A JFSC sustainability risk assessment should start with the firm’s business model and sources of revenue.
To determine financial materiality, firms need to understand what each material revenue stream depends upon and how sustainability-related risks could affect that exposure. Where revenue depends on asset values, this may require look-through analysis of underlying investment, lending, underwriting or client portfolios.
Financial materiality starts with the business model
The JFSC’s sustainable finance guidance focuses on financial materiality: whether sustainability-related risks could affect a firm’s financial position, performance or cash flows.
That means the starting point shouldn’t be a generic list of sustainability risks.
It should be:
Where does the business make its money, and what are those revenues economically exposed to?
A useful way to think about the assessment is:
Business model → Revenue → Economic dependency → Risk exposure → Financial materiality
This matters because different revenue streams can have very different exposures.
A fixed administration fee, for example, creates a different economic dependency from revenue calculated as a percentage of assets.
Understanding those dependencies is fundamental to identifying where sustainability risk could become financially material.
When does a JFSC sustainability risk assessment require portfolio look-through?
Where revenue is materially dependent on the value, performance or risk characteristics of underlying assets, assessing the regulated entity alone may not reveal the real financial exposure.
Firms may need to look through to the portfolio sitting underneath the revenue model.
Depending on the business model, this could include:
- Investment portfolios for investment managers and asset owners
- Lending portfolios for banks and credit providers
- Underwriting and investment portfolios for insurers
- Client portfolios or assets where these create a material economic dependency for fiduciary or administration businesses
The question becomes:
What are our revenues economically exposed to – and what sustainability risks sit underneath that exposure?
From sustainability risk to business risk
Consider a financial services firm with a relatively small operational footprint.
Looking only at its offices and direct activities might suggest limited climate risk.
But if a significant proportion of revenue depends on underlying assets exposed to physical climate risk, transition risk, regulatory change or market repricing, the firm’s financial exposure could look very different.
The important connection is the transmission mechanism: how does a sustainability-related risk affecting an underlying exposure ultimately affect the firm’s revenue, costs, asset values, clients or cash flows?
This is what turns sustainability risk analysis into business risk analysis.
Four questions for assessing financial materiality
A robust JFSC sustainability risk assessment should be able to answer four questions:
- Where do we make our money?
- What does each material revenue stream economically depend upon?
- Do we need to look through to underlying assets, clients or counterparties to understand that exposure?
- What physical or transition risks could affect those exposures and ultimately our financial performance?
For firms responding to the JFSC’s sustainable finance guidance, this is the critical shift:
Don’t start with sustainability. Start with the business model – and follow the revenue to the risk.
