Why Green Credit Works for Some Firms but Raises Emissions for the Economy Overall

The paper shows that financially constrained firms are less productive and more polluting, which weakens the impact of carbon pricing and shapes how firms respond to climate policy. It finds that green finance can cut emissions without hurting growth only if it is tightly targeted to frontier technologies and carefully coordinated with carbon pricing and permit design.

A study, “Financial Constraints and the Effectiveness of Green Financial Policies,” produced by economists at the International Monetary Fund (IMF) Research Department, with contributions developed during IMF research programs and informed by European policy institutions, carbon market regulators, and academic climate-economics networks, responds to a central policy challenge: while carbon pricing is the most effective tool to reduce emissions, it is politically difficult to scale up, and many firms, especially smaller, private ones, lack the financial capacity to invest in cleaner technologies. Governments and central banks have therefore turned to green credit, public guarantees, and free emissions permits, but there is little clarity on whether these tools actually deliver lower emissions without harming growth.

What the Data Shows About Firms and Emissions

Using detailed firm-level data from the EU Emissions Trading System (ETS) combined with financial statements from Orbis, the authors study more than 3,200 European manufacturing firms between 2005 and 2021. Two clear patterns emerge. Firms with higher net worth, meaning they are less financially constrained, are more productive. At the same time, more productive firms emit less pollution per unit of value added than comparable firms in the same country and industry. Financial constraints, therefore, shape not just how much firms produce, but how dirty their production is. Smaller, financially stretched firms tend to operate with older, less efficient technologies that generate more emissions.

How Financial Constraints Shape Technology Choices

To explain these patterns, the paper develops a model in which firms must choose both how much to invest and what type of technology to use. Technologies come in “vintages.” Newer vintages are cleaner and more productive, but they are also more expensive. Firms face borrowing limits linked to their net worth, so constrained firms cannot freely finance large investments in advanced technologies. As a result, firms face a trade-off: they can invest in cleaner technology and stay small, or use cheaper, dirtier technology and operate at a larger scale. The model predicts a clear “pecking order” of technology adoption. Financially constrained firms use inferior technologies, while firms that accumulate internal funds gradually upgrade. Once firms are no longer constrained, they all converge to the same frontier technology. This mechanism closely matches what is observed in the data.

What Happens When Credit Is Expanded

The model is then used to evaluate green financial policies. The first result is surprising. When financial constraints are relaxed for all firms and all types of investment, emissions increase rather than fall. Easier credit allows firms to expand production, invest more in capital, and use more energy. Although technology becomes slightly cleaner, the output growth dominates. In the model, eliminating financial constraints raises GDP by over 30 percent but increases total emissions by a similar amount. Broad credit expansion, on its own, is therefore not a green policy.

Targeted green credit tells a different story. When preferential loans or guarantees are restricted to the cleanest, frontier technologies, the model delivers both higher output and lower emissions. Firms invest in genuinely cleaner capital, productivity rises, and energy use per unit of output falls. However, this result is fragile. If green credit is extended even slightly beyond frontier technologies, emissions start rising again as output growth overwhelms efficiency gains. Effective green finance, therefore, requires very precise targeting and strong definitions of what counts as “green.”

Carbon Pricing, Free Permits, and Policy Trade-Offs

The paper also shows that green financial policies interact closely with carbon pricing. As carbon prices rise, firms naturally shift toward cleaner technologies. Green credit policies must be continuously adjusted to remain aligned with this moving technology frontier. Otherwise, they lose effectiveness.

Finally, the paper re-examines the role of free emissions permits. In standard models, giving permits away for free does not change real outcomes. Here, financial constraints change the result. Free permits act like transfers that raise firms’ cash flow, relax borrowing constraints, and encourage both investment and entry. When combined with higher carbon prices, free permits can sharply reduce emissions while avoiding large output losses. In the model, emissions can fall by more than 40 percent with virtually no GDP decline, an outcome that would be much more costly under carbon pricing alone.

Overall, the paper shows that financial constraints are central to understanding climate policy. Green finance can help, but only if it is carefully targeted and coordinated with carbon pricing. Poorly designed financial policies risk accelerating both growth and emissions at the same time.