Towards a Low‐Carbon Economy: How Carbon Pricing Mitigates the Adverse Environmental Impact of Financial Development

This study examines whether carbon pricing can reconcile financial development with environmental sustainability using a panel of 70 developed and developing countries over the period 1990–2024. Employing an interaction framework and alternative measures of carbon‐pricing adoption and price stringency, we find that financial development increases CO 2 emissions, whereas carbon pricing directly reduces emissions and weakens the adverse environmental effects of financial expansion. Emissions trading systems exhibit more consistent and precisely estimated mitigation effects than carbon taxes. Importantly, the effectiveness of carbon taxation depends on the strength of the price signal: while the adoption of a carbon tax alone is not significantly associated with emissions, higher carbon‐tax rates are associated with significant emissions reductions. This finding suggests that introducing a carbon tax may be insufficient unless rates are stringent enough to alter production, investment and energy‐use decisions. Mechanism analysis further indicates that carbon pricing supports decarbonisation by encouraging a shift from fossil fuels towards renewable energy. Its effectiveness has strengthened since the Paris Agreement, particularly for emissions trading systems. The findings are robust to alternative specifications and tests addressing endogeneity. Overall, the results demonstrate that carbon pricing can mitigate the environmental costs of financial development and facilitate the transition towards cleaner energy. They also highlight the importance of aligning the choice and design of carbon‐pricing instruments with countries' economic conditions, institutional capacities and climate‐policy objectives.