Dec 14 (Reuters) - European Union leaders meet on Dec. 16-17 to approve a change in the EU's treaty that should lead to the creation of a permanent mechanism for handling euro zone financial and debt crises from mid-2013.
The year-end, two-day summit will also discuss ways to prevent the euro area's debt crisis escalating, given fears that it could soon spread from Greece and Ireland to Portugal and Spain. No firm decisions are expected on that front.
Following is a look at what has been decided ahead of the summit, what's formally on the agenda for the meeting and other topics that could be raised by any of the 27 heads of state and government attending.
TREATY CHANGE
The leaders will agree to amend the EU's Lisbon treaty, which came into force a year ago, by adding the following sentences to the existing article 136:
"The member states whose currency is the euro may establish a stability mechanism to safeguard the stability of the euro area as a whole. The granting of financial assistance under the mechanism will be made subject to strict conditionality."
Germany had demanded the change in large part out of concern that its constitutional court could soon rule that bailouts of euro zone countries are illegal.
Three months ago, such a change to the treaty so soon after it was passed was unthinkable. But after a deal was struck between France and Germany in Deauville, France, in October, the possibility of treaty change gained substantial currency.
The aim is for the treaty amendment to be formally adopted by member states in March 2011, allowing ratification by all 27 countries to take place by the end of 2012, so that the measures can come into force from Jan. 1, 2013.
Lawyers and officials say that since the change is small and adopted through a simplified procedure, no country should need a national referendum to ratify it, smoothing its passage.
EUROPEAN STABILITY MECHANISM (ESM)
This permanent aid mechanism will replace the European Financial Stability Facility (EFSF), a 750 billion euro ($1 billion) EU-IMF-backed mechanism, when the EFSF expires in mid-2013. At the same time, a smaller fund called the European Financial Stability Mechanism will be absorbed into the ESM.
Unlike the current aid facilities, the ESM will open the possibility of private sector investors taking a loss in case of a sovereign debt restructuring. The change is designed to increase the pressure on euro zone governments to reduce deficits and conduct sound fiscal policies so as to avoid the threat of market-driven uncertainty.
The ESM will provide financial support to euro zone countries that suffer liquidity, but not solvency problems, so its size is likely to be bigger than the EFSF.
Finance ministers will discuss details of the fund in 2011.
The threat of private bondholders taking a haircut -- or writedown -- on sovereign bonds in the case of a default or restructuring under the ESM has helped drive yields on the debt of riskier countries such as Portugal and Spain higher in recent weeks, exacerbating the crisis.
EUROPEAN FINANCIAL STABILITY FACILITY
There are no formal plans to discuss the current aid mechanism for the euro zone. But some leaders may privately mention some ideas floated recently, such as increasing the size of the fund, using it to buy government bonds or to provide credit lines.
European Central Bank Governor Jean-Claude Trichet said on Tuesday the EFSF, of which the EU provides 440 billion euros, should have "maximum flexibility" in its size and scope.
The fund is being used to lend cash to countries that can no longer borrow at normal rates on financial markets. The fund, guaranteed by euro zone members, raises funds on international markets at competitive rates as it enjoys a top credit rating. There are strict conditions for receiving aid.
So far, Ireland has been granted around 20 billion euros from the EFSF to help its deficit and bank debt problems. Greece has received aid via separate, bilateral EU loans.
E-BONDS?
The summit is not expected formally to discuss joint euro area bonds, an idea resurrected last week by Italy and Luxembourg. Germany opposes the plan firmly and is adamant that it will not be raised for debate. So-called e-bonds would effectively mean all euro zone member states sharing their credit risk and debt issuance, which would drag Germany down.
ECB'S CAPITAL INCREASE?
Central bank sources have told Reuters the European Central Bank is considering requesting an increase in its capital to help cope with the rising costs of fighting the debt crisis.
Although not on the summit's agenda formally, the leaders may have an informal exchange on the issue.
PENSION REFORM COSTS
The leaders will briefly discuss demands of Poland and some other countries that have overhauled their pension systems to be allowed to write off part of the reform's costs from their budget deficits and public debt, so as not to face EU budget discipline steps.
Details of the plan will be worked out by finance ministers early in 2013 after Poland and the European Commission reached a deal on the issue last week.
EU BUDGET
British Prime Minister David Cameron may reiterate his demands for cuts in the EU budget in the bloc's next long-term spending plan that will begin in 2014. This year's EU budget is worth some 123 billion euros ($165 billion).
At the EU summit in October, Cameron secured a leaders' statement that the budget should reflect fiscal consolidation carried out by many national governments.
Some diplomats say Britain would like the budget to be cut to 0.85 percent of the EU's economic output, from 1.0 percent currently, but London has not confirmed this.
The EU's 2011 budget has been put off the agenda since governments and the European Parliament have reached a last-minute deal on the spending plan.