In 2018, California’s cannabis tax revenues capped at $345 million, falling radically short of market analysts’ predictions. The culprit: the black market. The cannabis industry is heavily inundated with unlicensed businesses, and they likely aren’t going anywhere. The black market is worth an estimated $3.7 billion, despite more than two years of state and local governments’ attempts to enforce compliance.
A 2018 Eaze report found that one in five California consumers purchased cannabis from an illegal source, and that many are likely to repeat that behavior due to the tax-free products the illegal market provides. While hundreds of unlicensed dispensaries are estimated to operate under the table, opportunities for illicit players to manipulate the supply chain span far beyond retail. Before reaching consumers, cannabis products are passed through five unique businesses types: cultivators, manufacturers, lab testers, distributors, and retailers. This presents significant licensing vulnerabilities in the supply chain, resulting in a market ripe with illegal actors.
Why are businesses still functioning illegally?
Legalization was meant to generate a pathway for safely tested cannabis product to reach consumers, but ever-shifting regulation and uncharted legal territory has left California’s cannabis market even more convoluted than before Prop 64. Despite almost 60% of California citizens voting for legalization, less than one fourth of cities and counties allow dispensaries to operate in their communities. The intricacies of state vs.municipal law make it difficult for local law enforcement to know what to pursue as illegal activity, and whether jurisdictional law overrides state policy. This vein of legal uncertainty adds to the already uncoordinated and underfunded state efforts of driving the industry into compliance.
Further, local and state government tensions exacerbate the barriers that come with obtaining and maintaining a cannabis license. In California, there’s a sizeable gap between the number of cultivation licenses and retail licenses available to cannabis businesses. Vessel Logistics found that more than 1,142 acres of cannabis farms hold state permits- they can produce up to 9 million pounds of crop every year, but the permitted wholesale market can realistically support 1.8 million to 2.2 million pounds. The California market has bitten off more than it can chew, or rather, trimmed more than it can smoke. The report indicates that even if a 50% cut in production is accounted for, a significant oversupply is unavoidable in by the end of 2019. This oversupply results in cultivators and manufacturers either sending weed overstate lines through the mail or selling wholesale to unlicensed and fraudulently licensed retail locations.
To add bureaucratic insult to injury, in 2019, hundreds of state-issued temporary licenses were due to expire before the government finished processing annual or provisional licenses. This left many fully legal businesses with a difficult decision - shut down operations while waiting for the state to catch up or enter the black market to maintain functionality. For now, California is giving businesses more time on their temporary permits while they sort out the details. This allowance, however, comes at the cost of major opposition from environmental groups who say that some farms are not compliant with laws that protect people, land, and water. The hundreds of businesses waiting for their provisional and annual licenses to be approved are stuck in legal limbo- one that is environmentally uncompliant and lawfully inconsistent.
Even more than bureaucratic delay, the most salient barrier to white market functionality tends to be the incredibly steep entry prices and taxes associated with running a licensed cannabis business. The costs that come with applying for and maintaining a license is several thousands of dollars higher than functioning outside the eyes of the law. Ironically, taxes are so high on both the production and retail ends of the supply chain that the state is completely underfunded and, thus far, unable to dig its way out of this cumbersome cycle.
Distribution as legal reinforcement
The California Market is unique in that a distribution license is required in order to transport product from cultivators and manufacturers to retail and delivery services. Some legal players in the industry argue that an additional license requirement is an unnecessary checkpoint, but distributors do serve as useful legal intermediaries in the supply chain. “Distribution was written into California law, in large part, to help prevent illegal market entry and diversion,” argues Demetrius Daniels, the California Distribution Association’s Membership and Program Director.
Because many distributors work with dozens of brands and hundreds of retailers each week, they have visibility on all sorts of business types in California. This sort of clarity gives distributors a unique perspective on the inner workings of operators attempting to function legally(and sometimes illegally) in the supply chain. With eyes on every facet of the market, distributors will play a key role in the implementation of California’s new track and trace system, MERTC.
METRC acts as a seed to sale compliance management solution by using a cloud based reporting system to manage the entire supply chain. California began using METRIC in January, but has yet to come fully online. So far, the state only allows companies with provisional or annual licenses to integrate with the system, leaving dozens of businesses with temporary licenses completely out of the loop. This in ability to participate means a substantial lack of both inventory and tax-related accountability. Assuming the software becomes fully integrated this year, the vision is that it will be extremely difficult to function illegally inCalifornia. From the moment the seeds hit soil, all cannabis products will be implemented into the cloud, making white market diversion easily detectable.
Despite integration complications, METRC is now a mandatory aspect of the cannabis supply chain, and distribution will aid in the facilitation of this complex software. Further, because distributors often carry several brands at a time, they tend to consolidate orders and paperwork requirements on the retail end of the supply chain. Instead of maintaining 30different orders from separate brands, retailers can order a variety of products from one or two third party distributors with comprehensive portfolios, massively simplifying METRC’s order processing workflow.
California passed Prop 64, anticipating the massive tax revenue would fund the government and streamline a supply chain, just as it did in states like Colorado and Oregon. Two years later, the state is stuck in a vicious cycle where a lack of government resources causes the legal industry to unsuccessfully chase after the heels of thousands of black market players. The light at the end of the tunnel is METRC’s integration, allowing streamlined track and trace and BCC auditing to come full circle. Transitioning to a fully legal industry is an evolving landscape, but third party distributors invested in compliance software solutions like METRC should provide the industry an avenue for a comprehensive illegal market shakeout.