Regional carbon policies in an interconnected power system: How expanded coverage could exacerbate emission leakage

Interconnected regional electricity markets are often subject to asymmetric carbon policies with partial coverage for CO2 emissions. While the resulting problem of carbon leakage has been well studied, its mitigation has received relatively less attention. We devise a proactive carbon policy via a bi-level modelling approach by considering the impact of an emission cap that limits the cost of damage from a regional power market. In particular, a welfare-maximising policymaker sets the cap when facing profit-maximising producers and the damage costs from their emissions at two nodes. A partial-coverage policy could degrade maximised social welfare and increase total regional CO2 emissions with potential for carbon leakage due to a higher nodal price difference. A modified carbon policy that considers CO2 emissions from both nodes tightens the cap, which increases maximised social welfare and decreases total CO2 emissions vis-à-vis the partial-coverage policy, albeit at the cost of greater scope for carbon leakage as it causes nodal prices to diverge. As a compromise, an import-coverage policy, implemented by California, that counts only domestic and imported CO2 emissions could alleviate carbon leakage at the cost of lower maximised social welfare with higher total emissions vis-à-vis the modified-coverage policy.