Ontario’s cannabis retailing arm is putting pressure on some growers to reduce prices as the province strives to ensure marijuana on its shelves will be cheap enough to compete with the illicit market.

In talks with producers to determine which companies will supply the recreational market, officials for the Ontario Cannabis Store (OCS) are pushing for some strains of flower to be available to consumers at a retail price of about $7.50 a gram, including taxes, according to sources familiar with the matter.

The Ontario government stands to be the biggest buyer of legal cannabis in Canada once the non-medical use of the drug becomes legal on Oct. 17. Companies made submissions to the OCS last month, outlining the product selection they have to offer and the wholesale prices at which they are willing to sell.

The OCS was unsatisfied with the producers’ prices for what the government considers entry-level cannabis, and sources said the OCS is in the process of haggling with growers in a bid to keep retail prices low without sacrificing its own margins.

A spokesman for the Liquor Control Board of Ontario, which operates the OCS, said that he was unable to answer questions on Thursday regarding the state of talks with potential suppliers.

It is unclear whether the OCS, which has been touring production facilities and meeting with companies for weeks, will be able to persuade growers to lower their wholesale prices to a point where both parties are content with their cut of the pie. Some sources believe that the threat of a supply shortage could hurt the OCS’s bargaining power.

Ontario is telling the potential suppliers that it wants to have product available at a price point that can compete with the illicit market, the sources said. The talks so far suggest that this price would include the proposed tax that growers have to pay to the government, as well as the taxes paid by the consumer at the point of sale. Offering competitive pricing from legitimate sources is seen as one way to snuff out illegal sales, fulfilling one of the policy objectives expressed by the federal government.

According to data compiled by Statistics Canada, a gram of illicit cannabis sold for an average of about $7.29 in February. (Obviously, there are no taxes on these purchases.)

Pricing is one of the remaining unknowns in Ontario after the Senate voted last week to approve Bill C-45 – and it could be crucial to the profit margins of young businesses looking to capitalize on a shift in public policy that has spawned a rapidly expanding sector.

The number of cannabis licences in Canada has exploded to 111 in the run-up to legalization. The largest growers – Canopy Growth Corp. and Aurora Cannabis Inc. – boast market valuations of $8.1-billion and $5.3-billion, respectively.

Companies have poured hundreds of millions of dollars into high-tech production facilities and are already incurring steep operational costs, from labour to energy, packaging to marketing. The biggest players have expanded their footprints in search of scale. But whether they can generate meaningful profitability – and justify their lofty valuations – remains to be seen. This will be highly dependent on price point.

Analysts expect margins to improve once producers are legally allowed to sell edibles. But that won’t be the case for at least another year.

The cost to produce a gram of cannabis varies widely depending on how it’s grown – and also whether companies include certain expenses in their calculation. Growing indoors, such as in a warehouse, is usually more expensive than growing in a greenhouse. That’s why average growing costs can range from less than $1 in a greenhouse to almost $2 indoors, excluding things such as packaging and delivery fees.

A template form the OCS posted on its website as part of its call for product submissions said that recreational cannabis to be sold in Ontario will be divided into three categories for pricing purposes: good, better and best.

Sources said the OCS is defining quality based on where cannabis is grown. Greenhouse cannabis is being deemed to be of lesser quality than product grown indoors. Growers with indoor facilities say that they’re able to achieve better flavours and aromas because the environment is fully controlled.

It’s unclear, however, if many consumers will notice any difference and be willing to pay extra for the cannabis that’s grown indoors.

Competing in the recreational market will require an adjustment for most growers. The business model is about to be transformed, shifting from the relatively low volume and high margins offered by selling cannabis for medical use to higher volume and lower margins in the recreational market. In the latter, sales will have to be shared in most provinces with a distributor or retailer. As a result, producers big and small are racing to become more efficient growers by boosting their yields and reducing their costs.

Ontario is looking to sell cannabis in 1-, 3.5- and 7-gram packages. This compares with 5-, 10- or 15-gram containers in the medical market. The smaller sizes are supposed to appeal to consumers who want to sample many strains from different brands. But they are also more costly to make.

The negotiations come in the middle of a change in government as Progressive Conservative Leader Doug Ford prepares to be sworn in as premier on Friday. Mr. Ford has been critical of the province’s approach to selling alcohol and his plans for the retail of cannabis are unclear. The OCS has previously announced the location of four of the 40 stores it plans to open in the first year of legalized cannabis sales, but has not yet specified when any of them will open for business.