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Linking financial development, economic growth and energy
consumption in Pakistan
Rabia Komal, Faisal Abbas
n
Department of Management Sciences, COMSATS Institute of Information Technology (CIIT), Park Road, Islamabad 44000, Pakistan
article info
Article history:
Received 15 August 2014
Received in revised form
23 November 2014
Accepted 12 December 2014
Available online 5 January 2015
Keywords:
Energy consumption
Financial development
Economic growth
GMM
Pakistan
Energy prices
Urbanization
abstract
This paper aims at exploring the finance–growth–energy nexus for Pakistan over the 1972–2012 period.
By employing the system GMM estimation technique, the study tries to capture the impact of financial
development over energy consumption through economic growth channel and includes energy prices
and urbanization in the structural model. The study finds positive and significant impact of economic
growth and urbanization on energy consumption, while the effect of energy prices over energy
consumption is significant but negative. Financial development positively and significantly affects
energy consumption through the economic growth channel. Our analysis is important for policy makers
for effective energy demand planning and conservation policies that would ensure sustainable economic
development as well as serve as motivation to search alternative energy sources to meet the
bourgeoning energy demand in Pakistan.
&2014 Elsevier Ltd. All rights reserved.
Contents
1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
2. Energy crisis of Pakistan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
3. Literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
3.1. Finance–energy nexus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
3.2. Finance–growthnexus ......................................................................................... 214
3.3. Energy–growthnexus.......................................................................................... 216
4. Theoretical framework and model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
5. Data and methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
5.1. Data........................................................................................................ 216
5.2. Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
6. Results and discussion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
6.1. Energy consumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217
6.2. Economic growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
6.3. Summary of channel effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 218
7. Conclusion and policy implication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
1. Introduction
Literature reveals that energy is crucial for enhancing economic
productivity [27,35,49]. Furthermore, growth in production activ-
ities stimulates energy demand due to increase in consumption
Contents lists available at ScienceDirect
journal homepage: www.elsevier.com/locate/rser
Renewable and Sustainable Energy Reviews
http://dx.doi.org/10.1016/j.rser.2014.12.015
1364-0321/&2014 Elsevier Ltd. All rights reserved.
n
Corresponding author. Tel.: +923233844383.
E-mail addresses: rabia_komal_09@yahoo.com (R. Komal),
fabbas@comsats.edu.pk (F. Abbas).
Renewable and Sustainable Energy Reviews 44 (2015) 211–220
[52]. EIA [18] estimated increase in the global energy consumption
by about 56 percent during the period 2010–2040. Most of this
increase will take place in non-OECD countries, where energy
consumption is stimulated by strong growth in the economy
[23,29]. Industrial expansion and population growth has led to
increased energy consumption in Asian economies in general, and
in Pakistan in particular [61]. Pakistan, falls in low middle income
group country, has been facing the worst energy crisis for the past
few years and its energy demand has continuously increased with
economic and population growth. Furthermore, as a result of
financial reforms, Pakistan's financial sector has shown excep-
tional and notable growth, particularly with respect to the banking
sector [30].
1
This would also have implication for both economic
growth and energy consumption [26].
Economy's long run growth potential is about 6.5 percent per
annum but power outages have reduced it to 2 percent [21]. This
indicates that growth of the economy is largely suppressed due to
energy shortages. Kessides [28] has pointed out that electricity
shortage has a negative impact on international competitiveness
and exports, employment, and poverty alleviation in Pakistan.
Recent energy literature includes financial variables when model-
ing energy consumption for an economy, asserting that financial
variables can impact energy demand. It is, therefore, essential to
consider financial variables in such a study to exclude the
possibility of underestimation of energy demand.
2
Moreover, studies on finance–energy nexus highlight the direct
impact of financial development on energy consumption [23,52].
Financial development affects energy consumption indirectly via
economic growth. This effect may be either positive or negative
depending whether economic growth occurs in an efficient
manner or not. For instance, growth in financial sector improves
funds availability for investment projects that results in industrial
growth leading to expansion in production activities. This in turn
enhances economic growth, and increases the demand for new
infrastructure and more energy, thereby positively influencing
energy consumption [23,52]. However, the ability to adopt tech-
nological innovations in industrial sector development varies
across countries that affect the intensity of energy consumption
[52]. Thus, this study intends to explore the finance–growth–
energy nexus in Pakistan i.e. how financial development affects
energy consumption (i.e., positively or negatively) using economic
growth channel?
Empirical literature on finance–energy nexus follows one of the
two approaches. The first approach estimates the model in terms
of elasticity in the variables by including energy consumption and
financial development jointly in a single equation without much
theoretical base. The second approach estimates the model using
conventional unit root, cointegration and causality tests. The
present study is different from these approaches in that it uses
system GMM technique to separately capture the impact of
financial development over energy consumption through eco-
nomic growth. It, therefore, prepares a strong theoretical ground
for empirical analysis. It explores the channel variable (economic
growth) through which financial development may likely affect
energy consumption. This channel variable is used to capture the
effect of change in financial development on energy consumption,
and to infer if increased financial development is linked to more
energy consumption in Pakistan or vice versa. To the best of our
knowledge, there is no published study that captured the indirect
relation of financial development and energy consumption.
This paper is organized as follows: Section 2 discusses energy
scenario of Pakistan. Section 3 provides an overview of empirical
literature. Section 4 elaborates theoretical framework and model.
While data, and econometric methodology for analysis is
described in Section 5.Section 6 deals with empirical results and
their discussion. Section 7 concludes the study along with policy
implications and future research directions.
2. Energy crisis of Pakistan
The energy sector of Pakistan is in crisis and has been facing
many challenges for the past few years. Circular debt, fragile
financial situation of energy supply firms, intense reliance on
gas/oil (above 80%), declining gas production, less utilization of
cheap hydel and coal resources and unexploited power production
capacity are a few major limitations contributing to energy scarcity
[4,11,20,21,44]. Dependence on expensive furnace oil within ther-
mal electricity production has increased that is coupled with
volatile international oil prices which has adverse implications
for cost structure of electricity production and could further
undermine energy shortage in Pakistan [28]. According to GoP
[21], rate of growth in net primary energy supply remained
1.8 percent while rate of growth in final energy consumption
remained 2.9 percent for the past six years, that is clear evidence
of energy shortage. Considerable increase in the usage of electric
appliances has contributed to increase in domestic demand that
led to increase in the share of native users in total electricity
consumption from 23 percent in 1980–81 to about 43 percent in
2012–13.
Kessides [28] has highlighted that industrialization, urbaniza-
tion, agricultural and service sector growth, rising per capita
income and rural electrification are considered among key factors
of growth in energy demand. There are estimates that electricity
shortage will rose to 8000 MW in 2017 and over 13,000 MW in
2020. Although technical and financial support has been provided
by international donor agencies to enhance production capacities
and performance of generation companies (GENCOs), but this
enhancement is insufficient in the light of rapidly growing energy
demand.
3. Literature review
The existing literature on energy economics is mainly based on
three nexus; finance–energy nexus, finance–growth nexus, and
energy–growth nexus. We discuss these one by one below.
3.1. Finance–energy nexus
Literature on finance–energy nexus highlights the ways by which
financial development can potentially affect energy consumption. At
the household level, it is easier for consumers to gain an easy and
cheap access to borrowed funds to purchase energy consumable
products that directly affect energy demand. At the industrial level, it
is easier for entrepreneurs to gain access to financial capital in order
to expand existing businesses or start a new one, thereby creating a
business effect. Increased stock market activity is regarded as an
indicator of economic growth because it increases risk diversification
for consumers and businesses that result in increased fund avail-
ability for investment projects, and thereby creates a wealth effect.
This builds up consumer and business confidence that leads to
expansion in the economy and creates demand for energy intensive
products [17,49]. Shahbaz and Lean [52] mentionthatgrowthin
industrial sector raises energy demand in two ways; firstly due to
cross-sectoral growth; and secondly, as with increase in labor
1
Financial reforms are introduced in several areas relevant to financial markets
and institutions with the core purpose to encourage competition, improve super-
vision and governance and adopt monetary, credit and exchange mechanism that
ensure efficient allocation of financial resources [32].
2
Present study uses energy consumption and energy demand interchangeably.
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220212
Table 1
Summary of empirical studies on finance–energy nexus.
Author Country Sample
period
Econometric technique Main findings
Single country studies
Kakar et al. [27] Pakistan 1980–2009 Johnson Co-integration test, VECM Granger causality test Significant long run relationship exists.
Unidirectional causality from M2 to EC and EC to DC.
Islam et al. [23] Malaysia 1971–2009 ARDL, VECM Granger causality test Cointegration among FD, EG, and ED.
Short run causality from FD to EC.
Tang and Tan [57] Malaysia 1972–2009 Johansen–Juselius cointegration test Energy and financial sector development in long run relation.
Shahbaz and Lean
[52]
Tunisia 1971–2008 ARDL, UECM Granger causality test Long run relationship exists among EG, FD, URB, IND and EC.
Bidirectional causality between FD and EC.
Shahbaz et al. [54] China 1971–2011 ARDL, Granger causality test Long run relationship exists among EC, EG, FD, capital, and trade.
Bidirectional causality between FD and EC.
Mehrara and Musai
[40]
Iran 1970–2009 ARDL Long run relationship exists among EC, EG, Capital stock, FD, Oil revenues in
long run.
Multi-country studies
Mudakkaret al. [41] SAARC countries 1975–2011 Toda–Yamamoto–Dolado–Lutkephol (TYDL) Granger causality test Bidirectional causality between FD and EC in short run in Pakistan.
Sadorsky[49] 22 emerging economies 1990–2006 Generalized method of moments (GMM) Stronger impact of stock market variables on energy consumption.
Greater impact of income on energy consumption.
Sadorsky [50] 9 Central and East European
economies
1996–2006 Generalized method of moments (GMM) Stronger impact of banking variables on energy consumption.
Coban and Topcu
[17]
European Union (EU) 1990–2011 Generalized method of moments (GMM) No significant association between FD and EC in EU.
U-shaped pattern for banking variables with energy.
Omri and Kahouli
[43]
65 countries 1990–2011 Generalized method of moments (GMM) Unidirectional causality from FD to EC for global panel.
Al-mulali and Sab
[5]
30 SSA countries 1980–2008 Pedroni (Engle–Granger based) cointegration test, VECM Granger
causality test
Increased EC increases EG and FD but with high pollution
Long run relation and causality exist between EC, FD, EG and CO
2
emissions.
Note: EC¼Energy consumption, FD ¼Financial development, EG¼Economic growth, M2 ¼money supply, DC¼Domestic credit, URB¼Urbanization, IND¼Industrialization, UECM¼Unrestricted Error Correction Model.
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220 213
demand due to economic growth, income improves that boosts
demand for energy consumable products, and thereby enhance
energy consumption.
However, evidence also implies that financial development
lessens energy consumption by achieving efficiency in its use for
which amendments in infrastructure is required. This comes from
investment in research and development of advance technologies
that is linked to the development of financial sector. Besides, if
consumers use energy efficient products like home appliances, it
lowers energy use [23]. Coban and Topcu [17] also assert that
financial development makes accessibility to advance technology
easier that leads to energy efficiency, hence reduces energy
consumption. Kakar et al. [27] have asserted that financial devel-
opment can significantly contribute to efficient economic growth
by reducing energy consumption in Pakistan. Several studies have
explored the impact of financial development over energy con-
sumption incorporating other variables in the model (see Table 1).
3.2. Finance–growth nexus
Literature on financial development and economic growth
nexus discusses two channels with which financial development
promotes economic growth i.e. capital accumulation and total
factor productivity (TFP).
3
Literature reveals that financial
development comes from stock market development, banking
sector development, increased domestic and foreign direct invest-
ment, and financial deregulation through liberalization measures,
that promotes economic growth. Levine [36] has stated that banks
perform a significant role in enhancing growth at initial level of
economic development and in weak institutional settings. Services
offered by financial intermediaries' i.e. evaluating projects, mobi-
lizing savings, monitoring managers, diversifying risk, and aiding
transactions, are necessary for technological progress and eco-
nomic development. Better performing financial intermediaries
are efficient in directing credit from households (savers) to
business enterprises (borrowers) that promotes economic growth
[37]. Financial liberalization has positive impact on growth
through improving monetary transmission mechanism, increasing
savings and investment, and improving risk sharing that lowers
the cost of capital [6,49,52]. However, countries with weak
regulatory framework may experience the negative effect of
liberalization which leads to domestic capital flight and increasing
the risk of financial fragility [2]. Several studies have confirmed the
existence of a positive (negative) significant association between
financial development and economic growth. Besides, causality
between these two variables has been investigated with mixed
results (for example, see Table 2).
Table 2
Summary of empirical studies on finance-growth nexus.
Author Country Sample
period
Econometric technique Main findings
Single country studies
Khan et al.
[32]
Pakistan 1971–2004 ARDL and ECM Positive and significant impact of financial depth on EG in long run and of investment share
on EG in short run.
Ang [6] Malaysia 1960–2003 ARDL, UECM, and Dynamic
OLS
FD leads to higher EG through improved efficiency of investment.
FD2EG
Rufael [48] Kenya 1966–2005 VAR and TYDL causality
test
Bidirectional causality between intermediary financial development and economic growth.
Bojanic [16] Bolivia 1940–2010 Cointegration, Granger
causality and ECM
Cointegration exists between FD and EG.
Causality runs FD-EG.
Anwar and
Sun [7]
Malaysia 1970–2007 Generalized method of
moments (GMM)
Domestic capital stock is affected by level of FD that leads to EG.
Multi-country studies
Ahmed and
Ansari [3]
Pakistan, India,
Bangladesh
1973 –1991 Granger causality test FD-EG
Gregorio and
Guidotti
[22]
98 countries 1960–1985,
1950–1985
OLS regressions FD leads to EG but effect changes with regions, time period and income level.
Effect is stronger in middle and low income countries.
FD hinders EG in absence of proper regulation.
King and
Levine [33]
80 countries 1960–1989 Correlation, OLS regression FD stimulates EG via boosting rate of capital accumulation and promoting efficient capital use
Beck and
Levine [14]
40 countries 1976–1998 OLS regression, GMM
technique
Banks and stock market independently spur economic growth.
Wu et al. [60] 13 EU
countries
1976 –2005 Unit root test and PMG
method
Long run relationship exists among banking sector, stock market and economic development.
Effect of FD on output may be negative in long run but stable economic development may be
recurred via improving risk diversification and information services of banks.
Ahmed [2] 21 SSA
countries
1981–2009 System Generalized
method of moments
(GMM)
Negative relationship between FD and EG due to financial liberalization.
Countries experience positive effects of liberalization that are having strong legal institutions,
stable inflationary environment and higher human capital.
Note: 2indicates bidirectional causality, -indicates unidirectional causality.
3
Financial development increases domestic and foreign capital investment by
enhancing confidence of investors over financial system. As borrowing and lending
mechanisms increase in economy, investment is promoted so output is increased.
This channel is referred as capital accumulation or quantitative channel. Efficient
financial system does better screening of available investment opportunities.
(footnote continued)
Thereby, it facilitates adoption of advance or innovative technology by channeling
funds to knowledge and technology intensive industries, so economy grows. This
channel is referred as total factor productivity (TFP) [also called technological
innovation] or qualitative channel [6,7].
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220214
Table 3
Summary of studies on energy-growth nexus.
Author Country Sample
period
Econometric technique Main findings
Single country studies
Jamil and Ahmad [24] Pakistan 1960–2008 Johansen cointegration and VECM causality test Long run relationship exists among EG, EC, EP.
EG-EC
Tang and Tan [58] Malaysia 1970–2009 ARDL and VECM Granger causality test Direct relationship between EC and EG.
Bidirectional causality between EC and each variable.
Belaid and Abderrahmani
[15]
Algeria 1971–2010 Johansen and Gregory–Hansen cointegration test, VECM causality
test
EC2EG.
Oil price X EC
Shiu and Lam [55] China 1971–2000 Johensen cointegration test, ECM causality test EC-EG
Multi-country studies
Abbas and Choudhury [1] Pakistan and India 1972–2008 Johansen cointegation test, ECM causality test EC2Agriculture GDP (For Pakistan)
Agriculture GDP-EC (For India)
Odhiambo [42] South Africa, Kenya,
Congo
1972 –2006 ARDL-bounds testing approach and Granger causality test EC-EG (SA & Kenya)
EG-EC (Congo)
Fatai et al. [19] New Zealand, Australia 1960–1999 ARDL and Toda and Yamamoto (TY) Granger causality test EC X EG (For New Zealand)
EG-EC (For Australia)
Masih and Masih [39] Korea and Taiwan 1961–1990 Johansen cointegration test, VECM Granger causality test Long run relationship and mutual causality exists among EC, EG and price level.
Masih and Masih [38] 6 Asian countries 1955–1991 Johansen cointegration test, VECM Granger causality test Long run relationship between EG and EC exists only in Pakistan, India and
Indonesia
EC2EG (For Pakistan)
Kahsai et al. [26] 40 SSA countries 1980–2007 Pedroni cointegration test, Granger causality test Direct relationship between energy demand and income level
Low income countries: EC2EG
Middle income countries: EC X EG
Note: EC¼Electricity consumption, EP ¼Electricity price, X¼No existence of causality.
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220 215
3.3. Energy–growth nexus
Discussion on growth–energy nexus was initiated by Kraft and
Kraft [34] who concluded that economic growth was followed by
rising energy demand in the United States (US) over the 1947–
1974 period. Afterwards, a number of researchers have examined
the relationship through two way Granger causality, leading to
four testable hypotheses, (a) growth hypothesis, (b) conservation
hypothesis, (c) feedback hypothesis and (d) neutrality hypothesis
[8,24,26,31,42,53]. Causality relationship is different for different
countries due to a number of factors including model estimation
techniques, problems caused by non-stationary data, model spe-
cification issues, choice of variables, study period, sample selec-
tion, development level of country being studied [19,26,38,54].
Omri and Kahouli [43] assert that causality between the two
variables may be mutually determined, as higher economic
growth needs more energy consumption, as well as efficient
energy consumption needs higher level of economic growth,
therefore, causality direction may not be judged earlier. Studies
on this nexus have explored relationship in terms of cointegration
and causality (see Table 3).
4. Theoretical framework and model
Financial development affects growth of an economy
[32,49,60], it means that it may influence energy consumption
through economic growth channel. Furthermore, financial devel-
opment increases the efficiency of a country's financial system
[49]. Well-established financial system boosts the effectiveness as
well as the efficiency of financial institutions through enhancing
innovation in financial services delivery, reduction of information
cost, efficient management of complex and risky transactions,
enhancement of transparency between borrowers and lenders;
thereby guaranteeing profitability of investment [2,23,52]. All
these factors improve business investment and economic activ-
ities, thereby boosting domestic production and economic growth.
This in turn leads to increase energy consumption [49,50,52,54].
However, energy consumption may be relatively reduced if use of
efficient technology is encouraged. Shahbaz et al. [54] has asserted
that entrepreneurs are the key agents behind innovation and
technological progress in a free market system. This means that
the impact of financial development on energy consumption
depends on the efficiency of overall system that includes quality
of labor, capital, technology, investment environment and govern-
ment sector policies and institutions. Impact can either be positive
or negative depending on whether the economic growth occurs in
an efficient or not i.e. if less energy is consumed to produce more
or the same level of output or not. Less energy will be consumed
when in an economy industrialist or business can upgrade their
technology through easily credit availability. Hence, emphasizing
the role of financial sector in bringing the efficiency in energy
utilization while improving growth in an economy. Available
literature is directly linking financial development with energy
consumption by inserting both variables in a single equation. This
research study employs system GMM technique (simultaneous
equation model) to estimate separate equations to capture the
effect of financial development over energy consumption through
economic growth. For Pakistan, a positive relationship between
energy and financial development is postulated because energy
saving mechanisms is not up to the mark.
Conceptually, energy consumption in an economy is directly
affected by economic growth, energy price and urbanization, while
it is indirectly affected by financial development through eco-
nomic growth channel. Thus, a multivariate framework, based on
the literature reviewed, is employed to empirically study the
(indirect) impact of financial development over energy consump-
tion. The following structural model is designed for the purpose of
estimation:
EC
t
¼β
1
þβ
2
Y
t
þβ
3
EP
t
þβ
4
URB
t
þμ
t
ð1aÞ
Y
t
¼α
1
þα
2
FD
t
þα
3
I
t
þα
4
Si
t
þα
5
T
t
þα
6
Sc
t
þυ
t
ð1bÞ
where EC
t
is energy consumption, Y
t
is real GDP, EP
t
represents
energy price, URB
t
is urbanization, FD
t
is financial development,
I
t
denotes investment, Si
t
is government size, T
t
is trade, Sc
t
is
schooling (human capital), μ
t
and υ
t
are stochastic error terms,
tdenotes time period in years.
In the above model, two equations have been constructed
where Eq. (1a) is the main equation that includes variables directly
affecting energy consumption, while Eq. (1b) serves as a channel
equation in which economic growth (Y
t
) serves as a variable
through which financial development may influence energy con-
sumption (positively or negatively). The motive for Eq. (1b) is to
analyze finance-growth relationship by inserting control variables
following literature [22,33,37,13].
Empirical literature has highlighted that increase in income is a
contributing factor towards increase in energy consumption in
developing economies [52]. As production activities increase,
energy requirement for input in production process is created
that leads to increase in energy demand, except when economic
growth occurs in energy efficient manner that conserves energy
[23]. Mehrara and Musai [40] have mentioned that economic
activities shift from manufacturing to services sector with eco-
nomic growth that would reduce energy use reinforcing a
hypothesized positive relation between income and energy con-
sumption. Masih and Masih [39] have asserted that change in price
level alters energy consumption. So, it can be postulated that
energy prices would have significant negative effect over energy
consumption in Pakistan [42]. Pakistan's urban population has
increased to 69.87 million in 2012–13 from 67.5 million in 2011–12
[21]. Urbanization involves swelling population that participates in
economic activities thereby increases energy consumption [25,56].
Shahbaz and Lean [52] assert that rising population in the urban
areas boosts energy use due to more household appliances. Hence,
it can be postulated that urbanization is directly and significantly
linked with increased energy consumption in Pakistan.
5. Data and methodology
5.1. Data
Data is annual time series for Pakistan ranging from 1972–2012
because continuous data is available from this period onwards.
Secondly, it includes reasonable time length of observations to
employ model estimation techniques. Data is transformed into log
form for analysis that makes the interpretation of results com-
paratively easier. Variables used for estimation purpose with their
measurement, definition, source, and expected sign are mentioned
in Table 4.
Financial development on domestic level has two aspects;
intermediary development and stock market development. The
present study is limited to intermediary development only
because data on stock market development based on different
indicators in the literature is not available for initial years; rather it is
available from late 1980s. Thus, present study uses financial devel-
opment through intermediary development measured through
domestic credit to private sector. This not only measures efficiency
of financial intermediaries in credit provision [22], but also indicates
private sector activities within the economy. According to Rufael [48],
it measures opportunities for new firms, as it has the ability to
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220216
scrutinize unviable projects for financing. Furthermore, this measure
isolates credit being channeled to government sector. King and
Levine [33] point out that financial system that channels funds to
the private sector firmswillpossiblyoffermoreservicesascompared
to financial systems issuing credit to government sector or state
owned enterprises. However, range of variables is used in literature
that measure different aspects of intermediary development, but
each measure has its pros and cons. Take the example of size that is
measured by liquid liabilities as a share of GDP. King and Levine [33]
mention that pure size of the financial system may not be robustly
linked with financial services like risk management and information
processing; it just indicates the volume of financial sector; so it may
not be a realistic measure. Energy price data is not available for
Pakistan. For this reason, researchers have used consumer price
index as proxy for energy price [see inter alia; 26,29, 39,42,49,58].
However, Sadorsky [49] has mentioned that CPI does not seem to be
a good proxy for energy price; hence, in the present study, it is
proxied by consumer price index (CPI) with respect to group i.e. Fuel
and Lighting. This indicator is a reasonable proxy of energy prices,
since it considers price of fuel and lighting only, while CPI considers
the prices of other commodity groups and services as well. Splicing
method is used to make year 2005 as common base year (i.e.
2005¼100).
5.2. Methodology
Earlier studies have employed cointegration and causality
approaches to estimate structural parameters of a single equation
model. Those techniques allow for estimation of relationship in the
long run and short run. The present study focuses to capture the
indirect effect of financial development on energy consumption
through economic growth channel. Instrumental variable estimation
technique such as Generalized Method of Moments (GMM) has been
used for estimation of parameters. Our approach is to estimate
structural parameters while in the estimation of structural model,
economic growth variable is treated as endogenous while financial
development variable is treated as exogenous.
Endogenous variables and disturbances are mutually correlated in
simultaneous equation models that create the problem of simulta-
neity or endogeneity bias. Consequently, inconsistent and biased
parameter estimates are obtained using ordinary least square (OLS)
regressions that leads to violation of one of the assumptions of
classical linear regression model (CLRM). However, the use of
estimation techniques that involves instrumental variables may lead
to the attainment of consistent and unbiased parameter estimates.
Instrumental variables provide a set of variables that are correlated
with independent variables of the equation but are uncorrelated with
disturbances. Instruments eliminate the correlation between inde-
pendent variables and disturbances. Therefore, estimates obtained
are reliable and consistent. Arellano and Bond [10] and Arellano [9]
proposed Generalized Method of Moments (GMM) estimator that is
both single equation and system estimator. It is preferred over other
estimators of its class because of several reasons. Firstly, GMM offers
a simple substitute to other estimators, particularly when it is
problematic in writing maximum likelihood estimator. Secondly,
GMM covers many standard estimators, thereby offers valuable
framework for their evaluation and comparison. Thirdly, GMM is a
robust estimator since it does not require information about accurate
distribution of error terms. Fourthly, GMM is asymptotically unbiased
and consistent estimator regardless of weighting matrix used.
Separate instruments are employed for both equations of structural
model that are the lagged values of the variables included in that
particular equation.
6. Results and discussion
Instrumental variable estimation technique, that is Generalized
Method of Moments (GMM), has been employed in this paper to
jointly estimate the parameters of the structural model. Separate
instruments have been used for both the equations of structural
model that are the lagged values of the variables. Results of both
the equations are reported in Table 5.
6.1. Energy consumption
Parameter estimates of the energy consumption equation (1)
are reported in the second column of Table 5. The results are
consistent with existing findings in the literature (Jamil and
Ahmed [24], Kahsai et al. [26], Masih and Masih [38], Masih and
Masih [39], Tang and Tan, [58]). Estimated coefficient of Eq. (1a) is
significantly positive. It shows that one percent increase in
economic growth has led to about 0.57 percent increase in energy
consumption. Energy price has negative and statistically signifi-
cant effect over energy consumption which shows that energy
consumption decreases by about 0.03 percent with increase in
Table 4
Names, definitions, sources and expected signs of variables.
Variables (Measurement)Definition (Sign) Sources
Energy consumption (kt of oil equivalent) Utilizing primary energy that is equal to native production including imports and stock changes, and excluding
exports and fuel supplied to aircraft and ships transport.
WDI
[59]
Energy Price (CPI) Changes in cost to average consumer of obtaining a basket of goods and services that may or may not be fixed
at particular periods. (Negative)
GoP
[21]
Gross Domestic Product (GDP in Billion
Pakistani Rupees)
It refers to collective gross value added by all local manufacturers in the country including product taxes and
excluding subsidies not included in value of the products. (Positive)
WDI
[59]
Urbanization (% of urban population in total
population)
People residing in urban areas as percentage of total population of the country. (Positive)WDI
[59]
Financial Development (Domestic credit to
private sector as %of GDP)
It means financial capital granted to private sector, i.e. through loans, trade credits, purchases of non-equity
securities, and other accounts receivable that set up a claim for reimbursement. (Positive)
WDI
[59]
Investment (Gross fixed capital formation
as %of GDP)
Involves land developments, machinery, plant and equipment procurement; and construction of roads,
railways, and other, including hospitals, schools, offices, private residential dwelling, and commercial and
industrial buildings. (Positive)
WDI
[59]
Government Size (Government final
consumption expenditure as %of GDP)
Government current expenses on purchase of goods and services (including compensation of employees). It
also includes expenses on national defense and security, but excludes government military expenses that are
component of government capital formation. (Positive/Negative)
WDI
[59]
Trade openness (Trade as %of GDP) It refers to collective imports and exports of goods and services calculated as a share of GDP. (Positive)WDI
[59]
Human Capital (Gross Secondary School
enrollment)
It refers to enrollment in secondary education in all programs, regardless of age. (Positive)WDI
[59]
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220 217
energy price by one percent. This result is in line with economic
theory that as price of commodity increases, its consumption
decreases. However, the estimated coefficient is too small which
indicates that the energy consumption in the country has dropped
very little with increase in energy prices. This is justifiable in the
current energy scenario where energy demand far exceeds the
supply due to which energy prices are increasing. Also, energy is
highly subsidized for low end consumers in Pakistan, and hence
any change in energy prices is likely to have little impact on
energy consumption as is evident from our empirical estimates.
Urbanization is significantly and positively linked with energy
consumption. Positive relation of urbanization with energy con-
sumption is in accordance with past studies (for instance, Parikh
and Shukla [45], Poumanyvong et al. [47], Sadorsky [51], Zhang
and Lin [62]). Possible justification for somewhat high value of
coefficient is that urban residents are relatively high consumers of
energy goods due to TV, refrigerator, and mobile phones etc. With
reference to the income level, the present study supports the
findings of Poumanyvong et al. [47] and Sadorsky [51] who
reported that urbanization is positively linked with energy con-
sumption for developing countries like Pakistan and opposes the
finding of Poumanyvong and Kaneko [46] that urbanization is
negatively linked with energy consumption for high income
countries.
6.2. Economic growth
The results of economic growth equation are reported in
column three of Table 5. Estimates show that financial develop-
ment is positively and significantly linked with economic growth.
One percent increase in financial development led to 0.04 percent
increase in GDP in Pakistan. Possible justification for the small
effect of financial development over economic growth is that only
one indicator of financial development has been employed in the
present study rather than a range of indicators. Underlying
intuition regarding this effect is that when financial development
happens, investor's confidence in the financial system grows
which incentivizes their investment in the productive or econom-
ically viable projects via financial institutions, due to which real
output increase and economic growth occurs. Consequently,
income level improves that causes the aggregate demand to rise
leading to higher energy demand.
Other determinants of economic growth are government size
and human capital (enrollment at secondary school). Economic
growth increases with increase in both the variables, but this
relation is insignificant for government size and significant for
secondary school enrollment. Review of literature shows that
government consumption expenditure (size) has both positive
and negative link with economic growth. The insignificant positive
impact of government size with economic growth is consistent
with Barro [12] who mentioned that government consumption
expenditure particularly non-productive one (such as on defense)
would have negative impact over economic growth because it has
no direct impact on private productivity. Rather it lowers saving
and growth as well as increases the cost of inputs through
distorting effects such as high tax rates and government expendi-
ture programs. However, this impact may be positive when it
comes to productive government consumption expenditure (such
as on services that act as input for private production and on
implementation of property rights). Positive and highly significant
effect of schooling (human capital) on economic growth is in line
with Barro [13] who asserted that higher human capital matters
for economic growth because of the evolution of new products
and ideas that trigger technological innovation in an economy.
Though investment is insignificantly related with economic
growth, and trade has a positive and significant impact on
economic growth in Eq. (1b). Results are consistent with Anwar
and Sun [7]; Beck and Levine [14]; Levine et al. [37]. Insignificant
impact of investment over economic growth is also justifiable
since the share of public investment in Pakistan is quite large and
this sector is quite inefficient. Investment is negligible in the
productive sectors. Most of the time, government is borrowing
from the central bank to meet the current expenditures. Political
instability in the country is responsible for low return on
investment.
Problem of autocorrelation is normally encountered in time
series data. This has been resolved by using autoregressive (AR)
process.
4
High p-value of J-statistics shows validity of instruments
used in the estimation of structural equations (see Table 5).
6.3. Summary of channel effect
The present study has gone for a different strategy from the
existing literature that it has captured the impact of financial
development over energy consumption through economic growth
by working on a system of equations. However, the methodologi-
cal approach used in the study allows estimating elasticity in the
short run only in contrast with single equation estimation that
indicates long run relationship as well. Two coefficients of interest
are simultaneously put equal to zero under the null hypothesis i.e.,
rejection of null hypothesis indicates significance of joint coeffi-
cient determined by the test (see Table 6). Wald test is used to test
the joint significance of two terms estimated in Eqs. (1a) and (1b).
It computes test statistic based on unrestricted regression by
imposing restrictions on the estimated coefficients and follows
chi-square distribution under the null hypothesis of no relation-
ship [10]. This test can be employed to test multiple parameters
simultaneously. Wald test explored product of elasticity of effect of
financial development on economic growth and of economic
growth on energy consumption that came out to be 0.024 (see
column 3 Table 6). It shows that one percent increase in financial
development resulted in 0.024 percent rise in energy consumption
Table 5
GMM estimates for the model.
Independent variables Dependent variables
Energy consumption Economic growth
(1a) (1b)
Economic growth 0.568
nnn
(21.116) –
Energy price 0.027
nn
(-2.193) –
Urbanization 2.465
nnn
(13.097) –
Financial development –0.043
nnn
(4.923)
Investment –0.048 (1.413)
Government size –0.0008 (0.053)
Trade –0.044
nn
(2.122)
School (Human capital) –0.265
nnn
(7.749)
AR(1) 0.942 [0.000] 0.982 (0.00 0)
AR(2) 0.280 [0.35] –
R
2
0.9984 0.9989
Adjusted R
2
0.9981 0.9987
J-statistic (p-value) 0.090 (1.000) –
Note: Column (1) explains main equation of the model. Column (2) explains
channel equation of the model.
*** and **, indicate significance at 1 and 5 percent respectively. Robust t-statistics
are reported in parenthesis. P-values for autoregressive tests are shown in square
brackets.
4
AR (1) is first order autoregressive process which means that present value is
depending on preceding one value. AR (2) is second order autoregressive process
which means that present value is depending on preceding two values. According
to Arellano and Bond [10], AR (1) and AR (2) are test for autocorrelation in first
differenced errors.
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220218
in the short run which is highly significant. In short, financial
development affects energy consumption positively and signifi-
cantly through economic growth channel.
This positive relationship between financial development and
energy consumption is in line with previous studies (Coban and Topcu
[17], Islam et al. [23],Sadorsky[49],Sadorsky[50], Shahbaz and Lean
[52]). On the contrary, the present study negates the finding of Kakar
et al. [27] who reported the absence of significant short-run relation-
ship between financial development, energy consumption, and eco-
nomic growth in Pakistan. Results show that Pakistan's economy has
experienced increase in its energy consumption because of financial
development that shows that economic growth has not occurred in an
efficient manner with respect to energy use. Funds funneled to
entrepreneurs for carrying out business activities has played a pivotal
role in increasing both economic growth and energy consumption in
the last four decades. This result has the implication for energy
consumption of country.
7. Conclusion and policy implication
Pakistan's financial sector has seen notable and unprecedented
growth particularly with respect to the banking sector since 1990s
[30]. Islam et al. [23] point out that emerging economies that are
developing their financial sector should anticipate growth in
energy demand in addition to that the one caused by increasing
income. This means that financial development also has influence
over energy consumption because of its impact on economic
growth. For such economies, estimation of energy demand with-
out considering financial development would provide inaccurate
picture.
There has been increasing demand for energy over the years in
Pakistan because of economic and financial development that has
not been fulfilled due to which economy suffered, since lack of
sufficient energy supply has suppressed growth rate of Pakistan's
economy to a great extent. Rapid population growth and industrial
growth has led to increase in demand for energy sources but the
supply of energy has not increased with similar pace to meet the
growing demand. The objective of present study is to investigate
empirically the effect of financial development on energy con-
sumption through economic growth channel in Pakistan. For this
purpose, we estimated a system of equations to investigate this
indirect relationship. Energy price and urbanization are also
included in model pertaining to their potential influence over
energy consumption. The structural energy consumption model
has been estimated by employing Generalized Method of
Moments (GMM) estimation technique. Annual time series data
covering period 1972–2012 is taken for study.
Short run parameter estimate of individual equation of the model,
confirmed the existence of the hypotheses constructed for the
present study. Results for the main equation indicated that energy
consumption was positively and significantly linked with economic
growth and urbanization, while negatively and significantly linked
with energy prices. The results for channel equation indicated the
positive and significant effect of financial development on economic
growth along with control variables namely, investment, government
size, trade, and human capital, where trade and school affect
economic growth in a positive and significant manner, while the
effect of size and investment is positive but insignificant.
Positive and significant effect of financial sector development
over energy consumption suggests that this increase in energy
consumption emerging from increase in financial development
must be considered at the time of planning energy consumption
for Pakistan economy; failing which would lead to the under-
estimation of energy consumption that is alarming for sustainable
economic growth. It is also possible that policies to save energy
may not meet desired targets if policy makers fail to consider the
impact of financial development over energy consumption. How-
ever, in order to reverse/avoid energy and overcome energy crisis,
financial sector can play a vital role in terms of intermediary
development. Banks can ensure that funds are channeled primar-
ily to those entrepreneurs who come up with innovative ideas and
advanced technologies. Human capital is central in bringing
technological innovation due to their involvement in generation
of new research ideas. Funds should be funneled to research and
development (R&D) sector of well-reputed firms to innovate and
promote energy saving technologies. Efficient energy use would
reduce cost of production for firms. In this manner, economic
growth will be accelerated along with decline in overall energy
consumption. Consequently, this would make cheap and easy
accessibility to energy efficient products at household level that
will further reduce energy consumption. However, it is to be noted
that financial sector development comes with financial reforms.
Provision of necessary infrastructure is important for sound
financial development policy. Credible and reliable support system
is essential to guarantee stable performance of financial sector,
since accomplishment of financial sector policies may rely on
effectiveness of institutions implementing them.
Pakistan is an energy dependent economy whose economic
growth has become crippled in the absence of adequate energy
supply. Continuous supply of energy is required to support economic
activities in Pakistan so that the economy may be able to achieve
potential level of economic growth. Furthermore, urbanization has a
strong positive influence over energy consumption which means that
the energy requirement is likely to increase in future to meet the
growing demand of increasing urban population. Government of
Pakistan should take serious steps to ensure efficient utilization of
available energy resources along with up-gradation of existing
energy production capacity at macro level to mitigate energy short-
age problem. Investment in renewable energy resources would
promote access to cheap energy for carrying out economic activities,
for which financial institutions can assist along with government.
Moreover, rising energy prices have adverse effect for economy since
production cost is increased that becomes a reason for the loss of
competitive advantage for manufacturers in foreign market. Promo-
tion of cheap renewable energy resources can mitigate this problem.
This is necessary for achieving optimum and sustainable economic
growth in Pakistan.
The present study uses only one indicator for financial sector
development. Therefore, it would be interesting to develop
Table 6
Effect of financial development on energy consumption.
Channel variable Effect of financial development
on channel variable
Effect of channel variable
on energy consumption
Effect of financial development
on energy consumption
(1) (2) (3)
Economic growth 0.043 0.568 0.024
nnn
(4.525)
Wald test (p-value) 20.474 (0.000)
Note:
nnn
Indicates significance at 1% level. t-statistics are reported in parenthesis.
R. Komal, F. Abbas / Renewable and Sustainable Energy Reviews 44 (2015) 211–220 219
financial development index in which foreign direct investment
along with domestic investment and other indicators of financial
development may also be included.
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