The announcement is a black eye for Prime Minister Nuri al-Maliki's government as it tries to lure foreign investors into Iraq and help rebuild the country's oil-reliant economy after years of war and sanctions.
"These contracts damaged Iraq's reputation," a visibly embarrassed Deputy Prime Minister Hussain al-Shahristani told reporters.
"But this does not mean that key projects to build large plants will be affected."
Shahristani made the announcement a day after a source said Maliki had ordered his electricity minister to step down and the government cancelled the two power generation contracts.
He said Iraq planned to sue the two companies for fraud. The Electricity Ministry said Iraq would not lose any money because the contracts were designed to be paid long term.
Iraq needs investment in most industries, but power generation is especially sensitive. Iraq's war-battered grid provides only a few hours of power a day and chronic shortages were at the heart of anti-government protests earlier this year.
The incident may also have fallout for Maliki's delicate coalition among Shi'ite, Sunni and Kurdish blocs. Electricity Minister Raad Shallal belongs to the Sunni-backed Iraqiya bloc that accuses Maliki of reneging on parts of their cross-sectarian power-sharing deal.
Shahristani said Iraq's investigation had found one of the companies involved, Canada's CAPGENT was a "fake" with no offices, manufacturing operations or ability to carry out the work it had been contracted to do for the ministry.