Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation

57 Pages Posted: 3 Feb 2022 Last revised: 24 May 2023

See all articles by Robin Döttling

Robin Döttling

Rotterdam School of Management, Erasmus University; Erasmus Research Institute of Management (ERIM)

Magdalena Rola-janicka

Tilburg University

Date Written: May 23, 2023

Abstract

We analyze jointly optimal carbon pricing and financial policies under financial constraints and endogenous climate-related transition and physical risks. The socially optimal emissions tax may be above or below a Pigouvian benchmark, depending on whether physical climate risks have a substantial impact on collateral values. We derive necessary conditions for emissions taxes alone to implement a constrained-efficient allocation, and show a cap-and-trade system or green subsidies may dominate emissions taxes because they can be designed to have a less adverse effect on financial constraints. Additionally introducing leverage regulation can be welfare-improving if environmental policies have a direct negative effect on financial constraints. Furthermore, our analysis highlights the positive effect of carbon price hedging markets on equilibrium environmental policies.

Keywords: Pigouvian tax, carbon tax, cap and trade, financial constraints, climate risk, financial regulation

JEL Classification: D62, G28, G32, G38, H23

Suggested Citation

Döttling, Robin and Rola-janicka, Magdalena, Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation (May 23, 2023). Available at SSRN: https://ssrn.com/abstract=4024366 or http://dx.doi.org/10.2139/ssrn.4024366

Robin Döttling (Contact Author)

Rotterdam School of Management, Erasmus University ( email )

P.O. Box 1738
Room T08-46
3000 DR Rotterdam, 3000 DR
Netherlands

Erasmus Research Institute of Management (ERIM) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Magdalena Rola-janicka

Tilburg University ( email )

P.O. Box 90153
Tilburg, Noord-Brabant 5000 LE
Netherlands

HOME PAGE: http://https://www.magdarolajanicka.com/

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