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

Magdalena Rola-Janicka, Robin Döttling

Research output: Working paperDiscussion paperOther research output

Abstract

​We analyze jointly optimal emission taxes and financial regulation in the presence of environmental externalities and financial constraints. If polluters are financially constrained, optimal emission taxes are below the Pigouvian benchmark (equal to the social cost of emissions). This wedge implies that emission taxes alone cannot implement a constrained efficient allocation. Welfare can be improved by complementing emission taxes with leverage regulation, which provides a rationale for considering climate risks in financial regulatory frameworks. Our model highlights that transition and physical risks have opposite implications for how emission taxes interact with financial constraints. When borrowers are exposed to the physical risk of environmental damages the effect of emission taxes on financial constraints can revert because lower emissions increase asset values and financial slack. As a result, the optimal emission tax may be above the Pigouvian benchmark if the impact of physical risk on asset values is sufficiently large.
Original languageEnglish
PublisherSSRN
Publication statusUnpublished - 2022

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