(Adds dropped word, paragraph 14)
* Spot carbon permits to be treated as financial instruments
* Proposals still have to be approved before adopted
* Compliance firms could face "lighter requirements"
By Barbara Lewis and Nina Chestney
BRUSSELS/LONDON, Oct 20 (Reuters) - European Union spot carbon permits face regulation alongside other financial instruments under proposed laws published on Thursday as the EU Commission seeks to bolster a market shaken by fraud and oversupply.
The EU Commission has proposed that spot carbon permits should be classified as financial instruments, adding to futures, forwards and options which are already covered by financial market rules (MiFID).
"By treating emission allowances as other financial assets, the proposal extends financial market protection to the carbon market," EU Climate Commissioner Connie Hedegaard said.
"It will provide further certainty for carbon market participants as the market grows and matures. This way, the carbon market will better play its full role to mobilise the substantial investments needed for the transition to a low-carbon economy," she added in comments emailed to Reuters.
Under the EU's emissions trading scheme, large emitters are required to monitor their CO2 emissions and if they exceed a certain level, must buy carbon permits to compensate.
A Commission source said companies that only bought allowances to cover their emissions output rather than to trade, such as utilities and industrials, would face "much lighter requirements".
Some traders and industry representatives argue against the inclusion of the entire carbon market in the new EU rules on financial instruments, arguing they required special treatment.
"(It) automatically triggers burdensome requirements that are not relevant to the risks in this market," said Henry Derwent, president and chief executive of the International Emissions Trading Association.
He said further work would be needed to ensure the inclusion of spot permits under MiFID does not undermine market functioning of the market and effectively prevents abuse.
A series of frauds, together with oversupply and concern about the European debt crisis, have battered the carbon market, meaning allowances no longer cost enough to be an adequate deterrent to polluters.
Fraudsters were able to penetrate the $120 billion European emissions market through spot carbon permit trade, which represents 5-10 percent of the overall market.
"This is definitely a step in the right direction, putting spot permits on the same basis as the derivatives market," Trevor Sikorski, head of carbon research at Barclays Capital, told Reuters.
"The idea is to make it harder for unscrupulous firms to enter the market as everyone will have to apply stringent know-your-customer to their customer base when dealing in the market which hasn't always been the case," he added.
Benchmark EU allowances CFI2Zc1 were trading around 10 euros a tonne on Thursday and have lost around 30 percent of their value so far this year.
Justifying its decision to include the entire market in the proposed new legislation -- which still has to go before the European Parliament and the Council of EU member states for adoption -- the Commission said the carbon market had grown significantly in size and sophistication.
On the question of which market participants would be required to disclose inside information on carbon allowances, the Commission said an exemption was foreseen for those whose activity was below a certain threshold, which it would determine.
$1 = 0.725 Euros editing by Rex Merrifield and Alison Birrane