Analysis of Green Finance : Funding for Investment Projects under Externalities

Abstract

Utilizing a simple economic model, this paper analyzes why many firms that have new investment projects such as green technology or product often fail to finance from the financial market and lose opportunity to start up in the market. In a sense that finance plays positive roles in economic activities, this paper focuses mainly on the roles that finance plays in Green Growth which is briefly defined as achieving higher output with less pollution at the same time. In this paper, we take the existence of externalities and asymmetric information problem between a bank and firms with green investment projects as important factors explaining why many green projects fail to be financed in the market. By using the economic model, we derive the socially optimum number of both conventional and green investment projects. The theoretical result shows that under the private choice, there are over-investment for non-environmentally friendly projects and under-investment for green projects compared to the socially optimum level. It implies that higher return and less pollution can be achieved eventually contributing to Green Growth, when banks consider the externalities when they allocate funds to each investment projects. Nevertheless, as one of the private agents, they do not have enough economic incentive to do so. That is why green investment projects often fail to start up in the market. While showing mathematically that it yields higher output and less pollution when banks allocate funds considering externalities, this paper discusses several policy methods to induce these private agents to fully internalize the externalities and simultaneously emphasizes the roles finance plays in Green Growth. In this regard, imposing taxes and subsidies depending on the type of the investment project to either side of a bank or firm is such example. Additionally, alleviating the asymmetric information problem such as decreasing the verification cost that a bank has to pay to detect green industry is possible.