As countries transition away from coal to achieve carbon neutrality, natural gas is often promoted as a transitional fuel. However, incomplete sectoral policies and preexisting price distortions can lead to emission leakage, undermining coal reduction efforts. This paper examines China’s 2017 coal-to-gas transition policy, which banned coal in central heating across 28 northern cities, triggering a 70% increase in natural gas prices while coal prices remained stable due to price controls. Using a comprehensive dataset of hourly pollution measures from 1,563 monitors and firm-level emissions and energy consumption data covering around 50% coal consumption in China, we find that instead of reducing coal consumption, the policy led to substantial leakage. Baseline industry composition, the stringency of environmental regulations, and uneven enforcement across polluting firms all contribute to leakage. A back-of-the-envelope calculation suggests that for every ton of coal reduced in the heating sector, coal use increased by 0.26 tons in targeted cities, 2.6 tons in northern non-targeted cities, and 3.07 tons in southern cities. The natural gas price shock shifted production to coal-intensive firms and less regulated firms in targeted cities, increasing overall emissions. We estimate that 23.27% of the coal consumption rebound could have been prevented if coal prices had been liberalized to fluctuate with natural gas prices, as in European markets. Alternatively, a carbon price of 17 RMB (2.4 USD) per ton of carbon dioxide would achieve an equivalent reduction in coal use while preventing leakage. These findings highlight the importance of addressing market distortions to enhance the effectiveness of coal phase-out policies.