Europe-wide government incentives to encourage consumers to buy more efficient cars should be phased out gradually, Fiat CEO Sergio Marchionne said.

“We do need to allow for the system to adjust gradually until the markets recover,” Marchionne told reporters at the introduction of Fiat’s updated Punto Evo model aboard the aircraft carrier Cavour in La Spezia, Italy.

Otherwise “you are going to see a substantial drop in demand in 2010 and phenomenal impact on production,” he said.

Incentives to buy fuel-efficient new cars and dispose of older models have improved CO2 emissions, said Marchionne, who is also CEO of the ‘new’ Chrysler Group.

He has called for the continuation of government incentives in Europe to help keep car factories open and protect jobs. Incentives in Germany, where Fiat made gains against other European brands, ended last month. The UK government announced on Monday it would extend its incentives while decisions have yet to be taken by Italy and France.

“If it was me, I would be planning for a gradual reduction of incentives over 2010 and 2011 and at the same time addressing the overcapacity,” Marchionne said, adding that scrappage incentives should be addressed at a pan-European level rather than country by country.