Financial development and the environment: evidence from heterogenous panel methods

Despite its viable economic significance, the role of financial development in achieving environmental sustainability is much less explored. Further, the conventional empirical methods substantially rely on the assumptions of slope homogeneity and cross-sectional independence in panels which may cause aggregation bias. Using an aggregate sample of 100 countries and two subsamples of developed and developing countries over the 1980–2020 period, the study empirically investigates the impact of financial development and production on carbon emissions. We utilize mean group (MG) and pooled mean group (PMG) methods to estimate heterogeneous panels while the common correlated effect mean group (CCEMG) estimator is employed to tackle cross-sectional dependence in panels and structural breaks in data. Results of the study confirm that financial development significantly reduces carbon emissions as it facilitates access to cleaner energy for the sustainable production process. Results also reveal that financial transparency, the structure of the banking sector and foreign investment contribute to environmental sustainability through their significant negative impact on carbon emissions. The estimates show the existence of the Environmental Kuznets Curve (EKC) for almost all the developed and most of the developing countries except for the fossil-rich countries. Furthermore, the short-run estimates of the production-finance-emissions nexus for individual countries also validate these results. The results are robust to several sensitivity checks. The paper concludes that a robust financial sector may resolve environmental degradation issues.