Buy coal and gas? Interfuel carbon leakage on deposit markets with market power

Abstract

Unilateral climate policies can lead to carbon leakage between countries. Deposit markets, where participants trade the right to keep fossil fuels unexploited in-situ, are a promising policy proposal to prevent leakage. For a single fossil fuel, deposit markets can only restore efficiency if there is no market power on the deposit market. With multiple fuels, however, multiple (interdependent) deposit markets could give rise to additional market power. We thus study deposit markets with market power and multiple fuels, and focus on comparing second-best policies. In contrast to a setting with a single fuel, more complex carbon leakage channels between both, countries and fuels, arise. Such effects can even hinder deposit markets covering all fuels from being implemented. At the same time, we identify conditions where deposit markets induce countries without emission reduction incentives to supply a cleaner fuel mix. Regarding the political economy, deposit markets covering all fuels can improve each country’s welfare compared to those covering only one fuel. Deposit markets which cover only a single fuel or multiple fuels rank differently in terms of consumer and producer rents. These welfare rankings can have highly relevant implications for policy-making. Even with market power, deposit markets covering multiple fuels can Pareto-dominate a situation with unilateral, domestic policies.