We study the performance of alternative climate policies in a dynamic stochastic general equilibrium model that includes an environmental externality and agency problems associated with financial intermediation. Heterogeneous polluting producers finance their capital acquisition by combining their resources with loans from banks, are subject to environmental regulation, are hit by idiosyncratic shocks, and can default. The welfare analysis suggests that a cap-and-trade system will entail substantially lower costs of the business cycle than a carbon tax if financial frictions are stringent, firm leverage is high, and agents are sufficiently risk-averse. Simple macroprudential policy rules can go a long way in reining in business cycle fluctuations, aligning the performance of price and quantity pollution policies, and reducing the uncertainty inherent to the chosen climate policy tool.
 

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