Morningstar - Winter 2019 - 15

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. K
Aron Szapiro is director of policy research with Morningstar.

The Present Bias
Booby Trap
You're not irrational.
Your mental math
is skewed.

BEHAVIORAL INSIGHTS

Sarah Newcomb

Behavioral scientists like to talk about how
some human decisions are "predictably irrational,"
meaning that they aren't objectively the best
choice, but we persist in them anyway. For
example, why do so many of us put off saving and

3 See http://www.centerforalcoholpolicy.org/wp-content/uploads/2012/06/Center-for-Alcohol-Policy-2011-Winning-Essays.pdf.
4 See https://www.gao.gov/assets/680/674464.pdf.
5 See https://lcb.wa.gov/mjlicense/marijuana-licensing.

global.morningstar.com/Morningstarmagazine

http://www.centerforalcoholpolicy.org/wp-content/uploads/2012/06/Center-for-Alcohol-Policy-2011-Winning-Essays.pdf https://www.gao.gov/assets/680/674464.pdf https://lcb.wa.gov/mjlicense/marijuana-licensing http://global.morningstar.com/Morningstarmagazine

Morningstar - Winter 2019

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