Mis-measuring Externalities: Carbon Accounting and Equilibrium Capital Allocation

Abstract: We study how carbon accounting affects capital allocation when firms generate both direct and avoided emissions. In an equilibrium model, recycling raises reported emissions while displacing dirtier production elsewhere. Carbon accounting therefore changes the signal priced by investors and shifts equilibrium capital allocation. We show that accounting for avoided emissions can reverse sector rankings, mismeasurement creates a wedge between priced and welfare-relevant emissions, and static firm-level metrics generally fail to implement the efficient allocation.