Falling carbon prices have raised questions about the credibility of the European Union's flagship trading scheme as the bloc's main weapon to fight global warming.

But traders and analysts insist the scheme is working as a market mechanism should and concerns over persistent low prices detract from what the scheme was intended for.

Since 2005, the EU's Emissions Trading Scheme has imposed a cap on carbon emissions from factories and power plants in the 27-nation bloc using a fixed quota of emissions permits, called EU Allowances.

Since the economic slowdown, cash-strapped firms have been selling their permits to raise funds, causing prices to hit a low of 8.05 euros ($10.18) in February from nearly 31 euros last July.

The scheme was designed to cap emissions, which it is achieving. As industrial output declines due to the recession, there are less emissions which means companies have less demand for permits, meaning they should meet the cap.

The purpose of the system is to cap emissions and to do it at the lowest possible cost, said Harvard University's Rob Stavins.

HAVE FAITH

Some market experts say the fall in prices is a natural reaction to the recession and shows the scheme is working.

What's so special about the EU ETS? We expected economic growth of 2 percent but have minus 2 percent. We have lower emissions as a result and, predictably, lower prices, said Christian Egenhofer at the Center for European Policy Studies in Brussels.

If the scheme has shown it has worked in recession, it should also work when the economy recovers.

The long-term view is that low prices are what you would expect right now and they will go back up again, said Chatham House's William Blyth.

The EU ETS has three trading cycles running to 2020. The first phase saw prices collapse to near zero after the EU gave out too many permits. Recent low prices have arisen from the recession and companies raising cash because they got their quota for free.

The third phase, which runs from 2013-2020 is seen as the cycle in which these distortions will be put right. Because companies can bank their permits forwards throughout the cycles, it is hoped that they are forming investment decisions based on the future price of carbon.

Looking at one year is not a fair indication of what is going on. Real expectations should be based on 2012 and beyond, said Egenhofer.

The EU ETS was not designed to deliver a 20 percent cut in European emissions by 2020 on its own, experts point out. Other policies are needed to complement it, such as energy efficiency strategies, renewable energy subsidies and carbon capture and storage.

Investment has to be supported additional policies for most renewables. That is the same now as it was two years ago, Blyth said.

FURTHER FALLS COULD HURT

If prices fell to 5 or 6 euros for a sustained period of time in the lead up to important climate change talks in Copenhagen in December, the scheme could risk being damaged, however.

The credibility of the scheme would suffer if the price was below 8 euros for any length of time. That would call into question the viability of new clean development mechanism projects and have a major political impact globally, Deutsche Bank's head of carbon research Mark Lewis said.

(Editing by William Hardy)

Climate change