Too Levered for Pigou: Carbon Pricing, Financial Constraints, and Leverage Regulation
Robin Döttling1, Magdalena Rola-Janicka2
1Erasmus University Rotterdam; 2Imperial College London
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 the impact of physical climate risk on collateral values. We derive necessary conditions for emissions taxes alone to implement a constrained-efficient allocation, and compare the welfare consequences of introducing a cap-and-trade system, green subsidies, or leverage regulation. Our analysis also shows that efficient carbon pricing can be supported by carbon price hedging markets but may be hindered by socially responsible investors in equilibrium.