by Dominic Corva, Social Science Research Director
Last week I focused on how the retail application process, however planned, has had to be adjusted on the fly based on unexpected applicant phenomena. Our Medical Transitioners represent, by contrast, a segment of the applicant population that was expected by the LCB, and who may have initially designed their rules in anticipation of their participation. The LCB has had to adjust their rulemaking processes — all of them — significantly based on outcomes they did not, and perhaps could not, anticipate. This post sketches that phenomenon as it applies to “Producer/Processors.”
Before we begin, let’s establish that the formation of 3 different kind of licenses (producers, processors, and retailers) reflected a segmentation of the legal cannabis supply chain that was not balanced so in the underground and Medical markets. Many access points started out at least partially vertically integrated, as an extension of underground gardens and gardeners. Many Medical businesses were collective gardens (and networks of these) that vended to Access Points. And many Medical Cannabis brands developed from singular enterprises that grew, processed, and branded an array of products besides flower.
The tripartite division of licenses developed by the LCB meant that initially, our Medical Transitioners had to figure out what they were and how they would specialize in the I 502 market. So even given the regular input the LCB sought from Medical Collective Gardens like Solstice and Dama at the beginning of their rulemaking process didn’t necessarily give the bureaucracy a clear picture of who would be applying for what, and how many. The process was fraught with contingency and unexpected outcomes, rather than designed and executed in a way that could either benefit or damage existing actors. The purpose of our Producer/Processor chapter, as well as our Specialty Processing chapter, highlight just how uncertain the landscape was for everyone, and how that posed particular challenges for Medical Transitioners.
The evidence considered stems from the fact that the LCB always received far more applicants than it anticipated, for all of its licensing windows, and that a large percentage of these came from applicants that were not ready to actually open or operate their licenses for a variety of reasons. This conclusion is even more stark for Producer/Processors, and is a bit simpler to discern through an analysis not only of applicant numbers, but how these translated into canopy potentials.
That’s because the LCB’s own rules anticipated 2 million square feet of canopy would capture 13-25% of the cannabis consumption market in the first year of retail operation, based on initial BOTEC analysis. Those numbers are easy to identify and break down. By those calculations, it would take four or eight times as much canopy — 8 million to 16 million square feet — to meet 100% of the State’s adult consumption market. That potential canopy was far exceeded in the first round, and sort of only, application round. But only a tiny percentage of those applications were ever able to open, and it appears that of those that opened most have fallen far short of their maximum allotted canopy.
The 30 day application window started Monday, November 16, 2013 and lasted till December 20, 2013. The LCB received almost 3000 producer applications (processor applications usually but not always accompanied producer applications). More than 900 of those applied for the up to 3 licenses permitted by rules. The resulting potential canopy from those applications dwarfed the LCB’s 2 million square foot goal, and in fact exceeded the upper limit that BOTEC had calculated as sufficient for the entire State’s supply. This unexpected development immediately resulted in two significant rule changes.
First, all applicants who applied for more than one producer license were allowed to move forward on just one of them. Last month, the LCB made that change permanent, but with one caveat: starting in January 2016, all licensees would be permitted to acquire up to two more producer licenses by purchasing them on the open market. Over the course of three years, many licenses were acquired via “minority” partnership by existing licensees and new venture interests, a point to which I will return in a moment.
And second, the canopy allotment for each application was reduced by 30%. It was restored last fall, across the board. Let’s discuss the results not only up to now, but how those results threw LCB projections out the window very soon after retail stores opened in July 2014.
Eleven months after the application window opened, LCB director Rick Garza reported that 267 producer/processor applicants were either approved or had begun the process of approval, and that the canopy represented by that population was 2.8 million square feet, about 50% more canopy than their target date for having 2 million square feet of canopy … seven months ahead of schedule. Retail stores had only been open 5 months at that point. Of course, the fall harvest data indicated that about 70 of 182 approved licenses were actually producing and of that number, seven producers accounted for more than 50% of production through December 2014, of which most of it was the fall harvest. Six of those seven were outdoor Tier 3 producers.
This incongruity demonstrates the difference between LCB accounting and real production capacity, which has always been difficult to determine. It’s clear that most producers struggled to get off the ground once they were approved, and the ones that did averaged a very low percentage of their maximum possible canopy. As a result, the potential canopy of the system itself has far exceeded actual production.
This was difficult to “see” as late as December 2014, given the relatively high prices for flower in the few retail stores that struggled to stay open with so little product on the shelves. But the Fall outdoor harvest, which was driven by seven (!) outdoor producers, created an inventory glut that allowed retailers to open, and stay open, for good — and with lower and lower flower prices. Edibles and concentrates remained rare on the shelves until July 2015, when the tiered tax structure choking intermediate supply chains was replaced by an end tax through 2166, 5052’s companion bill.
The inventory glut stabilized about six months later, when monthly indoor production began to exceed monthly retail inventory, and was probably finalized after the Fall 2015 harvest when outdoor’s annual boost created, essentially, a bottomless inventory for the limited retail landscape to exploit.
After two years of production, when it came time to decide whether to open another canopy approval window, the LCB decided that the original application pool — active or not — still represented far more canopy than than the State system needed. As a result, they permanently closed the up to two more licenses applied for by 900 applicants and ruled that all remaining inactive license applications, as well as active ones, could be acquired on an open market starting January 1, 2016. This rule changed in tandem with the decision to allow out-of-state financing at the same time.
The decision to move from a “command economy” approach to a privatized market approach solved one technical problem, how to deal with the vast amount of potential canopy held up by nonviable canopy applicants. But it also created a potential social problem. Producer/processor expansion could only happen via investment, increasingly likely to be out of state investment. “Mom and Pop” small businesses that hoped to expand their way to sustainability given very low wholesale prices had to abandon that hope. They would either have to finance license acquisition themselves or take on investors that could buy them out. The likelihood of Producer/Processor industry consolidation just went through the roof.
This narrative addresses the “aboveground” evidence of canopy allocation and rule changes, but to be clear, investors have been finding ways to acquire licenses and control canopy over the last several years. This is not inherently “bad” for undercapitalized applicants and small businesses, as many have found new life with the right investment partners. But it has been happening in the “loopholes” of I-502 regulation. Shell corporations fronting for out of state money, the most underground example, operate in direct defiance of LCB rules and intent — and many of these are behind some of the biggest producers in the State.
But canopy control doesn’t have to happen through direct ownership. Instead, “brand” companies have emerged to coordinate supply chains from canopy production, usually through agreement with processing licensees, to develop and sell branded products for I 502 shelves. They are following a model pioneered by original applicant Producer/Processors that have used their Processor license to acquire production and create their own branded products. The tax structure reforms from July 2016 essentially opened up this business strategy by eliminating transaction costs associated with buying product from production licenses not held by the Processor — really, Brander — in question.
The emergence of the Processor/Brander as the market’s primary canopy allocator is really the story of the last year or so. There are plenty of Producers who just want to grow, harvest, and be done with it — especially outdoor producers, whose costs of production are so much lower than those of indoor producers. This is common across the Tiers, and many licensees who originally thought they would be processing and branding from their own production are now sourcing from “Producer only” licensees. This has helped many struggling producers with no branding or distribution inclination stay afloat, and provided otherwise struggling Producers with a way to increase their razor-thin margins.
The basic logic, though, is indifferent to whether its wielders are Big, Medium, or Small. Our interview subjects run the gamut, but every last one of them have shifted or are attempting to shift their business identities from Producers to Producer/Processor/Branders. In fact, that’s kind of what they were when they were Medical. In the book, we will examine how our Transitioners chose to become Producer/Processors, how that process worked for them, and how their business identities are adapting to the changing landscape.