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) model of corporate finance. While a cap-and-
trading system optimally governs both firms` abatement activities (internal emission
margin) and industry size (external emission margin) when firms have sufficient internal funds, 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.
