Too Levered for Pigou? A Model of Environmental and Financial Regulation

Abstract

We analyze jointly optimal emission taxes and financial regulation in the presence of environmental externalities and financial frictions. Our model highlights that climate-related transition and physical risks have opposite implications for how emission taxes interact with financial constraints. Absent physical risk the socially optimal emission tax is below the Pigouvian benchmark (equal to the social cost of emissions) because emission taxes and abatement costs amplify borrowers’ financial constraints. This implies that emission taxes alone cannot implement a constrained efficient allocation, as welfare can be improved by introducing capital regulation. With physical risk the effect of emission taxes on financial constraints may revert because lower emissions reduce physical risks and thereby loosen borrowers’ financial constraints. This collateral externality may motivate emission taxes above the Pigouvian benchmark and underlines the need to coordinate environmental and financial regulation.

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