By Kai Lessmann and Matthias Kalkuhl
Interest rates are central determinants of saving and investment decisions. Costly financial intermediation distort these price signals by creating a spread between the interest rates on deposits and loans with substantial eﬀects on the supply of funds and the demand for credit. This study investigates how interest rate spreads aﬀect climate policy in its ambition to shift capital from polluting to low-carbon sectors of the economy. To this end, we introduce financial intermediation costs in a dynamic general equilibrium climate policy model. We find that costly financial intermediation aﬀects carbon emissions in various ways through a number of different channels. For low to moderate interest rate spreads, carbon emissions increase by up to 7 percent, in particular, because of lower investments into the capital intensive clean energy sector. For very high interest rate spreads, emissions fall because lower economic growth reduces carbon emissions. If a certain temperature target should be met, carbon prices have to be adjusted upwards by up to one third under the presence of capital market frictions.
The financial sector is here to grease the wheels of the savings-to-investment engine. But there is still friction, and the consequences can be dramatic as illustrated in this paper. Now imagine if there were no financial sector: a model without a financial sector would find a “perfect” outcome, and the real world would show very inefficient investment. Glad this paper is bridging that.