We study the preferential treatment of green bonds in the Central Bank collateral framework as an environmental policy instrument within a DSGE model with environmental and financial frictions. Green and conventional entrepreneurs issue bonds to banks that use them as collateral. The associated collateral premium induce entrepreneurs to increase bond issuance, investment, leverage, and default risk. Collateral policy solves a trade-off between increasing collateral supply, adverse effects on entrepreneur risk-taking, and subsidizing green investment. Due to these adverse side effects, optimal collateral policy is characterized by modest preferential treatment, thereby increasing the green bond share and, to a smaller extent, the green investment share, which in turn reduces pollution. The limited response of green investment is directly related to higher risk-taking of green entrepreneurs. Furthermore, we show that preferential treatment is an imperfect substitute of Pigouvian taxation on pollution: only if the optimal tax can not be implemented, optimal collateral policy features preferential treatment of green bonds.