Financial Development and Industrial Pollution

Courtesy of Ralph De Haas (EBRD) and Alexander Popov (ECB)

At the 2015 Paris Climate Conference (COP21), the leaders of the G20 stated their intention to significantly scale up green-finance initiatives to fund low-carbon infrastructure and other climate solutions. A key example is the burgeoning market for green bonds to fund projects that save energy, reduce carbon emissions, or curtail pollution more generally. Somewhat paradoxically, the interest in green finance has also laid bare our as yet incomplete understanding of the relation between regular finance and environmental pollution. Are well-developed banking sectors and stock markets detrimental to the environment as they fuel growth and the concomitant emission of pollutants? Or can financial development steer economies towards more sustainable growth by favoring “clean” industries over “dirty” ones? In a recent working paper (De Haas and Popov, 2018) we aim to disentangle this nexus between finance, growth, and pollution (the latter proxied by the emission of carbon dioxide, CO2). To do so, we employ a unique 53-country, 18-industry, 40-year panel data set that allows us to assess the role of finance in shaping the so-called environmental Kuznets curve.

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, Mani and Wheeler, 2000). Second, when economies develop, technological breakthroughs (or the adoption of technologies from more advanced countries) may substitute “dirty” for clean technologies and reduce pollution per unit of output (within a given sector). Against this background, the goal of our paper is to assess how banks and stock markets affect these two Kuznets mechanisms: a shift towards less-polluting sectors and an innovation-driven reduction in pollution within sectors.

Banks, stocks, and pollution

A move towards green technologies may necessitate 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, Howitt and Mayer-Foulkes, 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 structure of 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 (“dirtier”) technologies (Minetti, 2011). Second, banks can also hesitate to finance green technologies if the related innovation involves assets that are intangible, firm-specific, and strongly linked to human capital. 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 characterized by both high risks and high potential returns. Equity investors may also care more about future pollution, so stock prices may rationally discount the future cash flows of firms in 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

In our paper, 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 first mechanism is one whereby some types of financial markets are better at reallocating investment away from technologically “dirty” towards technologically “clean” industries, holding technology constant. The second 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 four main findings are as follows:

  1. 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 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 holds. Our data show that carbon emissions start to decline at an annual income of around US$ 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 US$ 35,000.
  2. 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.
  3. There are two main channels that may underpin the relationship between financial development and environmental pollution that we document. The first one 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 declining levels 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 CO2 per 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.
  4. Lastly, we also provide direct evidence for the conjecture that the cleaning effect of stock market development is caused by accelerated 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, Tian and Xu (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 recent 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 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.



Aghion, P. Howitt, and D. Mayer-Foulkes (2005), “The effect of financial development on convergence: Theory and evidence”, Quarterly Journal of Economics, 120(1), 173–222.

De Haas and A. Popov, “Financial development and industrial pollution”, EBRD Working Paper No. 217, European Bank for Reconstruction and Development, London.

M. Grossman and A. B. Krueger (1995), “Economic growth and the environment”, Quarterly Journal of Economics, 110, 353–377.

Hettige, M. Mani, and D. Wheeler (2000), “Industrial pollution in economic development: The environmental Kuznets curve revisited”, Journal of Development Economics, 62, 445–476.

Holtz-Eakin and T. M. Selden (1995), “Stoking the fires? CO2 emissions and economic growth”, Journal of Public Economics, 57, 85–101.

P.-H. Hsu, X. Tian, and Y. Xu (2014), “Financial development and innovation: Cross-country evidence”, Journal of Financial Economics, 112, 116–135.

D. Klassen and C. P. McLaughlin (1996), “The impact of environmental management on firm performance”, Management Science, 42(8), 1199–1214.

Minetti (2010), “Informed finance and technological conservatism”, Review of Finance, 15, 633–692.

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