Cannabis Faces Significant ESG Risks
Industry would be wise to adopt sustainable practices from the beginning.
It's not often that an entirely new legal industry springs up practically overnight after having been mostly illegal for decades, but that's what is happening with cannabis today. Unlike most emergent industries, for which long-term survival cannot be assured, cannabis already has a long-established consumer base for both recreational and medical uses, making the question not so much whether legal cannabis will catch on with consumers, but how fast and how big the industry will grow.
The developing cannabis industry, however, faces significant sustainability risks that could put a dent in growth and potentially 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."
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 more efficient and more secure, produces better 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.1 As the industry grows, so will the negative impact of heavy energy usage and the resulting carbon emissions. Regulation putting a price on carbon would thus hit indoor producers hard, as could industry-specific 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 energy-intensive 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."2
Water use, especially in the Western United States, is another environmental risk for outdoor cannabis producers. A single outdoor-grown cannabis plant requires as much as six gallons of water per day during peak growing season.3 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 2017 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.4 All of these issues, especially if no proactive measures are taken within the cannabis industry, could invite public and regulatory scrutiny resulting in higher costs and a weaker social license to operate.
The cannabis industry faces a range of social risks associated with its products, starting with 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 their products and understating the possible detriments, pending further scientific study.5 Companies that put a premium on developing safe products, clear product labeling, and responsible marketing campaigns can mitigate these 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 and influence over 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.
As public companies involved in the cannabis industry consider the composition of their boards, they should pay attention to diversity and expertise. Having women and people of color on boards should be a given, especially the latter because of the disproportionate impact prohibition has had on people of color. Having board members with health, marketing, and environmental-impact expertise can better position a board to oversee the variety of risks a company faces.
Despite the momentum for legalization of cannabis, the social license to operate remains tenuous for cannabis companies. One way to strengthen the license to operate is for cannabis companies to become good corporate citizens committed to addressing ESG risks effectively. Sometimes in the chaos that happens with a fast-growing industry and a lot of new entrants, addressing sustainability issues gets put on the back burner, not regarded as central to building a business. But there is a strong case to be made that those firms that establish themselves as sustainability leaders will have a stronger license to operate than those that are laggards. Perhaps more important, 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.
This article will appear in the winter issue of Morningstar magazine.
1. Warren, G.S. 2015. “Regulating Pot to Save the Polar Bear.” Columbia Journal of Environmental Law, Vol. 40, PP. 385-432.
2. Vezer, M. & Morrow, D. 2018. “The budding cannabis industry: a first look at ESG considerations.” Sustainalytics Thematic Research, July 12, 2018.
3. Madhusoodanan, J. 2019. “Can cannabis go green?” Nature, Aug. 28, 2019.
4. Wang, I., Brenner, J., & Butsic, V. “Cannabis, an emerging agricultural crop, leads to deforestation and fragmentation.” Frontiers in Ecology and the Environment, Vol. 15 (9), PP. 495-501.
5. Ratte, A. & Swynghedauw, L. 2019. “Clearing the Smoke Around Cannabis.” MSCI Issue Brief, June 2019.
Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.