A year after legalization, Canada’s cannabis market is in shambles. The number of retail outlets is ludicrously insufficient; inventories are piling up in retail, wholesale and producer warehouses; the portion of the total market captured by legal sales is disappointing; state-owned monopolies are constipating the system; and almost every segment of the market is incurring financial losses. Not an auspicious beginning to the Liberal government’s enlightened intentions on legalization.
It has always been the case that if the legalization of cannabis is to reach its objective of supplanting the illegal stuff, two market characteristics are key: First, legal points of sale need to be plentiful and near potential consumers. Evidence from the US indicates that customers are willing to buy pot legally provided it is easily accessible. Second, the product needs to be priced competitively, that is at a price that is not too much above its illegal counterpart.
Legal pot is viewed as having less quality variability than illegal pot. However, at the time of legalization, in October of 2018, Canada had trusted trading relationships between buyers and sellers and well-organized supply networks, with one of the largest per-capita cannabis consumption rates in the world. And pot was really inexpensive by legalization day. When purchased in quantities of a half-ounce or ounce, a price in the neighborhood of $5 per gram was the street norm, according to Statistics Canada’s Cannabis Hub, which provides crowd-sourced data on illegal as well as legal cannabis purchase prices.
The legal market project in Canada will be successful only if it meets these two requirements – accessibility and price competitiveness. As of November 2019, the attainment of these twin objectives appears a long way away.
Useful reference points for analyzing the structure of cannabis sales are the tobacco and alcohol sectors. These products, like cannabis, can be unhealthy when consumed excessively, particularly tobacco, which presents fearsome health consequences. Tobacco is associated with premature deaths from cancer, stroke and heart conditions of tens of thousands of Canadians annually; the alcohol sector with merely a few thousand. In the cannabis sector, a score of individuals in the US died in late summer 2019 apparently as a result of consuming contaminated street-purchased liquid cannabis in which THC was suspended in a compound that is toxic even in small quantities, illustrating the risks of black-market offerings.
Tobacco is sold in every corner store, gas station and supermarket in the nation. Alcohol is available in an uncountable number of bars, hotels, restaurants, supermarkets, and (depending upon the province) corner stores. In some provinces, alcohol has a quasi-monopoly status in retail sales. For example, beer is sold through about 500 beer stores in Ontario, and liquor is sold through about 700.
How does the retailing of cannabis compare? Substantial differences characterize its sale in Canada’s provinces. The private sector plays a retailing role in some, not in others. In contrast, recreational cannabis in the US states where it is legal, is totally in the hands of the private sector. The retail structure in most of Canada’s provinces, and the wholesale structure in virtually all of the provinces, more closely resembles what one might have expected in the Brezhnev-era Soviet Union, had the apparatchiks there considered selling the stuff: government-owned and -operated monopsonies (a market situation where there is only one buyer) and monopolies with customer line-ups lasting hours. As of October 2019, my local pot shop on Ste. Catherine St. in Montreal has frequent eye-catching lineups.
Quebec ultimately plans on a pot chain containing 150 stores owned and operated by the Société québécoise du cannabis (SQDC). Today it has about 25. Ontario initially ran a lottery for 25 retail licenses and is processing another 50, though, as of late September, the process of allocation overseen by the Alcohol and Gaming Commission of Ontario (AGCO) had turned farcical as a result of AGCO process errors.
The combined population of these provinces is about 23 million. Ontario decided to make just 25 available in the first lottery, and declined to issue further licenses until production capacity was increased – on the premise, presumably, new businesses did not need to plan ahead for a period when supply would be more available. In contrast, Alberta aims to have several hundred privately run retail stores for a market of 4 million individuals. In British Columbia, the Liquor and Cannabis Regulation Branch operates government-owned stores, regulates, and issues licenses for the operation of privately owned stores. But British Columbia has a well-developed illegal market, and progress in selling legal recreational cannabis has been staggeringly slow. Early sales through government stores have been miniscule. Statistics Canada reports that such sales were the second lowest in the economy until August 2018, when they finally began to pick up. PEI, which has about 3 percent of British Columbia’s population, sold the least.
At the wholesale level, each province’s politburo has formed a central agency that is the sole legal conduit for the transit of cannabis from the producer to the consuming public. Thus, while some provinces have privatized retail sale, all (with the exception of Saskatchewan) have decided that at the wholesale level government monopsonies are superior to a somewhat freely functioning marketplace.
These monopsonies provide little additional value to consumers that could not be supplied by a well-regulated system of sale, where producers and processors sell directly to retailors subject to a “seed-to-sale” tracking policy combined with strict laboratory testing. Seed-to-sale systems can track plants in the growing stage through to the final production of bud.
While the early-to-legalize US states (Colorado, Oregon, Washington) adopted different methods of (a) allocating production and sale licenses and (b) laboratory testing, they share a similar philosophy. The outcome is that they arrived quickly at a point where each state had several hundred producers and processors and several hundred retail outlets. None has adopted Canada’s monopsony-monopoly model. Given that they each issued a total of at least 1,000 licenses in the space of a couple of years, and that Health Canada has managed to issue just 220 in a similar time frame, the process associated with granting a license is obviously more cumbersome in Canada than in the US. The difference could reflect a culture more favourably disposed to the role of competitive markets in the US: “if it’s in demand, allow it, and we’ll regulate it if necessary,” as opposed to “if it’s in demand, let’s see if we should allow it, and if we should, let’s create a government agency to act as vendor-in-chief.”
Well, what about sales in Canada at this stage of the game? A study of the data produced by Statistics Canada and Health Canada, and available on the Health Canada cannabis hub site, suggests that as of late summer 2019, about one-third of all medical and recreational cannabis consumed is being sold through legal outlets. Province-level data are provided in figure 1.
This constitutes a start, though the rate of progress in eating into the illegal recreational market is worrisome. Medical cannabis has been legal for several years. Consequently, the growth in the legal recreational share has been lower than the one-third fraction might suggest, since about 10 percent of the total market was already legal in the form of medical sales.
Our state monopolies have been slow to roll out retail stores. On the basis of current trends, it is difficult to predict whether this Soviet-style model will ultimately lead to a sufficient number of outlets so that the illegal market will be extinguished. Safe to say, it is unlikely to happen soon.
But store numbers are not the only reason to worry about the monopsony-monopoly model. There are at least three additional reasons for concern.
First, the injection of the monopsony-monopoly layer into the producer-consumer supply line raises costs. And if prices cannot be kept competitive with the illegal market, the legalization project will not succeed.
Second, the monopsony structure is likely to favour large producers over small, but a balance between large and small would make for a more efficient market than one in which just a limited number of large producers survive. Large corporations have the resources to undertake research and development, and perhaps reap the gains from scale economies. This will be ever more important as the market becomes more sophisticated with edibles and infused beverages.
But large organizations prefer to deal with fewer suppliers because costs are lower when fewer contracts are written. And in every province, a single group of individuals within government agencies will determine which products will reach the consumer. This process will limit choice.
The development of a craft sector should not be inhibited, even unintentionally. Small producers can fill niche markets and provide a competitive fringe to large suppliers. But if small producers are unsuccessful in selling to the provincial agencies, it is difficult not to contemplate what will happen to their product. Will it find its way to the illegal market? Might lobbying lead to unethical practices? These are moral hazards to consider. Direct access to private retailers would give small producers a greater chance of survival. If this sector does not survive, the very large illegal sector could be the beneficiary.
Third, and despite Ottawa’s slow progress in issuing production permits, we face a massive oversupply relative to what is being sold on a monthly basis. This is because the production capacity per application approved in the existing permits has been extremely high. Producers began to exploit this capacity in mid-2019, and inventories began to accumulate at that time. (It’s a familiar problem in Oregon, too.)
Had the major population provinces decided to license many individual retailers rather than just state agents, sales would be far higher, and inventories would be nowhere near their late 2019 level. In July of 2019, inventories of finished and unfinished product stood at about 25 times monthly sales (figures 2, 3, 4 and 5). By end of 2019, this ratio could be larger. As a point of comparison, inventories in the tobacco industry amount to about two months’ of retail sales.
It is easy to be critical of a process that has contributed to this state of oversupply. But even if Health Canada had granted more production licenses with reduced wait times, and retail outlets were more numerous, there is no guarantee that oversupply would have been avoided. Cannabis is a new business, and entrepreneurs wanted into it fast and furious. Despite the enormous production over-capacity, hundreds of production applications still wait approval from Health Canada. It is difficult to envisage that above-normal profits await any entrant into the sector at this point.
Carrying inventory is expensive. Finished product must be frozen, and even in that condition the product’s THC content degrades steadily until it is no longer marketable – after perhaps two years. Five hundred tonnes of slowly degrading cannabis is a massive amount of cannabis to store. Storage costs are set to rise, and producers might ultimately have to write off hundreds of millions of dollars of inventory.
To avoid such a scenario, where might the inventory go? If retail outlets were sufficiently numerous, it could be sold to the consumer. Will state monopsonies demand fire-sale prices from producers? We do not know the terms or the duration of contracts governing the supply of weed to provincial monopsonies. However, signs of downward pressure on wholesale prices are already apparent, and firms will be required to down-value their inventories in due course if they are to follow generally agreed upon accounting practices.
Another way of viewing this disaster is to say that every licensed producer in Canada right now could probably close growing facilities for a whole year, and the legal market (even under the assumption of a continuing growth in legal demand) could be met purely out of inventories!
Unsurprisingly, stock prices of cannabis producers have fallen to about one-third of their past 12-month peaks. How many producers at this point can avoid bankruptcy is a guessing game.
But the collapse in stock prices is only partly attributable to the monopoly mentality of our provincial governments. Yes, more outlets are vital. But the stock market has been in a bubble for at least 18 months. The oversupply scenario was predictable from observing how much production capacity was being granted all along under federal production licensing (on top of the existing illegal capacity).
Looking ahead: might we hold out hope that the forthcoming legalization of edibles and cannabis-infused beverages in Canada will equilibrate the market in favour of the legal sector? These products form a large and growing part of the US market – as much as one-quarter. Perhaps some of the inventory can be directed to this purpose. At the same time, total inventories of oil stand at about 15 times monthly sales (each gram of oil equates to about 5 grams of dried bud).
A likely feature of this new market is that it will draw in additional customers from a larger population base. The legal smokeables-vapables market is not so attractive to individuals who have never smoked or vaped some substance in their lifetime. In contrast, the infused beverage market should appeal to that segment of the population for whom the preferred source of mind-altering pleasures is alcohol. The illegal sector is less equipped to supply infused beverages and edibles on account of the technology and research required to develop these products, and on account of the greater consumer certainty required for THC and CBD content in a new product.
When the federal government embarked on an enlightened program of legalization, much of the electorate envisaged a world where potential users of cannabis could access the product with ease and pay a price not much higher than that of the illegal product.
Provincial governments have undermined this endeavour. Canadian consumers are being dramatically underserved by the legal market in most provinces as a consequence. They are still, nonetheless, well served by the illegal market, where web postings suggest that prices are falling.
One might reasonably ask why those provincial governments that have adopted non-competitive paradigms did not move forward more rapidly in 2016, when the intentions of the Liberal government in Ottawa became clear, and also why they chose to adopt those restrictive market structures. Had they co-opted the Apple Corporation, McDonald’s, or Shoppers Drug Mart to set up retail chains, or simply followed the more granular approach of Alberta, retailing (particularly in Ontario and Quebec) would not be suffering from the institutional torpor that encumbers it at present. We would have several hundred stores in the two most populous provinces instead of a mere 50. This in turn might have forestalled some of the producer bankruptcies that will likely characterize 2020.
Whether the choice of monopsony-monopoly market structures was dominated by government thinking (perhaps anxiety about an electoral response) or bureaucratic thinking, or was a reflection of a culture that has grown tolerant of government monopolies and supply management, is probably water under the bridge, even if two provinces (Ontario and New Brunswick) have changed tack.
At some point in 2020 or 2021, we will certainly see a dominant legal sector – one that will control more than half of all transactions. The growth of the legal sector will be greatly facilitated by the steep wholesale price reductions being reported in numerous industry analyses in November. Several major suppliers have seen their selling prices drop from $5 or $6 per gram to $3 or $4. While this will impact profitability, if the retail sector builds more storefronts and additionally passes on these reductions in the form of lower retail prices, consumers will be confronted with a major incentive to switch to a legal supplier. The critical issue is whether the monopsonies and monopolies are up to the task of getting product to the user in a timely manner.
This article is part of the The Making of a Cannabis Industry: Year One special feature.
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