Morningstar - Winter 2019 - 31

Cannabis Faces Significant ESG Risks
Industry would be wise to adopt
sustainable practices from the beginning.

ESG

Jon Hale

The developing cannabis industry faces significant
sustainability risks that could put a dent in
growth and threaten its still-tenuous social license
to operate. Investors should consider these
risks as they evaluate public companies that are
exposed to cannabis as well as those that
are pure plays. Cannabis companies should pay
attention to their environmental, social, and
governance risks and take steps to mitigate them
early on. Doing so could result in operational
and reputational benefits accruing to early
adopters and improve public perceptions of the
industry as a whole. Better for legal cannabis
to be seen as sustainable than as just another
"sin stock."
Environmental Risks

For cannabis-producing companies, energy
intensity is a major ESG-related risk. Indoor
cultivation appears to be the superior choice for
growing cannabis. It is efficient, secure,
produces product uniformity, and can be located
close to end markets. But indoor cultivation
is a massive energy hog. One study estimated that
cannabis production consumes at least 1%
of the nation's electricity. As the industry grows,
so will the negative impact of heavy energy
usage and the resulting carbon emissions.
Regulation putting a price on carbon, thus, would
hit indoor producers hard, as could industryspecific regulations requiring energy-efficiency
measures or stakeholder demands to eliminate
greenhouse gas emissions. The specter of
regulation puts pressure on companies to address
this risk sooner rather than later by focusing on
efficiency and innovation in the cultivation process.

Those that do so can lower their long-term energy
costs while also reaping the reputational benefits
of being seen as sustainable cannabis producers.
Outdoor cultivation is expected to expand
with widespread legalization and the growing
demand for concentrates that are used as
raw material for extracts and cannabis-infused end
products. Cannabis used for concentrates can be
grown under more variable outdoor conditions
because quality and consistency are less important
than for cannabis intended to be consumed
as flower. Outdoor cultivation is far less energyintensive, but has its own environmental
risks related to pesticide, water, and land use.
Cannabis crops grown outdoors are prone to
mildew, mites, and other pests that require
chemical treatment. Poor industry practices, warns
a Sustainalytics report, "can lead to environmental
contamination, health problems for exposed
employees and customers, product recalls,
litigation, fines, the destruction of crops, and the
loss of licenses to operate." Water use, especially
in the western U.S., is another concern. A
single outdoor-grown cannabis plant requires as
much as six gallons of water per day during
peak growing season. That puts a premium
on growers to develop more efficient ways to use
water and raises the potential of regulatory
restrictions on water use, especially during periods
of water stress or drought. Finally, a recent report
found that on a per-unit-area basis, cannabis
production can lead to more forest fragmentation than timber and is associated with stream
modification, soil erosion, and landslides.
Social Risks

their health effects. Widespread legalization
will lead to more scientific research on the health
effects of cannabis use in general and more
regulatory focus on the health effects of specific
products. While cannabis use is currently
thought to be relatively safe for recreational use by
adults and to offer some medicinal benefits,
further scientific study could bolster or undermine
those claims.
Producers and retailers of cannabis products
could face public and regulatory scrutiny
over marketing practices, particularly if it appears
to be directed at teens. More broadly, the
industry will need to be careful to avoid
overstating the healthful benefits of its products
and understating the possible detriments,
pending further scientific study. Companies that
put a premium on developing safe products,
clear product labeling, and responsible marketing
campaigns can mitigate these risks.
Governance Risks

In the realm of governance, the biggest risks
relate to ethics and transparency. The need
to obtain government permits for grow operations,
product manufacturing, and retail outlets means
that cannabis companies may come under
scrutiny over their interactions with public officials.
Companies with high ethical standards and a
commitment to be transparent about their
lobbying activities and political expenditures will
be better positioned to withstand such scrutiny.
Despite the momentum for legalization of cannabis,
the social license to operate for cannabis
companies remains tenuous. One way to strengthen
the license to operate is for cannabis
companies to become good corporate citizens
committed to addressing ESG risks effectively.
Embedding sustainable practices from the
beginning is easier than retrenching in response
to stakeholder pressure. A cannabis industry
that develops within the context of sustainability
will work better for all its stakeholders. K
Jon Hale, CFA, Ph.D., is director of sustainability research
with Morningstar Research Services. He is a member
of the editorial board of Morningstar magazine.

The cannabis industry faces a range of social
risks associated with its products, starting with

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Morningstar - Winter 2019

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