Despite attempts to tighten up the European Emissions Trading Scheme (ETS), the second phase of the scheme which began this year could still see millions of pounds of windfall profits handed to energy companies that continue to use fossil fuels to generate power.

That is the finding of a new report commissioned by the World Wide Fund for Nature (WWF) and carried out by carbon market analyst firm Point Carbon which suggests that electricity generators across Europe could earn up to €71bn in windfall profits between now and 2012 when the second phase of the scheme ends.

The ETS is a cap-and-trade system designed to help minimise carbon emissions from large emitting polluters. Companies are allowed to produce carbon emissions up to a set quota and are allocated carbon credits to cover those emissions. Firms that exceed this carbon cap, however, must purchase extra credits on the open market, while those companies that do not reach their quota can sell their excess credits, giving firms an extra financial incentive to curb emissions and not exceed their quota.

The first phase of the scheme was seen as a failure as the emission quotas were set too high, meaning the price of carbon collapsed as the vast majority of firms were left with excess credits to sell.

However, the WWF claims that despite a tightening of emission quotas for the second phase of the scheme, which has led to the price of carbon credits to climb to around €24 per tonne, it is still failing to deliver emission reductions because just as in phase one of the scheme power companies are initially given free offset credits to cover their emissions quota. The report argues that because the carbon credits have both a monetary and a carbon value, the free credits amount to free cash for companies that continue to rely on fossil fuels.

"The EU has mandated a 20 per cent cut in carbon emissions by 2020, and in the UK we have a 15 per cent target," said Kirsty Clough, a spokeswoman for the WWF. "But the emissions trading scheme isn't incentivising companies [to curb emissions."

The EU is currently reviewing plans for the trading scheme's third phase in 2013 to see if free credits will still be appropriate. Under proposals currently being considered the allocation of free credits to power companies would be axed and firms would be forced to buy all the credits they require at auction. Advocates of this approach claim it would place a clear price on all carbon emissions, making clean energy technologies more attractive by comparison.

Robin Oakley, climate campaign manager for Greenpeace UK, argued that in the meantime the ETS was continuing to fail. "Power companies are proposing climate wrecking new coal plants across Europe – such as the one proposed by German utility E.ON at Kingsnorth in Kent," he complained. "So long as dirty companies are going ahead with these pollution factories instead of clean renewable alternatives, the emissions trading scheme will have failed."