Working Paper: CEPR ID: DP16878
Authors: Roman Inderst; Florian Heider
Abstract: 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.
Keywords: Pigou Tax; Financing; Climate Change
JEL Codes: O16; L16; H23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| External financing constraints (G32) | Optimal cap on emissions (Q58) |
| Optimal cap on emissions (Q58) | Emission allowances allocation (Q52) |
| Financial constraints (D10) | Internal emission margin (D25) |
| Cap below Pigouvian benchmark (D62) | Market share to less polluting firms (Q52) |
| Financial constraints + Heterogeneity (D29) | Uniform cap-and-trade system not optimal (H21) |
| Financing constraints (G32) | Pricing of emissions (Q52) |
| Financing constraints + Environmental policies (Q58) | Effectiveness of policies (F68) |