Ministers were also pressed to outlaw predatory pricing of newspapers during a debate on the Competition Bill after Lord McNally, a Liberal Democrat, argued for an amendment to impose tough regulations.
He claimed substantial support among cross-benchers for the rules, similar to an amendment accepted by the Lords and overturned by the Commons earlier this year.
Defeat over choice of the electoral system for the European elections is likely to disrupt the Government's legislative timetable, coming near the end of the parliamentary session.
It came after an impassioned debate during the final stages of the European Parliamentary Elections Bill and an appeal by the Tory frontbench spokesman, Lord Mackay of Ardbrecknish, to the House to "rescue democracy." He argued against the "closed-list" system of proportional representation, under which the electorate determines the number of seats, though the choice of candidates is made by the party. Peers said this would remove power from the voters, and instead called for an open-list system.
Lord Mackay said: "If the Government insists on using closed lists, the voters should be concerned that the voting system is being manipulated for party political ends of the governing party." Lord Stoddart of Swindon, a Labour backbencher, said that in opposition his party would have denounced the Bill as disgraceful.
But the Home Office Minister Lord Williams of Mostyn said the changes would "redress the monstrous injustice" that disadvantaged women and ethnic minorities. The system was used in the 1996 elections leading to the peace process in Northern Ireland.
During the debate on the Competition Bill, Lord McNally said peers were in a "frisky mood" and should vote against the Government to protect democracy. "Newspapers have to be treated differently by competition laws because of the importance of a diverse media for a healthy democracy ... media moguls are not self- regulated and we will have to contain them."
Lord Harris of High Cross, a cross-bencher, said price-cutting by The Times, owned by Rupert Murdoch, was not the only reason its circulation had increased over recent years; there were also issues of quality. "These are do-or-die issues. We are not talking about baked beans but a sophisticated product ... what are we proposing, to put a newspaper like The Independent on a protected list?"
Lord Harris went on to dismiss the issue of predatory pricing as an "excitable distraction" made by critics outraged by Mr Murdoch's success.
But Lord Borrie, also a cross-bencher and former head of the Office of Fair Trading, said The Times would have never been able to cut its price consistently without the support of sister papers. He added that even if other newspapers' existence had not been jeopardised, they still had to cut costs and the quality for their reader had therefore been indirectly damaged.
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