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

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Version 2 2023-06-07, 08:06
Version 1 2023-02-23, 11:36
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posted on 2023-06-07, 08:06 authored by Robin DöttlingRobin Döttling, Magdalena Rola-Janicka

We analyze jointly optimal carbon pricing and financial policies under finan- cial 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. 

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