The Effects of Financing Green and Brown Sectors: What Do Theories and Evidence Say?

Abstract

This paper critically examines the economic and welfare implications of financing green and brown sectors. Drawing on a comprehensive review of recent theoretical and empirical literature, we highlight that while conventional green finance—allocating capital toward environmentally friendly (“green”) sectors and away from carbon-intensive (“brown”) sectors—can promote decarbonization, it may also produce unintended externalities. In particular, it can inadvertently incentivize higher emissions from brown firms and contribute to economic disruption. Using a dynamic stochastic general equilibrium (DSGE) model, we demonstrate that lowering the cost of capital for green sectors leads to only modest reductions in emissions, whereas raising it for brown sectors can paradoxically increase emissions. These findings underscore the importance of transition finance, which channels capital to support the decarbonization of brown sectors, especially in the context of Asia's carbon-intensive economies. We conclude with policy recommendations to strengthen transition finance markets across the region.