How do environmental policies affect financial markets? This paper finds that well-designed environmental policies could lead to lower risk premiums and higher real interest rates. We obtain this result by introducing an optimal environmental policy into a business cycle model in which finance matters. By correcting the externality responsible for climate change, the optimal policy reduces the welfare cost of business cycle fluctuations. This decline in aggregate risk in turn lowers the compensation demanded by investors for holding risky assets as well as the need for precautionary savings. Business cycle variations in environmental policies also have substantial welfare implications.
