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By Barbara Lewis and Michael Szabo

BRUSSELS/LONDON, Nov 8 (Reuters) - European Union diplomats on Friday agreed to begin talks on a legal text to slash permit supply and prop up carbon prices in the bloc's Emissions Trading Scheme (ETS), marking a big step forward for the divisive proposal.

Lithuania, current holder of the EU presidency, said member states would start three-way negotiations with the European Parliament and European Commission over the "backloading" plan.

Under it, the sale of 900 million carbon permits would be delayed until later this decade.

"Common sense prevailed. Almost unanimous support from member states. (We're) moving toward a stronger ETS," EU Climate Action Commissioner Connie Hedegaard wrote on social media site Twitter.

Europe's recession has resulted in a massive oversupply of permits in the EU ETS, which caused the price of allowances to tumble below 5 euros ($6.71) from over 30 euros in 2008.

The Commission wants to intervene in the market to lift these prices to a level that incentivises companies to cut their greenhouse gas emissions, for example by investing in energy efficiency or switching to renewable energy sources.

Even if agreed, analysts predict it will be years before European carbon prices rise to such a level, however, which they see at at least 40 euros ($53.53).

Still, the proposal has divided member states over fears it will push up energy prices and dent economic growth.

At least three countries including coal-reliant Poland oppose the move while others, including Germany and Spain, were undecided due to ministerial conflicts.

"Today's meeting was the litmus test for the process as influential member states such as Germany and Spain finally provided their view," said Marcus Ferdinand, an analyst at Thomson Reuters Point Carbon.

"This mandate is not the adoption of the backloading but has pushed the process a big step forward."

German MEP Matthias Groote, who will chair the Parliament's negotiating team, said it would allow the EU to advance quickly in adopting the text into law.

A Commission spokesman added: "In the next two weeks we should have a final agreement. We really hope that the institutions will finalise this by the beginning of next year."

Front-year EU carbon prices jumped to a seven-day high of 5.04 euros on the news, but retreated back to an intraday low of 4.60 euros by 1106 GMT, down 20 cents or 4.2 percent below Thursday's settlement.

SUPPORT

If agreed in the three-way talks, the final text would then go to the parliament's environment committee before being sent to the European Parliament for a final vote, tentatively scheduled for Dec. 10.

Member states in the EU Council of ministers would also need formally to approve the plan when they meet in mid-December, meaning the first permits could come out of the market in the first half of 2014.

While backloading still lacks enough formal support from member states, Friday's agreement suggests previously undecided countries have now warmed to the proposal.

Germany's two main political parties, which are in the midst of forming a new coalition government, said this week they had reached agreement on backloading, paving the way for the country to formally support it in Council next month.

Sources in Brussels said only Poland and Cyprus opposed the measure at Friday's talks, which, after a year of arduous negotiations, were seen as one of the last opportunities for countries to make known their views on backloading.

Greece had previously said it was opposed to it, but a government source in Brussels said Athens had "changed its mind" and is likely to support the measure.

Countries want backloading to be accompanied by an assessment of how it will impact the market, followed by wider reform of the ETS.

($1 = 0.7472 euros) (Additional reporting by Ben Garside in London; editing by Dale Hudson and Jason Neely)

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