IMF Working Papers

This paper analyzes the effectiveness of green financial policies—green credit policies and free emissions allowances—at improving emission efficiency while supporting output. We develop a heterogeneous-firm model with financial constraints and endogenous adoption of cleaner capital. The model matches key targeted and untargeted moments from granular micro-data, including the facts that more financially constrained firms are less productive, more emission intensive, and respond less to carbon pricing. In counterfactual simulations in our model, credit policies without green bias raise output but also raise emissions, as firms become more capital and energy intensive. In contrast, well-targeted green credit policies—focusing on frontier technologies—cut emissions while boosting output. In the presence of financial frictions, free emissions allowances offset the output costs of carbon pricing, breaking the usual irrelevance of permits allocation.