The report says German power generators are 70% reliant on coal
Europe's big power companies could make profits of up to 71bn euros (£56bn) from the EU's scheme to curb carbon emissions, according to a report.
Environment group WWF says the EU's Emissions Trading Scheme (ETS), which allocates firms a fixed number of free carbon permits, does not work.
It says the high level of free handouts benefits German generators most of all, despite their reliance on coal.
The EU wants to scrap the use of free permits in the power sector after 2012.
Under the current system, energy-intensive industries are allowed a fixed level of CO2 emissions.
Companies which exceed that level are able to buy other firms' surplus allowances at auction, with the aim of creating an incentive for businesses to reduce their emissions.
National governments are already allowed to auction up to 10% of emissions permits but WWF estimates that the proportion sold, in practice, is closer to 4%.
"Handing free pollution permits to power companies is like handing them a cash bonus," said WWF's Emissions Trading Scheme Co-ordinator, Sanjeev Kumar.
The report said German generators which were 70% dependent on coal power could make 14bn-34bn euros from the free handouts.
A spokesman for German company E.ON acknowledged that the scheme as it stood was "less than perfect, but it's a start".
"It's the first market-based mechanism to put a price on the use of natural resources," he said.
The European Union accepts the trading scheme has been a learning process, with caps on national emissions set at EU level and member states then allocating limits on individual companies.
European Commission spokeswoman Barbara Helfferich added that part of the problem had been the response from power companies.
"If they can pass on the costs to the customers, they will do it. Then they have a certain number of free certificates which they can sell on the market," she said.