You hear it every day. If cannabis is legal in California, why does the illicit market still exist? After all, when prohibition ended in 1933 you didn’t continue to see bootleggers running booze across the Canadian border, or rum runners coming up from Cuba, or moonshine stills in urban warehouses. But here we are, almost eight years after adult use legalization in Colorado and Washington and the illicit market is thriving.
In most states, as the following chart illustrates the illicit market is primarily on the sales side
but in certain markets, such as WA, OR, CO, MI, RI, ME, and certainly California, there is a very large illicit market on the production and processing side as well. Cultivators and extractors have been offered the opportunity to join the legal market and put their outlaw days behind them, but the vast majority have opted to remain in the shadows. The question is why? Why put your liberty on the line to continue doing something illegally that could also be done legally? Why purchase your cannabis products from the illegal market when you could just as easily access the same product or many others in different product categories from a retail storefront? There is no one right answer, but rather many answers in California that have led to this result. The simplest way to explain it, is that in order to eradicate an existing market, you must replace it with one that is more efficient.
The first part of this series will address why the inability to create a more efficient marketplace impacts the states ability to destroy the illicit market. The next part of the series will address taxes, and the third will address the change in criminal penalties that have provided a sense of security to those who still operate illegally.
In 1933 when alcohol prohibition was repealed, the bootleggers, rum runners, and organized crime figures did not immediately cede their market share to the legal market. It took creating a more efficient market to migrate the consumer back to the light. This required several key criteria to be addressed. First the consumer needed to have better access to the product. Second, they needed to have greater selection. Third required safety, predictability, and homogenization of product. And fourth, and most importantly, the legal market needed to cost less across the counter than the illegal market. If these criteria were not met, then there still would have been moonshine stills in every neighborhood. In California today, criteria two and three have been satisfied, but one and four are a great distance away. This will require government intervention on behalf of legal cannabis that so far has not materialized as quickly as the industry requires. The result will be that the industry will suffer a great deal more pain before the situation may improve.
From the time that California passed Prop 215 in 1996 legalizing medicinal cannabis until the time that Prop 64 passed in 2016, which legalized adult use cannabis in the state, California did not have a mandated application process for the licensing of cultivation, manufacturing, distributing and dispensing cannabis. Beginning in 2018, the state, through the CDFA and the BCC, began to license cannabis businesses. Unfortunately the license grants were still contingent on the applicant having local approval from either a municipality or, in the case of facilities that are located in an unincorporated municipality, the County. This means that despite cannabis being legal in the State of California, it may not be accessible to the consumer in many cities or counties that have prohibited commercial activity, which at this moment is still the vast majority of cities and counties in the state.
The effect of these commercial bans is that there are very few places that promote cannabis business. By way of example, in Orange County, with a population greater than 3 million people, there are only 2 of 34 cities that allow for cannabis businesses, and only one, Santa Ana, that allows for retail sales. In other cities and counties, businesses may be allowed, as they are in Los Angeles, San Francisco, San Jose, and San Diego, they may be capped as to the number of licenses that are granted which effectively still creates artificial scarcity among operators, especially as it pertains to retail establishments.
By way of comparison, there are currently 434 licensed retailers in Colorado in a population of 5.75 million people. California has a population of 39.5M people, but only had 873 licensed retailers as of September of 2019. That works out to roughly twice as many retail locations in California, but with more than 7.5X the population. Add to this that retail cannabis shops for medicinal and adult use sales only exist in 25% of the states incorporated municipalities and for just adult use in only 61 of the states 482 incorporated municipalities. These statistics are even worse for the areas encapsulated within the unincorporated portions of California’s 58 counties where only 14 of them allow for retail sales. This makes accessing legal cannabis very challenging for the vast majority of California consumers, which was never the intent of the voters when legalizing cannabis for adult use in 2016. In areas where consumers can access legal cannabis, there is often massive saturation in that market. For example, Santa Ana, the one town in all of Orange County that does allow for retail sales, has 17 storefronts, 14 of which are within two miles of one another.
The one major exception to this is on the cultivation side. Here the state was very motivated in migrating illicit cultivators to the legal market. Because there were already so many existing cultivators in the state, specifically in the Emerald Triangle region, the counties of Humboldt, Mendocino, and Trinity as well as several other well known cultivation hot spots such as Santa Cruz, Sonoma, Santa Barbara, and Nevada counties were encouraged to approve cultivation licensees. Local and State law enforcement was supportive of these counties legalizing cannabis cultivation, if for no other reason than it allowed them to identify who and where these cultivators were. Other counties, despite the widespread proliferation of illicit growers, such as Shasta, Tehama, Glenn, and Napa counties continued to ban cultivation effectively relegating all existing cultivators to remain in the illicit market.
Initially in 2018, when licensing first began, the belief was that most cultivators would want to migrate away from the illegal market, if they were allowed to, in order to enter the state licensed market. As alluded to previously, this turned out to be both misguided as the vast majority of outlaws were happy to remain outlaws, but it also underestimated the impact that widespread cultivation licensing would have on the state market if there were not enough retailers to service the consumer. By late 2018 it became obvious that if every cultivator that had applied for a temporary cultivation license actually followed through and were granted an annual license, the net effect would be that California would be producing more than ten times the amount of cannabis that California’s domestic legal market could consume. This made the legal market increasingly less attractive to the commercial cultivator and many of the temporary licensees abandoned their desire to secure a more permanent annual license, as there was no viable market for them to sell into without a large reduction in the price per pound that they were already able to command in the illicit market.
Ultimately this has left California with a glut of producers and a dearth of retailers, creating a market that is unable to achieve any level of equilibrium within the supply chain. In any other industry this would create market competition that would lead to a period of sustained consolidation among cultivators. With cannabis, it has only pushed the cultivators back to the illicit market where they continue to grow cannabis for sale domestically at a significantly lower price point than what they could sell for after the cost of licensing, strict regulation, and high taxes, or to consumers in other states where the economics are even more favorable.
While many municipalities are still in the process of opening their doors to cannabis businesses, including cultivation, extraction, and retail, many more are steadfast in their resolve to reject them. The net effect is that in their NIMBYism, these local lawmakers are only serving to preserve the well entrenched illicit market. It is a head in the sand mentality, where lawmakers surmise that if they do not provide for a legal venue for cannabis businesses in their town, that no cannabis will enter or be sold in their town. This is an obvious fiction, but not one in which many are ready to yet accept. Cannabis dealers from the illicit market are still reaching in to these municipalities to service their consumption demand. These dealers may be unlicensed, but they have a willing market participant in the buyer who appreciates the convenience, price, and lack of tax.
Understanding the nuances of the California market is ultimately the only way to prudently operate or invest in it. If one believes that “if they build it, they will come” applies to California cannabis, they may as well be writing their check and throwing it into the abyss. Launching or supporting a legal operation is not a guaranteed pathway to financial success. In order to succeed, one must be aware of all market dynamics and forces affecting the marketplace. In some states it is more challenging than in others, but “legalization” is never the panacea investors think it will be. So long as the illicit market can operate more efficiently than the legal, the illicit market will never be extinguished and unless and until lawmakers accept this reality, the illicit market will continue to outpace the sales of legal licensed operators.