• Environmental and Resource Economics Review
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• v.23 no.3
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• pp.497-513
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• 2014

Rate-of-return regulation where a regulator compensates the utilities based upon the cost incurred the regulated companies have the incentive to over-report cost level. However, in case of cost-based competition where a regulator knows the cost of each plant involved and induce the competition among them, one can encounter prisoner's dilemma situation in the short run where the regulated firms under-report cost level. For instance, in case of cost-based pool, a generator may have a strategic behavior to keep its registered variable cost higher than the actual level to maintain its operation rate and generation amounts higher. Eventually, however, such behavior decrease the profitability of a generator and discourage new entry jeopardizing required level of capacity reserves. This is a typical Prisoner's Dilemma situation. The power market operating rule should be revised so that generators' registered variable cost reflect actual level of variable cost.