Conference Agenda

Green or sustainable finance seeks to reduce greenhouse gas emissions by reallocating capital from the most to the least emissions-intensive economic activities. We examine the effectiveness and efficiency of the financial approach to a production externality using the standard microeconomic analysis apparatus traditionally used to assess externality pricing. We model green finance as a capital (or capital cost) intervention, which can be voluntary or induced by public regulation. First-best optimal green finance requires either a specific intervention for each economic project or complex firm-level interventions contingent on each firm's actions, instead of a single carbon pricing instrument. In practice, green finance interventions are imperfect. They target capital in a group of activities, such as, firms, sectors, and, most often, green or brown aggregates, changing the group's cost of capital in a non-contingent fashion, thus, not directly incentivizing emissions reduction. Moreover, green finance is an indirect approach seeking to change emissions through capital or its cost. We examine the grip of capital over carbon emissions at various levels of intervention. Our analysis highlights the difficulty of simultaneously exploiting the "between-groups" reallocation effect of green finance, and its "within-group" effect on emissions intensity. This limits the potential effectiveness of green finance and has the potential of making green finance interventions counterproductive. Our formulas have implications for the design of an effective taxonomy maximizing impact. We also derive (second-best) optimal investment rules balancing, on the one hand, within- and between-groups effects on emissions and, on the other hand, the production inefficiency due to the reallocation of capital. Finally, we illustrate how sector-level costs of capital should be adjusted to align finance with decarbonization objectives and the deadweight-loss of green finance.