Inefficient and expensive energy firms will face legal action over their behaviour, the European Commission's competition office has warned.
Neelie Kroes says breaking up large energy firms will help consumers
The comments were part of a report into Europe's energy markets, which added that splitting supply, generation and distribution would boost competition.
The Commission's competition czar Neelie Kroes said the report would make "uncomfortable reading" for some firms.
UK energy watchdog Ofgem welcomed the Commission's report.
"The Commission's tough proposals today are good news for Britain's energy consumers who, for too long, have paid the price for a lack of real competition in continental Europe," said Ofgem's chief executive Alistair Buchanan.
"And they're bad news for the dominant energy giants who must relinquish their stranglehold on their national energy markets and compete in the new European energy market," he added.
UK consumers have seen their gas bills surge during 2006, with a number of companies blaming a lack of supply and problems with delivery from Europe for pushing wholesale gas costs.
The Commission, which is already investigating possible cartels between German energy companies, said that there may be collusion among large firms to share out markets.
This was identified as one of the most serious threats to competition, the report added.
Ms Kroes said she would use powers available to her under anti-competition legislation to act against firms, a threat that means certain companies may face large fines.
However, there was little detail on measures the Commission would take to achieve the aim of opening up Europe's energy market.
The commissioner said she wanted to "unbundle" large companies such as Germany's E.On, and Electricite de France - so that the businesses that generated power and supplied gas were not the same ones that controlled the network of pipelines.
Ms Kroes said that breaking companies into production and distribution operations would allow other companies easier access to distribution networks, increasing competition.
It may also help promote firms to move into markets in neighbouring countries.
However, the Commission's proposals have not won the backing of Russia's state-owned energy giant Gazprom, which has been amongst Ms Kroes' loudest opponents.
Jayesh Parmar, head of energy advisory services at Ernst & Young, said that breaking up European power markets would not create competition overnight.
"Unbundling alone will not make European gas and power markets fully competitive," he explained. "Wholesale markets in gas and electricity need to be more liquid, and there needs to be greater competition for consumers.
"Without access to robust wholesale markets, new entrants will not be able to procure the gas and electricity to sell to consumers."