Optimal unilateral climate policy with carbon leakage at the extensive and the intensive margins

Abstract We derive the optimal unilateral climate policy for an open economy with a domestic emissions target and aversion to carbon leakage, distinguishing between leakage at the extensive margin, where domestic firms relocate to foreign countries, and leakage at the intensive margin, where domestic firms lose world market shares. Implementing the optimal allocation requires several instruments including a lump‐sum location subsidy to counter leakage at the extensive margin. Simulations indicate substantial leakage at the extensive margin and a social welfare gain of around 0.3 percent of national income from our optimal leakage‐adjusted tax‐subsidy scheme compared to uniform carbon taxation.