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.

The three states that make up the New York tri-state area, New York, New Jersey, and Connecticut, are all in the process of implementing adult-use cannabis laws. All have some kind of procedure that allows local authorities and municipalities to opt in or out of the licensing process and, as the OBEDIO data and analysis from THCregs.com clearly show, the enthusiasm for cannabis businesses at the municipal level has varied considerably from state to state. Of the three, the most positive responses so far have come in New Jersey, where around a third of the local governments have opted in, allowing at least the possibility of cultivation, processing, and/or retail businesses under their jurisdiction.

Why So Many Opt-Ins In NJ?

In some ways, that is surprising. People think of New York and Connecticut as more reliably liberal, Democratic controlled states which should, according to conventional wisdom, make them more open to recreational use than New Jersey. So, why would New Jersey be more receptive to adult-use cannabis? There are two probable reasons.

First, the demographics of the state as compared to the other two. New York, and to a lesser extent Connecticut, have populations largely concentrated in a few big urban areas, with many rural, conservative municipalities. New Jersey, by contrast, has a more even spread of population, making for numerically more jurisdictions that are not completely closed to the idea of cannabis from the outset. The state also has a history of seeking alternative tax revenue in order to keep income taxes lower. They were, for example, one of the earliest adopters of legal online sports betting.

That openness and proven propensity to tax vice, makes the second factor all that much more powerful. There is hard evidence that the cannabis industry can be beneficial to communities in terms of tax revenue, while not in and of itself resulting in increases in crime or other problems.

The first legalization and regulation of medical marijuana came in California in 1996 and, as you might expect with such a controversial subject, there has been a lot of research done on the impacts in the intervening 25 years or so. Mostly it, and subsequent more recent research around the legalization of cannabis for recreational use, has shown that crime is little impacted, if anything maybe decreasing slightly, and that there are benefits for previously disadvantaged communities. However, if local politics are dominated by a sense that the given locality is too upmarket to embrace marijuana, none of that matters, regardless of the potential tax revenue.

NJ’s Marijuana Tax Structure

That potential tax revenue is substantial. Estimates of the potential revenue to the state of NJ from pot vary, but most settle somewhere around $150 million annually, roughly the midpoint of the estimate by Rutgers University. There are a couple of things about the New Jersey tax structure for marijuana that are interesting.

Sales of recreational marijuana will be taxed under the general sales tax, but with an added excise fee. That fee has been structured in a way that seems counterintuitive in some ways but is actually designed with a specific goal in mind. It is a regressive tax in a way, that is structured as:

• up to $10 per ounce if the average retail price of an ounce was $350 or more.

• up to $30 per ounce if the average retail price of an ounce was less than $350 but at least $250.

• up to $40 per ounce if the average retail price of an ounce was less than $250 but at least $200; and

• up to $60 per ounce if the average retail price of an ounce was less than $200.

The idea here is to keep total retail costs in check and ensure that legal, regulated marijuana stays competitive with the illegal market, a goal in New Jersey that dates back to the days when just medical pot was legal. To that end, NJ Health’s Division of Medicinal Marijuana releases a biennial report. The latest version of that report deals with 2017 and 2018, and tracks prices relative to crowd-sourced estimates of the going rate in the illegal market, from various possibly questionable sites. That report showed that while the average price of regulated, quality-controlled medicinal marijuana was higher than of illegal weed, that difference was largely due to taxes. The above tax structure was designed to alleviate that problem to some extent.

In addition to sales taxes and excise fees, local authorities in NJ are permitted to charge a tax of 2% or less on each transaction, but that applies to each phase of the business. Thus, municipalities can charge 2% tax on cultivation revenues, then another 2% on processing, then 1% on distribution by a wholesaler, and finally 2% on retail sales. That leads to “tax pyramiding”, which upsets The Tax Foundation, whose research I have used above, but makes the business much more appealing to local governments.

Impacts on Investment Opportunities

In some ways, the relatively enthusiastic response to legalization of marijuana from NJ towns and cities make the state a good target for investment. Municipalities that have actively opted in to permitting are less likely to introduce obstacles to successful businesses at the planning, zoning, and local permitting level, which is obviously a plus. If we assume that the opt-ins also reflect positivity towards adult use establishments among the NJ population, that should also result in strong demand within the state.

There are, however, a few downsides to NJ from an investment perspective.

The aim of keeping legal weed at least competitive with the illegal market is a noble one, but it may well lead to disadvantages for NJ pot businesses, particularly at the retail level. If prices diverge despite the tax system, then a “logical” way to address the difference would be through outright price controls. If it did come to that, it would mean that should there be a local supply problem due to a weather event or whatever, retail prices might be capped, leading to a margin squeeze for outlets.

It might not even need an unusual event for prices to be squeezed. The NJ regs limit the number of cultivator licenses to 37 for at least a year or two, meaning that supply will be limited. There is no cap on the number of microbusinesses that can be allowed, but the relatively small limit to their canopy means that they will probably only be an attractive business proposition if prices are already high. You don’t need a Yale economics degree to know that if, as the OBEDIO data suggest, demand in NJ will be quite high and if, as the effective production caps suggest, supply will be restricted, wholesale prices will climb.

That in itself is not a problem, but history suggests that it may lead to a push for regulators to intervene, which would probably severely disadvantage retail businesses in the state.

Recent criticism of high prices for medical marijuana led to a state response that said in part “Unfortunately New Jersey is not a price regulated state.” The use of the word “unfortunately” there tells you a lot. However, economic history shows that price regulation leads to harmful distortions of almost any market, no matter how well intentioned. To avoid temptation in the future it may therefore be a good idea for regulators to look at restricting the opportunity to implement price controls now, before a situation arises.

In addition, the number of opt-ins make it likely that there will be plenty of businesses in NJ, with a wide geographic spread. Good for NJ residents, but not necessarily for retail businesses from a competition perspective. Here, regulators should pay close attention to the competitive environment if they want the businesses to survive and thrive.

Conclusions

Unsurprisingly given the state’s demographics and history and the significant potential tax revenues, New Jersey municipalities have embraced marijuana legalization more enthusiastically than have some of their near neighbors. That makes it an appealing state for investors, but the tax structure and stated aims of the state legislature make it seem at this point as if the cultivation, processing, and wholesaling businesses may be more tempting targets for investment than retail. 

Last year, Connecticut passed a law that made possession and consumption of marijuana legal from July 1st 2021 and which paved the way for the legal cultivation, processing, distribution and retail of the drug for adult use. Those that expected that by now, almost eight months later, those businesses would be underway, however, will have been disappointed. Progress towards that is slow. That has often been the case with adult-use cannabis legislation that has passed recently, but there are a few things about the law and regulations in Connecticut and the nature of the state that will make it even slower than elsewhere.

The Moratorium Option

Unlike in New York, where failure to opt out of the licensing process by a set date (December 31st 2021) meant that municipalities were automatically opted in, the Connecticut legislation allowed for them to essentially delay a decision by invoking a moratorium on license applications and the approval process. That has so far proven significant, as the OBEDIO data and analysis by THCREGS.com clearly shows. Up until the time of writing, 22 towns and cities have taken that option, as opposed to 20 that have opted out, and 11 that have actively embraced the opportunity.

That shouldn’t come as too much of a surprise. Maybe I am just a cynic, but it seems to me that if you give a politician an opportunity to kick the can down the road on a controversial decision, most of them will take it. That inevitability, however, doesn’t detract from the importance of the idea of a moratorium for potential investors. The popularity of the option means that there will be a significant number of locations where, while retail stores and other businesses won’t be opening soon, there is still the possibility that they will at some point. It is important to factor that in when looking at the opt in/out data.

It remains to be seen how many of those delaying will eventually allow marijuana businesses but, if they make their eventual decision based on data rather than on opinions, there is a good chance that it will be the majority of them. The studies that have been done so far, including the Federally funded one referenced here along with research by the Cato Institute and RAND, show little or no impact on property or violent crime rates following legalization or, in some cases, a reduction in those crimes.

However long it takes, though, and whatever the total of eventual opt-ins, the demographics of the state make it likely that the rollout will be successful, if geographically uneven.

Connecticut Demographics

When most outsiders think of Connecticut, they think of what those of us who live here often refer to as the ‘Gold Coast’, towns like Greenwich, Westport, and Darien close to the New York border that are populated largely by Wall Street refugees and high earning commuters to the big city. That, though, is only a tiny part of a quite economically diverse state that also includes large rural areas and some quite poor, post-industrial towns.

According to a survey released by the census bureau in 2018, at that time median household incomes by town in Connecticut ranged from around $200,000 in those Gold Coast towns to well under $50,000 in other parts of the state. One might think that legalization and the attendant economic opportunities would be more rapidly embraced by those poorer parts of the state but so far, that isn’t necessarily the case. Of the three Connecticut municipalities with the lowest median incomes, Hartford, New London, and New Haven, only Hartford has already opted in. That is despite the fact that the legislation allows them and other targeted towns significant advantages in the licensing and approval process.

Priority Towns

35 towns and cities in Connecticut, including the three mentioned above, have been designated priority areas for cannabis licenses and will be given earlier consideration and approval, allowing them a head start. The priority status was awarded to areas that had been disproportionately affected by the prohibition of cannabis in the past, defined as those with “…either a historical conviction rate for drug-related offenses greater than one-tenth, or an unemployment rate greater than ten percent, as determined annually by the Social Equity Council.”

It would seem logical that, priority status or not, municipalities that fit that description would be keen to start the licensing process early, if for no other reason than to start getting the 3% tax that local authorities are allowed by the act to levy on cannabis sales, but that hasn’t been the case. So far, only six of the priority towns have opted in, with two having opted out and the rest yet to decide. For potential investors, though, priority towns should be just that…a priority, as anything that streamlines applications and approvals in a regulated market is welcome.

What Next?

Retail sales of cannabis are scheduled to begin in Connecticut on July 1st, 2022. However, without a fixed deadline for municipalities to opt in or out and with the option of a moratorium available to those that do address the issue, it is likely that even then, the scale and scope of the market in the state will be unclear. It would be helpful if authorities could force the issue somewhat by creating a deadline, after which an opt-in would be assumed, but I have not seen any mention of that to date.

Even if they do, of course, there will still be zoning issues to be negotiated. Local authorities have the right to set zoning rules and restrictions around the cannabis industry and, if the history of legalization so far is to be trusted, they will enthusiastically embrace that right. There are some statewide rules relating to the proximity to schools, churches and the like but, as with all states, there is a risk that as the comment process gets underway, local groups will ask for additional restrictions.

Still, even with those potential problems, the cannabis market in Connecticut will probably turn out to be a decent one. It is a generally prosperous state with enough municipalities incentivized and willing to embrace the industry to take advantage of the inherent demand. Progress will be slow, but it will be progress, nonetheless.