SAFE Working Paper No. 345

A Corporate Finance Perspective on Environmental Policy

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.