June 8, 2018 / 2:32 PM / 15 days ago

INSIGHT-Why Canada's pot legalization won't stop black-market sales

(Updates with Senate vote in 14th paragraph)

By Nichola Saminather

TORONTO, June 8 (Reuters) - Jake Rowinski, a 20-year-old University of Toronto student, buys marijuana every week from one of the many self-described “medical” dispensaries in downtown Toronto.

The illegal store sells openly to customers ranging from budget-minded recreational users like Rowinski to silver-haired grandmothers treating legitimate ailments.

“Nobody really cares at this point,” Rowinski said outside the shop, near the city’s financial district.

As Canada’s Liberal government prepares to legalize recreational marijuana use this summer, the biggest remaining obstacle to regulated sales will be competition from a thriving black market, according to cannabis investors, researchers, policy analysts and government data.

Many buyers of illegal pot will have little incentive to switch to legal weed, which is expected to be more expensive and less available because of strict regulations on sales, according to hedge fund GTV Capital, which invests almost exclusively in Canadian cannabis stocks, and the Marijuana Policy Group, a U.S. research firm.

As the first major economy to fully legalize cannabis, Canada’s regulatory rollout will be closely watched by other nations considering the same path - and by global investors, who have already poured billions into Canadian marijuana firms.

Canada legalized medical marijuana in 2001 but still restricts it to mail-order purchases from licensed providers. That has spurred the proliferation of unsanctioned retailers like the one where Rowinski shops, which recently changed its name to Trees Station Medical Dispensary.

Employees at the store declined to comment.

Such illicit retailers may soon compete with new legal outlets, and many provinces plan initially to limit the number of government-operated or -licensed stores. Medical marijuana, meanwhile, will remain legal only by mail, despite a push by major pharmacy chains to sell it.

The cautious approach could restrain legal investment in a market estimated by Statistics Canada at C$5.7 billion in 2017. About a fifth of Canadians between 15 and 64 years old used marijuana, spending an average of C$1,200 per person at C$7.48 per gram, the agency found. Ninety percent of that money was spent illegally.

GTV Capital estimates an average pre-tax price of C$8.33 upon legalization, already higher than the average illegal price because of testing, packaging and security regulations. That doesn’t include a planned excise tax of $1 per gram or 10 percent, whichever is higher, or sales taxes of 5 to 15 percent.

If the price difference allows the black market to compete, that will hamper the public benefits of legalization - legitimate investment, job creation and tax revenue - and complicate efforts to stamp out crime associated with illegal drug trafficking. Statistics Canada, working with police data in a 2014 study, found organized crime involvement in about a third of marijuana production and trafficking.

“Canada’s been brave enough to take the step to make cannabis fully legal, but they’ve also taken the stance that they don’t want to promote it,” said Steve Ottaway, managing director for investment banking at GMP Securities. “I can appreciate their intent, but at the same time, this is an adult-use market.”

Canada’s Senate voted late Thursday to legalize recreational marijuana, but included amendments that still need approval in the House of Commons. The proposed changes include tighter advertising restrictions and allowing provinces to decide if Canadians can grow cannabis at home.

Mark Ware - a McGill University family medicine professor who served as vice-chair of the federal task force advising on the legalization - said the measured approach aims to curb underage use and install government-controlled supply networks, safety checks and legal processes before further expansion.

“I don’t think anybody can be under any illusion that it will happen right away,” said Ware, who will become chief medical officer of cannabis producer Canopy Growth Crop on July 1.

LIMITS ON RETAILING

Most investors and analysts predict legal sellers will be able to compete on price in the next few years as regulations loosen and legal supply networks grow. At least for now, provinces plan fewer stores than needed to meet demand.

Ontario, Canada’s most populous province, plans 40 government-run stores at first, rising to 150 by the end of 2020; Quebec, the second largest, will start with 20 stores and decide the pace of expansion later.

That compares to about 1,000 retailers in the U.S. state of Colorado, which legalized recreational marijuana use in 2012 and has seen prices drop from more than $12 a gram to less than $7 with the expansion of retailers, according to research firm BDS Analytics. Today, about 70 percent of Colorado marijuana users buy legally, a state spokesperson said.

In response to questions about their policies, Quebec and Ontario spokespeople pointed to previous statements. Ontario officials have said they looked to their experience with alcohol and tobacco retailers to guide marijuana policy; a Quebec official has said the province will consider as many as 300 retailers in the long-term.

(For details on marijuana regulation in Canadian provinces, see:)

Patchy availability and higher pricing are likely to reduce provincial tax revenues in the early years of legalization, Moody’s Investors Service said in a recent report. It predicted British Columbia, with the most liberal retailing regulations, will collect far more tax revenue, about $50 million, than provinces with tighter rules. The federal government will get 25 percent of the excise tax revenue, with the rest going to the province where any given sale occurs.

‘A LOT LIKE PIZZA’

Canada’s national legalization of recreational use has little precedent; it will be only the second country after Uruguay to do so.

But it’s clear from smaller-scale legalizations that heavy users drive pot-market economics - an obstacle in converting illegal sales to legal ones.

“Heavy users use more than everyone else combined,” said Damitha Pathmalal, portfolio manager at GTV. Many will “stick to the illicit market, given the price difference.”

Daily users are only 14 percent of the total but buy about two-thirds of all pot sold, according to GTV Capital and a 2016 report from the Office of the Parliamentary Budget Officer.

(For a graphic on Canadian marijuana consumption, see: tmsnrt.rs/2JvANMH )

Recreational consumers who don’t live near a legal store will be able to buy online. But many customers will turn to local outlets - legal or illegal - rather than wait for mail-order, said Miles Light, co-founder at the Marijuana Policy Group in Denver, Colorado.

“These are comfort goods; they’re a lot like pizza,” he said. “The model works, but it’s got to be pretty local.”

ENFORCEMENT DILEMMAS

Jeremy Jacob, president of the Canadian Association of Medical Cannabis Dispensaries, said availability issues could be solved by giving illicit retailers a path to legal status.

But most provinces want to “eradicate the existing industry,” Jacob said.

British Columbia is the exception. It plans to allow some existing dispensaries to apply for licenses, as Jacob plans to do for his Village Bloomery in Vancouver.

The province also plans to step up raids on shops who continue to sell illegally.

The goal is “to put a significant dent in the black market,” said Mike Farnworth, the province’s solicitor general and minister for public safety.

Ontario will set aside C$40 million for enforcement after legalization, including policing impaired driving.

The Royal Canadian Mounted Police plans to add analysts to monitor organized crime in the cannabis industry after legalization and determine what enforcement resources are needed, said the RCMP’s Yves Goupil, a director of federal policing.

“If the black market can still operate profitably, there will need to be significant justice resources devoted to enforcement,” said Rosalie Wyonch, a policy analyst at the C.D. Howe Institute, a nonprofit economic policy think tank.

Canada has no plans to allow storefront access for medical marijuana despite a pharmacy-industry push to dispense it.

Pharmacies including Shoppers Drug Mart - Canada’s biggest chain, owned by Loblaw Companies - and PharmaChoice, the country’s second-biggest independent pharmacy group, have signed supply agreements with marijuana producers in case rules change.

A survey by the Canadian health regulator Health Canada last year found that only 29 percent of those reporting medical cannabis use had a medical document from a health professional, a requirement for buying from licensed producers.

The rest bought illegally. ($1 = 1.2855 Canadian dollars)

Reporting By Nichola Saminather Editing by Denny Thomas and Brian Thevenot

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