| ARIZONA PUBLIC SERVICE CO ITEM 1A RISK FACTORS In addition to the factors affecting specific business operations identified in connection with the description of these operations contained elsewhere in this report, set forth below are risks and uncertainties that could affect our financial results |
| We are subject to comprehensive government regulation by several federal, state and local regulatory agencies that significantly affect our business and our results of operations |
| APS is subject to comprehensive regulation by several federal, state and local regulatory agencies that significantly influence its business and results of operations |
| The ACC regulates APS’ retail electric rates and APS’ issuance of securities |
| The ACC must also approve any transfer of APS’ property used to provide retail electric service and approve or receive prior notification of certain transactions between us, APS and our respective affiliates |
| Our financial condition and results of operations are dependent upon the satisfactory resolution of APS’ retail rate proceedings pending before the ACC See Note 3 of Notes to Pinnacle West’s Consolidated Financial Statements in Item 8 |
| APS is required to have numerous permits, approvals and certificates from the agencies that regulate APS’ business |
| The FERC, the NRC, the EPA, and the ACC regulate many aspects of our utility operations, including siting and construction of facilities, customer service and, as noted in the preceding paragraph, the rates that APS can charge customers |
| We believe the necessary permits, approvals and certificates have been obtained for APS’ existing operations |
| However, changes in regulations or the imposition of additional regulations could have an adverse impact on our results of operations |
| We are also unable to predict the impact on our business and operating results from pending or future regulatory activities of any of these agencies |
| We cannot predict the outcome of APS’ retail rate proceedings pending before the ACC As noted above, our financial condition and results of operations are dependent upon the satisfactory resolution of APS’ retail rate proceedings pending before the ACC These proceedings consist of a general retail rate case, an application for an emergency interim rate increase, and an application for two separate surcharges under the PSA See Note 3 of Notes to Pinnacle West’s Consolidated Financial Statements in Item 8 |
| We cannot predict the timing or the outcome of these proceedings or the resulting levels of regulated revenues |
| We are subject to numerous environmental laws and regulations that may increase our cost of operations, impact our business plans, or expose us to environmental liabilities |
| We are subject to numerous environmental laws and regulations affecting many aspects of our present and future operations, including air emissions, water quality, wastewater discharges, solid 16 _________________________________________________________________ [90]Table of Contents waste, and hazardous waste |
| These laws and regulations can result in increased capital, operating, and other costs, particularly with regard to enforcement efforts focused on power plant emissions obligations |
| These laws and regulations generally require us to obtain and comply with a wide variety of environmental licenses, permits, inspections and other approvals |
| Both public officials and private individuals may seek to enforce applicable environmental laws and regulations |
| We cannot predict the outcome (financial or operational) of any related litigation that may arise |
| In addition, we may be a responsible party for environmental clean up at sites identified by a regulatory body |
| We cannot predict with certainty the amount and timing of all future expenditures related to environmental matters because of the difficulty of estimating clean-up costs |
| There is also uncertainty in quantifying liabilities under environmental laws that impose joint and several liability on all potentially responsible parties |
| We cannot be sure that existing environmental regulations will not be revised or that new regulations seeking to protect the environment will not be adopted or become applicable to us |
| Revised or additional regulations that result in increased compliance costs or additional operating restrictions, particularly if those costs are not fully recoverable from APS’ customers, could have a material adverse effect on our financial position, results of operations or cash flows |
| There are inherent risks in the operation of nuclear facilities, such as environmental, health and financial risks and the risk of terrorist attack |
| Through APS, we have an ownership interest in and operate, on behalf of a group of owners, Palo Verde, which is the largest nuclear electric generating facility in the United States |
| Palo Verde is subject to environmental, health and financial risks such as the ability to dispose of spent nuclear fuel, the ability to maintain adequate reserves for decommissioning, potential liabilities arising out of the operation of these facilities, and the costs of securing the facilities against possible terrorist attacks and unscheduled outages due to equipment and other problems |
| We maintain nuclear decommissioning trust funds and external insurance coverage to minimize our financial exposure to some of these risks; however, it is possible that damages could exceed the amount of insurance coverage |
| The NRC has broad authority under federal law to impose licensing and safety-related requirements for the operation of nuclear generation facilities |
| In the event of noncompliance, the NRC has the authority to impose fines or shut down a unit, or both, depending upon its assessment of the severity of the situation, until compliance is achieved |
| In addition, although we have no reason to anticipate a serious nuclear incident at Palo Verde, if an incident did occur, it could materially and adversely affect our results of operations or financial condition |
| A major incident at a nuclear facility anywhere in the world could cause the NRC to limit or prohibit the operation or licensing of any domestic nuclear unit |
| 17 _________________________________________________________________ [91]Table of Contents Deregulation or restructuring of the electric industry may result in increased competition, which could have a significant adverse impact on our business and our financial results |
| In 1999, the ACC approved rules for the introduction of retail electric competition in Arizona |
| Retail competition could have a significant adverse financial impact on us due to an impairment of assets, a loss of retail customers, lower profit margins or increased costs of capital |
| Although some very limited retail competition existed in the service area of APS in 1999 and 2000, there are currently no active retail competitors offering unbundled energy or other utility services to APS’ customers |
| As a result, we cannot predict when, and the extent to which, additional competitors will re-enter APS’ service territory |
| As a result of changes in federal law and regulatory policy, competition in the wholesale electricity market has greatly increased due to a greater participation by traditional electricity suppliers, non-utility generators, independent power producers, and wholesale power marketers and brokers |
| This increased competition could affect our load forecasts, plans for power supply and wholesale energy sales and related revenues |
| As a result of the changing regulatory environment and the relatively low barriers to entry, we expect wholesale competition to increase |
| Our results of operations can be adversely affected by milder weather |
| Weather conditions directly influence the demand for electricity and affect the price of energy commodities |
| Electric power demand is generally a seasonal business |
| In Arizona, demand for power peaks during the hot summer months, with market prices also peaking at that time |
| As a result, our overall operating results fluctuate substantially on a seasonal basis |
| In addition, we have historically sold less power, and consequently earned less income, when weather conditions are milder |
| As a result, unusually mild weather could diminish our results of operations and harm our financial condition |
| Our cash flow largely depends on the performance of our subsidiaries |
| We conduct our operations primarily through subsidiaries |
| Substantially all of our consolidated assets are held by such subsidiaries |
| Accordingly, our cash flow is dependent upon the earnings and cash flows of these subsidiaries and their distributions to us |
| The subsidiaries are separate and distinct legal entities and have no obligation to make distributions to us |
| The debt agreements of some of our subsidiaries may restrict their ability to pay dividends, make distributions or otherwise transfer funds to us |
| An ACC financing order requires APS to indefinitely maintain a common equity ratio of at least 40prca and does not allow APS to pay common dividends if the payment would reduce its common equity below that threshold |
| As defined in the ACC financing order approving the arrangement, common equity ratio is common equity divided by common equity plus long-term debt, including current maturities of long-term debt |
| At December 31, 2005, APS’ common equity ratio, as defined, was approximately 54prca |
| 18 _________________________________________________________________ [92]Table of Contents Our ability to meet our debt service obligations could be adversely affected because our debt securities are structurally subordinated to the debt securities and other obligations of our subsidiaries |
| Because we are structured as a holding company, all existing and future debt and other liabilities of our subsidiaries will be effectively senior in right of payment to our debt securities |
| None of the indentures under which we or our subsidiaries may issue debt securities limits our ability or the ability of our subsidiaries to incur additional debt in the future |
| The assets and cash flows of our subsidiaries will be available, in the first instance, to service their own debt and other obligations |
| Our ability to have the benefit of their assets and cash flows, particularly in the case of any insolvency or financial distress affecting our subsidiaries, would arise only through our equity ownership interests in our subsidiaries and only after their creditors have been satisfied |
| If we are not able to access capital at competitive rates, our ability to implement our financial strategy will be adversely affected |
| We rely on access to short-term money markets, longer-term capital markets and the bank markets as a significant source of liquidity and for capital requirements not satisfied by the cash flow from our operations |
| We believe that we will maintain sufficient access to these financial markets based upon current credit ratings |
| However, certain market disruptions may increase our cost of borrowing or adversely affect our ability to access one or more financial markets |
| Such disruptions could include: • an economic downturn; • the bankruptcy of an unrelated energy company; • increased market prices for electricity and gas; • terrorist attacks or threatened attacks on our facilities or those of unrelated energy companies; or • the overall health of the utility industry |
| Changes in economic conditions could result in higher interest rates, which would increase our interest expense on our debt and reduce funds available to us for our current plans |
| Additionally, an increase in our leverage could adversely affect us by: • increasing the cost of future debt financing; • increasing our vulnerability to adverse economic and industry conditions; • requiring us to dedicate a substantial portion of our cash flow from operations to payments on our debt, which would reduce funds available to us for operations, future business opportunities or other purposes; and • placing us at a competitive disadvantage compared to our competitors that have less debt |
| 19 _________________________________________________________________ [93]Table of Contents A further reduction in our credit ratings could materially and adversely affect our business, financial condition and results of operations |
| We cannot be sure that any of our current ratings will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a rating agency if, in its judgment, circumstances in the future so warrant |
| Any downgrade could increase our borrowing costs, which would diminish our financial results |
| We would likely be required to pay a higher interest rate in future financings, and our potential pool of investors and funding sources could decrease |
| In addition, borrowing costs under certain of our existing credit facilities depend on our credit ratings |
| A downgrade could also require us to provide additional support in the form of letters of credit or cash or other collateral to various counterparties |
| If our short-term ratings were to be lowered, it could limit our access to the commercial paper market |
| We note that the ratings from rating agencies are not recommendations to buy, sell or hold our securities and that each rating should be evaluated independently of any other rating |
| The use of derivative contracts in the normal course of our business and changing interest rates and market conditions could result in financial losses that negatively impact our results of operations |
| Our operations include managing market risks related to commodity prices and, subject to specified risk parameters, engaging in marketing and trading activities intended to profit from market price movements |
| We are exposed to the impact of market fluctuations in the price and transportation costs of electricity, natural gas, coal, and emissions allowances |
| We have established procedures to manage risks associated with these market fluctuations by utilizing various commodity derivatives, including exchange-traded futures and options and over-the-counter forwards, options, and swaps |
| As part of our overall risk management program, we enter into derivative transactions to hedge purchases and sales of electricity, fuels, and emissions allowances and credits |
| The changes in market value of such contracts have a high correlation to price changes in the hedged commodity |
| We are exposed to losses in the event of nonperformance or nonpayment by counterparties |
| We use a risk management process to assess and monitor the financial exposure of all counterparties |
| Despite the fact that the majority of trading counterparties are rated as investment grade by the rating agencies, there is still a possibility that one or more of these companies could default, resulting in a material adverse impact on our earnings for a given period |
| Changing interest rates will affect interest paid on variable-rate debt and interest earned on variable-rate securities in our pension plan and nuclear decommissioning trust funds |
| Our policy is to manage interest rates through the use of a combination of fixed-rate and floating-rate debt |
| The pension plan is also impacted by the discount rate, which is the interest rate used to discount future pension obligations |
| Declining interest rates impact the discount rate, and may result in increases in pension costs, cash contributions, and charges to other comprehensive income |
| The pension plan and nuclear decommissioning trust funds also have risks associated with changing market values of fixed income and equity investments |
| A significant portion of the pension costs and all of the nuclear decommissioning costs are recovered in regulated electricity prices |
| Actual results could differ from estimates used to prepare our financial statements |
| In preparing our financial statements in accordance with accounting principles generally accepted in the United States of America, management must often make estimates and assumptions 20 _________________________________________________________________ [94]Table of Contents that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures at the date of the financial statements and during the reporting period |
| We consider the following accounting policies to be our most critical because of the uncertainties, judgments and complexities of the underlying accounting standards and operations involved |
| • Regulatory Accounting — Regulatory accounting allows for the actions of regulators, such as the ACC and the FERC, to be reflected in our financial statements |
| Their actions may cause us to capitalize costs that would otherwise be included as an expense in the current period by unregulated companies |
| If future recovery of costs ceases to be probable, the assets would be written off as a charge in current period earnings |
| A major component of our regulatory assets is the retail fuel and purchased power costs deferred under the PSA APS defers for future rate recovery 90prca of the difference between actual retail fuel and purchased power costs and the amount of such costs currently included in base rates |
| We had dlra324 million, including dlra173 million related to the PSA, of regulatory assets on the Consolidated Balance Sheets at December 31, 2005 |
| Included in the dlra173 million is approximately dlra45 million related to the 2005 unplanned Palo Verde outages, which currently are the subject of inquiry by the ACC Since December 25, 2005, Palo Verde Unit 1 has been operating at reduced power levels due to a non-safety related acoustic impact in one of the unit’s shutdown cooling lines |
| APS estimates that these reduced power levels and a planned Unit 1 outage to resolve the Unit 1 issue will result in additional PSA deferrals of approximately dlra85 million pretax in 2006 |
| See Notes 1 and 3 for more information about regulatory assets and liabilities, APS’ pending retail rate proceedings, and the PSA • Pensions and Other Postretirement Benefit Accounting — Changes in our actuarial assumptions used in calculating our pension and other postretirement benefit liability and expense can have a significant impact on our earnings and financial position |
| The most relevant actuarial assumptions are the discount rate used to measure our liability and net periodic cost, the expected long-term rate of return on plan assets used to estimate earnings on invested funds over the long-term, and the assumed healthcare cost trend rates |
| We review these assumptions on an annual basis and adjust them as necessary |
| • Derivative Accounting — Derivative accounting requires evaluation of rules that are complex and subject to varying interpretations |
| Our evaluation of these rules, as they apply to our contracts, will determine whether we use accrual accounting (for contracts designated as normal) or fair value (mark-to-market) accounting |
| Mark-to-market accounting requires that changes in the fair value are recognized periodically in income unless certain hedge criteria are met |
| For fair value hedges, the gain or loss on the derivative as well as the offsetting loss or gain on the hedged item associated with the hedged risk are recognized in earnings |
| For cash flow hedges, the effective portion of changes in the fair value of the derivative are recognized in common stock 21 _________________________________________________________________ [95]Table of Contents equity (as a component of other comprehensive income (loss)) and are recognized in earnings when the related transaction occurs |
| The market price of our common stock may be volatile |
| The market price of our common stock could be subject to significant fluctuations in response to factors such as the following, some of which are beyond our control: • variations in our quarterly operating results; • operating results that vary from the expectations of management, securities analysts and investors; • changes in expectations as to our future financial performance, including financial estimates by securities analysts and investors; • developments generally affecting industries in which we operate, particularly the energy distribution and energy generation industries; • announcements by us or our competitors of significant contracts, acquisitions, joint marketing relationships, joint ventures or capital commitments; • announcements by third parties of significant claims or proceedings against us; • favorable or adverse regulatory developments; • our dividend policy; • future sale of our equity or equity-linked securities; and • general domestic and international economic conditions |
| In addition, the stock market in general has experienced volatility that has often been unrelated to the operating performance of a particular company |
| These broad market fluctuations may adversely affect the market price of our common stock |
| We may enter into credit and other agreements from time to time that restrict our ability to pay dividends |
| Payment of dividends on our common stock may be restricted by credit and other agreements entered into by us from time to time |
| At December 31, 2005, there were no material restrictions on our ability to pay dividends under any such agreement |