We show that firms increase their pollution intensity as they become more financially distressed. This is particularly the case in high-environmental liability risk locations, akin to a risk-taking motive. We then rationalize these facts by calibrating a dynamic model featuring endogenous default, and dirty vs. clean investment. Dirty assets reduce short-term costs but expose firms to persistent liability and regulatory risks. Thus, as firms become more financially distressed, they gradually take on more risk and shift the composition of their assets toward the more polluting ones. Our counterfactuals highlight the limited environmental impact of blanket divestments when heightened financing costs lead firms to increase their pollution intensity while scaling down. Tilting strategies, however, are more effective at tapering pollution.
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