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Sustainable Investing

Beware of Rent Seekers

Regulation will shape who profits from cannabis.

From a policy perspective, cannabis regulation invites a lot of questions and only the first signs of answers. However, the way cannabis is grown, distributed, and sold will depend on the approach regulators take. Investors need to keep an eye on a developing regulatory system that will create many of the winners and losers in a post-legalization environment. Investors should be especially vigilant about tracking the way the nascent cannabis regulatory structure evolves to reward determined rent seekers—companies that seek to use regulation to set up private flow of profits.

The end of Prohibition and the resultant regulation of alcohol sales provides an important case study and offers clues as to how history may repeat itself. As with the end of Prohibition, an entirely new business might grow up profiting off regulators’ desires to monitor or curb the sale of legal cannabis. If regulators follow the alcohol blueprint, they risk inviting early players to squeeze into the industry and slam the door behind them, keeping others out with regulatory barriers.

Right now, state and federal laws differ as to the legality of cannabis. A shaky, untenable détente between federal and state regulators reveals the challenges of operating in such an ambiguous environment. Still, we expect Congress to eventually align federal law with state practice, in a way that will look very similar to the end of alcohol prohibition in 1933: The federal government will allow states to decide on an appropriate regulatory scheme or whether they wish to legalize marijuana at all. Monitoring these state approaches to regulation—and the risks and opportunities they present to various incumbents or new entrants—will be challenging but important for investors looking to capitalize on the “green rush.”

Lessons of the Past Alcohol sales were once unregulated. Before Prohibition, the bar in which people drank was often the brewer or distiller as well.1 Today, a "three-tier system" in most states keeps alcohol manufacturers, wholesalers, and retailers separate from each other except in cases where states directly run the distribution and sale of alcohol. This heavy-handed approach was designed to keep people from drinking too much in the years after prohibition, and it worked. As Daniel Okrent observes:

"In the surprisingly slow growth of post-Prohibition drinking lay the central irony of Repeal: across most of the country, the Twenty-first Amendment made it harder, not easier, to get a drink. During the latter stages of Prohibition, especially in the big cities or near the coasts or adjacent to the Canadian border, little effort was required to obtain and drink, a bottle, or in some places even a shipment of liquid contraband, few questions asked. What was formally illegal was necessarily unregulated, as if it didn't exist." 2 The end of Prohibition led to a rent-seeking cartel that exists to this day. The current byzantine system means an enormous economic benefit to middlemen to whom manufacturers are obliged to sell their products and creates enormous advantages for entrenched incumbents, who can argue for licensing requirements that make it difficult for new entrants to the business.

The arguments that industry made more than 85 years ago may still be persuasive to regulators and the public today in the context of cannabis regulation. They too face the challenge of legalizing a product that can lead to all kinds of social ills. The architects of the post-Prohibition regulatory environment wanted to make alcohol available without incentivizing private industry to aggressively market it, they wanted to ensure that alcohol that got sold was safe, and they wanted an easy way to collect excise taxes.3 So, they focused their efforts on ensuring that there was minimal vertical integration of alcohol production and sales, and that distributors were responsible for taxes and ensuring safety.

The underlying issues still ring true today for cannabis sales, particularly for recreational marijuana. The solutions states deploy as cannabis becomes fully legalized may look different from the solutions they’ve deployed in the past, but they will likely be similar in at least one aspect: They will create winners and perhaps even whole subindustries that exist only because of regulation.

Envisioning the Future Early cannabis regulation shows state regulators have similar concerns as erstwhile regulators after Prohibition. The first two states to fully legalize cannabis—Colorado and Washington— have so far not adopted such a stringent division of responsibilities, but it's not hard to see how they might drift into having similar regulatory barriers. Further, because of the variety of strains of cannabis, with distinct effects compared to alcohol, and the need to test final products, proponents of a similar centralized regulatory system may be able to make a stronger case than they otherwise would have.

As with alcohol regulation, Washington and Colorado have distinct licenses for different parts of the supply chain, including producing, processing, selling marijuana products, and testing marijuana, according to a U.S. Government Accountability Office review.4 Unlike with alcohol regulation, in which ingredients that are not controlled (such as barley, wheat, and corn) are farmed and turned into alcohol, nascent marijuana regulations make a distinction between the growers of the plant and processors, which can package and label the plant as well as turn it into other cannabis-infused products. Additionally, both states have licensed testing labs to perform state-mandated quality assurance testing.

The states diverge on whether to allow vertical integration, but the extent to which states ultimately allow such integration will affect who can earn what profits from cannabis sales. Colorado allows for more vertical integration, as an entity can concurrently hold cannabis producer, processor, and retailer licenses. In contrast, Washington law does not allow producers or processors to also have a direct retail license, an echo of the three-tier alcohol system. This is not surprising because Washington built on its existing alcohol regulations and even tasked liquor officials with regulating cannabis by adding cannabis to the name and purview of the Washington State Liquor and Cannabis Board. Both states keep testing labs separate from other parts of the cannabis supply chain, which makes sense given the conflict of interest that would present.

If the Washington model wins out, the biggest beneficiaries of cannabis regulation could well end up being the middlemen that distribute and test cannabis. Furthermore, it might quickly become difficult for new entrants to come into the market. Some early producers might not squeeze through the door before incumbents fortify their moat with a trench of regulation. All producers will have to deal with a handful of distributors in each state, potentially stifling innovation and certainly siphoning profits.

Even without a three-tier system for cannabis, existing restrictions on licensing can quickly lead to a regulation-powered cartel. Washington state, for example, is no longer issuing new producer, processor, or retail licenses.5 The longer they don’t, the more power existing incumbents will gain. And as some states will likely continue to keep cannabis illegal, much of the production is likely to be at the state level.

Regardless of whether most states will follow the alcohol playbook or create a new regulatory structure for cannabis, expect regulation to shape the cannabis industry. For investors looking to avoid regulatory risk, one path might be to target companies that supply material and equipment to grow cannabis. These companies are less vulnerable to difficult-to-predict regulatory actions that create various winners and losers. In any case, it will be important for investors seeking to invest in the green rush to consider the inevitable rent seekers who will argue for a protected place in the cannabis supply chain.

1 Elsner, J.R. 2019. "An Argument Against Regulating Cannabis Like Alcohol." Ohio State Public Law Working Paper 482. 2 Okrent, D. 2010. Last Call: The Rise and Fall of Prohibition. Simon and Schuster. 3 See 4 See 5 See

This article originally appeared in the Winter 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

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