California cannabis industry sending SOS to state leaders

San Francisco(CNN Business) About 170 years after California's gold rush came the promise of the green rush.

California's legalization of cannabis for adult recreational use was expected to be massive. In 2016, industry investors claimed sales could top $6.5 billion by 2020.

And as 2019 comes to a close, California is indeed home to the world's largest cannabis market, totaling close to $12 billion in estimated sales. But here's the rub: $8.7 billion of that is changing hands in the illicit market.

Now, members of California's cannabis industry are sending an S.O.S. to the state capitol, saying they're struggling to compete against black market operators who don't have to meet stringent regulations or pay taxes and fees. They're urging leaders to make swift regulatory changes or risk the collapse of their emerging industry.

"The hard truth is that until legislative changes are made, our industry will continue to wither away," said Michael Steinmetz, CEO of cannabis distributor Flow Kana, which recently joined a growing list of California cannabis firms that have cut their workforces.

Following the job cuts, which were first reported by the Sacramento Bee and described as an an "epidemic" of layoffs, Steinmetz cobbled together an informal coalition of more than a dozen leading companies and business associations to lobby the state.

California cannabis businesses that have cut their workforces or scaled back growth plans say their woes aren't limited to the capital markets turbulence and the growing pains ricocheting through the broader cannabis industry. Their challenges, they say, are homegrown: California has too few licensed cannabis businesses, too much taxation and overly onerous regulation.

The group is calling for an emergency summit between industry leaders, state regulators and Governor Gavin Newsom to address those three key concerns.

"This is a massive opportunity for the state," Steinmetz said. "I think it could dwarf the size of the wine industry."

Although California wasn't the first state to legalize and start adult-use cannabis sales, it's quickly become home to the largest recreational cannabis industry in the world, according to a report from Arcview Market Research and BDS Analytics, which track and analyze cannabis points-of-sale transactions.

In 2019, California's sales are expected to top $3 billion, which is more than the combined output of the more mature markets of Colorado ($1.6 billion) and Washington state ($1.1 billion). By comparison, Canada's recreational cannabis industry is expected to hit $1.1 billion this year.

But those sales pale in comparison to the estimated $8.7 billion illicit market in California, according to Arcview and BDS Analytics projections for 2019. In 2018, California's illicit sales were an estimated $8.99 billion.

California has a deeply rooted cannabis culture and legacy, and cultivation and retail operations became more sophisticated following the passage of medical cannabis laws in 1996.

However, not all legacy businesses transitioned to licensed operations under the new laws. While some have no intention to become regulated, others believe it's cost-prohibitive or currently operate in municipalities where cannabis sales are banned, said Josh Drayton, spokesperson for the California Cannabis Industry Association.

Fewer than 40% of California's municipalities have cannabis regulations in place, and only one in four of those allow for regulated retail operations, Drayton said. Earlier this year, lawmakers struck down a bill that would have required municipalities to allow recreational cannabis programs if a majority of their residents voted for the 2016 measure that legalized cannabis.

State lawmakers and businesses originally anticipated that legalization would make a much bigger dent in unregulated sales than it did, said Dennis Hunter, co-founder of CannaCraft, a seed-to-shelf producer of sun-grown cannabis. CannaCraft recently laid off 20% of its 240-person workforce.

"They didn't realize how strong this illicit market was going to stay," Hunter said. "I think people really thought that it was just going to stop [after legalization]. And actually, the opposite has happened. It almost feels like the illicit market is getting stronger.

An entrenched black market creates more than just headaches for licensed operators, it's also a potential public health issue, said Jake Heimark, co-founder and CEO of CBD edibles maker Plus Products, who compared it to the recent illnesses and deaths linked to illicit vaping devices.

"I'm hoping the state will step in and take some action to correct some of this," he said. "If we don't solve it here in California, I think it's difficult to make a case for a national rollout."

The cannabis industry's concerns hit a fever pitch late last week when the California Department of Tax and Fee Administration announced an increase in cultivation taxes and a higher mark-up rate -- from 60% to 80% -- used in the calculation of excise taxes paid by retailers to distributors.

The adjustments weren't discretionary but rather mandated by law to reflect what's already occurring in the market, said Nicolas Maduros, director of the CDTFA.

State officials are working closely with the industry to address challenges and concerns, said Nicole Elliott, the governor's senior advisor for cannabis. But creating an industry from whole cloth won't happen overnight.

"It's not an event that happened with one election," she said. "It's a process that unravels over the course of time."