DP16878 A Corporate Finance Perspective on Environmental Policy

Author(s): Florian Heider, Roman Inderst
Publication Date: January 2022
Keyword(s): climate change, Financing, Pigou Tax
JEL(s): H23, L16, O16
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16878

This paper examines optimal enviromental policy when external financing is costly for firms. We introduce emission externalities and industry equilibrium in the Holmström and Tirole (1997) workhorse model of corporate finance. While a (Pigouvian) cap-and-trading system optimally governs both firms' abatement activities (internal emission margin) and industry size (external emission margin) when firms have sufficient funds on their own, external financing constraints introduce a wedge between these two objectives. When a sector is financially constrained in the aggregate, the optimal cap is strictly above the Pigouvian benchmark and emission allowances should be allocated below market prices. When a sector is not financially constrained in the aggregate, a cap that is below the Pigiouvian benchmark optimally shifts market share to less polluting firms and, moreover, there should be no "grandfathering" of emission allowances. With financial constraints and heterogeneity across firms or sectors, a uniform policy, such as a single cap-and-trade system, is typically not optimal.