ESG, KYC & Client Onboarding: Why You Should Integrate, Not Isolate

Mark Bands, Partner at Aurora, and Volker Lainer, VP of Product Management and Regulatory Affairs at GoldenSource explore the intersection between ESG, KYC & Client Onboarding.

Mark Bands, Partner at Aurora, and Volker Lainer, VP of Product Management and Regulatory Affairs at GoldenSource explore the intersection between ESG, KYC & Client Onboarding, and how to overcome the data challenges associated with ESG.

Tesla CEO Elon Musk called ESG “an outrageous scam” after the electric vehicle maker lost its spot on an S&P Global index that tracks companies on their environmental, social and governance standards. – Bloomberg, 18th May 2022. Whether or not, like Elon Musk, you think environmental, social, and governance (ESG) is a scam driven by a political agenda, ESG is here to stay. The focus on ESG has been growing for the past 10 years or more, as the effects of the climate crisis and a broad concern over diversity and equity have come to the fore in consciousness of both the public and governing bodies, globally. It is only, though, within the last 3 years that ESG has truly entered the regulatory mainstream and now holds sway in the zeitgeist of the financial services sector, latterly also interlinking the concepts of ESG, KYC and client onboarding.

The intersection of ESG, KYC and client onboarding – a new discipline

Regulators across the world are now embedding ESG criteria in their guidelines and even explicitly in regulations. For financial services institutions (FI’s), including asset managers, insurance and fund investors, there are two distinct “angles” to the context of needing to understand the ESG criteria of the corporates, funds and investment vehicles on their books. On the one hand there is the need for firms to divulge how they evaluate various ESG criteria as part of their investment decisions and offerings. On the other hand, very much aligned to the existing regulatory context of Anti Money Laundering (AML), Know your Customer (KYC) and Anti Bribery and Corruption (ABC), prior to onboarding new customers for the provision of banking services, FI’s will need to understand and record where and how, in the context of ESG provisions, their clients make their money and conduct their business. This intersection of ESG, KYC and client onboarding is new to most financial firms.

As noted above, the latter context particularly falls naturally within the compliance field, and the broader domain of Client Life Cycle Management (CLM). While traditionally ESG checks and investigations have been catered for by “specialist” teams within a firm, it is not surprising that many heads of Compliance are now seriously considering including ESG as part of their existing suite of client due diligence and onboarding processes/checks. Positive public perception is critical for FI’s, as is the avoidance of large fines and/or censure from the regulators. It’s clear then that firms that onboard, service and make money from clients with poor ESG behaviour run the risk of significantly harming their businesses. Integrating ESG into the background checks firms undertake when onboarding clients is now a necessity.

Adding to the burden of compliance

While undertaking ESG KYC and AML checks may, at first, seem to be adding further complexity to the burdensome load compliance functions in FI’s already manage, we know that current KYC, Sanctions and AML assessments, while separate, are usually catered for within the capabilities of one cohesive compliance function. It is analogous then that ESG should be brought into the CLM supply-chain at the same juncture. Doing so will allow firms to benefit from the joining of forces, creating natural opportunities for operational efficiency and risk reduction by bringing the teams together. A look at benefits would not be complete without considering data and information. The data management imperative in the CLM domain has been to gather as much client related information at the top of the onboarding process as possible, with as little impact as possible caused to the client by repetitive information requests from multiple teams. It follows therefore that embedding ESG KYC checks and data gathering in the onboarding process will further add to information that, if it is utilised correctly, will save FI’s significant time, expenditure and regulatory risk in the years ahead.

This realisation provides a good segue from onboarding process to the important foundation of ESG data gathering and data management. New data sources are already required to track ESG rankings, ‘product controversy’ and other relevant compliance indicators. The inevitability of ESG regulatory enforcement measures being taken against non-compliant firms creates a real and present need for both sources that provide ESG data content and platform solutions that can ingest and make the data available to the compliance process and assessments.

ESG, KYC and AML data management

As further ESG related regulations come into force, like the EU Sustainable Finance Disclosure Regulation (SFDR) and MiFID II Sustainability Preferences, it is apparent that large volumes of non-financial ESG-specific data needs to be sourced, managed and governed within the FI’s existing data management frameworks. Much of this data is proving to be tricky to locate while some of it is essentially unstructured and of variable quality and completeness. Coverage of private companies is also proving a challenge, with no single data source addressing all industry sectors in all geographies. These raw-content challenges are significantly worsened by a lack of global ESG data standards and the fact that FI’s are sourcing their ESG data from a multitude of data vendors who are already (and unsurprisingly) using divergent practices for classifying and scoring the criteria. As firms know, the availability of standardised, quality data is fundamental to all compliance processes (ESG, KYC, AML, Sanctions etc.) and this is equally so for ESG. With standards in this space emerging slowly, FI’s will battle to create a roadmap for how they will accurately and consistently achieve ESG compliance.

The ESG data management challenge related to client onboarding involves outright scoring, bucketing and comparisons with peers. Scoring can simply identify if a client falls short of some sort of requirement, such as diversity. However, the ability to do this is dependent on having a consistent methodology and the data to run it. Whilst data providers and sell side services include scoring, it must be at the level of granularity that is relevant to the particular aspect of ESG in question, such as product controversy. Bucketing or flagging might include the confirmation as to whether a client is subject to a particular ESG regulation, and any record that they have failed in any disclosure. Clients might need to initially self-declare such things, and a look at public information or a cross-check with peers will be required as a check. For some areas of ESG, such as climate risk, the potential onboarding check might simply be to compare their score with the sector average. Down the line, this might impact credit terms.

ESG pre-checks during onboarding

Because aspects of ESG, such as energy efficiency and the environmental impact of building materials, will influence the future value of real estate, loan covenants for developments/buildings are now taking into account these factors. Part of the onboarding process might be to run pre-checks on such factors, to ensure the client will be in a position to report back to lending institutions, with formal certifications acceptable to them. There is every likelihood that collateral management will have similar ESG-related constraints and requirements, all requiring the gathering and validation of new data types.

The earlier this data is gathered, the sooner a new client can start doing business. This is to everyone’s advantage. Subsequently, it appears onboarding processes are ripe for expansion, with ESG set to come into play at the outset of the client lifecycle.