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A Corporate Finance Perspective on Environmental Policy

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  • Heider, Florian
  • Inderst, Roman

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.

Suggested Citation

  • Heider, Florian & Inderst, Roman, 2022. "A Corporate Finance Perspective on Environmental Policy," CEPR Discussion Papers 16878, Centre for Economic Policy Research.
    • Handle: RePEc:cpr:ceprdp:16878
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    Cited by:

    1. is not listed on IDEAS
    2. Allen, Franklin & Barbalau, Adelina, 2024. "Security design: A review," Journal of Financial Intermediation, Elsevier, vol. 60(C).
    3. Allen,Franklin & Barbalau,Adelina & Zeni,Federica, 2023. "Reducing Carbon using Regulatory and Financial Market Tools," Policy Research Working Paper Series 10539, The World Bank.
    4. Inderst, Roman & Opp, Markus, 2022. "Socially optimal sustainability standards with non-consequentialist ("warm glow") investors," SAFE Working Paper Series 346, Leibniz Institute for Financial Research SAFE.

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    JEL classification:

    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • L16 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Industrial Organization and Macroeconomics; Macroeconomic Industrial Structure
    • H23 - Public Economics - - Taxation, Subsidies, and Revenue - - - Externalities; Redistributive Effects; Environmental Taxes and Subsidies

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