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Abstract:
Carbon pricing aims to shift the risk-adjusted returns on investment in favor of green technologies vis-‘a-vis fossil investment, relying on efficient capital markets to redirect investment accordingly. Capital markets with financial frictions can distort this transmission of climate policy. This study analyses the impact of emission taxes on mitigation and low-carbon investment in the presence of financial frictions. We develop a two-sector environmental dynamic stochastic general equilibrium model calibrated to the Euro Area, to simulate an economic transition in line with the EU climate targets. Financial frictions dampen the response of the economy to the carbon tax such that the emissions target will be missed by 11 percentage points. Moreover, the adverse effects of financial frictions increase when climate policy is delayed. We further identify a volume and a risk effect that drive the impact of a financial wealth shock and an uncertainty shock on emission intensity.
