European energy policy faces a number of interrelated challenges, including making the transition to a low–carbon economy, increasing cross–border competition in electricity and gas markets and diversifying Europe’s energy supply. The EU has developed a comprehensive strategy in all of these areas, encapsulated in 2020 targets for reducing greenhouse gas emissions, raising renewable energy and increasing energy efficiency. These targets are underpinned by an Emissions Trading Scheme, legally binding reduction commitments by member states for the emissions not covered by the trading scheme, the third energy liberalisation package and the Energy Security and Solidarity Plan. The steps the EU have taken are worthwhile but there is also room for improvement. To ensure that the transition to a low–carbon economy is achieved at a low cost, the EU should seriously consider including all transport sectors in the Emissions Trading Scheme when practical and appropriate, and ensure that only sectors rigorously identified as being at genuine risk of carbon leakage should continue to receive free allowances until 2020. Consideration should be given to making use of an EU–wide market instrument to deliver the EU’s renewable energy target, and it will be important to ensure that the 10% renewable transport fuel target efficiently achieves its objectives of sustainability and security of supply given the high cost of many renewable transport fuels. Measures to raise energy efficiency will have to be designed carefully so that the overall cost of mitigation is not raised. The Commission’s third energy market liberalisation package should be strengthened by requiring full ownership unbundling of transmission service operators and ensuring the powers of the proposed Agency for Co–operation of Energy Regulators are broad enough to contribute effectively to a truly single European energy market. This Working Paper relates to the 2010 Economic Survey of the European Union. (www.oecd.org/eco/surveys/EuropeanUnion)