Abstract

This paper examines how firms’ investments in pollution abatement are influenced by financial frictions and policy uncertainty. Our data analyses suggest that financially constrained firms are less likely to invest in pollution abatement and are more likely to release toxic pollutants. Such a pattern is intensified by policy uncertainty measured by close gubernatorial elections or uncertainty revealed in firms’ earnings conference calls. We then develop a heterogeneous firm general equilibrium model, in which financially constrained firms face increased marginal costs of finance from pollution abatement. The marginal costs of finance are further amplified by policy uncertainty in environmental regulation, reducing firms’ pollution prevention. The aggregate effect of environmental policy may therefore depend on the distribution of financial frictions and policy uncertainty.