Norsk Hydro backed out of the project in July this year and Alcoa, the world's largest aluminium producer, said it intended to build a smaller smelter on the same site.

"The changes in the plans to build an aluminium smelter in Reydarfjordur are not likely to have a considerable environmental impact, and are not to be subject to an environmental evaluation," the government planning agency said in a report.

Alcoa has said it plans to decide early next month whether to proceed with construction of the smelter.

The new operation would nearly double aluminium smelter capacity in the North Atlantic island, which has abundant geothermal energy and potential to generate hydro-electricity.

The smelter and the hydropower plant which national power producer Landsvirkjun plans to build to power it have caused controversy in Iceland due to environmental concerns.

The plan would dam two of the country's largest glacial rivers, turning highland valleys and canyons into reservoirs.