Lit Steel fire arrows are used during the Underground Pass quest. They are created by using a damp cloth on regular steel arrows to create unlit steel fire arrows, which are then lit by using them on a fire. Any lit fire arrow can be used to pierce the rope in the Underground Pass Dungeon, which lowers a bridge. This is necessary to complete the quest.
Steel fire arrows have the same Ranged Strength bonus as regular steel arrows, and the fire provides no additional benefit.