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

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posted on 2023-02-23, 11:36 authored by Robin DöttlingRobin Döttling, Magdalena Rola-Janicka

We analyze jointly optimal carbon pricing and leverage regulation in a model with financial constraints and endogenous climate-related transition and physical risks. The socially optimal emissions tax is below the Pigouvian benchmark (equal to the direct social cost of emissions) when emissions taxes amplify financial con- straints, or above this benchmark if physical climate risks have a substantial impact on collateral values. Additionally introducing leverage regulation can be welfare- improving only if tax rebates are not fully pledgeable. A cap-and-trade system or abatement subsidies may dominate carbon taxes because they can be designed to have a less adverse effect on financial constraints.