Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation
57 Pages Posted: 3 Feb 2022 Last revised: 24 May 2023
Date Written: May 23, 2023
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
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