Green Capital Requirements

Abstract:

We study bank capital requirements as a tool to address financial risks and externalities caused by carbon emissions. We characterize optimal prudential adjustments to capital requirements in response to emerging climate risks. A prudential mandate that excludes externalities is welfare-maximizing in the presence of an optimal carbon tax. When carbon taxes are not set optimally, using capital requirements to reduce emissions may require sacrificing financial stability or may be altogether infeasible. However, capital requirements can play an indirect role by removing stranded asset risk, thereby making future carbon taxes credible.