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

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.