Designing energy policy in the presence of underground economy: the case of Pakistan

Purpose In the presence of informal sector in the country, designing an energy policy and the pursuit of higher economic growth become challenging for emerging economies. These economies are usually resource starved, and the presence of underground economy leads to faulty estimates of energy demand. The authors explore the energy-growth nexus in the presence of underground economy for Pakistan, an emerging economy host to large informal sector and facing recurring energy crises. Design/methodology/approach The authors evaluate the impact of underground economy on energy demand in the presence of explanatory variables, including official gross domestic product (GDP), foreign direct investment and financial development. The authors first assess the influence of official economy on the consumption of energy. The authors investigate how energy consumption is influenced solely by underground economy. Finally, the authors evaluate the impact of true GDP on the energy consumption. The authors employ combined cointegration method of Bayer and Hanck (2013) and then apply vector error correction model. Findings The results reveal that official GDP, underground economy and true GDP positively and significantly affect energy consumption in both short and long run. Similarly, financial development as well as foreign direct investment enhance energy consumption. The authors find unidirectional causality between energy consumption and official GDP variables (OGDP -> EC), underground economy (UE -> EC) and true GDP variables (TGDP -> EC) in the long run. The authors observe bidirectional causality in the short run between energy consumption and official GDP (OGDP <-> EC) and true GDP (TGDP <-> EC). Originality/value To the best of the authors' knowledge, no study examines the causal relationship of energy consumption and underground economy. Overall, the findings assist policymakers to consider and implement different energy-related policies considering the significant role of underground economy for energy consumption in Pakistan.