Nuclear power capacity is now back on stream in Germany, where environmental rules had during the hot weather restricted use of rivers for cooling turbines, but dry weather is lingering in Spain and Scandinavia.

"There was a very strong drought in 2005 and power companies in Spain were then significant buyers of EU allowances (carbon credits) -- to the extent that pattern's repeated you'd expect the same this year," said Garth Edward, environmental products trading manager at Shell.

Spain typically gets some 12 percent of its electricity from hydropower, but water shortages force generators to fall back on coal and fuel oil.

A continuing drought has cut water reserves for a fifth consecutive week and hydropower reserves are currently more than 20 percent below the average over the last 10 years, although they are 15 percent above this time last year.

Water reservoirs in both Norway and Sweden fell last week, and both are more than 20 percentage points below long-term levels for the time of year. The Nordic region gets roughly half its power from hydroelectric stations.

In past years such shortages have raised Danish CO2 emissions by up to 20 million tonnes but this is likely to be less now due to the carbon-emitting costs imposed by the EU carbon market, said Seb Walhain, director of environmental markets at Fortis Bank.

The EU market accounts for emissions by energy-intensive companies which have to buy carbon credits if they exceed EU-imposed limits.

Walhain has raised his estimated credits shortage for the market's first phase, from 2005-07, by 10 million tonnes to 110 million tonnes due to the recent weather.

SURPLUS

Like many other analysts, New Carbon Finance forsees a phase 1 credits surplus but has cut its estimated size, now estimating 17 million tonnes more CO2 emissions -- more than the annual output of Luxembourg -- particularly as a result of the drought and heatwave.

"We believe that the impact of above average CO2 emissions as a result of the drought will be limited," said Gerhard Mulder, carbon marketer at ABN AMRO. "While there will be extra CO2 emissions from the drought in the Nordic countries this will not tip 2006 into a short position."

The expectation of an overall phase 1 surplus follows the disclosure in 2005 that businesses held more carbon credits than they needed to cover their actual emissions.

Prices are holding at the current 15 (US$19.33) to 16 euros partly because of the problem of getting to market the surplus, mostly held by metal manufacturers and cement and paper plants.

"Industrials are very risk averse," said one carbon broker. "They say their only objective is to ensure compliance. This is keeping the market buoyed at artificially high levels."