Can economies innovate their way out of climate trouble? I provide the first systematic evidence outside agriculture that firms adapt to extreme heat through directed technological change. Linking firm-level data with patent records for nine EU countries (2000–2020), I establish three findings. First, extreme heat operates as a labor-biased productivity shock: labor-intensive firms suffer disproportionate losses and cede market share to capital-intensive competitors. Second, firms respond by shifting production toward capital and redirecting innovation toward labor-saving technologies, with the strongest responses in labor-intensive industries facing the greatest heat exposure. Third, this endogenous innovation response has quantitatively meaningful consequences: labor-saving patents filed in response to heat attenuate aggregate productivity losses by 26 percent over the study period. These findings demonstrate that innovation is not merely a driver of growth but an active margin of climate adaptation.

Using manufacturing sector firm-level data from Orbis for 2000–2020, we examine the effects of temperature shocks on industry market power across 12 European countries. Our analysis shows that temperature extremes reduce firm productivity, with significant heterogeneity across firms. Small firms experience larger productivity declines, leading to a reallocation of market share toward larger firms. As a result, temperature shocks increase industry concentration and aggregate markups. To quantify the welfare costs arising from both the productivity impact and the increase in market power, we develop an equilibrium model of heterogeneous firms with a variable elasticity of substitution that endogenizes markups. Based on the estimated marginal effects of temperature shocks on firm productivity and markups, the model suggests that the observed changes in the temperature distribution between 2000 and 2020—relative to a counterfactual scenario in which the temperature distribution remained constant—resulted in heterogeneous welfare effects across EU countries. Spain, which experienced the largest temperature increase over this period, incurred the largest welfare loss, equivalent to 0.44 percent of manufacturing sector GDP. A model that does not endogenize markups would miss over 40 percent of the welfare loss from extreme heat. Our findings underscore the importance of incorporating firm-level heterogeneity and market power into climate impact assessment.