By Valerie Volcovici

Aug 21 (Reuters) - A U.S. appeals court on Tuesday overturned a key Obama administration rule to reduce harmful emissions from coal-burning power plants, sparking a rally in coal company shares and relief among utility firms.

The U.S. Court of Appeals for the D.C. Circuit said in a 2-1 decision that the Environmental Protection Agency had exceeded its mandate with the rule, which was to limit sulfur dioxide and nitrogen oxide emissions from power plants in 28 mostly Eastern states and Texas.

In the latest setback for the EPA, the court sent the Cross-State Air Pollution Rule back for revision, telling the agency to administer its existing Clean Air Interstate Rule - the Bush-era regulation that it was updating - in the interim. The EPA said it was reviewing the ruling.

The decision was cheered by some Republicans, who have made the EPA and President Barack Obama's environmental policies a major campaign theme ahead of November elections.

The agency is endangering a fragile economic recovery by saddling U.S. industries with costly new rules, Republicans say.

"The Obama-EPA continues to demonstrate that it will stop at nothing in its determination to kill coal," said Republican Senator James Inhofe, one of the Senate's most vocal EPA opponents. "With so much economic pain in store, it is fortunate that EPA was sent back to the drawing board."

Power groups, which had argued that they could not meet the timeframe or bear the financial burden of installing costly new equipment, welcomed the court's decision. The EPA had estimated it would cost $800 million annually from 2014.

"The court was clear in finding that EPA had overstepped its legal authority in developing the rule," said Scott Segal, director of the Electric Reliability Coordinating Council.

Coal company stocks, which have suffered this year as cheap natural gas undercut demand for coal from power companies, soared. Peabody Energy was 3.7 percent higher and Arch Coal rose 1.1 percent.

U.S. natural gas futures briefly fell more than 3 percent after the ruling's announcement as traders bet it would mean less demand for the cleaner fuel over the coming months. By midday, prices had recovered those losses.

But some analysts saw little material impact from the ruling, with dozens of coal-fired plants already slated for closure due to other EPA regulations.

"It gives the EPA a little bit more of a black eye," said Andrew Weissman, senior energy adviser at law firm Haynes and Boone, which advises power and gas sector clients.

"But in the bigger picture, it many not be important in terms of the practical consequences."

POLLUTION CONTROLS

The EPA's rule was designed to reduce sulfur dioxide emissions by 73 percent and nitrogen oxide by 54 percent at coal-fired power plants from 2005 levels, improving health for over 240 million people, according to the agency. The reasoning is that unhealthy emissions from those plants, pollutants that cause acid rain and smog, cross state lines.

Two of the three judges ruling on the case said the EPA had exceeded its "jurisdictional limits" in interpreting the Clean Air Act and imposed "massive emission reduction requirements" on upwind states.

"By doing so, EPA departed from its consistent prior approach to implementing the good neighbor provision and violated the (Clean Air Act)," Judge Brett Kavanaugh said in the court's opinion.

The rule, known as CSAPR, also established a cap-and-trade system that enabled power producers to comply with the emission limits by buying, trading and selling pollution permits.

Environmental market traders said they were "surprised and disappointed" by the ruling.

Power generators, such as Southern Co, had argued that the Jan. 1 implementation date was too soon to design and install the needed pollution control equipment.

Texas, along with the National Mining Association and the International Brotherhood of Electrical Workers, also challenged the EPA, arguing the rule would cause undue financial burden on power producers and force companies to shut some older plants.

"Vindicating the state's objections to EPA's aggressive and lawless approach, today's decision is an important victory for federalism and a rebuke to a federal bureaucracy run amok," said Greg Abbott, attorney general in Texas, where the power industry had warned that the rule could result in peak-season blackouts.

Democratic Senator Tom Carper, who authored bills to curb mercury, SOX and NOx emissions in previous years, said he would try to push for new legislation if an appeal failed.

EPA OVERREACH?

Segal of the Electric Reliability Coordinating Council said the CSAPR, along with other EPA rules, did not show sufficient respect or deference to state programs.

"Today's decision is a stern warning against EPA's recent views," he said.

Luke Popovich, a spokesman for the National Mining Association, hailed the ruling.

"This was not entirely surprising because it's the third or fourth ruling by a federal court that shows the EPA to be overriding the authority that the states have and conducting an unlawful regulatory program against coal," he said.

Environmental groups warned that the decision would put lives at risk and urged the EPA to appeal the decision.

"The court's decision significantly imperils long overdue clean air safeguards for millions of Americans," said Vickie Patton, general counsel of the Environmental Defense Fund.

Patton said the EPA should move in parallel to "swiftly put in place replacement protections" and to ask the three-judge panel and the full court to rehear the case.

John Walke, clean air director at the Natural Resources Defense Council, said the dissenting opinion of Judge Judith Rogers more accurately reflected the opinion of the court.

"The EPA can - and should - immediately appeal this decision. The dissenting judge correctly follows the Clean Air Act and prior rulings by this court. The majority opinion is an outlier at odds with the court's own rulings as well as the Clean Air Act," Walke said.

Judge Rogers said the other two judges were "trampling on this court's precedent on which the Environmental Protection Agency was entitled to rely in developing the Transport Rule rather than be blindsided by arguments raised for the first time in this court".

The appeals court had in June ruled 2-1 in favor of the EPA in a challenge to the agency's greenhouse gas regulations. (Additional reporting by Stephen James and Eileen O'Grady; Editing by Russ Blinch, Matthew Lewis and Dale Hudson)