Deep in the Stanislaus National Forest, an hour's drive from the foothill town of Sonora, two forests stand side by side.
One is open and airy, with light that streams through gaps between vast sugar and ponderosa pines down to an almost bare forest floor. The other is so dense with brush and smaller trees that little sun peeks through, even at noon on a clear day.
Standing between them during a visit two months ago was a group of would-be financiers — an investment analyst, an engineer and a bond trader — who see potential profit in that stark contrast.
In the coming year, they hope to sell investors on a new type of bond that, instead of financing a corporate acquisition or a pool of mortgage loans, would address two of the biggest challenges facing California: fire and water.
The founders of fledgling San Francisco firm Blue Forest Conservation want to use the proceeds of what they call a forest-resilience bond to pay crews to cut down small trees, clear out shrubs and burn off ground cover in overgrown forests.
That thinning work would reduce the risk of destructive forest fires by removing extra fuel, and theoretically allow more water to flow downstream to reservoirs, hydroelectric dams, farms and faucets, instead of being soaked up by plant life.
That would benefit the U.S. Forest Service, public water agencies, private power utilities and possibly other entities that rely on a healthy forest ecosystem — stakeholders that need to be persuaded to pay back those bonds, with interest, for the whole scheme to get off the ground.
"There are all these entities that benefit from the work, but there's not really any money to pay for it," said former investment analyst Leigh Madeira, one of Blue Forest's founders. "If you can bring all those parties together and repay investors over time, you have a financial instrument."
The Forest Service, which owns vast tracts of forest land in Western states, pays for thinning or restoration work, but lately has had to spend more on fighting fires than preventing them, a trend made worse by a drought that has killed millions of trees. Last year, firefighting accounted for more than half its budget, up from 16% in 1995.
The Forest Service estimated it did restoration work on 4.6 million acres of land in 2014 — but still has a backlog of as much as 82 million acres.
For Blue Forest's founders, a September visit to the Stanislaus National Forest was a chance to see up close the difference between a thinned forest and an overgrown one. Crews in 2012 thinned out a section of the forest near the town of Pinecrest but didn't touch an area along a dry creek bed.
"It's unbelievable," Madeira said. "In some forests, there are between four and 10 times as many trees as there used to be. Until you see it, it's hard to picture."
Which is why, when pitching potential investors, Madeira begins her presentation with a photo of a forest taken in the 1890s — when small fires were allowed to naturally burn off brush — and the same, much denser forest in 1993 after decades of fire suppression.
The images, she said, help audiences get past a common question: Why does a company focused on conservation want to cut down trees?
"People are unaware that we have so many trees and that that's a problem," she said.
What Blue Forest's founders envision is the latest variety of a relatively new class of investments dubbed social-impact bonds, which channel private capital into programs aimed at addressing social problems.
When those programs meet their goals, governments pay investors back. But when programs fall short, investors lose their money. That's why they are also called pay-for-success bonds.
The first program funded by a social-impact bond — one aimed at reducing recidivism at a British prison — kicked off in 2010. The first domestic project, another recidivism program, was launched in New York in 2012.
Last year, California's first social-impact bond program, aimed at reducing homelessness, launched in Santa Clara County. Blue Forest's effort is among several new ones in the state under development.
Madeira, along with cofounders Zach Knight, Nick Wobbrock and Chad Reed, met while finishing their MBA degrees at UC Berkeley last year. They developed their forest bond for a sustainable-investment competition sponsored by Morgan Stanley and Northwestern University's business school.
They won and were invited to speak at last year's Milken Institute Global Conference in Beverly Hills. There, they drew the attention of an investment officer of the California State Teachers' Retirement System, a massive pension fund with hundreds of billions of dollars to invest. Though he made no promises, he said their idea was interesting.
"That's when we realized we were on to something," Madeira said.
Though state and local governments, as well as major philanthropic foundations, have been keen on the idea of social-impact bonds, the financing mechanism has its detractors.
One persistent argument is that they give private investors a chance to profit from what the government should be doing already. Jon Pratt, a bond skeptic and executive director of the Minnesota Council of Nonprofits, said the programs have only become popular because governments are chronically underfunded and there's little will to raise taxes.
"Much of government has lost public confidence, and so this feels like a solution," Pratt said. "It can feel like we're going to get better results, and it's going to create new money to do this work, which kind of sounds too good to be true."
He likened these new financing mechanisms to user fees, lottery proceeds and other alternative sources of funds that governments have turned to. They might help in the short term, but ultimately they create a mindset that makes it more difficult for governments to raise needed revenue, he said.
But Wobbrock argues that the forest-resilience bond actually broadens the revenue sources for forest thinning, and that even if the Forest Service had the money to pay all on its own, it shouldn't.
"A host of utilities — some of which are investor-owned — would benefit financially, but they didn't pay anything for that work," Wobbrock said.
It's also simply not realistic for the Forest Service to work through its backlog alone, he said. With thinning costs of about $1,000 per acre, the work runs into the tens of billions of dollars, many times the agency's 2015 budget of $5.5 billion.
Though Blue Forest aims to start small, raising perhaps just a few million dollars for its first bond, the firm ultimately hopes to raise much more by tapping into a growing amount of capital earmarked for investments that promise more than a financial return.
Social-impact investing, which advances a social good or at least avoids promoting social or environmental ills, is drawing more and more money.
There are now about $8 trillion in U.S. investments guided by environmental, social or corporate governance criteria, up from less than $1 trillion in 1995, according to a report this year by US SIF, an advocacy group for sustainable investing.
Richard Jones, a wealth manager at Merrill Lynch in Los Angeles, said some of his clients have even started asking about social-impact bonds.
For now, though, he is advising clients to think about social-impact bonds as more akin to a donation — as "philanthropy with the possibility of a return" — and less like a true investment.
"This whole area is still so new," he said. "If you want something that will maximize your financial return, that's a different story. We're not going to recommend social-impact bonds for that purpose."
One question in particular has dogged some early social-impact bond programs: how to measure whether they are successful. Traditional bonds measure success in dollars and cents, but the math behind behind this new class of bonds is often fuzzier.
In 2013, Pritzker and an impact-investing arm of Wall Street investment bank Goldman Sachs backed a bond that paid for a preschool program in Utah that targeted students believed to be at risk of needing special education. If the program kept students out of the pricey programs, much of the savings would be paid back to investors.
But last year, after the state made its first payment to investors, the program was criticized by experts who said it overestimated the number of students likely to need special education in the first place.
Pritzker said that's the kind of problem that's bound to arise from any novel financing mechanism. He noted that another social-impact bond he backed, one that will pay for a preschool program in Chicago, uses a more complicated and rigorous metric to figure out savings.
"Until you do something and make a mistake or two, you don't really know what's going to work," he said.
That's the same approach taken by the Rockefeller Foundation, a proponent of social-impact bonds that has backed Blue Forest with about $1 million in grant funding.
Saadia Madsbjerg, a managing director at the New York foundation, said the goal is for Blue Forest to develop a bond attractive to any investor.
"We want to develop it into a viable investment product that stands on its own," she said. "We want investors to invest just based on the pure financial merits."
Adam Connaker, an associate at the foundation, said Blue Forest could have a shot at meeting that goal because its bonds will be structured to guarantee some repayment even if the program doesn't meet all its objectives.
The start-up's founders hope to persuade the Forest Service and utilities to pay a fixed amount of money every year, probably for a decade, for each acre that's thinned. That not only would reduce the risk of costly fires, but it would have ancillary benefits for utilities. Burned slopes are more prone to erosion, resulting in dirt and silt running into reservoirs, which lowers storage capacity and raises water-treatment costs.
The utilities would only make additional payments if they are convinced the thinned forests send more water into their reservoirs than they otherwise would expect given that year's rainfall.
Major water users such as breweries and bottling companies might be willing to pay for water benefits, too, said Todd Gartner of environmental research nonprofit World Resources Institute, which is helping develop the bond.
"These companies are often the biggest water user in a watershed," Gartner said. "They recognize this as a legitimate strategy to help them with physical risk to their water supply."
Still, like other social-impact bonds, Blue Forest's has a metrics problem. It will have to come up with ways of measuring how much, if any, extra water their program produces — and get utilities and others to agree on its methods.
The idea that forest thinning can produce more downstream water is not radical, as several studies over the last few years have suggested that's the case. But it's never been proved on a large scale and there's no hard data to pinpoint the potential benefit.
"The question is, how much?" said Roger Bales, a UC Merced professor who studies mountain hydrology. "We're trying to provide accurate estimates to that question. And we're trying to write predictions that are accurate enough for investors to see there's a benefit."
It's a complex problem. No watershed, no mountain, no single hillside in the Sierra Nevada range is exactly like another, and all sorts of factors — including elevation, slope, soil thickness and underlying rock features — can affect how much water flows downstream.
One possibility is to use satellite imagery documenting forests before and after thinning. That information would be combined with models developed by Bales and UC Merced research Philip Saksa, Blue Forest advisors who have data from weather sensors throughout the Sierra. The idea is to come up with a rough estimate of how much less water is being absorbed by the forest, and how much more is heading downstream.
Blue Forest has met with hydrologists at Pacific Gas & Electric, but has yet to persuade the utility to commit to the project. Utility spokeswoman Lynsey Paulo said PG&E is interested but needs to know more about the water benefits and other details.
A bigger issue is that the Forest Service has yet to commit to participating. "The Forest Service is sort of the elephant in the room," Knight said.
Mike Illenberg, a spokesman for the Forest Service’s parent agency, the
And even if the Forest Service signs on and clear metrics can be agreed upon, Blue Forest will have to convince the other entities that the forest-thinning work will save them enough money or provide enough extra water to be worth backing the bond offering.
"If we spend $5 million to avoid a $2-million potential cost, that doesn't sound like good business to me," said Richard Sykes, an official with the East Bay Municipal Utility District water agency, which has spoken with Blue Forest.
He likened Blue Forest's bond proposal to a shopping mall — one that needs a few big, anchor tenants to support many smaller ones.
"They need to have the Forest Service. They're the biggest beneficiary," he said. "You've got to have a Macy's in there. We're the taqueria."
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