If you are planning on driving whilst in Europe, it is recommended that you obtain an international licence, officially called an International Driving Permit (IDP), prior to your departure from Australia (or your home country). An IDP is an internationally recognised form of identification, and in many cases is a pre-requisite for hiring a car.
It is compulsory in some European countries to present an IDP, as well as your current Driver's Licence from home, when collecting your hire or lease vehicle, or when pulled over by police.
In my own experience, on the past couple of occasions when renting a car in Europe we haven't been asked to present an international drivers licence - our Australian licence has been sufficient. However, for the sake of $40, I would rather be safe than risk a fine for not having one if pulled over by the police for any reason.
UPDATE June 2017: I have recently made car hire bookings for my upcoming trip to Europe in July 2017. As you'll see from the photos below, the confirmations clearly expressed what licence/s are required to be presented on collection of the vehicle. The car rentals I have made for Germany and France require only regular drivers' licence from home but the rental in Switzerland requires both the regular licence and an IDP to be presented.
UPDATE August 2017: On collection of our hire car in Geneva, we were NOT asked to present our International Driving Permit.
However, it is worth keeping in mind that the requirement to hold and International Driving Permit may be a law of a specific country and not necessarily a requirement of a rental car company. If you are pulled over by police whilst driving in Europe, you may be fined for not holding a valid IDP if that particular country requires foreign drivers to present one. (See the comment by Suzanne below.)
According to the RACV website, failure to hold an International Driving Permit can result in exclusion from your travel insurance policy for a loss caused whilst driving overseas. If you plan to drive in Europe without an IDP, I strongly recommend you check the conditions of your travel insurance regarding this.
IDPs can be purchased from your local motoring organisation (RACV, NRMA, etc) by presenting your current drivers’ licence and a passport-sized photo. The International Driving Permit is valid for 12 months, and costs around $40 (2017 price). IDP's are usually issued on the spot.
Visit the Australian Government's Smart Traveller website for further details about international drivers licences.
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