The system of trading carbon emissions at the heart of the ambitious low-carbon plan announced by the government last week is seriously flawed and close to becoming irrelevant, according to researchers behind a new analysis.

So-called “hot air” carbon credits – those which do not result in any actual emissions cuts – could be so numerous that companies covered by the EU Emissions Trading Scheme would not have to make any cuts to their own emissions until 2015, says the report from climate campaign group, Sandbag. The hot air permits result from the over-allocation of emissions allowances and from those going unused as the recession cuts economic activity.

The ETS covers 50% of the UK and EU’s carbon emissions, mainly in the energy, cement, steel, glass and manufacturing sectors. Companies in these sectors are allocated allowances for the carbon they emit, with the total number shrinking over time, theoretically forcing companies to buy additional permits to pollute if they do not cut their emissions.

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A large proportion of the UK’s promised cut of 34% by 2020 will come via British companies in the ETS. Globally, the carbon trading market was worth €92bn (£79bn) in 2008, trading 5bn tonnes.

However, the large number of carbon permits that have been allocated and a fall in emissions due to the recession, have made the trading system less effective.

“With too many rights to pollute in circulation, the scheme is in danger of being rendered irrelevant,” said Sandbag founder, Bryony Worthington. “At a time when other countries are looking to set up their own trading schemes and the world is set to debate a global deal on how to tackle climate change, [this] flagship policy urgently needs rescuing – starting with much tougher caps.”

She called for an immediate tightening of the cap on permits to 30% of industry’s emissions by 2020, compared to the existing 21%, and a commitment to 40% if a strong global deal results from a UN climate change summit in Copenhagen in December. Making the 30% cut would cost virtually the same as was originally envisaged for the 21% cut, she said, and be much closer to the cuts scientists say must be made to avoid dangerous climate change.

Ed Miliband, energy and climate secretary said: “The UK has been successful in arguing for big improvements to the EU ETS and making sure it’s far more effective in tackling climate change. As part of a global climate deal we want Europe to up its targets and that will mean a greater contribution from the EU ETS.”

But MP Tim Yeo, chair of the environment audit committee, said: “These findings confirm what many have begun to suspect. Although emissions trading remains conceptually valid, in practice the EU ETS has not succeeded in driving investment in low-carbon technology.”

The ETS price for a tonne of CO2 at the close of the market on Friday was €14. To make it economical for generators to switch from coal to less-polluting gas for electricity production requires a price of around €25, while carbon capture and storage technology needs a price of €40-€50 a tonne to be worth investing in.

But Guy Turner, director of analysts New Carbon Finance, said the current relatively low carbon price simply meant the emissions cuts required by the existing ETS cap were being made less expensively than expected. “There is some surplus in the system. But the set targets are being achieved – albeit by a mechanism not predicted: the recession.”

He believes emissions will begin to rise once again from 2010 as economic growth returns, and that a year or two after that demand for permits will outstrip supply. “The 21% target will look tight by 2020.”

Sandbag’s calculation of the potential hot air permits are undisputed and highlight the gap between what is politically possible – loose caps – and what science demands – tight caps – say experts.

The Sandbag analysis comes on the same day as a report by the prime minister’s special representative on carbon trading, Mark Lazarowicz MP, published at a government conference on the subject. Lazarowicz’s report is expected to argue that carbon trading is a crucial part of the world’s response to climate change, and that schemes around the world should be integrated in future.

The potential hot air credits identified by Sandbag include 400m tonnes which industry will not need in the current 2008-12 ETS trading period. These could be sold as windfall profits, raising £5bn at current prices, or banked for the next period, depressing the future price. A further 300m ETS permits exist in a reserve, which supplies them to newly formed businesses. Lastly, companies have the option to offset their emissions by buying credits from outside the EU, usually from hydroelectric or other schemes in China and India. On current trends 900m of these could be available up to 2012, and bankable for use up to 2020.

The non-EU credits come mainly from the UN’s clean development mechanism, which is widely acknowledged to be flawed. It includes many projects that would have happened without CDM funding, meaning the carbon reductions are not true cuts. Campaigners also argue it allows rich nations a “get out of jail free card”, when they should be making cuts in their own countries.

“Concern remains about the extent to which British companies can purchase credits overseas instead of cutting emissions at home,” said Yeo. Sandbag estimates the British companies could spend up to £1.7bn overseas on credits by 2012.

Carbon trading will also be at the heart of the global climate change treaty negotiated in Copenhagen to succeed the Kyoto protocol.

The world’s top climate change expert, Rajendra Pachauri, told the Guardian that he shared concerns that the ETS was not being effective in tackling global warming. As the most mature trading system, it is seen as a model for newer markets around the world, which will need to be integrated for a truly effective global system of cutting emissions.

But Pachauri, head of the Intergovernmental Panel on Climate Change, said a strong Copenhagen agreement could lead to a substantial shift in the carbon market, lifting the price: “It may change the whole dynamic. That is my feeling, though I may be wrong.”