* Real risk of "undermining orderly functioning"
* EU must explore longer-term plans "without delay"
* Potential for structural surplus of about 2 bln allowances
* International credits have added to EU ETS surplus
By Barbara Lewis
BRUSSELS, Oct 23 A rapid rise in surplus EU carbon credits is expected to slow from 2014 onwards, but to tackle a short-term glut member states need to decide before the end of the year on a temporary fix, a European Commission draft document said.
The draft report on the carbon market also called on the member states to discuss and explore options for more lasting changes to the Emissions Trading Scheme (ETS) after allowance prices hit a record low in April.
It urged the Climate Change Committee "to decide on the proposed amendment to the auctioning regulation before the end of the year in order to provide certainty for market participants".
The committee brings together representatives of member states as part of a fast-track process for lawmaking.
The Commission document seen by Reuters also urged the European Parliament and the European Council of member states to adopt a "mini-amendment" of the relevant law on the ETS, which could ward off any legal challenge, for instance from industry.
Climate Commissioner Connie Hedegaard announced early this year she would bring forward the market review, originally planned for next year, and open the debate on changing the auctioning timetable to govern when new permits are available.
The Commission is expected to publish its report officially in November, as well as a legislative proposal to withhold temporarily - or backload - some of the surplus of carbon permits from the first part of the third phase of the market (2013-2020).
The Commission routinely declines to comment on unpublished drafts, although it gave an outline of its plan in July, when it mapped out options for withholding either 400 million, 900 million or 1.2 billion allowances over the first three years of the market's next phase.
RISK OF DISORDERLY MARKET
The draft seen by Reuters said the carbon market, meant to be the central pillar of EU climate policy, was still "widely recognised as a liquid and functioning market".
However, the surplus generated by economic recession was a serious risk to its effectiveness.
"While from 2014 onwards the rapid build-up of the surplus is expected to come to an end, the overall surplus is not expected to decline significantly during phase 3, resulting potentially in a structural surplus in most of phase 3 of around 2 billion allowances," it said.
"There is a real risk of seriously undermining the orderly functioning of the carbon market by causing excessive price fluctuation due to the additional short-term oversupply of allowances."
The expectation the EU will agree a course of action has helped carbon allowances to recover from the low of 5.99 euros hit in April, but they are still far too weak to encourage investment in green energy. On Tuesday, the market was trading just below 8 euros a tonne.
It is not yet clear how much member state support there is for a temporary withdrawal of carbon permits, or how many allowances EU nations might agree to withdraw.
So far Poland, which is heavily dependent on carbon-intensive coal, has stood out as the main opponent.
In a statement on Tuesday, Polish Environment Minister Marcin Korolec said the Commission's plans raised "the possibility of arbitrary interventions and damage a sense of stability of the market and undermine its very nature as a market-based tool".
From the business community, some representatives of heavy industry say intervening would impose an undue burden in difficult times and could drive plants out of Europe.
Others, including oil majors, such as Royal Dutch Shell , keen to justify investment in carbon capture and storage, for instance, and Dong Energy, have spoken in favour of action.
Eurelectric, which represents the European electricity industry, has said it supports backloading, but wants that to be a step on the way to permanent change.
Beyond the short-term fix, the draft carbon market report lists options for lasting reform, which would require a much more extensive EU process.
They include raising the carbon reduction target to 30 percent in 2020 compared with an existing 20 percent goal, permanently retiring allowances and revising the ceiling on the number of permits to pollute that are made available.
The Commission also raises the prospect of bringing new sectors into the ETS and limiting access for international equivalents of the EU's credits.
"Without international credits, the surplus in the EU ETS by 2020 would potentially be only around a quarter of the presently expected surplus," the draft said.
The last option listed is "discretionary price management" measures, such as setting a carbon price floor.