This paper examines the circular debt problem in the Pakistani energy sector. After presenting the profile of the energy sector in Pakistan, the paper explains why circular debt has emerged in the sector. Two principal reasons are discussed for the circular debt problem: First, consumer tariffs were insufficient to recover the rising costs of power generation and the government (due to fiscal constraints) was not compensating PEPCO for the resulting losses. Second, PEPCO has faced significant problems in recovering dues from consumers. In order to resolve the circular debt problem, sharp adjustments in power tariffs may be required combined with the need by the government to explicitly recognize the costs of power subsidies in the budget.