We study the relation between financial market development and industrial pollution in a large panel of countries and industries over the period 1974-2013. We find a strong positive association between credit markets and aggregate CO2 emissions per capita, but a strong negative association between stock markets and such emissions. Industry-level analysis shows that stock market development (but not credit market development) is linked to cleaner production processes in technologically “dirty” industries. These industries also produce more green patents as stock markets develop. Moreover, our results suggest that stock markets (credit markets) reallocate investment towards more (less) carbon-efficient sectors. Together, these findings indicate that the evolution of a country’s financial structure helps explain the non-linear relationship between economic development and environmental quality documented in the literature.

JEL classification: G10, O4, Q5.

Keywords: Financial development, industrial pollution, innovation, reallocation.