By James Grubel

CANBERRA, June 1 (Reuters) - Australia should set up its own carbon trading system by 2012 to combat global warming, a government report said on Friday, dismissing Kyoto Protocol measures to curb greenhouse emissions as flawed.

But the report, commissioned by Prime Minister John Howard to steer the administration's response to global warming, cautioned the government against deep cuts in greenhouse gas emissions, arguing instead for a gradual reduction.

It said a national carbon trading system should be in place by 2011 so trading could start the following year, when the Kyoto Protocol emissions limits for developed nations expired.

"Climate change is a global challenge, but global efforts to reduce greenhouse gas emissions have fallen short of what is required to effectively tackle the problem," Howard said.

Carbon trading involves putting a price and limits on pollution, allowing companies that clean up their operations to sell any savings below their allocated level to other companies.

Howard's conservative government refused to ratify the Kyoto Protocol and has been a strong critic of the climate pact, which imposes cuts on greenhouse emissions on developed countries but no binding cuts on developing nations.

Greenhouse emissions are blamed for global warming, which has become an election issue in Australia, with polls showing 80 percent of voters want the government to do more on climate change.

After 11 years in office, polls show Howard's conservative government would overwhelmingly lose an election held now and the prime minister wants the report and the government's response to help turn public opinion.

The centre-left Labor opposition party has promised to sign the Kyoto Protocol and to slash greenhouse gas emissions by 60 percent of 2000 levels by 2050.

Howard set up the inquiry into carbon trading six months ago to find ways of pricing carbon pollution without hurting Australia's economy or standing as the world's leading coal exporter.

The report, compiled by government officials and business leaders, stopped short of setting a specific price for carbon emissions, but recommended setting guidelines with the ultimate price left to the market.

It said agriculture and land use should initially be excluded from the trading scheme, and said carbon permits should be free to industries such as coal mining, or "trade-exposed emissions-intensive" industries.

The report also said an Australian trading scheme should be able to link up eventually with other global schemes.

"The overriding goal of Australia's efforts should be to lower emissions at least cost," the report said.

The report said Australia, which accounts for 1.5 percent of global carbon emissions, could not wait for a co-ordinated global response to address climate change. Australia relies on coal for about 80 percent of electricity generation, with renewable energy contributing only about five percent, and Howard said prices would have to increase.

"We can't curb greenhouse gas emissions over the years ahead, without paying higher prices for electricity," he said.

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