* EU court rejects Polish argument for coal-reliant states
* Says permit rule is not discriminatory
* Poland can appeal to highest EU court on points of law
* Market edges higher (Adds reaction, updates price)
By Barbara Lewis
LUXEMBOURG, March 7 (Reuters) - The European Union's second-highest court on Thursday dismissed a Polish challenge to the European Commission over the allocation of free carbon permits to energy-intensive industry.
The verdict was a rare piece of positive news for the EU Emissions Trading Scheme (ETS), which is meant to be the prime EU tool for engineering a shift to a low-carbon economy but is struggling with a surplus of allowances generated by recession.
Poland has argued that the rules for free allocation of CO2 permits do not take into account its situation as an emerging eastern European economy reliant on carbon-intensive coal.
The General Court in Luxembourg disagreed.
"The Court rejects Poland's argument that the contested decision would decrease the competitiveness of companies in member states whose production is linked mainly to coal as a fuel," the court said in a statement.
In essence, the dispute comes down to whether countries in eastern Europe, which have had limited time since the collapse of Communism to overhaul their coal-dependent economies, should be given more leeway to pollute.
Poland has the right of appeal on points of law to the European Union's highest court, the European Court of Justice.
A verdict in Poland's favour would force the Commission to review the rules for all member states, dealing a blow to the foundations of the ETS system.
Welcoming Thursday's decision, Commission spokesman Isaac Valero-Ladron said: "It confirms (the Commission's) interpretation of the EU ETS Directive and provides legal certainty with regard to free allocation."
The Polish environment ministry said that it needed to analyse the verdict but would continue its fight against rigorous targets for 2020 and beyond.
"Our economy is not based on gas and yet we have to distribute allowances based on gas-based benchmarks," spokesman Pawel Mikusek said. "We had to learn this lesson the hard way. Now, when working on the 2030 horizon, we will be better prepared."
Traders said Thursday's verdict was bullish, but the market remained preoccupied by the lack of progress on reducing the surplus of permits, which pushed the price of allowances to a record low of less than 3 euros ($3.90) per tonne in January.
Poland and energy-intensive industry have led opposition to a Commission plan for a temporary withdrawal of some of the excess permits, pending deeper reforms of the market.
By 1345 GMT, ETS carbon permits were trading 1.6 percent higher on the day at 4.35 euros a tonne.
Last year the European Court of Justice threw out a case brought by the steel sector, which also contested the rule that the most efficient 10 percent of plants determine the number of free allowances that can be awarded.
Thursday's ruling again found the benchmarking system for free permits was fair.
"The Commission did not breach the principle of equal treatment when it decided to treat uniformly installations that are in different situations due to the use of different fuels," the court statement said.
Energy-intensive industry says it could be driven out of Europe by the extra costs resulting from the ETS and Poland says that a stronger carbon market would inflict economic pain.
Green campaigners disagree. For them, the worry is that the ETS is too feeble to drive a transition to low-carbon energy.
"The case is important confirmation of the powers of the European Commission to set the rules for emissions allocations," said Karla Hill, director of programmes at environment law group ClientEarth. "Industry will only get handouts of free emissions allowances up to a maximum benchmark set according to an objective and challenging standard." ($1 = 0.7692 euros)
Additional reporting by Nina Chestney in London and Agnieszka Barteczko in Warsaw; editing by Rex Merrifield and David Goodman