Lessons From the World’s Largest Retail Cannabis Market

California pioneered the cannabis industry in America by passing Proposition 215 in 1996 that legalized medical marijuana. It is now, by most measures, the world’s largest locally regulated cannabis market. In 2021, retail stores in the state sold over $5.2 billion worth of products, a 20% increase on the 2020 numbers, and the market there is still growing. adult-use was approved by a large majority of voters in 2016, so the state also has one of the more mature recreational cannabis markets in the U.S. Its size and state of development mean that the state of the California cannabis industry is an important study for both regulators of newer markets and for potential investors.

Fortunately, California requires regular, extensive, detailed analysis of the impact of the industry and changes that are taking place, analyses which provide valuable information. The most recent is the Final Report of a team led by Economic & Planning Systems, Inc., who have been analyzing the industry in the state’s capital, Sacramento. It makes for interesting reading.

Reaffirming The Industry’s Negligible Negative,
and Overall Positive Impact

In many ways the most important conclusions of the report are regarding something that has been shown elsewhere too… that the introduction of legal, adult-use cannabis businesses has virtually no negative impacts on the areas that accept them, and significant positive financial impact at both the state and local levels.

The biggest problem seems to be the aroma in some locations, something that is quite easily solved by updating regulations around air filtration at the indoor cultivation and processing sites. There is, however, no significant impact on more substantial issues such as commercial and residential property values, lease and rent rates, and crime. As studies in other places have shown, if there is any impact, it is a slight positive in all of those areas.

On the fiscal side, the industry generates a surplus of nearly $20 million annually for the city’s general fund, creating a positive economic impact of $2 billion and around 12,500 jobs annually in Sacramento.

This all shows, once again, that states that are not moving towards legalization and the municipalities that are opted out are missing out and are probably on the wrong side of history. Right now, the OBEDIO data and analytics of thcregs.com shows that around 38% of California municipalities are participating, and reports like this make it likely that that number will increase over time.

Where Investment is Going

The one area where the California regulations are not doing as well is in their goal of promoting social equity and supporting small businesses. There is an increasing trend towards vertical integration by big, outside investors. That, combined with some disadvantageous tax laws such as not allowing depreciation of assets in the industry, is squeezing margins and cash flow for smaller entities, resulting in some falling behind on tax payments.

The outside investment right now is focused on the distribution side of the business, which makes perfect sense. Limiting the numbers of cultivation and retail businesses any one company can own is fine, but if just a few companies control distribution, they can make sure that their products get maximum exposure and gain a significant advantage in market share. That is true within the state, but it appears that many of these investors are also preparing for a time when cannabis is legalized at the federal level and interstate commerce in products is possible.

As more and more states legalize in one way or another, that is a reasonable bet. Eventually, as happened with online gambling, the level of adoption will reach a critical mass, where federal bans are impractical and essentially unenforceable. When it does, the law will change.

Possible Opportunities

The one area of the cannabis industry that is not attracting big investment so far, but where there are significant opportunities, is that of testing labs. These facilities perform required quality control checks on products but are also used by growers and processors to develop and refine products.

In the early days, the labs faced a lot of problems, both in terms of their own procedures and a high failure rate among products submitted to them. That led to 66 testing licenses being canceled, revoked, or expired, leaving only 27 testing labs operating in the state. For now, they are managing the workload, but any expansion of the business in the state will require more labs. That, though, isn’t the whole story. The potential for that side of the industry in a state like California with a thriving cultivation business should federal law change is huge so investment here, while flying in the face of recent history and not without risk, has enormous upside potential.

Risks and Conclusions

The principal risks for investors in California are around changes to regulations designed to increase the social equity value of the industry. If those are focused on helping small businesses, fine, but if California legislators go down the road of trying to punish larger operations for their success and ambition it will reduce the value of investments considerably.

However, California’s experience with the legalization of adult-use marijuana has so far been largely positive, and the already large market there can be expected to grow as a result. As it does, there will be further investment opportunities, particularly in distribution and testing, areas that will see increased business as the industry in the state expands, but which offer huge potential should federal law allow the cannabis industry to operate in a more normal manner.

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