A European court injected a fair bit of doubt and confusion into carbon markets Wednesday, ruling that the European Commission exceeded its authority when it imposed tighter caps for greenhouse gas emissions in Poland and Estonia (Reuters, The Times)

At first glance, the ruling could be interpreted to curtail the commission’s authority to impose a European cap, which would threaten the integrity of the entire multi-national system and fuel existing tensions among countries. But analysts say the ruling is actually limited to the second commitment period, which runs from 2008 to 2012. The commission’s authority moving forward does not appear to be in any danger, which means the impacts, whatever they turn out to be, will likely be temporary.

Milo Sjardin, an expert on carbon markets for the consultancy New Energy Finance in New York, said he isn’t expecting any major changes in the overall European cap, in part because the recession has already significantly reduced pressure on European industries. NEF’s latest estimates indicate that covered emissions (which include power and major industrial sources) are likely to drop by a whopping 10 percent in 2009 alone.

The result is a 50 percent reduction in the cost of curbing emissions by 20 percent by 2020. In fact, NEF now says it will be cheaper to curb emissions by 30 percent (an EU pledge that is contingent on action by the rest of the world) than original forecast for the 20 percent target, Sjardin says.

For his part, EU Environment Commissioner Stavros Dimas made it clear that the commission isn’t about to back down (AFP).

Regardless, the price of carbon allowances in Europe dropped on the news as traders weighed the possibility of the commission losing its battle and granting additional allowances, not only to Poland and Estonia but six other countries that have appealed their caps. That would make compliance easier and thus decrease the likelihood that companies would need to buy additional allowances to cover their emissions.

If all eight countries were to return to their originally proposed CAP, NEF says allowances would increase by 15 percent. And because companies can carry their allowances forward into the third trading period, which runs from 2013 to 2020, such a scenario could theoretically depress prices for years to come. That would be good news for traditional industries, although it might make clean energy technologies less competitive.

“But we regard that as a very unlikely scenario,” Sjardin says. “There’s likely to be a compromise somewhere down the road.”