The EU must undertake a major overhaul of its emissions trading scheme (ETS) if it is to deliver the long-term stable price on carbon that businesses are increasingly demanding.

That is the conclusion of a new report from the Aldersgate Group, a coalition of businesses, regulators and non profit organisations, which argues that the scheme needs to be significantly tightened if it is to deliver the reductions in carbon emissions expected.

The study comes as the EU prepares to launch the second phase of the ETS from next month. The first phase, which ran from 2005, has faced hefty criticism after governments allocated too many emission allowances (EUAs) to polluters, leading to a collapse in the price of carbon credits and windfall profits for some energy firms.

The Aldersgate Group's Trading for Growth report claims it is essential this problem is rectified in phase II of the scheme through much tighter caps on carbon emissions for companies in the scheme.

The EU has attempted to deliver tighter caps from next year, rejecting proposals for EUA allocations put forward by several governments earlier this year as too generous and demanding stricter limits on emissions. Tighter caps are expected to drive up the price of carbon from next year as more firms exceed their mandatory carbon cap and are forced to buy in extra credits through the carbon market.

However, Andrew Raingold of the Aldersgate Group said it was unclear if even these new caps would be tight enough.

The report also recommends that a greater proportion of EUAs are auctioned to polluters rather than allocated for free, a scenario which led to profitability in the UK power generation sector increasing by approximately £800m a year during phase I of the ETS as they sold off their freely allocated carbon credits.

Under phase II of the scheme, governments can auction up to 10 per cent of their credits to polluters. But Raingold insisted a far higher proportion of credits should be auctioned as a means of providing a clearer financial incentive for firms to cut their emissions.

Many businesses have lobbied against proposals for auctioning of credits, arguing that the increased cost would put them at a competitive disadvantage compared with firms from outside the EU.

But Raingold insisted this could be avoided by imposing tariffs on products imported to the EU based on those products' carbon footprint. "With auctioning there are worries about competitiveness, but that could be relatively addressed by imposing tariffs on imported products that have not been subjected to the same carbon price," he argued.

Finally, the report urges the EU to impose tighter restrictions on the number of carbon offset credits that firms are allowed to buy from outside Europe to help them avoid breaching their emissions caps.

The EU has put in place measures to try and limit the number of offset credits introduced to the scheme from outside Europe, but Raingold insisted these safeguards did not go far enough and that there was a danger that many firms could meet their emission obligations by acquiring large numbers of offsets from carbon reduction projects in the developing world rather than addressing their own carbon footprint.