* EU Parliament rejects plan to cut permit supply by 15 pct
* EU carbon prices fell 40 pct to under 3 euros on Tuesday
* Campaigners and traders say could drop as low as 1-2 euros
* Market liquidity to suffer as banks pull out
By Andrew Allan and Nina Chestney
LONDON, April 17 (Reuters) - More banks and trading houses could abandon Europe's carbon market, making government auctions of permits more likely to fail, after the European parliament on Tuesday rejected an emergency measure to prop up prices.
Prices for EU carbon permits under the Emissions Trading Scheme (ETS) fell 40 percent to under 3 euros on Tuesday after lawmakers rejected a plan to temporarily cut permit supply by 15 percent for fear that higher carbon prices would cost European jobs and harm economic growth.
About 5,000 companies generating half of the EU's greenhouse gas emissions must surrender a carbon permit for each tonne of carbon dioxide they emit. Some factories receive permits for free, while most power firms buy them from companies with a surplus or from state-backed auctions held almost every day.
Campaigners and traders warn the carbon price could now fall below 2 euros or even to near zero in the coming weeks, and government sales could fail if they don't meet minimum price requirements, as banks that act as liquidity providers pull out.
"Forthcoming auctions may struggle to go ahead as technical reserve prices, intended to prevent sales significantly below the market price, could kick in," said Bryony Worthington at environmental campaign group Sandbag.
Under EU rules, any unsold government permits must be offered in the next four scheduled auctions after the failed sale, putting more pressure on carbon prices.
That will be put to the test next week when more than 23 million permits will be offered in government sales in a market drowning in an estimated 1.7 billion surplus.
Parliament's rejection of the so-called backloading bill ends months of bitter debate among European ministers, lawmakers and industry. The $148 billion market, once the cornerstone of EU climate policy, has since 2008 been hit by an economic slowdown that slashed demand and created a surplus of permits.
Despite the fall to just 3 euros from 30 euros five years ago, speculators have stuck with the market to turn a profit from price volatility triggered by the threat of political intervention.
But they might quit the market now it looks likely that prices may be low for some time, which would require them to stump up much more capital to get the same returns.
"We are in for a protracted period of lower prices after this vote. The danger is that this can only hasten the rush to the exit for some carbon players," said Mark Meyrick, head of carbon at Dutch power company Eneco.
Some big players have already left or cut trading staff.
This year alone, Deutsche Bank shut its carbon desk, and Swiss trading house Mabanaft will wind down operations in June. Credit Agricole, MF Global and Cantor have already withdrawn.
Barclays, JP Morgan and Morgan Stanley have also pared back operations in recent years.
The Commission says it could still get agreement on the plan by year-end, but analysts say it is unlikely to be implemented in the current Commission's lifetime.
Proponents of higher carbon prices, such as some EU power companies who want to invest in cleaner sources of energy, have called on the Commission to introduce deeper structural reform that could include expanding it to transport and adopting a more ambitious emission reduction target.
Power suppliers say low carbon prices remove the incentive to switch from coal to cleaner sources. Analysts say a carbon price of about 50 euros is needed to encourage such a switch.
Debate on deeper reform started last month, but it might take two or three years to go through Europe's complex lawmaking process, meaning the market will be in limbo until 2015.
For now, even as banks pull out, the market will survive as it is anchored in EU legislation until at least 2020, forcing big European emitting companies to comply with emission caps.
"Speculators might exit, but industrials can't, so we will see a shrink in liquidity and therefore volatility might increase sharply," said Jacopo Visetti, emissions trader at AitherCO2.
The effect of fewer banks could result in wilder price swings as utilities, which are big buyers of permits, tend to block-buy permits in the so-called hedging season, when they sign annual contracts to supply electricity to industry.
Traders say the glory days of a market that was once tipped to be bigger than oil have now passed, at least for this decade.
"There will always be business as there are always clients to serve," said one trader at a London-based bank. "Desks have been getting smaller, teams have been shrinking or vanishing. I wouldn't be surprised if the exodus accelerated now."