A cross-party group of Lords has called on the government to reinvest the millions raised from the sale of carbon emission permits in green technology, following criticism that ministers are planning to add the funds to the Treasury's books.

In a bid by member states to reach the EU target of cutting carbon emissions by 20% by 2020, a portion of permits are already being auctioned within the emissions trading scheme (ETS), but plans to be decided in Poznan tomorrow could see 100% of permits auctioned.

The scheme puts a cap on emissions from about 12,000 factories and power plants across the EU responsible for about half of the region's emissions. Companies receive a quota of allowances that they can then trade, thereby creating a price for polluting.

If the plans go ahead, the environmental consultancy WSP predicts the UK government could possibly raise as much as £1bn from 85m permits in 2012 and £2.5bn in 2013.

Next year alone the British government plans to auction 25 million permits – a process that would raise nearly £350m.

Environmental groups fear a Treasury decision to keep the proceeds rather than ring-fence them for use in environmental projects plays into the hands of those who regard the ETS to be a stealth tax. Instead they point to Netherlands and Germany, which have pledged to spend the cash on measures such as improved energy efficiency and alternative energy.

In their report the Lords - who support a move towards 100% auctioning by 2013 - say the funds raised through the ETS should be ploughed back into "climate change-related measures" to "maintain the credibility of the scheme".

When EU leaders meet tomorrow in Poznan, member states such as Poland and other poorer ex-communist EU member states worried that the plans to cut carbon emissions by 20% from 1990 levels by 2020 will damage their economies would like an exemption.

They are supported by the German chancellor, Angela Merkel, who yesterday argued that industries facing higher costs and tougher international competition should be 80-100 % exempt from buying emission permits from the ETS.

Yesterday the Lords said the moves by some European countries to "postpone" the increase in auctioning until industry might be in a better position to absorb the costs, should be "resisted".

Referring to revenue raised by the current auctioning, the committee said the funds raised through the ETS should be ploughed back into "climate change-related measures" to "maintain the credibility of the scheme".

At the moment firms receive some of their permits for free but at the end of November the government carried out its first auction of carbon emission permits from the operator of Europe's largest coal-fired power station, Drax, and raised over £50m.

The Lords' report said: "It is our firm view that member states should invest considerable funds in climate change-related measures – including R&D and demonstration projects, as well as adaptation measures – and in measures to ease the social problems that may arise as a result of the ETS, such as increases in electricity prices. In our view this will be essential to maintaining the credibility of the scheme, by signalling that governments are willing to foot part of the bill that they are imposing on the private sector."

The Polish prime minister, Donald Tusk, is opposed to European commission plans to make power stations buy permits to pollute by 2013. Tusk has in the past threateneda Polish veto – fearing it would ramp up costs for its power sector, which is about 95% reliant on highly polluting coal.

Western European governments point to 10% of revenues earmarked for a 7.5b euro "solidarity fund" to compensate Poland the other ex-communist states for the heavy cost of overhauling their power stations. (The Guardian)