(Report on Form 10-Q for the fiscal quarter ended June 30, 2005)
Set forth below and in other documents we file with the Securities and Exchange Commission are
risks and uncertainties that could affect our financial results.
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 Arizona Corporation Commission (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 our service
area in 1999 and 2000, there are currently no active retail competitors offering unbundled energy
or other utility services to our customers. As a result, we cannot predict when, and the extent to
which, additional competitors will re-enter our 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. As competition
continues to increase, our financial position and results of operations could be adversely
affected.
We are subject to complex government regulation that may have a negative impact on our
business and our results of operations.
We are subject to governmental regulation that may have a negative impact on our business and
results of operations. We are a “subsidiary company” of a “holding company” within the meaning of
the Public Utility Holding Company Act of 1935 (“PUHCA”); however, we are exempt from the
provisions of PUHCA (except Section 9(a)(2) thereof) by virtue of the filing of an annual exemption
statement with the Securities and Exchange Commission (the “SEC”) by our parent company, Pinnacle
West Capital Corporation (“Pinnacle West”).
We are subject to comprehensive regulation by several federal, state and local regulatory
agencies, which significantly influence our operating environment and may affect our ability to
recover costs from utility customers. We are required to have numerous permits, approvals and
certificates from the agencies that regulate our business. The FERC, the Nuclear Regulatory
Commission (“NRC”), the Environmental Protection Agency (“EPA”), and the ACC regulate many aspects
of our utility operations, including siting and construction of facilities, customer service and
the rates that we can charge customers. We believe the necessary permits, approvals and
certificates have been obtained for our 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 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
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 our customers, could have
a material adverse effect on our results of operations.
There are inherent risks in the operation of nuclear facilities, such as environmental, health
and financial risks and the risk of terrorist attack.
We have an ownership interest in and operate, on behalf of a group of owners, the Palo Verde
Nuclear Generating Station (“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.
The uncertain outcome regarding the creation of regional transmission organizations, or RTOs,
may materially impact our operations, cash flows or financial position.
In a December 1999 order, the FERC established characteristics and functions that must be met
by utilities in forming and operating RTOs. The characteristics for an acceptable RTO include
independence from market participants, operational control over a region large enough to support
efficient and nondiscriminatory markets and exclusive authority to maintain short-term reliability.
Additionally, in a pending notice of proposed rulemaking, the FERC is considering implementing a
standard market design for wholesale markets. On October 16, 2001, we and other owners of electric
transmission lines in the southwestern U.S. filed with the FERC a request for a declaratory order
confirming that our proposal to form WestConnect RTO, LLC would satisfy the FERC’s requirements for
the formation of an RTO. On October 10, 2002, the FERC issued an order finding that the WestConnect
proposal, if modified to address specified issues, could meet the FERC’s RTO requirements and
provide the basic framework for a standard market design for the southwestern U.S. Since that
time, we have been evaluating a phased approach to RTO implementation in the desert Southwest. We
are currently participating with other entities in the southwestern U.S. in a cost/benefit analysis
of implementing the WestConnect RTO, the results of which are expected to be completed in 2005.
If we ultimately join an RTO, we could incur increased transmission-related costs and receive
reduced transmission service revenues; we may be required to expand our transmission system
according to decisions made by the RTO rather than our internal planning process; and we may
experience other impacts on our operations, cash flows or financial position that will not be
quantifiable until the final tariffs and other material terms of the RTO are known.
Recent events in the energy markets that are beyond our control may have negative impacts on
our business.
As a result of the energy crisis in California during the summer of 2001, the recent
volatility of natural gas prices in North America, the filing of bankruptcy by the Enron
Corporation, and investigations by governmental authorities into energy trading activities,
companies generally in the regulated and unregulated utility businesses have been under an
increased amount of public and regulatory scrutiny. The capital markets and rating agencies also
have increased their level of scrutiny. We believe that we are in material compliance with all
applicable laws, but it is difficult or impossible to predict or control what effect these or
related issues may have on our business or our access to the capital markets.
Our results of operations can be adversely affected by milder weather.
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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.
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 or a downgrade of
our credit ratings 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;
•
capital market conditions generally;
•
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.
A significant 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
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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 by
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. Continuation of recent decreases in the discount rate would 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
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 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. Some of those judgments can
be subjective and complex, and actual results could differ from those estimates. 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. We had approximately $174 million of regulatory
assets on our Condensed Balance Sheets at June 30, 2005.
•
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, changes in the
fair value of the derivative are recognized in common stock equity (as
a component of other comprehensive income (loss)).
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Dates Referenced Herein and Documents Incorporated by Reference
