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

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