How Financial Deepening Shapes Carbon Emissions: Insights from Global Economies

The study by the World Bank finds that financial deepening generally increases carbon emissions intensity, but countries with strong environmental regulations and better institutional frameworks can mitigate this effect. Tailored policy reforms are essential to balance economic growth with environmental sustainability.

A recent working paper from the World Bank's Finance, Competitiveness, and Innovation Global Practice, authored by Boris Fisera, Martin Melecky, and Dorothe Singer, investigates the impact of financial deepening on carbon emissions intensity across 125 economies between 1990 and 2019. The paper explores the relationship between the expansion of financial systems and carbon dioxide emissions per unit of GDP. Financial deepening, defined as an increase in bank credit relative to a country’s GDP, has long been considered an engine for economic growth, especially in developing countries. However, the environmental consequences of this financial expansion, particularly regarding carbon emissions, remain less understood. The paper addresses this knowledge gap by analyzing data from a global sample and investigating how different institutional environments affect the relationship between financial deepening and carbon intensity.

Financial Deepening and its Role in Carbon Emissions

The study finds that, on average, financial deepening leads to an increase in carbon emissions per unit of GDP, primarily because financial institutions tend to channel resources into traditional, carbon-intensive industries rather than cleaner, more innovative sectors. This means that as countries develop financially, the carbon intensity of their economies tends to rise. This result holds across the majority of countries in the sample, indicating a general trend in how financial deepening correlates with higher carbon emissions. However, the relationship is not straightforward. The paper highlights that certain institutional factors can mitigate the adverse effects of financial deepening on carbon emissions. Countries with stronger environmental regulations, more robust rule of law, and financial systems that are more market-based as opposed to being primarily bank-driven show significantly lower increases in carbon emissions intensity when financial deepening occurs. These findings suggest that institutional quality plays a critical role in determining whether financial deepening exacerbates or alleviates carbon intensity.

Institutional Quality as a Key Factor

The research further distinguishes between countries with high and low initial carbon emissions intensity. In economies with lower initial carbon intensity, improving the institutional environment, particularly by strengthening the rule of law and developing more market-oriented financial systems can help mitigate the negative environmental impacts of financial deepening. In contrast, countries with higher initial carbon intensity benefit more from enhancing environmental regulations to reduce the carbon emissions resulting from financial expansion. This suggests that different policy approaches are needed depending on the starting point of a country’s carbon intensity. For nations already on a lower carbon trajectory, governance and financial structure reforms are key. Meanwhile, for countries struggling with high carbon intensity, environmental laws become the most effective tool.

The Impact of Financial Deepening on Carbon Emissions

The study provides empirical evidence that a one-standard-deviation increase in credit-to-GDP leads to a relative increase in carbon emissions per unit of GDP by about 0.6 percentage points over five years. While this may seem like a small change, the cumulative impact is significant. On average, over five years, carbon emissions per unit of GDP decrease by 3.9 percentage points, compared to the expected 4.5 percentage points without financial deepening. This finding implies that financial deepening slows the rate at which carbon emissions are reduced, trimming about 13% of the emissions reduction that might otherwise be achieved. The paper attributes this to the fact that financial institutions, particularly banks, are generally conservative and prefer to invest in established, carbon-intensive technologies to protect their existing assets rather than financing riskier, innovative, and greener alternatives. This conservatism results in higher carbon emissions as financial deepening expands.

Policy Interventions and Institutional Reforms

The researchers also explore the potential for policy interventions to manage the trade-off between financial deepening and carbon emissions. They identify several dimensions of a country’s institutional environment that can mitigate the negative effects of financial deepening. For instance, countries with a higher number of climate-related laws experience a much smaller increase in carbon emissions per unit of GDP following financial deepening. Similarly, in countries with stronger adherence to the rule of law, financial deepening does not lead to a significant rise in carbon intensity. Financial systems that are more market-based also contribute to better outcomes, as markets tend to support investments in cleaner technologies compared to traditional bank financing. Interestingly, foreign bank ownership did not show a significant impact on carbon intensity, indicating that domestic institutional factors are more influential in managing the environmental effects of financial deepening.

Implications for Policymakers

The paper’s findings have important policy implications for countries aiming to balance financial development with environmental sustainability. It suggests that while financial deepening remains crucial for economic growth, targeted reforms in regulatory frameworks and governance structures are essential to minimize the environmental costs associated with increased financial activity. Strengthening environmental laws, improving the rule of law, and fostering market-based financial systems are key strategies that can help countries leverage financial deepening for green growth. As the world moves toward a low-carbon future, these institutional reforms will be vital in ensuring that financial development supports rather than hinders the transition to cleaner economies. The study underscores the need for timely and decisive action from policymakers to align financial growth with global climate goals.