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Preparing for the Coming Economic Shift in California as Adult Use Looms

There is a big economic shift coming to California’s cannabis industry in January, when recreational adult use becomes operational.

But the economic shift may be bigger than expected, according to report by the Bureau of Marijuana Control (BMC), even with projections based on assumptions about an industry that is short of reliable economic data.

Data collected and analyzed in the report show how the $2 billion medical marijuana part of the industry in California will begin shrinking by $1.4 billion, while lab services and investments hold steady and show signs of growth.

Some industry analysts are predicting that medical marijuana in states where both medical and recreational adult use are legalized could cease altogether once California’s huge adult-use market gets underway and the decline of medical-only facilities begins in earnest. Already some medical-only shops in states like Oregon are transitioning into the recreational markets for economic cover.

In February 23, 2017, a 208-page report prepared for the BMC by the University of California Agricultural Issues Center, “The Economic Costs and Benefits of Proposed Regulations for the Implementation of the Medical Cannabis Regulation and Safety Act (MCRSA)” goes into great detail about the rollout of the new state regulations and how the industry is expected to react.

As a result of the passing of Proposition 64, adult-use was added as a legal segment of the total cannabis market, establishing a new tax structure for medical and adult-use cannabis, and assigned the BMC responsibility for regulating both California’s adult-use cannabis industry and medical cannabis industry.

Now, with the merging of the MCRSA and the Adult Use Marijuana Act (AUMA) to form the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA) as the result of a new law passed in June, both recreational adult use and medical use have a set of rules and regulations scheduled to be launched on January 1, 2018, creating legal sales in two cannabis segments – medical cannabis and adult-use cannabis.

When in place, the system will let some buyers who had previously been buying in the medical segment to shift purchases to the adult-use segment without any significant switching costs.

But there is a problem with the economic model. The report found that measuring the economic impact of a regulation is contingent on estimating relevant baseline market prices, quantities, revenues, taxes, and related aggregates that would occur in the absence of the regulation.

There are no official government data sources on output, prices, jobs, or other economic aggregates for the industry to which the proposed regulations on medical cannabis apply, and official tax collections reflect only a minority of operating businesses.

On top of that, businesses have not reported their financial results in standard ways. In many cases, businesses have been operating with cash, outside of the normal banking system, in a quasi- legal, quasi-regulated manner.

The BMC reported that, based on their best assessment, the California medical cannabis segment, as of fall 2016, had aggregate revenue on an annualized basis of about $2 billion.

According to the report, after legalization of the cultivation and sale of adult-use cannabis and taxation of legal cannabis, but without yet considering the implications of the proposed regulations, economic calculations suggest that revenue in the medical cannabis segment will fall to about $600 million.

That means that the medical cannabis proposed regulations are likely to apply to a medical cannabis segment that is approximately 30 percent the size of the current medical cannabis segment.

“We estimated that 60 percent of current demand in the legal medical cannabis segment will shift to the newly legal adult-use segment due to the lower annual transaction costs,” the report states.

There are no similar transaction costs with adult use cannabis. An adult use cannabis purchase does not require an annual doctor’s recommendation, which is costly for buyers of medical cannabis. Costs are likely to be $50 to $100 or more per year plus the cost of time and inconvenience.

Relevant medical marijuana costs include an in-person doctor visit, which is mandated by MCRSA. “In our models,” the report continued, “there will be a reduction in the demand in the legal medical segment and an increase of the same magnitude in the legal adult-use segment.”

The changes in demand, costs, and taxes, as included in the bureau’s simulation of the California cannabis market, can be summarized as follows: Once these market changes are incorporated, and new consumers from the state, along with visitors to the state, begin flooding into the market, the legal, adult-use segment will have about 61.5 percent of the overall market as measured in pounds.

The unregulated illegal segment will have about 29.5 percent of the overall market, and the legal medical cannabis segment will have about 9 percent of the overall market.

While all this looks like bad news for medical marijuana companies, under the regulations, the expanded laboratory testing sector part of the medical marijuana business will see significant new economic activity, according to findings in the report.

Information from industry sources indicates that as of November 2016, there are two to four medical cannabis testing laboratories currently operating in California that are equipped with the type of wet-lab facilities that would be necessary to conduct the required pesticide tests.

As a result, most testing businesses will be new businesses generated by the proposed regulations. These businesses are expected to be located near distribution centers and spread across the state in major centers of medical dispensary sales.

Many of the added costs of the proposed regulations are associated with laboratory testing, meaning that the laboratory testing sector will require a substantial increase in investment in equipment.

But there are other reasons for the strong opening for recreational adult-use over medical and the issue of whether medical remains.

Adult-use legalization lowers the “risk premium” for supplying cannabis, which the report points out is a significant cost of doing business.

This reduction of risk premium costs is greatest in the newly legal adult-use segment, as formerly illegal sellers whose business activities that had formerly been punishable by lengthy imprisonment terms open legal adult-use operations with little fear of state criminal prosecution.

This lowers the premium wages that illegal cannabis businesses would previously have had to pay employees in exchange for assuming such risks, as well as lowering security costs, costs of concealment, and other costs of doing illegal business.

The new combined regulations allow a retailer to have both adult use and medical licenses, but it’s unclear if they can both be operated on the same premises.

So the industry is watching California carefully because on the horizon is a time of economic shifts, the potential for significant earnings for compliant operations, a significant change in how medical marijuana does business, and for some, a scramble for survival.

David HodesDavid Hodes

David Hodes

David Hodes is based in the greater Washington DC metropolitan area. He is the former editor of seven different business magazines, and has contributed feature articles to several business/lifestyle publications and national cannabis magazines. Hodes is also a former field producer for CBS News, NBC, NFL Network, ESPN and other media outlets; worked as a news promotions producer for two network affiliates; and was the morning news editor for a third network affiliate.

He is member of the National Press Club, and deputy booking agent for the National Press Club Headliners Committee.

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