FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

(Mark One)

     Indicate by check mark whether each registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

PINNACLE WEST CAPITAL CORPORATION
Large accelerated filer      þ     Accelerated filer      o     Non-accelerated filer      o      Smaller reporting company o
ARIZONA PUBLIC SERVICE COMPANY
Large accelerated filer      o     Accelerated filer      o     Non-accelerated filer      þ      Smaller reporting company o

     Indicate by check mark whether each registrant is a shell company (as defined in Exchange Act Rule 12b-2).

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

     Arizona Public Service Company meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format allowed under that General Instruction.

     This combined Form 10-Q is separately filed by Pinnacle West Capital Corporation and Arizona Public Service Company. Each registrant is filing on its own behalf all of the information contained in this Form 10-Q that relates to such registrant and, where required, its subsidiaries. Except as stated in the preceding sentence, neither registrant is filing any information that does not relate to such registrant, and therefore makes no representation as to any such information.

 

ADEQ — Arizona Department of Environmental Quality

ALJ — Administrative Law Judge

APS — Arizona Public Service Company, a subsidiary of the Company

APSES — APS Energy Services Company, Inc., a subsidiary of the Company

Base Fuel Rate — the portion of APS’ retail base rates attributable to fuel and purchased power costs

Clean Air Act — Clean Air Act, as amended

Company — Pinnacle West Capital Corporation

DOE — United States Department of Energy

El Dorado — El Dorado Investment Company, a subsidiary of the Company

EPA — United States Environmental Protection Agency

ERMC — Energy Risk Management Committee

FASB — Financial Accounting Standards Board

FERC — United States Federal Energy Regulatory Commission

FIN — FASB Interpretation Number

Fitch — Fitch, Inc.

GAAP — accounting principles generally accepted in the United States of America

IRS — United States Internal Revenue Service

kWh — kilowatt-hour, one thousand watts per hour

Moody’s — Moody’s Investors Service, Inc.

Native Load — retail and wholesale sales supplied under traditional cost-based rate regulation

Note — a Note to Pinnacle West’s Condensed Consolidated Financial Statements in Item 1 of this report

NRC — United States Nuclear Regulatory Commission

OCI — other comprehensive income

Off-System Sales — sales of electricity from generation owned or contracted by the Company that is over and above the amount required to serve APS’ retail customers and traditional wholesale contracts

Palo Verde — Palo Verde Nuclear Generating Station

Pinnacle West — Pinnacle West Capital Corporation, the Company

Pinnacle West Energy — Pinnacle West Energy Corporation, a subsidiary of the Company, dissolved as of August 31, 2006

Pinnacle West Marketing & Trading — Pinnacle West Marketing & Trading Co., LLC, a subsidiary of the Company

PRP — potentially responsible parties under Superfund

PSA — power supply adjustor approved by the ACC to provide for recovery or refund of variations in actual fuel and purchased power costs compared with the Base Fuel Rate

Salt River Project — Salt River Project Agricultural Improvement and Power District

SEC — United States Securities and Exchange Commission

SFAS — Statement of Financial Accounting Standards

Standard & Poor’s — Standard & Poor’s Ratings Services

SunCor — SunCor Development Company, a subsidiary of the Company

Superfund — Comprehensive Environmental Response, Compensation and Liability Act

2005 Deferrals — PSA deferrals related to 2005 replacement power costs associated with Palo Verde outages

2007 Form 10-K — Pinnacle West/APS Annual Report on Form 10-K for the fiscal year ended December 31, 2007

VIE — variable interest entity

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements.

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements.

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements.

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements.

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements.

     The unaudited condensed consolidated financial statements include the accounts of Pinnacle West and our subsidiaries: APS, SunCor, APSES, El Dorado and Pinnacle West Marketing & Trading. Intercompany accounts and transactions between the consolidated companies have been eliminated. Our accounting records are maintained in accordance with GAAP. The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

     Our unaudited condensed consolidated financial statements reflect all adjustments that we believe are necessary for the fair presentation of our financial position, results of operations and cash flows for the periods presented. These condensed consolidated statements and notes should be read in conjunction with the consolidated financial statements and related notes included in our 2007 Form 10-K. These condensed consolidated financial statements and notes have been prepared consistently with the 2007 Form 10-K with the exception of the following items: (1) we have reclassified certain prior-year real estate segment revenues and expenses to discontinued operations on our Condensed Consolidated Statements of Income in accordance with SFAS No. 144; (2) we have netted certain prior-year amounts on our Condensed Consolidated Balance Sheets and Statements of Cash Flows to reflect the adoption of FASB Staff Position No. FIN 39-1 (see Note 10); and (3) “contributions in aid of construction” was previously reported as part of “capital expenditures” on the Condensed Consolidated Statements of Cash Flows. This item has been disclosed separately to provide more detail.

     Weather conditions cause significant seasonal fluctuations in our revenues. In addition, real estate activities can have significant impacts on our results for interim periods. For these reasons, results for interim periods do not necessarily represent results expected for the year.

     The following table shows principal payments due on Pinnacle West’s and APS’ total long-term debt and capitalized lease requirements as of June 30, 2008 (dollars in millions):

     The interest rates on eleven issues of APS’ pollution control bonds, in the aggregate amount of approximately $343 million, are reset every seven days through auction processes. These bonds are supported by bond insurance policies provided by Ambac Assurance Corporation, and the interest rates on the bonds can be directly affected by the rating of the bond insurer. Certain bond insurers have had actual or potential downgrades of their “AAA” credit ratings due to their insuring certain mortgage-backed securities and collateralized debt obligations. Downgrades of bond insurers also increase the possibility of a “failed auction,” which results in higher interest rates during the failed auction periods. During the first quarter of 2008, we had seven failed auctions, which represented about 5% of all of our auctions for the quarter. When the auctions failed, the bondholders received the maximum 14% annual interest rate for the week of the failed auction. The bonds were successfully re-auctioned the following week. We had no failed auctions during the second quarter of 2008 and the average interest rate at the end of the quarter on the auction rate securities was 4.8%. We continue to monitor this market. We do not expect, however, that our auction rate interest exposure will have a material adverse impact on our financial position, results of operations, cash flows or liquidity.

     An existing ACC order requires APS to maintain a common equity ratio of at least 40%. As defined in the ACC order, the common equity ratio is common equity divided by the sum of common equity and long-term debt, including current maturities of long-term debt. At June 30, 2008, APS’ common equity ratio, as defined, was 55%, its total common equity was approximately $3.6 billion, and its total capitalization was approximately $6.5 billion. APS would be prohibited from paying dividends if its common equity falls below approximately $2.6 billion, assuming APS’ total capitalization remains the same.

     SunCor has a $150 million loan facility secured primarily by an interest in land, commercial properties, land contracts and homes under construction. The loan facility requires compliance with certain loan covenants pertaining to debt to net worth, debt service, liquidity, cash flow coverage and restrictions on debt. As of June 30, 2008, the amount of SunCor’s net assets that could not be transferred to Pinnacle West in the form of cash dividends as a result of these covenants was approximately $224 million.

     As a result of the restrictions in the preceding two paragraphs, as of June 30, 2008, the restricted net assets of our subsidiaries exceeded 25% of our consolidated net assets (at June 30, 2008, our consolidated net assets were approximately $3.7 billion). These restrictions do not materially affect Pinnacle West’s ability to meet its ongoing capital requirements.

     On June 2, 2008, APS filed with the ACC updated financial statements, testimony and other data in the general rate case originally filed on March 24, 2008. As requested by the ACC staff, the updated information reflects a test year ended December 31, 2007, rather than the September 30, 2007 test year used in APS’ original filing. As a result of the updated filing, APS is requesting a net rate increase of $278.2 million for retail customers effective no later than October 1, 2009. As proposed by APS, the updated request would result in an average rate increase of 8.5% for existing customers plus the establishment of a new growth-related impact fee charged to new connections. A hearing on this case is scheduled to begin on April 2, 2009.

     The key financial provisions of the request include:

     The update also requests that the ACC adopt certain goals for APS to improve its financial strength, which include: allowing APS’ internal cash flow generation to cover its operating and capital costs of providing service; stabilizing and improving APS’ credit ratings; and providing a meaningful and ongoing opportunity for APS to achieve a reasonable return on the fair value of its property.

     In addition, APS requested various modifications to the Environmental Improvement Surcharge and the Demand Side Management Adjustment Clause that will allow APS to expand its conservation and demand-side management programs and support environmental upgrades to APS facilities in response to and in anticipation of future environmental requirements.

     Motion for Approval of Interim Rate

     On June 6, 2008, APS filed with the ACC a motion in its currently pending retail rate case, requesting an interim base rate surcharge that would be subject to refund pending the final outcome of the rate case. The motion requested that the interim base rate surcharge of $0.003987 per kWh become effective upon the expiration of the $0.003987 per kWh 2007 PSA charge (the “2007 PSA Adjustor”), the latter of which remained in effect through the last billing cycle in July 2008. On June 30, 2008, APS submitted a proposed schedule to the ACC ALJ, with a goal to resolve the motion by November 2008, without otherwise changing the nature or amount of the request. The proposed procedural schedule was approved by the ACC ALJ on July 16, 2008, with a hearing scheduled to begin September 15, 2008. Rather than becoming effective upon the expiration of the 2007 PSA Adjustor, APS proposed that the interim rates, if approved, would be reflected in customer bills during the month of November when APS switches from summer to winter rates, which are generally lower than summer rates by an amount that is more than the requested interim relief.

     The purpose of the interim surcharge is to better position APS to fund customer-centered programs and needed infrastructure, access needed capital on reasonable terms, minimize the risk of credit rating downgrades by improving APS’ credit metrics until the ACC is able to grant permanent rate relief, allow APS to partially recover already incurred costs related to necessary capital expenditure programs to serve its customers, and provide a better opportunity for APS to achieve a return on equity closer to the level deemed reasonable and approved by the ACC in APS’ last rate case. The interim base rate surcharge would produce approximately $115 million in annual pretax retail revenues. APS cannot currently predict the outcome of this matter.

     2007 Retail Rate Order

     As previously disclosed, in June 2007 the ACC issued an order (the “Retail Rate Order”) in a general retail rate case that APS filed in late 2005. The Retail Rate Order approved a $322 million increase in APS’ annual retail base revenues, effective July 1, 2007, which included a $315 million fuel-related increase and a $7 million non-fuel related increase. The Retail Rate Order also authorized APS’ recovery of approximately $34 million of 2005 Deferrals through a temporary PSA surcharge over a twelve-month period beginning July 1, 2007, modified the PSA in various respects and increased the Base Fuel Rate. In addition, the Retail Rate Order provided that the 2007 PSA Adjustor, which took effect on February 1, 2007 and that was scheduled to expire on January 31, 2008, remain in effect as long as necessary to allow APS to collect $46 million of 2007 fuel and purchased power costs deferred as a result of the mid-2007 implementation of the new Base Fuel Rate. The 2007 PSA Adjustor expired as of the last billing cycle in July 2008.

     PSA Balance

     The following table shows the changes in the deferred fuel and purchased power regulatory asset for the six months ended June 30, 2008 and 2007 (dollars in millions):

     The PSA rate for the PSA Year (February 1 through January 31) beginning February 1, 2008 was set at the maximum $0.004 per kWh. Any uncollected deferrals during the 2008 PSA Year resulting from this limit will be included in the historical component of the PSA rate for the PSA Year beginning February 1, 2009.

     Rate Request for a Formula Transmission Tariff

     On July 10, 2007, APS submitted a revised Open Access Transmission Tariff filing with the FERC to move from fixed rates to a formula rate-setting methodology in order to more accurately reflect the costs that APS incurs in providing transmission services. The originally requested formula rate, based on fiscal year 2006 data, proposed an estimated $37 million increase in annual transmission revenues, effective October 1, 2007. The proposed formula rate would be updated each year effective June 1 on the basis of APS’ actual cost of service, as disclosed in APS’ FERC Form 1 report for the previous fiscal year, and projected capital expenditures. Approximately $30 million of the originally requested increase represented charges for transmission services to serve APS’ retail customers (“Retail Transmission Charges”).

     On September 21, 2007, the FERC issued an order on the proposed revisions to APS’ transmission rates in which it accepted APS’ proposed formula rates and ordered settlement judge procedures. The proposed rates became effective March 1, 2008, subject to refund based upon the ultimate outcome of proceedings at the FERC on this matter.

     In order to recover the Retail Transmission Charges authorized by the FERC described above, on December 31, 2007, APS filed with the ACC an application to increase annual pretax retail revenues by approximately $30 million, effective March 1, 2008. This retail rate increase implemented an ACC-approved mechanism, the transmission cost adjustor (“TCA”), by which changes in Retail Transmission Charges can be reflected in APS’ retail rates. On February 13, 2008, the ACC voted to approve APS’ request, subject to refund pending final outcome of FERC proceedings on this matter.

     APS and intervening parties reached and filed a proposed settlement with the FERC on May 29, 2008 that contained some minor variations from the originally proposed formula method used for calculation of the rates. Through the proposed settlement, APS agreed to an initial increase of $28 million in annual transmission revenues, of which $27 million represents Retail Transmission Charges. Pursuant to the proposed settlement agreement, refund of any difference between the originally requested amount and the amount agreed to in the settlement will be netted against the next annual rate

change. On July 25, 2008, the FERC approved the rates and substance of the settlement through a conditional approval of the settlement, subject to the parties’ revision of a procedural provision.

     In addition, during the period of settlement discussions described above, APS filed calculations with the FERC, based on fiscal year 2007 data, which resulted in the automatic adjustment on June 1, 2008 of our transmission rates under the formula mechanism (as modified in accordance with the proposed settlement at that time). As a result, APS filed a new request with the ACC to allow APS to reflect the resulting increased Retail Transmission Charges in its retail rates through the TCA. On July 3, 2008, the ACC issued an order approving this request. These calculations produced an increase in annual transmission revenues of $15 million, of which $13 million represents Retail Transmission Charges. Also on July 3, 2008, the ACC agreed to follow the refund method contained in the settlement agreement by allowing for the refund of any difference between the originally requested amounts and the amounts resulting from the settlement to be netted against the next annual change in Retail Transmission Charges under the TCA.

     Equity Infusion Notice

     On May 2, 2008, Pinnacle West filed a notice with the ACC that would allow Pinnacle West to infuse up to $400 million of equity into APS in the event Pinnacle West deems it appropriate to do so to strengthen or maintain APS’ financial integrity. Under Arizona law and implementing regulatory decisions, Pinnacle West is required to give such notice at least 120 days prior to an equity infusion into APS that exceeds $150 million in a single calendar year. On July 2, 2008, the ACC staff recommended approval of the proposed infusion, and on July 29, 2008, the ACC voted to approve the recommended order which permits the infusion to occur on or before December 31, 2009.

     FERC Order

     On August 11, 2004, Pinnacle West, APS, Pinnacle West Energy, and APSES (collectively, the “Pinnacle West Companies”) submitted to the FERC an update to their three-year market-based rate review pursuant to the FERC’s order implementing a new generation market power analysis. On December 20, 2004, the FERC issued an order approving the Pinnacle West Companies’ market-based rates for control areas other than those of APS, Public Service Company of New Mexico (“PNM”) and Tucson Electric Power Company (“TEP”). The FERC staff required the Pinnacle West Companies to submit additional data with respect to these control areas, and the Pinnacle West Companies did so.

     On April 17, 2006, the FERC issued an order revoking the Pinnacle West Companies’ authority to make sales at market-based rates in the APS control area (the “April 17 Order”). The FERC found that the Pinnacle West Companies failed to provide the necessary information about the calculation of transmission imports into the APS control area to allow the FERC to make a determination regarding FERC’s generation market power “screens” in the APS control area. The FERC found that the Pinnacle West Companies may charge market-based rates in the PNM and TEP control areas.

     On August 13, 2007, the FERC issued an order on rehearing, reinstating the authority of the Pinnacle West Companies to make sales at market-based rates in all seasons for sales outside of the Phoenix Valley, and in all seasons except the summer for sales within the Phoenix Valley. The Pinnacle West Companies submitted a compliance filing implementing this order to the FERC on

October 12, 2007. This compliance filing was accepted conditionally by FERC in an order issued January 17, 2008. In compliance with the January 17, 2008 order, the Pinnacle West Companies filed a revised mitigation plan to implement cost-based rates for sales in the Phoenix Valley during the summer months. On May 30, 2008, the FERC issued a letter order accepting our mitigation plan. The first summer period under this cost-based mitigation began on June 1, 2008. This proceeding is now concluded.

     Pinnacle West sponsors a qualified defined benefit and account balance pension plan, a nonqualified supplemental excess benefit retirement plan, and other postretirement benefit plans for the employees of Pinnacle West and our subsidiaries. Pinnacle West uses a December 31 measurement date for its pension and other postretirement benefit plans. The market-related value of our plan assets is their fair value at the measurement date.

     The following table provides details of the plans’ benefit costs for the three and six months ended June 30, 2008 and 2007. Also included is the portion of these costs charged to expense, including administrative costs and excluding amounts billed to electric plant participants or capitalized as overhead construction (dollars in millions):

     The contribution to our pension plan in 2008 is estimated to be approximately $35 million. The contribution to our other postretirement benefit plans in 2008 is estimated to be approximately $20 million, of which $10 million has been contributed through August 2008. APS and other subsidiaries fund their share of the contributions. APS’ share is approximately 96% of the plans.

     Pinnacle West’s two reportable business segments are:

     Financial data for the three and six months ended June 30, 2008 and 2007 and at June 30, 2008 and December 31, 2007 is provided as follows (dollars in millions):

     8. Income Taxes

     As a result of a change in IRS guidance, we previously claimed a tax deduction related to an APS tax accounting method change on our 2001 federal consolidated income tax return. The accelerated deduction resulted in a $200 million reduction in the current income tax liability and a corresponding increase in the plant-related deferred tax liability on our 2002 financial statements. Our 2001 return was the subject of an IRS review and the IRS finalized its examination in the second quarter of 2008, which included a settlement on the tax accounting method change and favorable

resolution of other various tax matters. As a result of this settlement and the lapse of federal statutes prior to 2004, we recognized income tax benefits of approximately $30 million in the second quarter of 2008, including approximately $23 million related to interest. Additionally, the settlement and lapse of federal statutes resulted in a net decrease in uncertain tax positions of $115 million through June 30, 2008.

     As of June 30, 2008, the tax year ended December 31, 2004 and all subsequent tax years remain subject to examination by the IRS. With few exceptions, we are no longer subject to state income tax examinations by tax authorities for years before 1999.

     In 1986, APS entered into agreements with three separate VIE lessors in order to sell and lease back interests in Palo Verde Unit 2. The leases are accounted for as operating leases in accordance with GAAP. We are not the primary beneficiary of the Palo Verde VIEs and, accordingly, do not consolidate them.

     APS is exposed to losses under the Palo Verde sale leaseback agreements upon the occurrence of certain events that APS does not consider to be reasonably likely to occur. Under certain circumstances (for example, the NRC issuing specified violation orders with respect to Palo Verde or the occurrence of specified nuclear events), APS would be required to assume the debt associated with the transactions, make specified payments to the equity participants, and take title to the leased Unit 2 interests, which, if appropriate, may be required to be written down in value. If such an event had occurred as of June 30, 2008, APS would have been required to assume approximately $188 million of debt and pay the equity participants approximately $169 million.

     We use derivative instruments (primarily forward purchases and sales, swaps, options and futures) to manage our exposure to the commodity price risk inherent in the purchase and sale of fuel, electricity and emission allowances and credits. As of June 30, 2008, we hedged exposures to the price variability of the power and gas commodities for a maximum of 39 months. The changes in market value of such contracts have a high correlation to price changes in the hedged transactions.

     The changes in the fair value of our hedged positions included in the Condensed Consolidated Statements of Income, after consideration of amounts deferred under the PSA, for the three and six months ended June 30, 2008 and 2007 are comprised of the following (dollars in thousands):

     During the next twelve months ending June 30, 2009, we estimate that a net gain of $182 million before income taxes will be reclassified from accumulated other comprehensive income as an offset to the effect of market price changes for the related hedged transactions. To the extent the gains are eligible for inclusion in the PSA, the amounts will be recorded as either a regulatory asset or liability and have no effect on earnings.

     We adopted FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts” (FIN 39-1), on January 1, 2008. In accordance with this guidance, we elected to offset the fair value amounts for derivative instruments, including collateral, executed with the same counterparty under a master netting arrangement. Collateral was previously reported in other current assets or other current liabilities on our Condensed Consolidated Balance Sheets. This guidance required retrospective application for all prior periods presented. As a result, our Condensed Consolidated Balance Sheet and Statement of Cash Flows line items changed by the following amounts (dollars in thousands):

     The following tables summarize our assets and liabilities from risk management and trading activities presented net in accordance with FIN 39-1 (dollars in thousands):

     We maintain a margin account with a broker to support our risk management and trading activities. Cash is deposited with the broker in this account at the time futures or options contracts are initiated. The change in market value of these contracts (reflected in mark-to-market) requires adjustment of the margin account balance.

     See Note 20 for a discussion of SFAS No. 157, “Fair Value Measurements,” which we adopted January 1, 2008.

     We are exposed to losses in the event of nonperformance or nonpayment by counterparties. We have risk management and trading contracts with many counterparties, including one counterparty for which a worst case exposure represents approximately 10% of Pinnacle West’s $437 million of risk management and trading assets as of June 30, 2008. Our risk management process assesses and monitors the financial exposure of this and all other counterparties. Despite the fact that the great majority of trading counterparties’ securities are rated as investment grade by the credit rating agencies, including the counterparty discussed above, there is still a possibility that one or more of these companies could default, resulting in a material impact on consolidated earnings for a given period. Counterparties in the portfolio consist principally of financial institutions, major energy companies, municipalities and local distribution companies. We maintain credit policies that we believe minimize overall credit risk to within acceptable limits. Determination of the credit quality of our counterparties is based upon a number of factors, including credit ratings and our evaluation of their financial condition. To manage credit risk, we employ collateral requirements, standardized agreements that allow for the netting of positive and negative exposures associated with a single counterparty and credit default swaps. Valuation adjustments are established representing our estimated credit losses on our overall exposure to counterparties.

     Components of comprehensive income for the three and six months ended June 30, 2008 and 2007 are as follows (dollars in thousands):

Palo Verde Nuclear Generating Station

     Spent Nuclear Fuel and Waste Disposal

     Nuclear power plant operators are required to enter into spent fuel disposal contracts with the DOE, and the DOE is required to accept and dispose of all spent nuclear fuel and other high-level radioactive wastes generated by domestic power reactors. Although the Nuclear Waste Policy Act required the DOE to develop a permanent repository for the storage and disposal of spent nuclear fuel by 1998, the DOE has announced that the repository cannot be completed before at least 2017. In November 1997, the United States Court of Appeals for the District of Columbia Circuit (D.C. Circuit) issued a decision preventing the DOE from excusing its own delay, but refused to order the DOE to begin accepting spent nuclear fuel. Based on this decision and the DOE’s delay, a number of utilities, including APS (on behalf of itself and the other Palo Verde owners), filed damages actions against the DOE in the Court of Federal Claims. APS is currently pursuing that damages claim and trial is expected to occur in 2009.

     APS currently estimates it will incur $132 million (in 2008 dollars) over the life of Palo Verde for its share of the costs related to the on-site interim storage of spent nuclear fuel. At June 30, 2008, APS had a regulatory liability of $17 million that represents amounts recovered in retail rates in excess of amounts spent for on-site interim spent fuel storage.

     FERC

     In July 2001, the FERC ordered an expedited fact-finding hearing to calculate refunds for spot market transactions in California during a specified time frame. APS was a seller and a purchaser in the California markets at issue and, to the extent that refunds are ordered, APS should be a recipient as well as a payor of such amounts. In addition, on March 19, 2002, the State of California filed a complaint with the FERC alleging that wholesale sellers of power and energy, including APS, failed to properly file rate information at the FERC in connection with sales to California from 2000 to March 2002 under market-based rates. Since 2004, the Ninth Circuit and the FERC have issued various decisions and orders involving the aforementioned issues, including decisions related to: entities subject to FERC jurisdiction and, therefore, potentially owing refunds; applicable refund methodologies; the temporal scope and types of transactions that are properly subject to the refund orders; and the appropriate standard of review at the FERC on wholesale power contracts in the refund proceedings. A settlement, resolving APS’ issues with certain California parties for the current refund period, was approved by the FERC in an order issued on June 30, 2008. The resolution of the claims related to the parties involved in this settlement had no material adverse impact on our financial position, results of operations or cash flows. We currently believe the refund claims at the FERC related to the parties not involved in this settlement will have no material adverse impact on our financial position, results of operations or cash flows.

     On March 26, 2003, the FERC made public a Final Report on Price Manipulation in Western Markets, prepared by its staff and covering spot markets in the West in 2000 and 2001. The report

stated that a significant number of entities who participated in the California markets during the 2000-2001 time period, including APS, may potentially have been involved in arbitrage transactions that allegedly violated certain provisions of the Independent System Operator tariff. After reviewing the matter, along with the data supplied by APS, the FERC staff moved to dismiss the claims against APS and to dismiss the proceeding. The motion to dismiss was granted by the FERC on January 22, 2004. Certain parties sought rehearing of this order; however, under the settlement agreement mentioned above, these parties withdrew their request for rehearing on July 22, 2008.

     On July 25, 2001, the FERC also ordered an evidentiary proceeding to discuss and evaluate possible refunds for wholesale sales in the Pacific Northwest. The FERC affirmed the ALJ’s conclusion that the prices in the Pacific Northwest were not unreasonable or unjust and refunds should not be ordered in this proceeding. This decision was appealed to the U.S. Court of Appeals for the Ninth Circuit. On August 24, 2007, the Ninth Circuit issued an opinion that remanded the proceeding to the FERC for further consideration. Petitions for rehearing of this opinion were filed. Although the FERC has not yet determined whether any refunds will ultimately be required, we do not expect that the resolution of these issues will have a material adverse impact on our financial position, results of operations or cash flows.

     In June 1999, the Navajo Nation served Salt River Project with a lawsuit filed in the United States District Court for the District of Columbia (the “D.C. Lawsuit”) naming Salt River Project, several Peabody Coal Company entities (collectively, “Peabody”), Southern California Edison Company and other defendants, and citing various claims in connection with the renegotiations of the coal royalty and lease agreements under which Peabody mines coal for the Navajo Generating Station and the Mohave Generating Station. APS is a 14% owner of the Navajo Generating Station, which Salt River Project operates. The D.C. Lawsuit alleges, among other things, that the defendants obtained a favorable coal royalty rate by improperly influencing the outcome of a federal administrative process under which the royalty rate was to be adjusted. The suit seeks $600 million in damages, treble damages, punitive damages of not less than $1 billion, and the ejection of defendants “from all possessory interests and Navajo Tribal lands arising out of the [primary coal lease].” In July 2001, the court dismissed all claims against Salt River Project.

     In January 2005, Peabody served APS with a lawsuit filed in the Circuit Court for the City of St. Louis naming APS and the other Navajo Generating Station participants and seeking, among other things, a declaration that the participants “are obligated to reimburse Peabody for any royalty, tax, or other obligation arising out of the D.C. Lawsuit.” Based on APS’ ownership interest in the Navajo Generating Station, APS could be liable for up to 14% of any such obligation. On July 10, 2008, Peabody agreed to dismiss this litigation without prejudice. APS cannot currently predict whether the lawsuit will be refiled based upon the final outcome of the D.C. Lawsuit.

     Superfund establishes liability for the cleanup of hazardous substances found contaminating the soil, water or air. Those who generated, transported or disposed of hazardous substances at a contaminated site are among those who are PRPs. PRPs may be strictly, and often jointly and severally, liable for clean-up. On September 3, 2003, the EPA advised APS that the EPA considers

APS to be a PRP in the Motorola 52^nd Street Superfund Site, Operable Unit 3 (OU3) in Phoenix, Arizona. APS has facilities that are within this Superfund site. APS and Pinnacle West have agreed with the EPA to perform certain investigative activities of the APS facilities within OU3. Because the investigation has not yet been completed and ultimate remediation requirements are not yet finalized, at the present time neither APS nor Pinnacle West can accurately estimate the expenditures that may be required.

     Salt River Project has notified APS that Salt River Project allegedly failed to bill APS for (a) energy losses under certain service schedules of a power contract between the parties and (b) certain other charges under the contract. Salt River Project asserts that certain of these failures to bill APS for such losses and charges may extend back to 1996 and, as a result, claims that APS owes it approximately $29 million. APS disputes that it is required to pay these amounts. No lawsuit or litigation has been initiated in the matter at this time. We do not expect that resolution of this matter will have a material adverse impact on our financial position, results of operations, or cash flows.

     We are party to various other claims, legal actions and complaints arising in the ordinary course of business, including but not limited to environmental matters related to the Clean Air Act, Navajo Nation issues and EPA and ADEQ issues. In our opinion, the ultimate resolution of these matters will not have a material adverse effect on our financial position, results of operations or cash flows.

     The Palo Verde participants have insurance for public liability resulting from nuclear energy hazards to the full limit of liability under federal law. This potential liability is covered by primary liability insurance provided by commercial insurance carriers in the amount of $300 million and the balance by an industry-wide retrospective assessment program. If losses at any nuclear power plant covered by the program exceed the accumulated funds, APS could be assessed retrospective premium adjustments. The maximum assessment per reactor under the program for each nuclear incident is approximately $101 million, subject to an annual limit of $15 million per incident, to be periodically adjusted for inflation. Based on APS’ interest in the three Palo Verde units, APS’ maximum potential assessment per incident for all three units is approximately $88 million, with an annual payment limitation of approximately $13 million.

     The Palo Verde participants maintain “all risk” (including nuclear hazards) insurance for property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $2.75 billion, a substantial portion of which must first be applied to stabilization and decontamination. APS has also secured insurance against portions of any increased cost of generation or purchased power and business interruption resulting from a sudden and unforeseen accidental outage of any of the three units. The property damage, decontamination, and replacement power coverages are provided by Nuclear Electric Insurance Limited (NEIL). APS is subject to retrospective assessments under all NEIL policies if NEIL’s losses in any policy year exceed accumulated funds. The maximum amount of retrospective assessments APS could incur under the current NEIL policies totals $20.8 million.

     The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions.

     The following table provides detail of other income and other expense for the three and six months ended June 30, 2008 and 2007 (dollars in thousands):

     We have issued parental guarantees and letters of credit and obtained surety bonds on behalf of our subsidiaries. Our parental guarantees for Pinnacle West Marketing & Trading and APS relate to commodity energy products. Our credit support instruments enable APSES to offer energy-related products and commodity energy. Non-performance or non-payment under the original contract by our subsidiaries would require performance under the guarantee or surety bond. No liability is currently recorded on the Condensed Consolidated Balance Sheets related to Pinnacle West’s current outstanding guarantees on behalf of our subsidiaries. Our guarantees have no recourse or collateral provisions to allow us to recover amounts paid under the guarantees. The amounts and approximate terms of our guarantees and surety bonds for each subsidiary at June 30, 2008 are as follows (dollars in millions):

     At June 30, 2008, Pinnacle West had approximately $7 million of letters of credit related to workers’ compensation expiring in 2009. We intend to provide from either existing or new facilities for the extension, renewal or substitution of the letters of credit to the extent required.

     APS has entered into various agreements that require letters of credit for financial assurance purposes. At June 30, 2008, approximately $200 million of letters of credit were outstanding to support existing pollution control bonds of approximately $200 million. The letters of credit are available to fund the payment of principal and interest on such debt obligations and expire in 2010. APS has also entered into approximately $79 million of letters of credit to support certain equity lessors in the Palo Verde sale leaseback transactions (see Note 9 for further details on the Palo Verde sale leaseback transactions). These letters of credit expire in 2010. Additionally, at June 30, 2008, APS had approximately $4 million of letters of credit related to counterparty collateral requirements expiring in 2008. APS intends to provide from either existing or new facilities for the extension, renewal or substitution of the letters of credit to the extent required.

     We enter into agreements that include indemnification provisions relating to liabilities arising from or related to certain of our agreements; most significantly, APS has agreed to indemnify the equity participants and other parties in the Palo Verde sale leaseback transactions with respect to certain tax matters. Generally, a maximum obligation is not explicitly stated in the indemnification provisions and, therefore, the overall maximum amount of the obligation under such indemnification provisions cannot be reasonably estimated. Based on historical experience and evaluation of the specific indemnities, we do not believe that any material loss related to such indemnification provisions is likely.

     The following table presents earnings per weighted average common share outstanding for the three and six months ended June 30, 2008 and 2007:

     Dilutive stock options and performance shares (which are contingently issuable) increased average common shares outstanding by approximately 264,000 shares and 550,000 shares for the three months ended June 30, 2008 and June 30, 2007 respectively, and by approximately 269,000 shares and 580,000 shares for the six months ended June 30, 2008 and 2007 respectively.

     Options to purchase 713,291 shares of common stock for the three-month period and 688,167 shares for the six-month period ended June 30, 2008 were outstanding but were excluded from the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares. Options to purchase shares of common stock that were excluded from the computation of diluted earnings per share for that same reason were 113,250 shares for the three-month period ended June 30, 2007. There were no such options outstanding for the six-month period ended June 30, 2007.

     SunCor (real estate segment) - In 2008 and 2007, SunCor sold or expects to sell commercial properties that are required to be reported as discontinued operations on Pinnacle West’s Condensed Consolidated Statements of Income in accordance with SFAS No. 144. The following table contains SunCor’s revenue, income before income taxes and income after income taxes classified as discontinued operations on Pinnacle West’s Condensed Consolidated Statements of Income for the three and six months ended June 30, 2008 and 2007 (dollars in millions):

     To fund the costs APS expects to incur to decommission Palo Verde, APS established external decommissioning trusts in accordance with NRC regulations. APS invests the trust funds in fixed income securities and domestic equity securities. APS applies the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” in accounting for investments in decommissioning trust funds, and classifies these investments as available for sale. As a result, we record the decommissioning trust funds at their fair value on our Condensed Consolidated Balance Sheets. Because of the ability of APS to recover decommissioning costs in rates and in accordance with the regulatory treatment for decommissioning trust funds, we have recorded the offsetting amount of gains (losses) on investment securities in other regulatory liabilities or assets. The following table summarizes the fair value of APS’ nuclear decommissioning trust fund assets at June 30, 2008 and December 31, 2007 (dollars in millions):