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Timeline of US Marijuana Laws

California Is Different from Other Legalized States

Description and Implications of CA Legislation

Marijuana Supply Chain Regulations and Realities

Players of the CA Market Transition Game

CA Market Evolution to Date

Future Market Evolution

 

California is currently transitioning from illegal and semi-legal markets for marijuana to legal markets. The black and grey markets for marijuana in California are enormous in both size and scope. For the State to successfully transition to a legal market, it must reign in the size and scope of black market activity. Will the State be able to do this?

Key players in the Marijuana Transition Game include:

• State and Local Governments
• Marijuana Growers
• Marijuana Distributors
• Marijuana Dispensaries/Retailers
• Recreational Users
• Medical Users
• Black Market Suppliers

This analysis examines how the market has evolved to date and how we think the market will continue to evolve in the future.

Timeline of US Marijuana Laws

Timeline information comes from Wikipedia.

Federal

1937: The Marihuana Tax Act is enacted, effectively prohibiting cannabis at the federal level. Although medical use is still permitted, new fees and regulatory requirements significantly curtail its use.

1970: The Controlled Substances Act is enacted, officially prohibiting cannabis for any use (medical included) at the federal level.

2014: The Rohrabacher–Farr amendment was signed into law, prohibiting the Justice Department from interfering with the implementation of state medical cannabis laws.

State

1911: Prohibition begins

1973: Decriminalization begins

1996: Medical cannabis begins

2012: Recreational legalization begins

Figure 1: Legality of Cannabis by State

Source: Lokal_Profil, CC BY-SA 2.5, https://commons.wikimedia.org/w/index.php?curid=2370050

Tax Rates

Taxes on cannabis include

• Cultivation taxes paid by growers
• State excise taxes paid by either dispensaries or users
• State sales tax paid by users
• Local taxes paid by users

Figure 2 compares tax rates across states than have legalized cannabis activity.

Figure 2: Cannabis Tax Rates by State

 

California Is Different from Other Legalized States

Colorado and Washington were the first states to legalize marijuana for recreational use, in 2012. Alaska and Oregon followed suit in 2014, and California, Nevada, Maine and Massachusetts did so in 2016. Many believe the transition in California from illegal to legal recreational marijuana use should be easy, since Colorado, Washington, Alaska, and Oregon have all paved the way. California simply has to follow the lessons these earlier legalizing states have learned from their experiences.

The California Growers Association disagrees. In its report, “An Emerging Crisis: Barriers To Entry In California Cannabis,” the Association claims California is in a unique situation: California currently has over 60,000 cannabis farmers who produce more than 15 million pounds of cannabis annually. Whereas other states must simply establish a legal market for cultivation and sales, California must transition a humongous, established market from illegal (black market) and semi-legal (grey market) to fully legal.

While there are some lessons to be learned from other states that are regulating cannabis, California is an outlier. Our state has the most robust and productive cannabis industry of any state. Other states replaced an illicit import based market with domestic production whereas California must transition an existing unregulated marketplace.

To boot, the Association believes the transition must involve a decrease in cannabis production, not an increase, as is the case in other states that have legalized recreational use.

California produces more than 15 million pounds of cannabis per year. The state consumes less than 3 million... There may be some growth in demand thanks to new consumers, but it is widely estimated that such growth will be modest because most people in California have had access to cannabis in the past. These factors point to the need to reduce production if regulation is to succeed.

Cannabis supply in California ($23.3 billion) is so extensive that it is not only the largest cash crop in California, but it is also larger than the next 5 largest cash crops combined ($22.2 billion). From StoptheDrugWar.org,

Using cash farm receipt data from the state Department of Food and Agriculture for ag crops and its own estimate of in-state pot production … the Register pegs the value of California's marijuana crop at more than the top five leading agricultural commodities combined.

Here's how it breaks down, in billions of dollars:

• Marijuana -- $23.3
• Milk -- $6.28
• Almonds -- $5.33
• Grapes -- $4.95
• Cattle, calves -- $3.39
• Lettuce -- $2.25 

In “5 Things To Expect From California’s Gray Market Marijuana Crackdown,” Hilary Bricken emphasizes that California’s legal market for marijuana will only be successful, if it reduces, if not eliminates, existing black and grey markets. Otherwise, legal suppliers will be shut down by alternative sources of supply that don’t bear the same “financial pinch and responsibility of comprehensive licensing regulations and robust taxation”.

 

Description and Implications of CA Legislation

Let’s get a better understanding of the timeline of cannabis regulation in California, together with the laws’ impacts on the evolution of the cannabis market.

In 1996, California voters passed Proposition 215, also known as the Compassionate Use Act (CUA) of 1996. According to Ballotpedia.org,

It [Prop 215] exempts patients and defined caregivers who possess or cultivate marijuana for medical treatment recommended by a physician from criminal laws which otherwise prohibit possession or cultivation of marijuana.

At the time Prop 215 was passed, everyone knew the law was “poorly written”: holes in the law created opportunities for black market activities. In particular, the law didn’t clearly define how to identify an exempt user or how to define an exempt supplier. As Brian Brunkow notes in “Medical Marijuana Mayhem,”

However, the CUA was vague in certain respects: Most importantly, it did not create a means for identifying those eligible to transport, possess and use medical marijuana thus creating confusion for local and state law enforcement.

An LA Times article, “Medical marijuana in California: a history,” noted

About four weeks before the 1996 general election, Sen. Diane Feinstein said what would become the mantra of anti-medical marijuana forces. She said Proposition 215 was so poorly written that "you'll be able to drive a truckload of marijuana through the holes in it. While its seems simple, the devil is in the details or, in this particular bill, the lack of details."

In 2003, California passed Senate Bill 420, which was an attempt to clarify some of the ambiguities in Prop 215. In particular, under SB 240, “every cultivation facility, dispensary, and other canna-business theoretically functions as a patients cooperative or collective.” Unfortunately, SB 420 didn’t help clarify the situation much. Madison Margolin explains in “WTF Is Going On with Medical Marijuana in California? An Explainer”:

Since 2004, when SB 420 went into effect, the idea has been that every cultivation facility, dispensary, and other canna-business theoretically functions as a patients cooperative or collective. In practice, there's been a great deal of debate about defining profit and what constitutes a reasonable amount of cannabis.

Much illegal cannabis activity – cultivating and selling – occurs under the guise of legal cooperatives and collectives. As Brian Brunkow indicates,

Needless to say, law enforcement is concerned with criminals and drug cartels creatively piggybacking this state law exemption for illegal marijuana distribution as well as legitimate collectives and cooperatives turning a profit.

On March 18, 2009, Attorney General Eric Holder announced "a shift in the enforcement of federal drug laws, saying the administration would effectively end the Bush administration’s frequent raids on distributors of medical marijuana" (see, for example, this source). “The Ogden Memo” laid out the new guidelines on Federal enforcement (or, more accurately, lack thereof) of marijuana laws. The effects of the shift in policy were predictable: a boom in cannabis supply. As Ryan Grim and Ryan J. Reilly indicate in “Obama’s Drug War: After Medical Marijuana Mess, Feds Face Big Decision On Pot”:

“Nobody can argue that the number of medical marijuana shops in California and Colorado didn’t grow at an exponential rate directly because of this” Ogden memo, said a former senior White House official who worked on drug policy…

In 2016 California voters passed Proposition 64, the Adult Use of Marijuana Act, legalizing the recreational use of marijuana in the state. Prop 64 went into effect as of January 1, 2018. Under Prop 64, criminal immunity for cooperatives and collectives established under the CUA ends as of January 2019 (see, for example, this source).

 

Marijuana Supply Chain Regulations and Realities

Before we can understand how we think the players in the Market Transition Game will act, we need to understand the rules of the game, that is, the regulatory requirements for marijuana market participants. Figure 3 illustrates the cannabis supply chain associated with licensed cannabis activity.

Figure 3: California Marijuana Supply Chain

• Growers, Manufacturers, Dispensaries, Distributors, and Testing Labs must all be licensed by Local (City or County) and State governments (Bureau Of Cannabis Control Proposed Text Of Regulations).

• Any transport of cannabis samples or products between suppliers in the supply chain must be conducted by a Licensed Distributor (Bureau Of Cannabis Control Proposed Text Of Regulations). However, there is a shortage of licensed Distributors relative to demand. This shortage increases costs of business and creates a bottleneck for delivery services. The California Growers Association provides more detail:

From seed to sale, a given cannabis product is likely to pass though at least five, and sometimes more than ten, separate licensed businesses. At each step in the supply chain, the product must be transported by a licensed distributor. A shortage of licensed distributors acts as a brake on the entire supply chain, resulting in severe bottlenecks.

• Before being shipped to Retailers, samples from all cannabis products must be tested at a licensed Testing Lab for potency and contamination (Bureau Of Cannabis Control Proposed Text Of Regulations). There is also a shortage of licensed Testing Labs, which is further contributing to increases in the time and money costs of moving supplies of cannabis through the supply chain.

• All cannabis products are tracked from seed to sale by tracking software (METRC).

• Since cannabis is classified as a Schedule I drug, the Federal government has the power to sanction National Banks for servicing cannabis businesses. This means most cannabis businesses cannot get bank loans, cannot access bank accounts, and cannot use credit cards. As a result, most cannabis businesses are cash businesses, which creates large security risks (see, for example, “Why marijuana retailers can’t use banks”).

• Since cannabis is classified as a Schedule I drug, Tax Code Section 280e applies:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

   In short, no business expenses are tax deductible. Income tax must be paid on gross revenues less cost of goods sold. Income taxes for licensed business are thus substantial.

• In practice, legal cannabis businesses tend to incur high costs for legal and accounting services in an effort to comply with all laws and regulations. In “Legal Cannabis Entrepreneurs in California Get a Rude Awakening: A Thriving Black Market,” Will Yakowicz summarizes the situation faced by dispensaries:

Beyond permit costs, the even bigger inhibitor is the financial reality of being part of a regulated industry. Under U.S. tax code 280e, many marijuana companies pay effective tax rates as high as 60 percent …, they have to also "pay for security measures, mandatory product testing, licensing fees, taxes, employee benefits."

The high taxes and regulatory costs faced by Legal Suppliers gives Black Market Suppliers a large price advantage, as shown in Figure 4.

Figure 4: Price of Illegal vs. Legal Marijuana

High prices in dispensaries relative to those on the street are being blamed for User diversion to the Black Market. This diversion, as the argument goes, was a large contributing factor to the shortfall in tax revenues collected during the first part of the year (see, for example, “California Pot Revenue is Lower Than Forecast. Are Taxes Too High?”).

 

Players of the CA Market Transition Game

Figure 5 illustrates the Marijuana Market Transition Game. Players in the game that are not included in the regulatory supply chain (Figure 3) are In-State and Out-of-State Black Market Suppliers. In this section, we discuss the situation (environment) each player faces.

Figure 5: Marijuana Market Transition Game

The State

• The State establishes supply chain rules to ensure every gram of product from seed to sale is accounted for.

• The State cares that no product is diverted into or out of the legal supply chain.

• The State cares that only licensed suppliers and legal customers have access.

• The State cares that all licenses are filed, regulations are followed, and taxes are paid.

County/City

• Counties and incorporated Cities may have their own local policies for regulating commercial cannabis activities. Specifically, local entities may either approve or ban (i) cultivation, (ii) manufacturing, and/or (iii) retail activity in their jurisdictions.

• Counties and incorporated Cities care that the cultivation, manufacture and sale of cannabis do not impose upon minors nor upon taxpayers who would like to live free of cannabis interference.

To date, most cities and counties have chosen to ban cannabis activities in their jurisdictions. Chris Moore provides more detail in “Despite Statewide Legalization, Many California Towns Have Banned Marijuana”:

Prop 64 also allows individual municipalities to “opt out” of allowing legal canna-businesses in their jurisdictions, and a surprising majority of towns and cities have chosen to do just that.

… fewer than one-fifth [20%] of all California cities allow medical cannabis dispensaries, and fewer than one in seven [14%] allow recreational pot stores. Less than 10% of all California cities allow any type of canna-business to operate in their jurisdiction…

In “California’s Cannabis Cities Reap Millions in Sales Taxes, the Rest Miss Out,” Dan Mitchell claims that the large portion of cities that have opted out of the game has contributed to shortfalls in state tax revenues relative to projected levels.

Figure 6 shows how many cannabis licenses have been granted to date in California for each type of business. Note that not all licenses represent active businesses. Distributors (must transport all flows of cannabis between suppliers) and Testing Labs (must test samples from all products supplied to Dispensaries) play central roles in the supply chain. As such, the state needs large numbers of these two sets of licensees to avoid bottlenecks. To date, shortages of licensed Distributors and Testing Labs have impeded flows of cannabis through the system. In fact, suppliers have modified their actions in response to the bottlenecks. Specific responses are discussed in subsequent sections.

Figure 6: Cannabis Licenses Granted: State of California

Cultivators

“Cultivation” means any activity involving the planting, growing, harvesting, drying, curing, grading, or trimming of cannabis.

• Cultivators care about generating profits (or at least not generating losses) on their activities.

   Many cultivators are cultivating cannabis solely for the benefit of medical users. Many of these growers are not interested in generating profits, but rather, only want to cover their costs.

• Licensed Cultivators care about being compliant with the County/City and the State so they don’t lose their licenses.

While the California Growers Association claims there are over 60,000 cannabis growers in the state, only 6,000 cultivator licenses have been issued to date (see Figure 6 above). In the Report cited above from  The California Growers Association, a Sonoma County Cultivator has this to say:

The unintended consequence of making it so difficult at the local and state level to enter the regulated market is that 80-90% of those who were working with dispensaries prior to 1/1/2018 are being pushed to the black market.

   In “Legal Cannabis Entrepreneurs in California Get a Rude Awakening: A Thriving Black Market,” Will Yakowicz iterates the idea that high regulatory costs are barring small growers from becoming licensed.

Nat Buttrick, the co-founder and CEO of Madrone California, a licensed collective of small cannabis farmers, says many businesses are deciding not to get permits--which can cost between $5,000 and $120,000 a year depending on the size and scope of a business--because they don't have enough crops to justify the cost. Equally, if their current parcels of land are not zoned for marijuana growing under the new rules, they don't have the resources to move.

• Many Cultivators care about nuances in the mode of cannabis consumption and the effects of THC, CBD and other cannabinoids and terpenes, as well as differentiating their products for customers.

The potency, or concentration, of cannabinoids in cannabis plants has been increasing over time (see Figure 7). Samples of cannabis seized by the Drug Enforcement Agency (DEA) have been tested for potency. Tests indicate that average THC-group potency has increased from less than 1% in 1975 to about 12% in 2014. Increases in potency have generally been due to improvements in cannabis breeding, cultivating, and processing techniques.

Figure 7: Concentrations of Cannabinoids over Time in Cannabis Seized by DEA

Furthermore, researchers are discovering more about the nuances of cannabinoids and terpenes, and how interactions among particular profiles of compounds better address specific medical conditions. As the research develops, cannabis products are becoming more nuanced, so as to address specific needs of Users. That is, there is a trend toward more differentiation and diversification of products.

At the same time, however, the nature of regulations on legalized markets have increasingly pushed small, “artisan” Growers out of the market in favor of larger operations. For example, the Sonoma County Cultivator in The California Growers Association cited above lamented that the “artisan Cultivators and Manufacturers who were creating diverse, boutique products” are being cut out of the market by the burdensome regulatory requirements.

Finally, shortages of both Distributors and Testing Labs are leading Growers to aggregate batches to minimize testing costs and times delays. The aggregation of batches decreases product variety, which decreases suppliers’ abilities to best meet users’ needs. The California Growers describe this problem in more detail.

Together, these testing burdens [A shortage of licensed testing labs and a shortage of licensed distributors] create perverse and unintended incentives: to avoid excessive testing costs, some smaller producers been pushed towards monocropping or consolidating production into larger batch sizes. These practices create harms for both cultivators and consumers. From the cultivator’s perspective, it becomes more difficult to produce a diversity of strains that the market demands, and the push towards larger batches decreases quality. From the customer’s perspective, choices and quality are reduced. The most severe impacts are on patients who require access to specific strains to treat their medical conditions.

Manufacturers

“Manufacturer” means a person that conducts the production, preparation, propagation, or compounding of manufactured cannabis or cannabis products either directly or indirectly or by extraction methods, or independently by means of chemical synthesis or by a combination of extraction and chemical synthesis at a fixed location that packages or repackages cannabis or cannabis products or labels or relabels its container.

Cannabis Cultivators grow cannabis plants, then dry and cure them. Most cannabis is sold in this dried and cured form for use by customers. Increasingly, however, cannabis is being processed into concentrates, which is then used to produce dabs, tinctures, topicals, and edibles. Manufacturers either grow their own cannabis or they buy it from Cultivators and then process it into concentrates, dabs, tinctures, topicals, and edibles.

• Manufacturers care about being compliant with the County/City and the State so they don’t lose their licenses

• Manufacturers care about nuances in the mode of cannabis consumption and the effects of THC, CBD and other cannabinoids and terpenes, as well as differentiating their products for Customers.

Distributors

“Distributor” means a person licensed … to engage in the business of purchasing cannabis from a licensed cultivator, or cannabis products from a licensed manufacturer, for sale to a licensed dispensary.

• Licensed Distributors are responsible for all transportation of cannabis samples and products between suppliers in the supply chain.

• Licensed Distributors are responsible for collecting and remitting cultivation and excise taxes to the California Department of Tax and Fee Administration (CDTFA)

• Licensed Distributors are responsible for arranging for testing of cannabis samples to certify products before they can be shipped to Dispensaries.

• Services of Distributors
  • Storage
  • Transportation
  • Coordination of 3rd Party Testing
  • Branding & Package Design
  • Quality Assurance of Packaging and Labeling

• Licensed Distributors care about being compliant with the County/City and the State so they don’t lose their licenses

Suppliers rely on Licensed Distributors for having Suppliers’ products tested and delivered to Dispensaries in a timely manner. There are too few Licensed Distributors relative to demand. Contributing to the shortage is the fact that many of the Licensed Distributors are also Licensed Suppliers (Cultivators, Manufacturers, or Dispensaries). These multi-licensed Distributors focus on transporting their own products through the supply chain, which leaves fewer Distributors to transport other suppliers’ products. The California Growers provides more details about the situation:

We conducted a review of the 192 full-service distribution licensees as of February 2018 and found that at least 133 of them (69%) could be confirmed as controlling at least one additional non-distribution permit... In many cases, vertically-integrated businesses in this category are concerned primarily with transporting their own product, and don’t substantially add to the transportation capacity of the supply chain as a whole.

This shortage of Licensed Distributors could lead to a situation in which Suppliers are forced to vertically integrate into distribution so as to ensure timely delivery of their products. This would further raise the costs of new entry into the market and increase the probability the market ends up consolidating into large, vertically integrated providers.

Testing Labs

“Testing laboratory” means the premises where tests are performed on cannabis or cannabis products and that holds a valid certificate of accreditation.

• Some Testing Labs care about instrument calibration and generating accurate test results

• Testing Labs care about testing and reporting compliance

As mentioned, a shortage of testing labs is currently creating a backlog in testing and delaying supplies from reaching Dispensaries. Chris Moore, “California Cannabis Industry Faces Supply Shortage Due to Testing Backlog”

The safety testing regulations are one of the biggest hurdles that legal Cali canna-businesses must face. Every cannabis product available for sale at over 400 licensed retailers in the state must be tested for pesticides, potency, and pathogens, but there are currently only 31 testing facilities licensed to do so. As expected, this is creating a serious backlog, and retailers are struggling to keep their shelves stocked.

In “Analyzing Cannabis,” Bethany Halford claims that one of the reasons for the scarcity in Testing Labs is the fact that marijuana is illegal under Federal law. Its illegal status has caused established labs to “shy away from the budding marijuana market” to avoid being shut down by the Drug Enforcement Administration (DEA). “The void is being filled mostly by small labs dedicated solely to testing cannabis.”

Chris Moore further indicates that the “strict new rules on product safety testing are causing delays in the supply chain, convincing some customers to buy their weed on the black market.”

California requires cannabis products to be tested for potency and safety before being shipped to Retailers. However, testing results on the same sample vary from lab to lab, according to Michael Zoorob and Nick Jikomes in, “How will you know if there’s E. coli in your marijuana? No one’s figured out how to test and regulate it yet.” Bethany Halford indicates this variance is due at least in part to the fact that different labs use different means of testing (e.g., HPLC, GC, UPLC, UPC²). The problem persists, Debra Borchardt claims in “Cannabis Lab Testing Is The Industry's Dirty Little Secret,” because the State does not enforce the precision of lab results.

The labs themselves aren't inspected or graded by any agencies and customers have no idea whether or not products were tested at a reputable lab. Some believe that the problem is standardization, but there are plenty of state standards -- the real problem is enforcement.

Given the loose enforcement of standards, Testing Labs have incentives to cheat on the reported results. Since precision is costly, Labs can decrease their precision to offer Growers lower prices, and/or they can increase the reported cannabinoid concentrations to cater to Recreational Users’ demand for potency. As Michael Zoorob and Nick Jikomes explain:

Testing presents some complicated questions. Precision is costly, and states haven’t set standards about how much precision is required. Labs have incentives to charge growers lower prices — and, therefore, deliver less precise answers — and to report more THC and CBD, since cannabinoid-rich products sell for more.

There is a safety element here, too. Studies have found that the labeled potencies of cannabinoids on products don’t match the actual potencies of the product (see Figure 8). If Users are misinformed about product potency, they will end up miscalculating doses and not achieving the benefits they seek.

Figure 8: Study Results: Labeling Accuracy of Cannabis Products

Dispensaries/Retailers

“Dispensary” means a premises where cannabis, cannabis products, or devices for the use of cannabis or cannabis products are offered, either individually or in any combination, for retail sale, including an establishment that delivers cannabis and cannabis products as part of a retail sale.

• Dispensaries care about being compliant with the State so they don’t lose their licenses

• Dispensaries care about nuances in the mode of cannabis consumption and the effects of THC, CBD and other cannabinoids and terpenes, as well as differentiating their products for Customers.

Currently, one of the hottest jobs in the San Francisco Bay Area is that of Budtender. Budtenders help buyers in cannabis dispensaries find the right products to meet their needs. As Mike Adams states in, “Marijuana Industry Needs More Budtenders -- Here's How To Get The Job”

One of the most in-demand positions on the scene is the front-of-the-house-sales-professionals known as Budtenders.

These men and women are the first point of contact for a customer when they step inside a dispensary – they are the faces representing what legal marijuana is all about in its newly legal climate. These rock star consultants assist the consumer in a variety of ways: answering questions regarding the various cannabis products, offering up product recommendations, as well as providing them with expert advice over dosage and product safety.

Recreational Users

• Recreational Users care about product quality, particularly, potency and safety.

• Recreational Users care about the mode of cannabis consumption and the effects of THC, CBD and other cannabinoids & terpenes.

To give you an idea of how cannabis products are being advertised, and thus what’s presumably important to Recreational Users, here’s an example of a cannabis product description on Leafly:

Blue Dream, a sativa-dominant hybrid originating in California, has achieved legendary status among West Coast strains. Crossing a Blueberry indica with the sativa Haze, Blue Dream balances full-body relaxation with gentle cerebral invigoration. Novice and veteran consumers alike enjoy the level effects of Blue Dream, which ease you gently into a calm euphoria. Some Blue Dream phenotypes express a more indica-like look and feel, but the sativa-leaning variety remains most prevalent.

With a sweet berry aroma redolent of its Blueberry parent, Blue Dream delivers swift symptom relief without heavy sedative effects. This makes Blue Dream a popular daytime medicine for patients treating pain, depression, nausea, and other ailments requiring a high THC strain.

Medical Users

• Medical Users care about product quality, particularly, sample profile and safety.

• Medical Users care about how well the product addresses their medical symptoms, that is, the nuances of THC, CBD, other cannabinoids, and terpenes interrelationships

To give you an idea of how cannabis products are being advertised, and thus what’s presumably important to Medical Users, here’s an example of a cannabis product description on Curaleaf:

Aqua Tincture

(2:1) Tincture

A form of medication that is designed to take under the tongue, but may also be added to liquids such as tea or coffee. Patients can see effects of the medication in as quickly as 15 minutes.

UNIT: 30 ml

Ingredients: Ethanol, Propylene Glycol, Citric Acid

Available ratios:

2:1 (THC:CBD)

THC 8mg per 2 ml

CBD 4mg per 2ml

Black Market Suppliers

Black Market Suppliers are not licensed by the County/City or State. They either cultivate their own supplies of cannabis or buy cannabis from Cultivators, and they sell their products to Users, located either within the state or outside the state.

• Black Market Suppliers care about risk and about providing customers convenience, trust, and/or low prices.

On risk: From Trevor Hughes, “Marijuana's legalization fuels black market in other states”

"The cartel's going to grow their marijuana in California because the risk is minimal," said Paul Bennett, a lieutenant with the Riverside County Sheriff’s Department in California. "We have immediately seen and began to experience an increase in these large-scale ... plantations where 10,000, 25,000 plants are just growing in the open on public lands."

Legalizing marijuana at a state level has made the logistics of drug trafficking easier for cartels, Bennett said. They face only misdemeanor penalties in California and no longer need to worry about getting the drug through border security.

On trust: From Briar Stewart, “Why Colorado's black market for marijuana is booming 4 years after legalization”:

The results of Bolivar's Facebook survey suggested nearly 50 per cent of the respondents were not shopping at the state's licensed dispensaries. Bolivar says most are buying their pot off of friends or sticking to their regular dealers because they trust them.

On Price: From Chris Frey, “'I deliver to your house': pot dealers on why legalization won't kill the black market” referring to Canadian market activity:

What’s the key factor in determining whether the black market will continue? Is it price? Quality? Ease of access? Ministers have discussed $10/g, but the average street price nationally is only $7/g.

Ray: Price is 90% of it. The majority of people aren’t connoisseurs and don’t have a lot of money to spend on pot. They want a good deal and don’t care, or know, much about quality. If the government prices pot too high you’re not giving those people an option, so they will stick with the black market. I’m still going to deal with the regular people I deal with: people who go to work everyday and just want to smoke a little pot, but don’t want to pay the astronomical prices the government is going to charge.

On Convenience: From Chris Frey

What about convenience? Alberta is talking about having 250 storefronts, but Quebec only 15 – to service 8.2 million people.

Ray: We’ve had this period in Toronto where it seemed like illegal dispensaries were opening on almost every block. Now Ontario will have, what, something like 40 [government-operated] stores to start? There’s no way they’ll be as convenient for consumers. Once they shut down the illegal dispensaries it will just level the playing field for dealers like me. And I deliver to your home.

 

CA Market Evolution to Date

1996 – 2017

In 1996, Prop 215 legalized cannabis for medical use, but there was little government oversight of market activities. Under Prop 215, collectives and cooperatives proliferated, and many served as cover for illegal activities. Without government enforcement and without testing requirements, grey market activity thrived, but supply was of inconsistent and uncertain quality. As Chris Moore describes the situation,

The state's original medical cannabis law [Prop 215, 1996] imposed few restrictions on cannabis cultivators or processors... When the recreational adult use market legalized by Proposition 64 came into full effect this January [2018], it came with a raft of new guidelines, regulations, and restrictions that before now were foreign to the state's cannabis industry.

…

“Prior to these regulations, you could mix whatever you want in whatever you want, label it and sell it. So, it’s kind of a mixed bag of what you get,” Robert Brodnick, chief scientific officer at cannabis testing company Pharm Labs.

Jan 2018 – Aug 2018

As of January 1, 2018, suppliers in the newly expanded market under Prop 64 faced, as Chris Moore puts it, “a raft of new guidelines, regulations, and restrictions that before now were foreign to the state's cannabis industry.” The State was slow to issue licenses, which hampered the onset of cannabis activity. Also, as described earlier, the new regulations required all transport of cannabis products to be conducted by Licensed Distributors, and all products supplied to dispensaries to be tested at Testing Labs. Shortages in Licensed Distributors and Licensed Testing Labs have created bottlenecks in the supply chain, which have also hampered the flow of activity. Finally, the unexpected choice of most Counties/Cities to ban cannabis activities in their jurisdictions have also resulted in lower levels of activity – not to mention tax revenues for the State.

In the meantime, as the legal market has struggled to emerge, and given the high costs of regulations and taxes, the black market has continued to thrive.

Unexpected Actions by Players

The State: The regulations and taxes have ended up being extremely burdensome to industry suppliers. The supply chain is clogged, creating shortages of supply. Small players can’t afford the costs of licensing and regulations, leading to market dominance by large suppliers. And the high costs of regulations and taxes are driving Users to cheaper and more convenient Black Market Suppliers.

Cities: Most Cities have opted to ban cannabis activity within their jurisdictions.

Growers: The intention of the State was to issue licenses to small growers so as to prevent industry consolidation and market power by large suppliers. However, changes in the regulations have enabled growers to aggregate many small plots into large plots. As The California Growers Association describes it,

Prop 64 promised five-year prohibition on large- scale cultivation businesses. Following the decision to remove the cumulative one-acre cap from the emergency CDFA regulations, however, this prohibition is effectively irrelevant. A large-scale cultivation operation may now stack unlimited numbers of “small” cultivation license to grow an unlimited canopy area.

Large growers tend to create more commoditized products using industrial methods, whereas small growers provide niche, “artisan” products using traditional techniques. By aggregating cultivation into large plots, cultivation is thus evolving into industrial agriculture, with loss of biodiversity and increasing use of pesticides and synthetic fertilizers.

Distributors: If the industry continues to face a shortage of independent Distributors, more industry participants – Cultivators, Manufacturers, and Dispensaries – will vertically integrate into distribution to enable their own supply to move through the system in a timely manner. This will increase the cost of entry into the market and lead to industry consolidation.

Testing Labs: A shortage of licensed Testing Labs is increasing the time and money costs to Suppliers of testing. Suppliers have reacted by aggregating small batches into larger ones, decreasing product diversity in the process. Lack of standards and methods for testing have led to inaccuracies and corruption in the testing industry, to the extent that most products are inaccurately labeled as to potency, and perhaps also safety.

 

Future Market Evolution

 How Must Current Markets Evolve for the Legal Market to Thrive?

The current advantages and disadvantages of buying from Black Markets (Street) vs. Legal Markets (Dispensary) are summarized in Figure 9.

Figure 9: Street vs. Dispensary Cannabis: Advantages and Disadvantages

 

The larger is the size of the Black Market, the greater will be the threat it poses to Legal Market activity. A larger Black Market means lower prices and greater convenience to Users. It follows that the State must minimize the size of the Black Market to ensure the Legal Market thrives.

At present, however, there are ten times more unlicensed established growers than there are licensed growers. To minimize Black Market supply, the State must therefore find a way to bring the unlicensed growers into the legal market.

The existing growers who have foregone licenses have done so in large part for two reasons. First, the high costs of licensing and regulation have made it cost-prohibitive for small growers to become licensed. And second, high tax rates on legal cannabis are driving Users to the Black Market, that is Black Market demand provides profit opportunities for unlicensed growers. It follows that the State needs to find a way to reduce the regulatory burden on small growers. As for tax rates, some states have decreased tax rates below their initial levels at the request of both Suppliers and Users. In “Why State Marijuana Taxes Are Coming Down,” Dan Caplinger indicates that “Alaska, Colorado, and Oregon have all taken steps to reduce their tax rates on marijuana.”

At the same time, the current (Legal + Black Market) supply of cannabis is five times as large as the amount consumed by California Users. To minimize Black Market supply, the State must therefore find a way to reduce the supply of cannabis down to meet demand. On the other hand, most Cities have banned cannabis activity. It might therefore be easier for the State to convince more Cities to legalize cannabis activity (especially since this would generate more tax revenues for the State), thereby increasing demand towards supply. However, as noted earlier, shifting supply from the Black Market to the Legal Market won’t address the oversupply problem.

Realistically, Cities would be better off legalizing cannabis activity within their jurisdictions. By keeping cannabis activity illegal, Cities simply help existing Black Markets to thrive. Cities would be better off by legalizing and regulating the activities that already exist, not to mention generating revenues in the process.

There’s an interesting externality here: By banning cannabis activity within its jurisdiction, a City increases the size of the Black Market, thereby increasing the robustness and threat of Black Market activity to other Cities. Conversely, if all Cities were to legalize cannabis activity, it would substantially increase Legal Market supply, thereby decreasing prices and increasing convenience to Users, both of which would threaten Black Market supply.

To ease congestion in the supply chain, the State must find a way to increase the supply of Independent Licensed Distributors and Licensed Testing Labs. Finally, for obvious safety reasons, the State needs to find a way to increase the accuracy of labeled products. This could be accomplished by establishing standard operating protocols, monitoring labels for accuracy, and holding Testing Labs accountable for inaccurately reported information.

While the State can take several actions to increase legal supply relative to demand, it will be difficult to radically reduce the size of the Black Market. Given its current size and scope, it would take huge amounts of manpower to enforce the laws, to root out and shut down all the various illegal operations. Yet, the State simply doesn’t have the resources to accomplish this (see, for example, “Surge in Illegal California Pot Shops Undercuts Legal Market”.)

How Might Black Market Suppliers React to Licensed Competitors?

As long as Black Market Suppliers can undercut Legal Market Suppliers on price, Black Market Suppliers will have customers. Given the high costs of regulation and taxes, Black Market Suppliers will always have a price advantage over Legal Market Suppliers (see Figure 4).

Second, as long as there are Users who don’t want to be identified as cannabis Users, Black Market Suppliers will have customers. For example, in “Why Colorado's black market for marijuana is booming 4 years after legalization,” Briar Stewart talked to a drug dealer in Colorado.

He [the dealer] says legalization hasn't had a big impact on his business because he caters to clients who don't want to be seen going into a dispensary.

"I have had nurses that have contacted me via the internet and have a delivery brought to their home or their office or wherever they feel comfortable," he said.

His clientele also includes a number of truck drivers, who are prohibited from using marijuana under federal transportation laws.

Third, as long as Black Market Suppliers can offer more convenience to Users than Legal Market Suppliers, Black Market Suppliers will always have customers. In particular, Licensed Suppliers are only able to operate between 6 am and 10 pm. If Users want to buy cannabis during off hours, they will turn to Black Market Suppliers. Matt Garrison makes this point in, “California’s high taxes and regulation mean black market for marijuana is still appealing”:

… the Bureau of Cannabis Control’s mandated retail hours of 6 a.m.-to-10 p.m. for both medical and adult recreational use retailers is arbitrary and improper... By artificially prohibiting access during the times of day when intoxicant consumption peaks, the regulation encourages a black market for cannabis sales during those late-night hours.

Fourth, as long as cannabis remains illegal in some states, Black Market growers will continue to grow cannabis in legal states for export to illegal states.

Unless or until legal jurisdictions are able to put more resources into fighting the black market, Black Market Suppliers will find it profitable to supply Users.