Hybrid seminar: Too Levered for Pigou? A Model of Environmental and Financial Regulation

We analyze jointly optimal emissions taxes and financial regulation in a model with financial frictions 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 constraints, or above the Pigouvian benchmark if physical climate risks have a substantial impact on collateral values. With emissions taxes optimally set to account for this collateral externality, additionally introducing leverage regulation can be welfare-improving if tax rebates are not fully pledgeable. In this case, optimal financial regulation mandates a leverage cap or floor, depending on whether higher leverage is associated with more or less emissions.