This is an interesting finding. Sure, we know about the curve, developing countries get dirtier then cleaner as they get richer. But there is a connection between how that is all financed. A more Anglo Saxon economy, relying more upon equity ans stock markets, appears to produce fewer such emissions, a more continental one largely financed by bank loans create more emissions. Huzzah for Anglo Saxon capitalism then, eh?

Finance and pollution
Ralph De Haas, Alexander Popov 05 October 2018

The environmental Kuznets hypothesis predicts that pollution will increase at early stages of development but then decline once a country surpasses a certain income level. This column examines how banks and stock markets affect the mechanisms behind this hypothesis. Industries which pollute relatively more for technological reasons generate relatively more carbon dioxide in countries with expanding credit markets, whereas stock markets have the exact opposite effect. For middle-income countries in particular, where carbon dioxide emissions may have increased linearly during the development process, stock markets could play an important role in making future growth greener.

According to the environmental Kuznets hypothesis, pollution increases at early stages of development but then declines once a country surpasses a certain income level. Two main mechanisms underpin this idea.

  • First, during the early stages of development, a move from agriculture to manufacturing and heavy industry is associated with both higher incomes and more pollution per capita. After some point, however, the structure of the economy moves towards light industry and services, and this shift goes hand-in-hand with a levelling off or even a reduction in pollution (Hettige et al. 2000).
  • Second, when economies develop, technological breakthroughs (or the adoption of technologies from more advanced countries) may substitute clean for ‘dirty’ technologies and reduce pollution per unit of output (within a given sector).

In a recent paper (De Haas and Popov 2018), we assess how banks and stock markets affect these two Kuznets mechanisms. To do so, we employ a unique panel data set covering 53 countries and 18 industries over 40 years that allows us to assess the role of finance in shaping the so-called environmental Kuznets curve.

Banks, stocks, and pollution

A move towards green technologies may involve substantial investments and hence be conditional on the availability of external finance. Schumpeterian growth models suggest that financial constraints can prevent firms in less-developed countries from exploiting research and development (R&D) carried out in countries closer to the technological frontier (Aghion et al. 2005). Financial development can then facilitate the absorption of state-of-the art technologies and help mitigate environmental pollution.

A key question is whether banks or stock markets do a better job in enabling such green investments. That is, does the financial structureof a country (the relative role of banks versus stock markets) play a first-order role in determining how polluting a country’s development path is? Several theoretical arguments suggest that banks may be less suited to reducing industrial pollution than stock markets. First of all, banks are ‘dirtier’ financiers to the extent that they are technologically conservative – they may fear that funding new (and possibly cleaner) technologies erodes the value of the collateral that underlies existing loans, which mostly represent old (and less energy efficient) technologies (Minetti 2011). Second, banks can also hesitate to finance green technologies if the related innovation involves assets that are intangible and firm-specific. Third, bankers often have a shorter time horizon (the loan maturity) than equity investors and are hence less interested in whether assets will become less valuable (or even stranded) in the more distant future.

In contrast, stock markets may be better suited to finance innovative (and greener) industries. By their very nature, equity contracts are more appropriate to finance green innovations that are characterised by both high risks and high potential returns. Equity investors may also care more about future pollution so that stock prices rationally discount future cash flows of polluting industries. Empirical evidence shows that stock markets indeed punish firms that perform badly in environmental terms (such as after environmental accidents) and reward those that do well in terms of environmental friendliness (Klassen and McLaughlin 1996). Ultimately, however, whether banks or stock markets are better suited to limiting or even reducing environmental pollution remains an empirical question.

Empirical approach

We use a cross-country, cross-industry regression framework to assess the relative impact of financial development on different types of industries. In particular, we distinguish industries on the basis of their inherent, technological propensity to pollute. We measure this sector-level pollution intensity as the carbon dioxide emissions of a particular sector per unit of value added (averaged in our global sample during the whole sample period). We thus assume that the global average of a sector’s emissions per unit of output captures the sector’s global propensity to pollute.

An important technical point is that we saturate our regression framework with interactions of country and sector dummies, interactions of country and year dummies, and interactions of sector and year dummies. These fixed effects absorb all kinds of variation – such as the comparative advantage of agriculture in France, the British population’s evolving demand for regulation, and technological development in air transport – that might otherwise distort our estimate of the impact of finance on industry-level pollution.

Importantly, we also explicitly test for the channels through which financial development can affect pollution: between-industry reallocation and within-industry innovation. The former is a mechanism whereby some types of financial markets are better at reallocating investment away from technologically ‘dirty’ towards technologically ‘clean’ industries, holding technology constant. The latter mechanism is one whereby, holding the industrial structure constant,some financial systems are better at improving the energy efficiency of technologically ‘dirty’ industries, bringing them closer to their technological frontier. Related to the second mechanism, we also ask whether any within-industry efficiency gains are the result of more patented innovation by technologically ‘dirty’ industries. To do so, we measure the number of ‘green’ patents that are filed by firms across various industries and countries. The evolution of green patenting measures an industry’s propensity to innovate away from ‘dirty’ technologies.

Our findings in a nutshell

Our analysis produces four main findings:

  • At the country level, we observe that growing credit markets are associated with higher levels of CO2 pollution while, in sharp contrast, larger stock markets are associated with substantially less CO2 emissions. It could, of course, simply be the case that financial development is correlated with general economic development, and so the former may simply pick up the effect of a general increase in wealth on the demand for pollution. However, when we add GDP per capita to our analysis, we find that this is not the case. That is, while the economies of richer countries generate more per capita pollution, the positive effect of credit markets and the negative impact of stock markets still obtain. Our data show that carbon emissions start to decline at an annual income of around $40,000 which is line with earlier estimates by Holtz-Eakin and Selden (1995) who find a peak in CO2 emissions at a per capita GDP of around $35,000.
  • At the sector level, we compare the impact of financial development on relatively ‘dirty’ versus relatively clean sectors. As explained before, our proxy of an industry’s pollution intensity is its average CO2 emissions per unit of output, calculated across all countries and years in our sample. We use these data to test whether technologically ‘dirty’ sectors produce higher carbon dioxide emissions than technologically clean sectors in countries with growing financial markets. We find that industries which pollute relatively more for inherent technological reasons generate relatively more carbon dioxide in countries with expanding credit markets. Interestingly, we find that stock markets have the exact opposite effect: industries that pollute relatively more for technological reasons, produce fewer carbon dioxide emissions in countries with deepening stock markets.
  • There are two main channels that may underpin the relationship between financial development and environmental pollution that we document. The first is cross-industry reallocation whereby stock markets reallocate investment towards, and credit markets reallocate investment away from, relatively clean industrial sectors. We indeed find evidence that credit markets promote a reallocation of investment towards ‘dirtier’ sectors. This partially explains the positive impact of growing credit markets on per capita pollution. At the same time, the opposite holds for stock markets.

The second channel is within-industry technological innovation whereby industries over time adopt more efficient (in our case, cleaner) technologies. Here we present evidence of declininglevels of within-industry technological innovation as credit markets develop. In particular, we find that in countries with growing credit markets, and relative to clean sectors, ‘dirty’ sectors exhibit higher levels of CO2per unit of value added. Stock markets have the opposite effect: pollution levels per unit of value added decline in ‘dirty’ sectors, relative to clean ones, in countries with deepening stock markets.

  • Lastly, we provide direct evidence for the conjecture that the cleaning effect of stock market development is caused by faster green innovation in the dirtiest industries. We first show that patenting activity in technologically ‘dirty’ industries declines with credit market development. This is the case both for total patents and for various green patent aggregates. At the same time, however, the number of green patents per capita increases relatively more in technologically ‘dirty’ industries when stock markets grow. These results complement those of Hsu et al. (2014), who show that industries that depend on external finance and are high-tech intensive are less (more) likely to file patents in countries with better developed credit (equity) markets. We find that credit and stock markets also have contrasting effects on the ability of polluting industries to become greener through innovation.


Our research shows that financial development is to a large extent responsible for the inverse-U shape of the environmental Kuznets curve. Because stock markets only catch up with credit markets at later stages of development, our results imply that the pattern of per-capita pollution over time is intimately related to the sequential development of different types of financial markets. In other words, the evolution of financial structure helps explain the non-linear relationship between economic development and environmental quality that has been documented previously by Grossman and Krueger (1995).

From a public policy perspective, our findings suggest that countries with a bank-based financial system that aim to ‘green’ their economy, such as through the promotion of green bonds or other green-finance initiatives, should consider stimulating the development of conventional equity markets as well. This holds especially for middle-income countries where carbon dioxide emissions may have increased more or less linearly during the development process. There, according to our findings, stock markets could play an important role in making future growth greener, in particular by stimulating innovation that leads to cleaner production processes within industries.

In parallel, countries can take measures to counterbalance the tendency of credit markets to (continue to) finance relatively ‘dirty’ industries. Examples include the green credit guidelines and resolutions that China and Brazil introduced in 2012 and 2014, respectively, to encourage banks to improve their environmental and social performance and to lend more to firms that are part of the low-carbon economy.

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I suspect that this needs a LOT more work. Equity is always the first source of finance in a young economy. Only when it matures do banks appear on the scene. Correlation does not equal causation and environmentalism is a signal that a wealth threshold has been crossed.


Author mentions later, but omits from his early list, that as wealth spreads throughout a nation, the people (either as consumers or as voters) increasingly demand clean rivers.

But curtailing carbon dioxide? That is mostly gadflies, and people deluded by gadflies, and sometimes gadflies show their cards that that isn’t what they want to curtail at all. If humankind ever seriously cuts its production of this plant food, we might have an authentic Environmental Crisis on our hands, which we are unlikely to diagnose.


There is no comment on regulation. Governments of countries where the national bank is heavily invested in heavy industry are unlikely to threaten said bank with heavy-handed environmental regulations; where the owners of industry are dispersed — or better, foreigners — said regulation has little cost to the government.