The Effect of Financial Development on CO₂ Emissions: A Nonlinear Dynamic Panel Data Analysis

This study aimed to find out if it is possible to utilize the financial system and/or instruments to improve environmental quality.

Since the Industrial Revolution, there has been rapid global warming and climate change due to the use of fossil fuels, which produce greenhouse gas emissions due to economic activities that do not involve environmental sensitivity.

To analyze the effect of financial development on CO₂ emissions, we developed a nonlinear hypothesis by combining four hypotheses of carbon-friendly financing, carbon financing, pollution haven, and pollution halo. To test the validity of the hypothesis, we employed nonlinear system GMM analysis.

We found an inverse U-curve relationship between financial development and CO₂ emissions, supporting the nonlinear hypothesis for 120 countries over the period of 1999-2019.

Below the specific threshold, financial development has a significantly positive effect on CO₂ emissions if carbon-friendly financing is followed in underdeveloped financial systems, and above the specific threshold, financial development has a significantly negative effect on CO₂ emissions in well-developed financial systems. Beyond empirical analysis, the theory also introduces the concept of a 'financial trap', suggesting that the minimum achievable level of CO₂ emissions in countries with underdeveloped financial systems is consistently higher than that of countries with well-developed financial systems.