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

51 Pages Posted: 3 Feb 2022 Last revised: 6 Apr 2022

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: January 28, 2022

Abstract

We analyze jointly optimal emissions 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 emissions taxes interact with financial constraints. When transition risk dominates, the socially optimal emissions tax is below the Pigouvian benchmark (equal to the social cost of emissions) because emissions taxes and abatement costs amplify financial constraints. This implies that borrowers do not correctly internalize the effect of their leverage on welfare through emissions, and welfare can be improved by complementing emissions taxes with capital regulation. If physical climate risks have a substantial impact on collateral values, the effect of emissions taxes on financial constraints may revert because lower emissions reduce physical risks and thereby loosen financial constraints. This collateral externality may motivate emissions taxes above the Pigouvian benchmark and further underlines the need to coordinate environmental and financial regulation.

Keywords: Pigouvian tax, financial constraints, financial regulation, emissions taxes, capital regulation, physical risk, transition risk

JEL Classification: H23, D62, G28, G38

Suggested Citation

Döttling, Robin and Rola-janicka, Magdalena, Too Levered for Pigou? A Model of Environmental and Financial Regulation (January 28, 2022). 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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