NO : WP-2026-019
AUTHOR : Saurav Kumar
TITLE : Emission trading, financial frictions, and transition risks
ABSTRACT :
I examine how a carbon permit market affects financial stability by using a two-sector Environmental Dynamic General Equilibrium model with emission intensity target and financial frictions. The Ramsey-optimal environmental target and macroprudential policy (taxes or subsidies on bank assets) are contingent on initial permit allocation method and financial frictions. I find that the asymmetric effect of permit trading between firms due to their differing policy compliance propagates from firms’ profit maximization to banks’ portfolio composition. Permit trading and macroprudential policy shift lending toward permit sellers. When policy is implemented without prior announcement, bank net worth falls. However, macroprudential policy limits these losses. Auctioning generates larger losses and a recession, while free allocation entails smaller losses and avoids recession under optimal targets but can be recessionary under stringent targets. Advance policy announcements mitigate transition risk by reducing net worth losses under auctioning and increasing bank net worth under free allocation.
Keywords: Permit trading, intensity target, financial frictions, macroprudential policy, transition risk
JEL Code: E44, E32, G18, Q58, D47.
Weblink: http://www.igidr.ac.in/pdf/publication/WP-2026-019.pdf
