Morgan Stanley

Two years after winning the Kellogg-Morgan Stanley Sustainable Investing Challenge, Blue Forest Conservation is preparing to pilot a financing vehicle to fund forest restoration in California.

It’s been two years since the four founders of what is now Blue Forest Conservation won the Kellogg-Morgan Stanley Sustainable Investing Challenge —for their proposal to reduce the number of devastating wildfires and protect water resources in California.  They think it’ll likely take another two years before they’re ready to put their Forest Resilience Bond1 proposal in front of institutional investors. Yet as time-consuming as it can be, the progress Blue Forest has made so far is proof to graduate students taking part in this year’s Challenge that visions for a better way of financing social and environmental projects can be put into action.

“It’s taken a bit longer than we expected to get where we are today, but we’re reaching a tipping point,” says Zach Knight. He’s referring to the fact that he and his partners, Leigh Madeira, Nick Wobbrock and Chad Reed, are ready to have the U.S. Forest Service (USFS) and other beneficiaries sign on to the first of what will hopefully be four pilot projects of a larger effort to raise private capital. The objective of the project is to help reduce the number of devastating wildfires and protect water resources in California.

Proof of Concept

The Forest Resilience Bond pilots will test-drive the structure and will be pitched to family offices and foundations that specialize in financing for sustainable projects. Blue Forest expects all of the pilots to be sited by the end of this year and launched in 2018. They’ll raise funding to restore about 5,000 acres each, in different forest environments that typically occur across the western U.S.  If they show the project can monetize enough benefits from reduced wildfire severity and protected water resources to provide attractive returns, then institutional investors will be approached in 2019 with larger Forest Resilience Bond transactions.

“These pilot projects need to be done as proof of concept,” says Knight. “Before we can create a vehicle targeted at institutional investors, we need to show that we can actually implement this restoration work and that we can measure and verify the benefits that accrue to stakeholders."

Getting private investors to fund social and environmental projects by offering the potential for attractive returns is the ultimate goal of sustainable finance and the reason why Kellogg and Morgan Stanley’s Institute for Sustainable Investing hold the Challenge.  “There is a surge in private investor demand for sustainable investing products, but the challenge is creating financial solutions to social and environmental problems that also offer the potential for competitive returns,” says Audrey Choi, head of Morgan Stanley’s Institute for Sustainable Investing

The Problem

In the same year Blue Forest won the Challenge, more than 10 million acres of land burned across the country. It was the worst fire season on record for the U.S.2

It’s well documented that restoring forests by removing overgrown vegetation and dead trees not only reduces the severity of wildfires, but also protects water quality and can even help improve water quantity. Over 60% of California’s developed water supply comes from snowpack in the Sierras3, which remains at risk due to overgrown forests. While restoration projects are a common activity of the USFS, the pace and scale of these projects has been limited by the exploding costs of fighting fires.

Sharing the Costs

The Forest Resilience Bond will contract all of the beneficiaries of healthier forests to share in the cost of restoration.  Apart from the USFS, the other beneficiaries include water and hydro-electric utilities, which stand to receive more water and spend less on treating water or clearing fire-related sediment from their reservoirs. Fewer severe wildfires also reduces state and local government fire-fighting costs, avoids devastating carbon emissions, provides better protection for rural communities, and creates sustainable forest restoration jobs.

The proceeds of the Forest Resilience Bond will go to a third party to hire crews to do the restoration. The beneficiaries provide yearly cash flows into a Special Purpose Vehicle (SPV) so it can pay back investors. Some of the beneficiaries also provide cash flows for benefits that can be measured and valued.

“All of the beneficiaries will make payments into the SPV every year, via ‘cost share’ contracts, no matter the outcome of the restoration treatments,” explains Madeira. “Forest restoration is proven to lower the risk of severe wildfire and that lower risk is what they are paying for. It's like paying for a tutor to lower the risk of failing a test.”

Pay for Success

Some of the beneficiaries will also sign ‘pay-for-success’ cash flow contracts, which require payments based on measured improvement in certain benefits. “Additional water quantity is a perfect candidate for this pay-for-success structure,” says Madeira.

As complicated as it sounds, there is a risk diversification benefit of having multiple beneficiaries providing cash flows, and having steady yearly cash flow payments is a significant improvement on many existing social impact financial vehicles and pay-for-success contracts, which don’t pay out anything if the project fails and often need substantial philanthropic support.

One attraction of the pay-for-success cash flows in the Forest Resilience Bond structure, is that they’ll potentially provide the return required to attract institutional investors.   “We think there are a number of other benefits we can identify and use to support future restoration projects,” says Knight. “We can’t wait to get these pilots going and begin to gather the data.”

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