CannaVision - Environmental, Social and Governance

Environmental, Social, and Governance

Operationalizing ESG in the Cannabis Industry

As the cannabis sector matures it must brace for the shock of broader institutional demands. It has been 27 years since the passing of Proposition 215 in California. Five years ago, Canada legalized adult-use cannabis and currently several European countries are in different stages of the legalization process.

By Leonid Kotlyar

Four years ago, Constellation Brands committed 4 billion CAD to the Canadian cannabis industry, and less than a year after that it wrote down 1.1 billion CAD of that investment in Canopy Growth (CGC). CGC’s stock is currently hovering above the 1 CAD mark, down from an all-time closing high of 56.89 CAD. Cannabis’ formative years have provided many cases of corporate failure. Negative headlines included Canadian multinationals, US Multi-State-Operators, EU medical startups, and not to mention a Juicy financial scandal. Questionable growth projections, bloated valuations, faulty assumptions, lack of due diligence and a dose of wrongdoing have been the ingredients. The usual cocktail of issues experienced in developing sectors, but with a severe twist of added complexity, since Cannabis has been a prohibited commodity since the early 20th century. A policy of prohibition that had a strong racial and discriminatory component, resulting in a manufactured societal stigma and generations lost to the ‘war on drugs’. The corporate and societal challenges cannabis has to face are unique.

After going through the cycles of failure, M&A, and consolidation, cannabis should see itself as a real industry and should find its unique place and voice. Eventually, the cannabis sector

should see itself as a contributor to evolving regulatory frameworks and an actor within global capital markets. The wheel does not have to be reinvented to make the cannabis sector run properly, it just needs a few small shifts to improve it.  These shifts can be directly attributed to variables within ESG metrics and inherent reporting requirements. ESG, as a framework, is on its own path to maturity, looking for its champions and models to be reproduced across sectors. It is precisely here that a nascent industry can not only blaze a new trail but, from inception, collect and utilize operational data to ensure long term sustainability.

A brief history –The Risk Management Genesis of ESG

Environmental, Social, and Governance frameworks have been around for close to twenty years. At the term‘s birth in 2004, ESG represented a framework for corporate evaluation. Spurred by a list of signatories including some of the world‘s leading financial firms, ESG was a proposal to future-proof risk-management following headline corporate scandals of the early 2000s.  When pension money vanished due to corporate negligence, a public reckoning was inevitable. And so the Governance part of currently accepted ESG frameworks took shape out of the fallout of the Sarbanes-Oxley Act of 2002.

From Fiduciary Duties to Environmental & Societal Focus –PCA & UN-SDGs

With the signing of The Paris Climate Accords (PCA) in 2015 global attention turned to environmental targets. This included renewed focus on carbon emission reduction targets (CO2e) and the mechanism by which efforts can be coordinated on a global level through the markets. The result was the proliferation of carbon credit markets as well as corporate environmental accounting to meet <1.5C global warming scenarios. The ‘E’ of ‘ESG’ was beginning to take shape.

The UN Sustainable Development Goals (SDG) framework that came out that same year provided the perfect storm. While the nation signatories to the PCA and SDG commitments were bound by the UN, public pressure, flared by social media, was mounting on corporations to do their part. In this context, ESG happened to be a convenient tool – a tool used to measure the degree of corporate response to increasing public concerns relating to.

The Climate Crisis, Social Injustices, and Corporate Responsibility in these Matters

‘Creating’ ESG Compliant Companies to Account for ESG Capital Allocation - ESG Ratings & Greenwashing

Publicly listed multinationals became the first to show compliance with ESG directives. By 2021, 86 % percent of S&P 500 firms regularly issued some kind of ESG-related report, up from 35 % in 2010. The financial sector led the charge, given they were already legally bound to comply with the Sarbanes-Oxley Act, which contained a measurement and disclosure framework underpinning ESG.

As pressure mounted on capital markets to risk-manage portfolios according to newly minted ESG disclosures, there was a rapid increase in adherent and aligned investment opportunities, i.e. ESG-compliant companies, securities and ETFs. As a result, ‘ESG ratings’ emerged as a critical piece between capital and ESG-adherent investments. The ratings do the job of quantifying the ESG risk profile and performance of a company or portfolio, while providing investment guidance to capital markets.

ESG ratings can often cover for greenwashing or, at the very least, conflate future transition plans with current ESG performance. As an example, consider Pepsico, ranked 11th on Yahoo Finance top ESG rankings for 2022. Pepsico cites expansion of regenerative agriculture, with plans to go 100 % recyclable/biodegradable and net zero by 2040. But as it stands, Pepsico emitted 57 million metric tons of CO2e in 2019 and plans to emit 26 more million tons by 2029.

The old trader adage of ‘equities are forward looking, while debt markets tell the story of the current economy,’ certainly appears to be true in this case, however so-called green bonds are not without their controversy. The full life cycles of projects underpinning green bonds are rarely scrutinized, nor are their set standards for definition or due diligence associated with green bond underwriting. Lack of transparency and allegations of human rights violations have also plagued the industry, with experts pointing to an overreliance on third-party ratings.

Emerging industries, such as cannabis, not beholden to established sources of capital and influence and able to build novel foundations, are best positioned to take maximum benefit from adopting ESG metrics. They can utilize data to drive much deeper than compliance to achieve actual change and a systemic paradigm shift.

Cannabis has been a prohibited commodity since the early 20th century. A policy of prohibition that had a strong racial and discriminatory component, resulting in a manufactured societal stigma and generations lost to the ‘war on drugs’. The corporate and societal challenges cannabis has to face are unique.

Which ESG implementation strategy will provide the best path to capital and sustainable growth for my company?

Investment Portfolio Screening vs. Company Management – Top Down vs. Bottom-Up Applications of ESG

Examining the genesis and evolution of ESG, two pressure and application points shaping how ESG is operationalized become evident. On the one hand, Top-Down pressure from markets, investors, and regulators to influence movement of capital towards assets that provide a positive non-financial bottom line along with positive financial results. On the other hand, Bottom-Up pressure coming from implementation of ESG by companies themselves.

From the corporate, bottom up, point of view, ESG is both a regulatory requirement and a potent management tool. The question to answer for founders and executives of (cannabis) companies is, “Which ESG implementation strategy will provide the best path to capital and sustainable growth for my company?”

Sustainable growth is here used in a wider sense, i.e., long term growth that will persist through the test of time, and is not referring to narrow environmental targets (e.g. use, or not, of plastic packaging etc.).

transitioning to state-regulated cultivation and unlearning habits beholden to the demands of clandestine operations. From irrigation practices to wastewater dumping standards … to genetic choices, flowering duration, and associated energy usage –many industry Standard Operating Procedures (SOP) could and should fall under an environmentally critical lens.

Examining the evolution of these developments in established markets paints a sad picture. With 80 % of U.S. cannabis cultivated indoors, this relatively small industry uses a disproportionate share of the energy grid. Often consuming anywhere between ~2-8 % of the State‘s energy supply at any given time. Multiply that over the 37 States that allow for some form of cannabis cultivation, and you have a basis for a national emergency.  With the adoption of strict interpretations for GACP and EU GMP production standards, the European medical cannabis industry is walking into the same trap. Protectionist national economic policies in sun-deprived Northern Europe also have the potential to present ticking time bombs to their nation’s energy grids as Germany, Denmark and The Netherlands account for a greater share of European cannabis production.

Societal Threats

The fragmented regulatory reality of the cannabis industry created conditions favoring M&A driven expansion over organic growth. Curaleaf, one of the largest international players in the cannabis industry, was involved in no less than 14 M&A transactions in the last decade. Canopy Growth’s number of deals is staggering 17 in that same time period! Such frantic expansion rates coupled with a lack of adequate resources devoted to integration and disjointed regional supply chains, created a race to the bottom for social considerations.

Public discourse on ESG is skewed towards addressing top-down considerations, with macro regulatory topics dominating. The debate largely revolves around ratings, portfolio performance, flows of capital and asset-class performance. However, little is said from the company’s perspective – especially young, privately owned startups, which is the situation of most cannabis companies.

ESG and Cannabis: An Uncomfortable Reality

Environmental Baggage

Much of the initial emergence of cannabis as a legally produced commodity was thanks to legacy operators – simultaneously

Short corporate reporting cycles and executive compensation incentivized towards top-line revenue growth often leave workers to bear the brunt of neglect. At its most basic level, the risk lies in creating separation between company decision making and the personnel. Such fragmentation can lead to issues with retention, burn out and overall worker morale. At its most acute, the risks can result in class action lawsuits and wrongful death charges from prosecuting authorities.

While many of these risks can and should be mitigated by existing European frameworks for the pharmaceutical industry, regulators will need to be ever mindful of their oversight as supply chains become globalized and adult-use pilot programs begin in Europe.

Governance Opacity

Stemming from the aforementioned pressures pertaining to the legacy origins of the industry and rapid M&A driven expansion, many cannabis companies lack the necessary governance fra-

meworks expected of mature industries. This can be exemplified by: uninvestable cap-tables containing an endless list of providers, friends, or loan organizations; opaqueness surrounding ultimate beneficial ownership and lack of KYC due diligence to accurately account for these variables; and asymmetric share classes that create incongruence between various stakeholders.  With many public cannabis companies already feeling the pressure of ESG compliance, it has been illuminating to observe their response. Most licensed producers (LP) have chosen to keep the cards of governance close to the chest, focusing instead on emphasizing good social work done in the community and boasting about incremental environmental accountability. The key to successful ESG strategy implementation, however, is accountability. Without rooting ESG into the decision-making and accountability matrix of the executive team and board of directors, no meaningful change in company operations or culture can be expected.  Looking specifically at soon to be mandated TCFD disclosures affecting several stock exchanges, including Canadian and UK listings, leadership will have to be increasingly accountable. Placing executive responsibility on managing a company’s climate risks is a major regulatory step to link accountability with decision making.

ESG and Cannabis: Where Is the Source of Pressure?

Top Down – Public Markets, TCFD, SEC & CSRD

Regulators and stock exchanges have announced sweeping plans for mandatory ESG or climate related disclosures. With Canadian and UK exchanges opting for Task Force on Climate-Related Financial Disclosures (TCFD) and U.S. exchanges guided by emerging SEC requirements, all listed cannabis companies meeting the minimum capitalization requirements will soon be liable.  The passing of the Corporate Sustainability Reporting Directive (CSRD) in November 2022 by the European Parliament brings ESG reporting requirements even closer to the cannabis industry. While TCFD and SEC disclosures affect publicly listed companies, CSRD directives are geared towards a wider subset of companies satisfying scale and capitalization requirements. Meeting any two of the following conditions would make non-EU companies with EU interests bound to CSRD reporting requirements: a balance sheet total exceeding €20 million, a net turnover exceeding €4 million and >250 employees on average during the fiscal year. Given the deal size of European cannabis M&A, with North American companies in the past five years, it‘s reasonable to assume many multinationals will soon be bound to some level of reporting.

Founders looking at phased approaches to fundraising need to consider ESG risks earlier to meet the demands of investors. While cost and access to capital continue to be major drivers for ESG adoption, ease of regulatory compliance and scaled integration should not be underestimated. Most founders in the cannabis industry should have the ambitions to meet two out of three CSRD thresholds in relatively short order, hence warranting building their business on solid ESG foundations.

Bottom Up & Sector-Specific – Physical Risks, OpEx, Target Audience and Transitions

The physical risks inherent to climate change are ever present. Changing weather patterns are affecting precipitation levels, humidity, frequency of extreme weather events, and more. Responsible management increasingly depends on modeling company data against climate scenarios and associated physical risks. While advocating for more globalized, interdependent supply chains may positively affect decreasing physical risks to the cannabis industry, the current disjointed legal regime incentivizes localization where physical risks may be unavoidable.

Macro elements such as geopolitics and changing labor market patterns also act to pressure companies for more prudent and data driven management. When sanctions on foreign energy create spikes in operational costs, an ESG data strategy could make the difference between staying afloat and bankruptcy. Similar lessons can be deducted from labor statistics and used for predictive decision making. Consider a 1000% difference in labor costs between Switzerland and Northern Macedonia and that variable’s effect on the cost per gram of EU GMP certified flower. These disparities and resulting economic outcomes are at the heart of data analysis captured by holistic frameworks, such as ESG.

A recent Headset report showed that the majority of cannabis consumers in North America are Millennials and Gen Zs (~70%). This demographic is said to be the most socially conscious consumer and drives personal spending based on perception of value-based alignment. As the cannabis industry matures together with its core customer base, it will be prudent of companies to accurately measure and adapt to the transition risks presented by this unique industry.

Operationalizing ESG: a Vision for Measurable Impact

At its core, ESG is a framework to measure transition risks –both micro and macro. Some risks are more apparent than others. The increased risk of hurricanes and freshwater basin contamination may render some Florida cannabis cultivation facilities inoperable. How much of a company’s value is at risk due to that climatic risk? How many employees will need to be evacuated and what is a company’s liability? The same could

be asked of Dutch producers and their increased flooding risk, or Oklahoman producers and their hurricane risk. If data is confirming a change in certain environmental conditions, a company is responsible for measuring that risk and transparently informing their stakeholders. How does a Danish medical producer model their HPS to LED transition in light of spiking energy prices? The line between effective data-driven decision making and mandatory reporting of Scope 1 and 2 emissions is often very close.

Social transition risks are equally as testamentary. How does a company adjust its culture to societal shifts in order to retain and attract talent, create resonance with customers, and stay on the positive side of public opinion? A popular topic for this debate in the cannabis industry is a company’s position on the right to home grow. This polarizing topic alone presents a significant risk of alienating both internal staff and potential customers. ESG and its inherent call for tracking and measuring certain parameters is a natural catch-all for data collection that should be optimally purposed for corporate decision making. Deploying a consistent data driven ESG strategy will enable an organization to anticipate, as opposed to react to, physical and transition risks as they develop. A consistent strategy will deploy an ESG toolkit, consisting mainly of:

• Materiality assessments (internal, external, double materiality)

• Physical and transition risk analysis

• Supply chain mapping

• Life Cycle Analyses (LCAs)

• Governance accountability mechanisms

(Board accountability on non-financial outcomes)

• Consistent KPI reporting.

Principles of sound management, KPI driven record keeping, and continuous review and evaluation are cornerstones of ESG strategy. Yet aren’t those cornerstones of any modern, well-run, data-driven business – a business that standardizes the collection of data and uses it to guide their future decisions? Is this not congruent with formally accepted principles of ISO and GMP?  It is true that ESG frameworks may add considerations previously out of scope of corporate observation. However, given modern systems and data collection mechanisms, this should account for little additional resources. In practical terms, it is as simple as adding additional modules and dashboards to existing ERP software.  Acronyms used to code these initiatives and their reporting structures have changed and likely continue to change. Even the mighty “ESG” will one day fall! The oldest currently accepted

ESG framework, SASB Standards, were only published in 2011 and there is no telling whether those standards will continue to lead. However, the core principles of KPI driven management based on continuous observation and analysis will undoubtedly stay. Under one title or another.

Medical LPs & Distributors Already Have an Advantage in Value-Based ESG Approaches

Adapting cannabis value chains through ESG-centric data collection practices will have long term benefit on business operations. From direct relationships between current yields and quality parameters, to exact energy, labor, and overall resources used to produce that gram of flower – this industry is primed for a greentech revolution!

Envision the reporting aspect of ESG to be a healthy side effect of running a sound business, not the end goal worth working towards. This is already true for medical licensed producers. Companies having to comply with GACP, EU GMP, ICU, ISO, and other regulatory standards, are already primed for advanced data collection and record keeping. Expanding that data set further opens an additional window of opportunity.

With tightening margins across the industry and increasing costs of capital, not seizing this opportunity would be a material risk to the sustainability of any cannabis business. ↙

Leonid (Leo) Kotlyar

is the co-founder and Managing Director of DéWarrior Unlimited B.V., a sustainability focused managing consulting firm headquartered in The Netherlands. DéWarrior (www.dewarrior.com) offers its advisory service in ESG, M&A, and Management Consulting, utilizing comprehensive data collection and advanced modeling techniques to drive integrated decision making. Prior to founding DéWarrior, Leo spent 12 years in institutional equity derivatives, building and delivering the early cornerstones of ESG to his customer base of pension plans, insurers, and sovereign wealth funds.

How does a Danish medical producer model their HPS to LED transition in light of spiking energy prices? The line between effective data-driven decision making and mandatory reporting of Scope 1 and 2 emissions is often very close.

Pictures: Blue Planet Studio, pixardi, metamorworks, AUUSanAKUL+ /stock.adobe.com