Using a standard revenue-to-R&D elasticity, these valuation effects imply a 10% to 25% long-run contraction in investment. The framework provides a transparent mapping from policy design to project value and investment incentives.