Can sustainability-linked lending reconcile environmental and financial motives?

Differentiated lending terms for clean and dirty capital have become a popular tool among commercial banks as they promote themselves as advocates of environmental sustainability. Using a two-sector New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model where emissions are a by-product of dirty capital, we incorporate an interest spread responding elastically to carbon emissions: Banks offer lower lending rates to clean capital investment agencies when emission growth exceeds a target level. We find that while banks’ offering emission-elastic lending rate (EELR) is consistent with the regulator’s welfare objective, there is a tendency for banks to overreact to carbon emissions, resulting in increased loan volume, and thus, uncertainties in the financial sector. Although EELR faces more financial sector uncertainty, it outperforms Green Capital Requirements (GCR) in lowering the economic risk associated with the green transition.