URL encoding refers to taking simple text strings and converting them into URL format. URL format means the encoded text only contains alpha, digit, safe, extra and escape characters. The specification for URLs (RFC 1738, Dec. '94) limits the use of allowed characters in URLs to only a limited subset of the US-ASCII character set:
"...Only alphanumerics [0-9a-zA-Z], the special characters "$-_.+!*'()," [not including the quotes - ed], and reserved characters used for their reserved purposes may be used unencoded within a URL."
HTML, on the other hand, allows the entire range of the ISO-8859-1 (ISO-Latin) character set to be used in documents - and HTML4 expands the allowable range to include all of the Unicode character set as well. In the case of non-ISO-8859-1 characters (characters above FF hex/255 decimal in the Unicode set), they just can not be used in URLs, because there is no safe way to specify character set information in the URL content yet [RFC2396.]
URLs should be encoded everywhere in an HTML document that a URL is referenced to import an object (A, APPLET, AREA, BASE, BGSOUND, BODY, EMBED, FORM, FRAME, IFRAME, ILAYER, IMG, ISINDEX, INPUT, LAYER, LINK, OBJECT, SCRIPT, SOUND, TABLE, TD, TH, and TR elements.)
For more information about URL specification please refer to this W3 document.