By Ralph De Haas, Director of Research, EBRD and Alexander Popov, Principal Economist, ECB
This article provides evidence that economies generate fewer carbon emissions per capita if they receive relatively more of their funding from stock markets as opposed to credit markets. This is driven by two distinct mechanisms: equity finance is superior to debt finance in reallocating investment towards “green” sectors, and in pushing carbon-intensive sectors to develop “green” technologies and become more energy-efficient. Increasing the share of equity financing to fifty percent globally would achieve a reduction in aggregate per-capita carbon emissions equal to about one-quarter of the commitment embedded in the Paris Agreement.Our findings caution against embarking on an ambitious policy agenda aimed at decarbonising the European economy through the banking sector, and instead call for supporting equity-based initiatives, such as the Capital Market Union.
Financial markets and global heating
The 2015 Paris Climate Conference (COP21) has put finance firmly at the heart of the debate on environmental degradation. The leaders of the G20 stated their intention to scale up so-called green-finance initiatives to fund low-carbon infrastructure and other climate solutions. A key example is the burgeoning market for green bonds, whose issuance reached USD 48 bln. in the first quarter of 2019, or the creation of a green-credit department by the largest financial institution in the world, the Industrial and Commercial Bank of China.
Somewhat paradoxically, the interest in “green finance” has also laid bare our limited understanding of the relation between regular finance and the environment. Are expanding financial markets detrimental to the environment because they fuel economic growth and the concomitant emission of pollutants? Or do they rather steer economies towards sustainable growth by favoring “green” sectors over “brown” ones? And do credit markets and equity markets have the same impact on environmental degradation, or does it make economic sense to stimulate one segment of the financial system at the expense of the other?
Developing our understanding of the link between financial markets and carbon emissions is important because most of the global transition to a low-carbon economy will need to be funded by the private financial sector if international climate goals are to be met on time (UNEP, 2011). This article (based on De Haas and Popov, 2019) presents novel evidence that stock markets are superior to banks in decarbonising the economy. We demonstrate a robust new fact: for a given level of economic development, financial development, and environmental protection, economies generate fewer carbon emissions per capita if they receive relatively more of their funding from stock markets as opposed to credit markets.
The debt-equity mix
Our first finding is that economies generate fewer carbon emissions per capita if they receive relatively more of their funding from stock markets as opposed to credit markets. The overall size of financial markets does not appear to play a role in the environmental performance of the economy. The decarbonising impact of more intense equity-based intermediation is robust to controlling for economic development, environmental protection, and the phase of the business cycle. It also obtains when we control for unobservable heterogeneity, such as countries’ comparative advantage, and for temporal shocks common to all countries, such as the collapse of global trade in 2009. Finally, the impact of financial structure on carbon emissions survives when we use policy-driven shocks (bank deregulation and equity market liberalisation) to account for the endogeneity of financial markets size and structure. Chart 1 illustrates this result: between 1990 and 2013, per-capita carbon emissions declined by more in countries where stock markets were relatively more important in 1990.
Numerically, our estimates suggest that increasing the share of equity financing by 1 percentage point, while holding the size of the financial system constant, reduces aggregate per capita carbon emissions by 0.024 metric tons. What are the aggregate implications of this? We note that, although the relative importance of equity markets more than doubled in the sample period for the group as a whole, for several countries that are not financial centers and have large banking sectors, such as Australia, Canada, Finland, and the Netherlands, FS is approximately 0.5 throughout the sample period. Suppose that we take all countries below this threshold and lift them to FS=0.5, and we leave every country with FS>0.5 unchanged. For about 80% of the countries in the data set, this would imply an average increase in FS of 0.2 (from an average of around 0.3). This hypothetical shift in the global financial structure would lower aggregate per capita emissions by 0.8 metric tons, which corresponds to a reduction of 11.5%, or one-quarter of the 40% reduction in emissions that countries committed to achieve by 2030 in the context of the Paris Agreement.
Our second finding is that sector-level carbon emissions also decline faster in countries with more equity-based financial systems, a process that is more pronounced in sectors that are more carbon-intensive for technological purposes (e.g., water transportation or energy production). This is driven by two separate mechanisms. First, holding sector-specific technologies constant, stock markets are better than banks in reallocating investment towards “greener” sectors, a mechanism reminiscent of Wurgler (2000). Second, holding the industrial composition constant, a more equity-based economy experiences a faster reduction in carbon emissions per unit of output in carbon-intensive sectors. Clarifying the last point is the fact that deeper stock markets are associated with more green patenting in traditionally carbon-intensive industries. This effect is strongest for patented inventions whose goal is to increase the energy efficiency of the production and processing of goods. The effect of equity markets on energy efficiency is strengthened when we account for private equity, confirming the important role that investors such as Venture Capitalists play for innovation and technological adoption (see Kortum and Lerner, 2000).
Third, we show that there is a positive link between equity funding and lower carbon emissions at the firm level, too. In 2006, Belgium introduced a notional interest deduction (NID) for corporate equity, a policy shock that provides an arguably exogenous source of variation to the cost of equity financing. Matched data from Orbis and from the European Emissions Trading System suggests that the NID reform caused Belgian non-financial firms to increase their equity ratio by about 5% of the sample mean, an adjustment similar to that of Belgian banks (see Schepens, 2016). Subsequently, these same firms reduced the carbon intensity of their production, also in comparison to similar firms in the same sector in neighboring countries.
Finally, the reduction in emissions by carbon-intensive sectors due to domestic stock market development is accompanied by an increase in carbon emissions embedded in imports of final and intermediary goods of the same sector. This effect is stronger for sectors that can easily outsource part of their production structure abroad. However, the domestic-greening effect dominates the pollution-outsourcing effect by a factor of ten. Stock markets thus have a genuine cleansing effect on polluting industries and do not simply help such industries to shift carbon-intensive activities to pollution havens, a finding consistent with the negligible role played by outsourcing in the clean-up of US manufacturing (Levinson, 2009).
Why is equity superior to debt in debcarbonising the economy?
What are the underlying economic mechanisms whereby an increase in the availability of equity finance over time speeds up the decarbonisation of the economy? The first explanation is related to innovation and asset tangibility. R&D-intensive sectors grow faster in countries with deeper stock markets, while sectors rich in tangible assets expand faster in economies that rely more on bank financing. Carbon-intensive sectors tend to be simultaneously less R&D-intensive and richer in tangible assets, and so they grow relatively faster when credit expands. The reallocation of investment towards relatively energy-efficient sectors in countries with deepening stock markets is therefore largely a by-product of these sectors also being more innovative and less rich in tangible assets, and thus more likely to attract the attention of equity investors (Kim and Weisbach, 2008; Brown et al., 2017).
Second, environmental disasters expose firms to potential litigation costs, which is why equity investors tend to be more sensitive to the financing of firms that perform badly in environmental terms (Klassen and McLaughlin, 1996). Large-scale ecological accidents, such as the Bhopal gas tragedy or the Exxon Valdez oil spill, are associated with severe litigation risk (Salinger, 1992). The technological “greening” of carbon-intensive sectors as stock markets develop is to a large degree explained by equity investors pushing such sectors to adopt and develop greener technologies because they are concerned about future litigation costs.
At the same time, litigation risk does not fully explain away the positive effect that equity investment has on the reduction in carbon emissions per unit of output in carbon-intensive sectors. Our results thus leave a role for alternative mechanisms that are difficult to test, such as individual investors having different social objectives than banks, for example.
Our results suggest that countries with bank-based financial systems that aim to decarbonise their economy should consider stimulating the development of equity markets, in addition to promoting green-finance initiatives, such as green bonds. Equity investment can play an important role in the transition to low-carbon economies, in particular by stimulating innovation that leads to the adoption of greener technologies.
In parallel, countries can take measures to counterbalance the tendency of credit markets to finance relatively carbon-intensive sectors and firms. Examples include the green credit guidelines that China and Brazil recently introduced to encourage banks to improve their environmental performance and to lend more to firms that are part of the low-carbon economy.
Lastly, countries that aim to limit the negative environmental externalities stemming from an excessive reliance on credit intermediation can reduce tax-code favouritism towards debt. A positive example of that is the common corporate tax base that has been proposed to address the current debt bias in corporate taxation, in the context of the European Commission’s work on the Capital Markets Union. A so-called Allowance for Growth and Investment will give firms equivalent tax benefits for equity and debt. To the extent that such policies indeed move economies towards more equity-funded investments, they can also have important environmental benefits by making low-carbon technologies easier to finance.
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