Crédit Mutuel AM: The ECB’s climate conundrum

3 november 2025

By Océane Balbinot-Viale, Sustainable Investment Research Analyst, Crédit Mutuel Asset Management

What do inflation, sovereign spreads and climate disasters have in common? Increasingly, everything.

For those who still believe that climate change is merely a long-term ESG concern, distinct from short-term economic fundamentals, the European Central Bank (ECB) has issued a striking response: “climate-related risks are an immediate concern for financial stability and economic growth”.

The warning, issued in July 2025, came alongside a new analysis based on short-term scenarios developed by the Network for Greening the Financial System (NGFS) which reveals that extreme climate events starting as early as 2026 could reduce eurozone GDP by up to 4.7% by the end of the decade – a downturn similar in magnitude to the economic impact of the global financial crisis.

Even in the absence of direct domestic climate damage, indirect effects such as supply chain disruptions in region rich in raw materials could still dent euro area output by nearly 2%.

This is a pivotal moment in the narrative around climate risk: the focus is no longer exclusively long-term. In fact, physical risk is becoming a macroeconomic disruptor within investable time horizons, with direct implications for central banks and the financial system at large.

The most worrying economic ramifications outlined by the ECB stem from a scenario titled “Disasters and Policy Stagnation” in which a string of climate-related disasters (from heatwaves and droughts to wildfires, floods and violent storms) triggers widespread physical and economic damage.

The shock is twofold: production and distribution capacity are undermined, pushing prices upwards, while consumer and investment confidence deteriorates, thereby suppressing demand. The result is stagflation, an unfortunate combination of inflation and low growth that central banks are ill-equipped to manage.

While tightening monetary policy may seem like the textbook response to surging prices, doing so in a context of climate induced economic contraction may exacerbate the downturn. Conversely, failing to act against inflationary pressures risks de-anchoring inflation expectations, undermining central bank credibility.

Such a dilemma is particularly acute for the ECB, whose primary mandate is price stability, but which is also charged with safeguarding financial stability... In a scenario marked by physical destruction, declining productivity and fiscal expansion aimed at disaster recovery, these two priorities may, perhaps ironically, no longer align. Pressure on public budgets, under already constrained sovereign balance sheets, could amplify concerns around debt sustainability and market fragmentation.

This risk is most acute for fiscally fragile member states, even though at the aggregated level the eurozone still retains more fiscal room than other advanced economies and recent crises suggests that in the face of systemic shocks (such as the COVID-19 pandemic or the Russian invasion of Ukraine) fiscal responses have increasingly been coordinated at the EU level.

It is therefore plausible that future climate-related spending will also be at, least partially, mutualised. That said, financial institutions exposed to hard-hit regions or sectors could see asset quality deteriorate. The ECB could thus find itself forced to choose between supporting growth and preserving inflation discipline: an uncomfortable position for any central bank, but especially for one operating in a politically diverse monetary union.

What makes this tension even more troublesome is that monetary policy transmission is unlikely to remain neutral in the face of climate asymmetries. The burden of ECB rate hikes, for instance, may fall disproportionately on already vulnerable sectors, notably those most exposed to both transition and physical risks (carbon-intensive industries, resource-dependent manufacturing, or climate-exposed real assets).

Meanwhile, transition-aligned sectors such as renewables or energy efficiency technologies, although typically more promising in terms of long-term resilience, may struggle to attract capital in a context of tighter financial conditions.

This is not speculation: in a 2023 working paper, ECB researchers highlighted that a “slow green transition” can alter the distributional impact of monetary policy, signaling that the current toolkit may worryingly no longer deliver the intended results uniformly across the economy.

This growing asymmetry is further reflected in the ECB’s recent operational decisions: in July 2025, the Bank announced the implementation of a new “climate factor” to adjust the valuation of collateral assets used in refinancing operations.

In practice, bonds from issuers deemed more exposed to climate transition risk will be subject to stricter valuation haircuts, reducing their liquidity value for banks. While the measure is intended to safeguard the Eurosystem from climate-related financial risks, it may also amplify funding constraints in high-emitting sectors, reinforcing the divergence in monetary transmission already under way.

Sovereigns too are unlikely to be spared from growing investor scrutiny. The potential for climate-driven fiscal deterioration and bond market repricing raises the spectre of renewed fragmentation within the euro area.

While tools such as the Pandemic Emergency Purchase Programme (PEPP) and the Transmission Protection Instrument (TPI) were designed to prevent unjustified spreads between member states, their applicability in the face of climate-induced divergence remains uncertain.

While inflation expectations remain well anchored (with median consumer expectations for 2030 still close to the ECB’s 2% target), climate change is increasingly perceived by consumers as a driver of inflationary pressure: according to a 2024 survey conducted by PwC, nearly 9 in 10 consumers reported experiencing first-hand the disruptive effects of climate change in their daily lives, and almost 1/3 cited inflation as the top risk to their consumption habits.

The emergence of a perceived link between climate events and price increases could gradually shift inflation psychology, especially if extreme weather events become more frequent and damaging. This divergence between actual expectations and perceived drivers of inflation may complicate the ECB’s response function over time.

For investors such as ourselves, these developments have far-reaching consequences. The fundamental macroeconomic regime in which monetary policy operates is being reshaped by climate change.

This calls for a reassessment of portfolio construction, particularly when it comes to sovereigns. Eurozone government bonds, long considered risk-free or at least low-risk, may require a more nuanced view that integrates climate-adjusted fiscal capacity, adaptive infrastructure investments, and political polarization around climate change.

Similarly, sector allocation strategies must evolve. Beyond ESG ratings and climate disclosure metrics, what matters increasingly is how exposed a company or sector is to the new macro-financial environment: one seemingly characterised by disrupted growth patterns, unpredictable inflation, and potentially tighter financing conditions.

In this context, climate scenarios should no longer be confined to sustainability reporting or stress-testing exercises. They must become central inputs to economic forecasting, asset-liability modelling and long-term return expectations. This includes factoring in both physical disasters and chronic trends (regulatory tightening, resource scarcity…).

Just as importantly, climate-aware portfolio construction must be complemented by active engagement. We believe asset managers should continue pushing for more credible transition plans, better disclosure around physical risks, and clearer policy signals.

Advocacy for effective carbon pricing mechanisms, taxonomy-aligned investments, and resilience-building public policy is not simply a matter of values: it is also about preserving financial stability and long-term value.

The ECB’s message is clear… And the timeline is short. Climate change is no longer just a long-term sustainability issue. It is a macroeconomic reality, already seeping into the operating assumptions of monetary policy and threatening to upend the financial system as we know it.

For asset managers, it also requires acknowledging the principle of double materiality: in a world where financial decisions increasingly shape climate outcomes, investors must evaluate not only how climate change affects portfolios, but also how portfolios affect the climate. Anticipating and integrating these structural shifts is not only good practice; it is also increasingly vital to delivering resilient performance in an age of rising uncertainty.