Conservative lawmakers holding the largest block of votes in the Senate joined with Greens and independents to defeat the Carbon Pollution Reduction Scheme set to start in July, 2011 and aimed at reducing emissions in the biggest per-capita emitter in the developed world.
But the government renewed its pledge to push through the scheme before a December U.N. meeting in Copenhagen, where world nations will try to hammer out a broad global climate pact and where Canberra is eager to take a leading role.
"This bill may be going down today, but this is not the end," Climate Change Minister Penny Wong told the Senate. "We will bring this bill back before the end of the year because if we don't this nation goes to Copenhagen with no means to deliver our targets," Wong said before the vote.
Greens wanted tougher emissions targets, while conservative opponents are divided on the need for a scheme and want it delayed until after Copenhagen, fearing Australia will be disadvantaged if other nations fail to act on climate change.
In a sign some major industrial emitters are fearful of months more uncertainty over the scheme's $12 billion (US$10 billion) estimated cost, the second-largest power retailer warned of a possible energy supply crisis without a speedy resolution.
"The ongoing uncertainty surrounding the (carbon-reduction) legislation is delaying both the investment necessary to meet Australia's long-term baseload electricity needs and the investment in lower-carbon technology required to gradually reduce Australia's emissions," Origin Energy said.
"We remain convinced the CPRS legislation provides the framework for a good, workable scheme," it said.
Surveys show Rudd well ahead in opinion polls and that most Australians favor action to combat climate warming. Elections are due in late 2010.
Rudd has promised emissions cuts of 5-25 percent on 2000 levels by 2020, with the higher end dependent on a global agreement to replace the U.N.'s Kyoto Protocol.
But if the Senate blocks or rejects the legislation a second time, after an interval of three months, it will hand Rudd a trigger for an early poll likely to be dominated by climate change.
Some analysts said the legislation had become a victim of political point scoring that undermined efforts to fight climate change or reform the economy.
"Of more concern to future negotiations, the range of reasons for opposition to the scheme (within the Senate) is so wide as to make meaningful responses to all objections almost impossible," said Julie Toth, a senior economist with ANZ bank.
Rudd told parliament the defeat of his emissions trading plan had "put Australia's future on climate change in grave jeopardy". Scientists say Australia, the world's driest continent and prone to drought, faces a rapid rate of climate warming.
Australia's scheme is similar, but wider in scope, to one introduced in Europe four years ago that requires big industrial emitters to buy permits for producing carbon dioxide, or sell them if they invest in clean technology reducing emissions.
About 1,000 of Australia's top polluting companies will have to buy CO2 permits, covering 75 percent of national emissions.
Australia is the world's biggest coal exporter, and relies on coal for about 80 percent of electricity generation, prompting industry warnings some coalmines and coal-fired power stations will be forced to close under the carbon-trade regime.
But rich nations such as Australia are under pressure to firm up their emissions reductions targets to help seal a post-Kyoto pact. Big developing nations, such as India and China, which are not bound by emissions curbs under Kyoto, are already taking steps to tackle their growing CO2 pollution.
The Australia Greens, who control five crucial Senate swing votes, wrote to Rudd and Wong after the rejection to promise future support for the 11 CPRS bills if the government hardened its reduction targets and backed renewable energy.
"We invite the government to immediately engage in constructive discussions with the Greens on this proposal, so we can together create meaningful action on the climate crisis," Greens leader Bob Brown said.
Conservative opponents offered no such olive branch, but called on the government to delink the scheme from widely supported laws pushing a 20 percent renewable energy target. A vote on those laws is likely within days.
If that vote succeeds, it would unlock a potential $22 billion in planned renewable investment.
Business leaders, academics and carbon market experts all called on the government and its political opponents to end the domestic political squabbling and agree on an emissions scheme.
"It is now time to forge an agreement on climate change policy. An agreement is needed in the interests of business certainty," said Australian Industry Group chief executive Heather Ridout.