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One effect of climate change is an increase in global temperatures driven by rising carbon emissions. This trend imposes direct productivity losses on firms, as extreme heat reduces worker efficiency, raises absenteeism, and impairs machinery performance (Heal and Park 2016, Seppänen et al. 2006, Somanathan et al. 2021). While these direct effects are substantial, there are indirect effects which are equally important but often overlooked. These indirect effects come from the limited ability of firms to adjust inputs efficiently in response to climate shocks. Firm-level frictions, such as high adjustment costs, financial constraints and the inability to substitute labour for capital, can severely restrict this flexibility. For instance, when firms face barriers to scaling down capital inputs, they are forced to keep excess capital during periods of reduced activity. This diminishes its marginal productivity due to decreasing returns. To illustrate how such frictions turn into productivity losses, consider the example of an extreme temperature event that affects half of a country, causing firms there to be non-operational for 20% of the time, resulting in a 20% drop in their output. In a frictionless economy where it costs firms nothing to adjust inputs and firms can operate under constant returns to scale, aggregate productivity would stay the same, as inputs and outputs contract to the same extent. However, if unaffected firms can increase production while affected firms are unable to adjust their input use, the economy experiences a misallocation of resources. The result is a decline in aggregate productivity owing to an indirect effect (i.e. inputs are inefficiently assigned across firms). 
In the above scenario, this decline would be roughly 10%. The example highlights how firm-level frictions can magnify the overall economic consequences of climate shocks. This is also important for integrated assessment models, which often abstract from microeconomic detail, potentially underestimating the true economic costs of climate change.

In our recent paper (Caggese et al. 2025), we examined both the direct and indirect effects of extreme temperatures on firm performance. We achieved this by combining detailed microdata on Italian firms with high-resolution temperature records from the EU’s Copernicus E-OBS dataset. Italy’s diverse climatic and economic geography – spanning Alpine industrial hubs in the north to the warmer, less-industrialised regions in the south – provides an ideal natural laboratory for studying the economic consequences of temperature variation. Panel a of Figure 1 illustrates how average maximum temperatures have evolved across Italy, revealing both significant year-on-year volatility and a clear upward trend. Panel b of Figure 1 displays the geographical distribution of average annual temperatures in 1999 across very detailed geographic units using the Nomenclature of Territorial Units for Statistics (NUTS), the EU system for subdividing countries into regions for statistical purposes. The wide range of average temperatures, from 0.14°C to 23.82°C, highlights the large differences between regions and confirms how suitable Italy is for the analysis.

Figure 1 Temperature in Italy

Source: Caggese et al. (2025).
Notes: Panel a) shows the evolution of the average yearly temperature in Italy between 1950 and 2020. The grey shaded area shows the time frame (1999-2013) for which data are available in the Orbis database. Panel b) shows the average temperature across all the grid cells in Italy in 1999. It also plots regional boundaries at the NUTS 3 level.

What is the effect of temperature on firm performance?

Our analysis uncovers a significant direct effect of extreme heat on firm performance. Episodes of very high temperatures reduce sales by approximately 0.8%, with each additional day above 40°C equivalent to nearly two days of lost sales. In response to these conditions, firms substantially reduce labour and material inputs but notably do not adjust their capital usage (Figure 2, panel a). This rigidity is likely driven by high adjustment costs and other firm-level frictions, leading to an inefficient allocation of capital and a decline in its marginal productivity. For example, we find that a factory significantly scales back its production activity during periods of extreme heat. To cope with this reduced output, it cuts down on workers’ shifts and temporarily reduces raw material purchases. However, its machinery, cooling systems and physical infrastructure remain unchanged. These capital assets are costly to adjust or relocate, so they sit underused. As a result, the factory’s capital is not being deployed efficiently and the return on that investment – its marginal productivity – declines. To illustrate how this inability to reallocate capital contributes to productivity losses, panel b of Figure 2 shows the effect of temperature on the marginal product of different inputs. In a frictionless setting, aggregate productivity rises as inputs flow to firms that can use them the most efficiently, i.e. firms with the highest marginal returns. We also find that the marginal productivity of labour and materials remains relatively stable, reflecting the ability of firms to adjust these inputs flexibly. In contrast, the marginal productivity of capital declines sharply at high temperatures, indicating that firms are unable to shed excess capital when it becomes unproductive. We refer to these inefficiencies in capital use and the associated productivity losses as the indirect effects of temperature shocks.

Figure 2 The effect of temperature on firm outcomes and marginal returns

Source: Caggese et al. (2025)
Notes: Daily temperatures are aggregated to the annual level by counting the number of days falling within specific temperature bins. Panel a) shows the effect on the log of sales, expenditure on materials, employee compensation and capital. Panel b) shows the effect on the marginal revenue product of materials (MRPM), marginal revenue product of labour (MRPL) and marginal revenue product of capital (MRPK).

What are the aggregate implications of climate change?

To quantify the aggregate implications of these micro-level direct and indirect effects, we have developed a model that maps estimated firm-level semi-elasticities of sales and input use to temperature changes. To estimate how climate change affects overall productivity, we need to consider three main factors: how firm productivity responds to temperature; how firms’ use of inputs like labour and materials changes with temperature; and how temperatures are expected to change. We use our empirical results to quantify the first two factors, and we compute counterfactual scenarios of potential temperature increases. This framework allows us to break down aggregate productivity effects into two components: changes driven by efficiency losses within firms, and changes arising from misallocation across firms. Our new approach reveals differences compared with previous research. Under a moderate scenario involving a 2°C increase in average annual temperatures, our model predicts a 1.68% decline in aggregate productivity. This decline is more than four times the 0.39% loss that is estimated using a naïve approach, which is a basic method that averages firm-level effects without considering economics factors like allocative distortions. These effects become even more pronounced under an increase of 4°C, with productivity losses rising to approximately 6.81%, which emphasises how climate shocks can have complex effects that can intensify existing problems (Figure 3).

Figure 3 Aggregate productivity losses under different temperature change scenarios

Source: Caggese et al. (2025).

We conclude by examining two scenarios that could either amplify or mitigate the effects of climate change. First, we assess the role of firm-level adaptation. By comparing regions with a long history of exposure to extreme temperatures – where firms are more likely to have already adopted climate resilient technologies – with regions that have only recently started to experience such temperatures, we find evidence that adaptation can substantially reduce the economic impact of heat shocks. Specifically, the use of climate-mitigating technologies lowers estimated damages by 20-30%. Second, we construct aggregate damage functions at the NUTS 3 level to evaluate the regional distribution of climate-induced productivity losses across Italian provinces. This geographical analysis reveals considerable variation, with effects ranging from mildly positive to severely negative (Figure 4, panel a). Notably, provinces with lower GDP per capita are projected to experience greater temperature increases, suggesting that climate change is likely to make existing regional disparities worse. Panel b of Figure 4 plots projected productivity losses against regional GDP per capita, revealing that wealthier regions tend to incur smaller productivity losses, while poorer regions are more severely affected.

Figure 4 Regional productivity losses in a scenario of a 2ºC increase in temperature

Source: Caggese et al. (2025).
Notes: Panel a) shows the productivity losses across NUTS 3 regions owing to an increase of 2ºC, which was adjusted according to the ratio of gross output to value added. Productivity losses are shown as percentages. The darker the region is shaded, the larger the loss. Panel b) plots the same regional losses against average GDP per capita in our sample, showing a negative correlation of 0.232.

Conclusions

Our findings provide two key policy insights. First, the economic impact of climate-induced productivity shocks is substantially larger when accounting for the fact that labour, material inputs, and especially capital are relatively difficult to adjust. Policies that alleviate these constraints, such as promoting investment in adaptive technologies, can play a critical role in mitigating the economic costs of climate extremes (e.g. Carleton et al. 2025). Second, our analysis emphasises the risk that climate change may make existing regional inequalities worse. The analysis highlights the need for adaptation strategies that are targeted and region specific.

More broadly, our framework demonstrates the importance of incorporating detailed firm-level dynamics into integrated assessment models to more accurately estimate the economic costs of climate change. Future modelling efforts and policy assessments must go beyond aggregated damage estimates to explicitly account for microeconomic frictions. This approach will provide a more realistic picture of economic risks related to climate change and will support the development of adaptation and mitigation policies that are more effective and targeted.

Finally, our analysis shows that firm-level responses to extreme temperatures – particularly rigidities in adjusting capital and other inputs – can significantly amplify the aggregate productivity losses from climate change. These losses have broader macroeconomic implications; reduced productivity and output can constrain supply, while climate-induced disruptions to inputs like energy and materials can fuel inflationary pressures. Understanding these microeconomic channels is crucial for anticipating the inflationary impact of climate shocks and for designing policies that enhance firms’ resilience, support productive investment and safeguard economic stability in a warming world.

Authors’ Note: This column first appeared as a Research Bulletin of the European Central Bank. The authors gratefully acknowledge the comments from Catriona Layfield, Alex Popov, and Zoë Sprokel. The views expressed here are those of the author and do not necessarily represent the views of the European Central Bank or the Eurosystem.

References

Caggese, A, A Chiavari, S Goraya and C Villegas-Sanchez (2024), “Climate Change, Firms and Aggregate Productivity”, CEPR Discussion Paper No. 19164.

Carleton, T, E Duflo, K Jack G Zappalà (2025), “The economics of climate adaptation: From academic insights to effective policy”, VoxEU.org, 15 April.

Heal, G and J Park (2016), “Reflections – temperature stress and the direct impact of climate change: a review of an emerging literature”, Review of Environmental Economics and Policy 10(6): 347-362.

Nordhaus, W D (1977), “Economic growth and climate: the carbon dioxide problem”, American Economic Review 67(1): 341-346.

Seppänen, O, W J Fisk and Q Lei (2006), Room temperature and productivity in office work, Technical report, Helsinki University of Technology and Lawrence Berkeley National Laboratory.

Somanathan, E, R Somanathan, A Sudarshan and M Tewari (2021), “The impact of temperature on productivity and labor supply: evidence from Indian manufacturing”, Journal of Political Economy 129(6): 1797-1827.

The rise of digital currencies presents states with opportunities and challenges (Gorton et al. 2023). The EU and the US have taken starkly different approaches to the regulation of new monies issued using distributed ledger technology (‘on-chain money’; see Aldasoro et al. 2023). Under President Trump, the US now rejects central bank digital currencies (CBDCs) in favour of privately issued ‘stablecoins’ (Auer et al. 2025, Monnet 2025). Stablecoins are privately issued money that is intended to be convertible into more established forms of money at a one-to-one redemption or conversion rate (‘at par’) and backed by low-risk assets to meet redemptions and secure their value.

By promoting the global use of dollar-backed stablecoins, the US seeks to reinforce dollar dominance worldwide. It is meant to reinforce more international use of the dollar for payment and invoicing. Since US dollar stablecoins are mainly backed by US debt, they also create new demand for US dollar debt of public, and potentially even private, issuers.

In a recent report (van ‘t Klooster et al. 2025), we present this strategy and assess its risks for the EU. Does its 2024 Markets in Crypto Assets Regulation (MiCAR) protect the EU from the impact of US crypto-mercantilism? We argue it does, but third countries with low levels of financial inclusion and unstable currencies face severe risks. This is an opportunity for the EU to build new international payment systems premised on mutual respect for monetary sovereignty.

The EU’s regulatory framework: A robust protection

Dollar-pegged stablecoins raise three types of potential risks for the EU. First, stablecoins could increase financial stability risks either through redemption risk if the assets of stablecoin issuers are not properly regulated, or by increasing the risk of bank runs if stablecoins suddenly attract bank deposits. These risks are not limited to dollar-pegged stablecoins. Second, dollar-pegged stablecoins can potentially lead to a digital dollarisation of the euro area if they are widely adopted, at the expense of euro-denominated payments. This would create exchange rate risks for European households and companies, and strongly constrain European monetary policy. Third, if dollar-pegged stablecoins circulate widely in the world, this could limit monetary sovereignty in third countries (economic trade partners for the EU) and conflict with the recently restated objective of a greater international role for the euro (Lagarde 2025).

We assessed these risks through a deep analysis of the current European legal framework regulating stablecoins (MiCAR) and of the proposed GENIUS Act recently passed by the US Senate. The analysis leads us to conclude that, in the EU, MiCAR sets adequate safeguards to ensure financial stability and prevent the digital dollarisation of the European economy. Three features are crucial. First, foreign, non-MiCAR-compliant stablecoins can be held by Europeans but not offered to the public by foreign financial institutions. Second, in the EU, MiCAR-compliant issuers that are considered significant for their size, volume, or systemic relevance are subject to a significantly stricter regime, especially in terms of ‘reserves and asset safeguards’ and ‘core prudential principles’. Finally, for MiCAR-compliant stablecoins that are not denominated in euros, the European Banking Authority (EBA) and other national regulators, following a binding opinion of ECB, can halt the issuance of foreign currency-denominated stablecoins if they present significant risks. It remains crucial that the ECB actively monitors those risks as a final safeguard against dollarisation of the euro area. 

The main risk: Challenge to other countries and to the internationalisation of the euro

Our analysis highlights fundamental differences between the policy goals pursued by the EU and the US. In its current version, MiCAR seeks to ring-fence the EU’s financial and monetary system. The US GENIUS Act would do less for domestic financial stability, instead prioritising innovation in the private sector and widespread adoption worldwide.

Under the GENIUS Act, the regulator must set the necessary capital and liquidity requirements on a tailor-made basis and only to the extent necessary to ensure orderly operation. Under MiCAR, issuers – especially when designated as significant – must comply with quantitatively and qualitatively defined prudential requirements.

To understand the challenges of stablecoins to monetary sovereignty, we must also look at the impact of a jurisdiction’s rules beyond its borders. Both regimes state that unlicensed issuers cannot lawfully issue stablecoins in their jurisdictions. Besides this common starting point, the US also seems keen on attracting foreign issuers as long as it can retain some (political) control over the issuer. Accordingly, the Secretary of the Treasury can take ad hoc decisions to authorise a foreign issuer. Moreover, the Secretary of the Treasury can enter into agreements with other jurisdictions to facilitate international transactions and interoperability with US dollar-denominated payment stablecoins issued overseas. In contrast, in the EU none of these options is available and MiCAR limits itself to promoting supervisory cooperation agreements.

The proposed US law, in sum, reflects the US strategy of crypto-mercantilism. It promotes international circulation of dollar-pegged stablecoins, potentially at the expense of financial stability and consumer protection. While the euro area appears to be protected by MiCAR, this is not the case for other jurisdictions. The successful promotion of US dollar stablecoins globally will lead to further dollarisation in third countries, creating severe risks to their monetary sovereignty and financial stability. Dollar-pegged stablecoins will be most attractive to citizens of countries with low levels of financial inclusion and unstable currencies. To encourage the widespread circulation of dollar-pegged and dollar-backed stablecoins, the US already intends to leverage the strength of its crypto industry as well as its dominance in online commerce and social media (notably through the US big-tech companies).

These developments are also crucial for the international role of the euro. The internationalisation of a currency is closely tied to its role in payments (Eichengreen et al. 2024). Replacing euro-denominated transactions with stablecoin-based payments (pegged to the dollar) could reduce the euro’s attractiveness, including as a reserve asset. If dollar-backed stablecoins dominate and their reserves rival those of central banks, this would further entrench the dollar’s supremacy as a reserve currency and weaken the euro’s global standing.

A multilateral approach to counter US dominance

The EU should not wait for these developments to play out before deciding its response. For one, it would be a big mistake to compete with the US by promoting riskier euro-denominated stablecoins through a weakening of MiCAR. This is neither realistic, given the incumbency advantage of the dollar, nor is euroisation of third countries through risky stablecoins per se good for the EU. Instead, European policymakers, including the ECB, should actively support payment multilateralism by facilitating cross-border transactions between central bank digital currencies (CBDCs) and fast payment systems. The development of a cooperative and multilateral approach to payment systems across jurisdictions is the only way to avoid the privatisation of international payments through dollar-pegged stablecoins and the associated risks to monetary sovereignty. The EU should stick to promoting the internationalisation of the euro as a safe asset that can be held without constraint, rather than following the US in promoting currency internationalisation as a vehicle for big tech domination and quasi-dollarisation of domestic payment systems.

The EU can benefit from more widespread use of the euro while helping third countries counteract the risk of dollarisation through dollar-pegged stablecoins. This requires developing an infrastructure that guarantees the interoperability of central bank digital currencies and fast payment systems for cross-border payments.

Conclusion

We conclude that MiCAR currently offers good protection against financial stability risks of stablecoins and the threat of dollarisation of the euro area economy through dollar-pegged stablecoins. Caution is warranted, however. In particular, EU regulators should refrain from granting equivalence to stablecoin regimes in jurisdictions with weaker standards. The divergence between MiCAR and the US GENIUS Act underscores this risk. Still, the ECB should keep a close eye on the use of dollar-pegged stablecoins in the EU and limit their circulation if necessary.

The danger of US crypto-mercantilism is much stronger for other countries and thus for the international role of the euro. But it is also an opportunity: the EU should lead efforts to build interoperable central bank digital currencies and payment systems. This includes information sharing, consistent communication standards, and regulatory approaches to facilitate cross-border payments (BIS 2022, Aurazo et al. 2024, Reslow et al. 2024). To avoid financial stability risks associated with increased payment volatility, capital flow management measures should also be considered in payment infrastructures (Reslow et al. 2024).

References

Aldasoro, I, P Mehrling and D Neilson (2023), “On par: A Money View of stablecoins”, BIS Working Papers No 1146.

Auer, R, C Monnet and H S Shin (2025), “The economics of distributed ledgers and the limits of decentralised money”, VoxEU.org, 9 April.

Aurazo, J, H Banka, J Frost, A Kosse and T Piveteau (2024), “Central bank digital currencies and fast payment systems: rivals or partners?”, BIS Papers No. 151.

BIS – Bank for International Settlements (2022), Options for Access to and Interoperability of CBDCs for Cross-Border Payments, Joint report to the G20 by the Bank for International Settlements’ Committee on Payments and Market Infrastructures, the BIS Innovation Hub, the IMF and the World Bank.

Eichengreen, B, C Macaire, A Mehl, E Monnet and A Naef (2024), “Currency internationalization with Chinese characteristics: Is capital-account convertibility required for the renminbi to acquire reserve-currency status?”, International Finance 27(2): 102-128.

Gorton, G B, E C Klee, C P Ross, S Y Ross and A P Vardoulakis (2023), “Leverage and stablecoin pegs”, VoxEU.org, 23 February.

Lagarde, C (2025), “Europe’s ‘global euro’ moment”, ECB Blog, 17 June.

Monnet, E (2025), “Cryptomercantilism: Donald Trump’s monetary doctrine”, SUERF Policy Brief. 1139, 10 April.

Reslow, A, G Soderberg and N Tsuda (2024), “Cross-Border Payments with Retail Central Bank Digital Currencies: Design and Policy Considerations”, Fintech Notes, Washington, D.C.: International Monetary Fund.

van ’t Klooster, J, E Martino and E Monnet (2025), “Cryptomercantilism vs. Monetary Sovereignty. Dealing with the Challenge of US Stablecoins for the EU”, Report requested by the Economic and Monetary Affairs (ECON) Committee of the European Parliament ahead of the Monetary Dialogue, European Parliament, 17 June.