The European Union is facing severe challenges from the financial crisis and the deep recession. The European economy has been heavily affected by ongoing financial turmoil and the associated deep and synchronised recession in the global economy, reflecting the strong commercial and financial linkages between European economies and between Europe and the rest of the world. Output is projected to decline by around 4% this year, making this Europe’s worst post-war recession. The actions taken by central banks, member state governments, the Commission and other EU institutions have stabilised financial markets and supported the economy. It is important that these policy actions do not imperil the prospects for subsequent recovery or endanger the single market. The recession itself will result in a considerable loss of capacity in the European economy, adding to the pressures on long-term growth prospects that will come from population ageing, and has disrupted the progress that was being made towards achieving the objectives of the renewed Lisbon Strategy for Growth and Jobs. Reforms undertaken through the Lisbon strategy since 2005 have helped the EU to improve the resilience of its economy.

The EU economy experienced a deep economic slump. Monetary policy has eased and fiscal stimulus provided to revive the economy. Past experience shows that economic crises can provide momentum for introducing longer term structural reforms by demonstrating the limitations of existing policies and by weakening the resistance to change. The crisis has already triggered reforms to tackle weaknesses in the financial system which, if implemented effectively, should support financial stability and longer term growth prospects. Pursuing structural reforms in the context of the Lisbon strategy will also be important as the recession could result in a considerable loss of capacity in the European economy, adding to the pressures on long-term growth prospects that will soon come from population ageing.

The central importance of investing in knowledge and innovation for long-term growth is recognised in the Lisbon strategy. R&D expenditure in the EU is well below that in the United States and Japan and, despite the target for EU-wide R&D expenditure of 3% of GDP by 2010, limited progress has occurred in recent years. The Commission introduced a broad-based innovation strategy in 2006 and initial steps have been taken towards the formation of a European Research Area. More recently, the focus of policy has also turned towards encouraging and promoting the broader concept of “creativity”. A key challenge for the Commission is to improve the measurement of creative and innovative activities and the evidence base regarding the key policy influences on these activities. Further steps should be taken to strengthen the European Research Area and encourage cross-border research co-operation and the mobility of researchers. Progress in completing the internal market should also stimulate innovation.

The single market programme has been important in promoting integration in Europe and has improved longer term growth prospects. But much more can be done to raise living standards further, particularly by reforming service sectors and some network industries. OECD product market regulation indicators show that existing regulations remain relatively stringent and that competition is less intense than it should be. There also continue to be substantial delays in the full implementation of some directives by member states, especially in the areas of financial services, energy and transport. The Services Directive should bring further improvement provided it is implemented in a timely and effective fashion, as intended, by the end of 2009. Looking ahead, the Commission should continue efforts to raise competition and reduce administrative burdens by identifying and tackling obstacles to integration and by pursuing the Better Regulation agenda.

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 EU should be applauded for the significant steps it has taken; the EU’s environmental actions and targets are very ambitious and will increase the likelihood of a global climate agreement later in 2009. 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.

The global financial crisis and associated recession are putting pressure on many countries to increase protection for domestic firms. The next few years will be very challenging for global trade policy. The EU has a significant interest in opposing rising protectionist sentiment and undertaking further trade liberalisation. Historically, trade liberalisation in the EU has followed a number of tracks: multilateral through the WTO; reciprocal through bilateral and regional preferential trade agreements (PTA); and non-reciprocal through initiatives such as the General System of Preferences (GSP), GSP+ and Everything But Arms (EBA) initiative that give special access to European markets to the developing and least developed countries. As a result, the European market is already significantly open to the rest of the world. An important challenge for the EU is ensuring that its initiatives in all of these areas are mutually reinforcing and that resources devoted to negotiating new PTAs do not detract from efforts in the multilateral sphere. The efficiency of the Common Agricultural Policy (CAP) has improved considerably during the course of this decade as payments to producers have become increasingly decoupled from production. Nevertheless, the overall size of support to the agricultural sector remains close to the OECD average and the biggest farms continue to receive the bulk of funds under the Single Payment Scheme. There is still considerable scope to improve the targeting of payments under the CAP. As is the case for the other OECD countries, further reducing export subsidies and tariffs on agricultural imports as already proposed by the EU in the context of the Doha Round would benefit consumers.