FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2008

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     

		Exact Name of Each Registrant as specified in its
Commission File		charter; State of Incorporation; Address; and		IRS Employer
Number		Telephone Number		Identification No.
1-8962		PINNACLE WEST CAPITAL CORPORATION		86-0512431
		(an Arizona corporation)
		400 North Fifth Street, P.O. Box 53999
		Phoenix, Arizona 85072-3999
		(602) 250-1000
1-4473		ARIZONA PUBLIC SERVICE COMPANY		86-0011170
		(an Arizona corporation)
		400 North Fifth Street, P.O. Box 53999
		Phoenix, Arizona 85072-3999
		(602) 250-1000

     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.

PINNACLE WEST CAPITAL CORPORATION Yes þ No o

ARIZONA PUBLIC SERVICE COMPANY Yes þ No o

     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 (Do not check if a smaller reporting company)		Smaller reporting company o

ARIZONA PUBLIC SERVICE COMPANY

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ (Do not check if a smaller reporting company)		Smaller reporting company o

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

PINNACLE WEST CAPITAL CORPORATION Yes o No þ

ARIZONA PUBLIC SERVICE COMPANY Yes o No þ

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

PINNACLE WEST CAPITAL CORPORATION		Number of shares of common stock, no par value, outstanding as of October 30, 2008: 100,814,563
ARIZONA PUBLIC SERVICE COMPANY		Number of shares of common stock, $2.50 par value, outstanding as of October 30, 2008: 71,264,947

          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.

 

 

TABLE OF CONTENTS

						Page
Glossary							2
Part I							4
		Item 1.		Financial Statements			4
				Pinnacle West Capital Corporation			4
				Arizona Public Service Company			31
		Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			40
		Item 3.		Quantitative and Qualitative Disclosures About Market Risk			62
		Item 4.		Controls and Procedures			62
Part II							64
		Item 1.		Legal Proceedings			64
		Item 1A.		Risk Factors			64
		Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds			64
		Item 5.		Other Information			64
		Item 6.		Exhibits			68
Signatures							70
EX-12.1
EX-12.2
EX-12.3
EX-31.1
EX-31.2
EX-31.3
EX-31.4
EX-32.1
EX-32.2

GLOSSARY

ACC — Arizona Corporation Commission

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

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PINNACLE WEST CAPITAL CORPORATION

(unaudited)

(dollars and shares in thousands, except per share amounts)

		Three Months Ended
		September 30,
		2008				2007
OPERATING REVENUES
Regulated electricity segment		$	1,040,348			$	1,043,723
Real estate segment			18,965				46,711
Marketing and trading			11,737				99,203
Other revenues			8,925				15,597
Total			1,079,975				1,205,234
OPERATING EXPENSES
Regulated electricity segment fuel and purchased power			419,979				407,242
Real estate segment operations			28,941				46,075
Marketing and trading fuel and purchased power			9,503				93,860
Operations and maintenance			212,327				178,419
Depreciation and amortization			98,568				94,730
Taxes other than income taxes			28,423				34,940
Other expenses			8,321				11,246
Total			806,062				866,512
OPERATING INCOME			273,913				338,722
OTHER
Allowance for equity funds used during construction			4,673				5,235
Other income (Note 14)			2,274				4,276
Other expense (Note 14)			(7,132	)			(6,744	)
Total			(185	)			2,767
INTEREST EXPENSE
Interest charges			51,231				53,151
Capitalized interest			(3,976	)			(5,435	)
Total			47,255				47,716
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			226,473				293,773
INCOME TAXES			75,970				92,055
INCOME FROM CONTINUING OPERATIONS			150,503				201,718
INCOME FROM DISCONTINUED OPERATIONS
Net of income tax expense of $703 and $4,571 (Note 17)			1,083				6,990
NET INCOME		$	151,586			$	208,708
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING — BASIC			100,750				100,324
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING — DILUTED			101,018				100,829
EARNINGS PER WEIGHTED-AVERAGE COMMON SHARE OUTSTANDING
Income from continuing operations — basic		$	1.49			$	2.01
Net income — basic			1.50				2.08
Income from continuing operations — diluted			1.49				2.00
Net income — diluted			1.50				2.07
DIVIDENDS DECLARED PER SHARE		$	0.525			$	0.525

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

PINNACLE WEST CAPITAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(dollars and shares in thousands, except per share amounts)

		Nine Months Ended
		September 30,
		2008				2007
OPERATING REVENUES
Regulated electricity segment		$	2,492,627			$	2,291,067
Real estate segment			103,587				171,662
Marketing and trading			119,868				264,311
Other revenues			26,824				36,113
Total			2,742,906				2,763,153
OPERATING EXPENSES
Regulated electricity segment fuel and purchased power			1,016,918				880,932
Real estate segment operations			118,906				153,328
Marketing and trading fuel and purchased power			106,270				226,337
Operations and maintenance			601,360				527,307
Depreciation and amortization			291,959				276,584
Taxes other than income taxes			94,826				104,416
Other expenses			21,081				28,537
Total			2,251,320				2,197,441
OPERATING INCOME			491,586				565,712
OTHER
Allowance for equity funds used during construction			16,211				14,874
Other income (Note 14)			10,050				11,976
Other expense (Note 14)			(22,103	)			(13,685	)
Total			4,158				13,165
INTEREST EXPENSE
Interest charges			157,580				155,104
Capitalized interest			(14,593	)			(15,455	)
Total			142,987				139,649
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			352,757				439,228
INCOME TAXES			92,489				141,809
INCOME FROM CONTINUING OPERATIONS			260,268				297,419
INCOME FROM DISCONTINUED OPERATIONS
Net of income tax expense of $13,431 and $4,446 (Note 17)			20,707				6,813
NET INCOME		$	280,975			$	304,232
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING — BASIC			100,642				100,200
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING — DILUTED			100,911				100,767
EARNINGS PER WEIGHTED-AVERAGE COMMON SHARE OUTSTANDING
Income from continuing operations — basic		$	2.59			$	2.97
Net income — basic			2.79				3.04
Income from continuing operations — diluted			2.58				2.95
Net income — diluted			2.78				3.02
DIVIDENDS DECLARED PER SHARE		$	1.575			$	1.575

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

PINNACLE WEST CAPITAL CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands)

		September 30,				December 31,
		2008				2007
ASSETS
CURRENT ASSETS
Cash and cash equivalents		$	104,528			$	56,321
Customer and other receivables			552,629				456,007
Allowance for doubtful accounts			(3,960	)			(4,782	)
Materials and supplies (at average cost)			162,969				149,759
Fossil fuel (at average cost)			28,109				27,792
Deferred income taxes			22,847				31,510
Home inventory			82,086				98,729
Assets from risk management and trading activities (Note 10)			26,534				57,605
Other current assets			23,961				33,988
Total current assets			999,703				906,929
INVESTMENTS AND OTHER ASSETS
Real estate investments — net			440,723				532,600
Assets from long-term risk management and trading activities (Note 10)			20,507				48,928
Nuclear decommissioning trust (Note 18)			359,697				379,347
Other assets			123,542				117,941
Total investments and other assets			944,469				1,078,816
PROPERTY, PLANT AND EQUIPMENT
Plant in service and held for future use			12,090,518				11,640,739
Less accumulated depreciation and amortization			4,110,345				4,004,944
Net			7,980,173				7,635,795
Construction work in progress			572,575				625,577
Intangible assets, net of accumulated amortization			134,190				105,746
Nuclear fuel, net of accumulated amortization			97,756				69,271
Total property, plant and equipment			8,784,694				8,436,389
DEFERRED DEBITS
Deferred fuel and purchased power regulatory asset (Note 5)			57,703				110,928
Other regulatory assets			559,837				514,353
Other deferred debits			106,472				114,794
Total deferred debits			724,012				740,075
TOTAL ASSETS		$	11,452,878			$	11,162,209

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

PINNACLE WEST CAPITAL CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands)

		September 30,				December 31,
		2008				2007
LIABILITIES AND COMMON STOCK EQUITY
CURRENT LIABILITIES
Accounts payable		$	307,410			$	323,346
Accrued taxes (Note 8)			145,083				269,628
Accrued interest			41,783				39,836
Short-term borrowings			441,547				340,661
Current maturities of long-term debt (Note 4)			155,817				163,773
Customer deposits			79,093				80,010
Liabilities from risk management and trading activities (Note 10)			44,795				24,510
Other current liabilities			145,808				102,685
Total current liabilities			1,361,336				1,344,449
LONG-TERM DEBT LESS CURRENT MATURITIES (NOTE 4)			3,047,404				3,127,125
DEFERRED CREDITS AND OTHER
Deferred income taxes			1,429,385				1,243,743
Regulatory liabilities			630,825				642,564
Liability for asset retirements			271,814				281,903
Liabilities for pension and other postretirement benefits (Note 6)			503,724				504,603
Liabilities from long-term risk management and trading activities (Note 10)			46,948				4,701
Other			548,457				481,510
Total deferred credits and other			3,431,153				3,159,024
COMMITMENTS AND CONTINGENCIES (SEE NOTES)
COMMON STOCK EQUITY
Common stock, no par value			2,142,475				2,135,787
Treasury stock			(2,854	)			(2,054	)
Total common stock			2,139,621				2,133,733
Accumulated other comprehensive income (loss) (Note 11):
Pension and other postretirement benefits			(43,566	)			(39,336	)
Derivative instruments			(19,056	)			23,473
Total accumulated other comprehensive loss			(62,622	)			(15,863	)
Retained earnings			1,535,986				1,413,741
Total common stock equity			3,612,985				3,531,611
TOTAL LIABILITIES AND COMMON STOCK EQUITY		$	11,452,878			$	11,162,209

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

PINNACLE WEST CAPITAL CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)

		Nine Months Ended
		September 30,
		2008				2007
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income		$	280,975			$	304,232
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization including nuclear fuel			317,366				301,383
Deferred fuel and purchased power			(104,774	)			(203,065	)
Deferred fuel and purchased power amortization			157,999				198,677
Deferred fuel and purchased power regulatory disallowance			—				14,370
Allowance for equity funds used during construction			(16,211	)			(14,874	)
Deferred income taxes			228,567				46,023
Change in mark-to-market valuations			1,411				18,907
Changes in current assets and liabilities:
Customer and other receivables			(91,038	)			(120,832	)
Materials, supplies and fossil fuel			(13,527	)			(29,786	)
Other current assets			25,906				13,351
Accounts payable			(10,571	)			(49,457	)
Other current liabilities			66,289				106,609
Expenditures for real estate investments			(17,397	)			(99,487	)
Other changes in real estate assets			34,875				4,991
Change in unrecognized tax benefits			(107,069	)			25,285
Change in margin and collateral accounts-assets			19,510				(50,367	)
Change in other long-term assets			11,152				10,260
Change in other long-term liabilities			478				1,254
Net cash flow provided by operating activities			783,941				477,474
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures			(707,685	)			(734,802	)
Contributions in aid of construction			40,950				24,447
Capitalized interest			(14,593	)			(15,455	)
Proceeds from sale of investment securities			—				69,225
Purchases of investment securities			—				(36,525	)
Proceeds from nuclear decommissioning trust sales			255,706				203,014
Investment in nuclear decommissioning trust			(271,263	)			(218,570	)
Proceeds from sale of commercial real estate investments			94,171				33,615
Other			5,628				(3,010	)
Net cash flow used for investing activities			(597,086	)			(678,061	)
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of long-term debt			88,550				181,321
Repayment of long-term debt			(179,796	)			(119,700	)
Short-term borrowings and payments — net			100,886				237,858
Dividends paid on common stock			(158,477	)			(157,772	)
Common stock equity issuance			8,165				18,626
Other			2,024				(3,042	)
Net cash flow (used for) provided by financing activities			(138,648	)			157,291
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS			48,207				(43,296	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD			56,321				87,210
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	104,528			$	43,914
Supplemental disclosure of cash flow information
Cash paid during the period for:
Income taxes, net of refunds		$	202			$	87,974
Interest, net of amounts capitalized		$	136,996			$	142,741

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

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Consolidation and Nature of Operations

          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.

2. Condensed Consolidated Financial Statements

           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); (3) “contributions in aid of construction” was previously reported as part of “capital expenditures” on the Condensed Consolidated Statements of Cash Flows; and (4) “change in unrecognized tax benefits” was previously reported as “change in other long-term liabilities” and “other current liabilities” on the Condensed Consolidated Statements of Cash Flows. Items (3) and (4) above have been disclosed separately to provide more detail.

3. Quarterly Fluctuations

          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.

4. Liquidity Matters

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

		Consolidated
Year		Pinnacle West				APS
2008		$	126			$	—
2009			46				1
2010			199				197
2011			578				401
2012			376				376
Thereafter			1,886				1,884
Total		$	3,211			$	2,859

          The credit and liquidity markets experienced significant stress beginning the week of September 15, 2008. Pinnacle West and APS have been able to access existing credit facilities, ensuring adequate

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

liquidity. Cash on hand is being invested in money market funds consisting of U.S. Treasury and government agency securities and repurchase agreements collateralized fully by U.S. Treasury and government agency securities.

          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 downgrades of their 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. When auctions of APS bonds fail, the APS bondholders receive the maximum 14% annual interest rate for the week of the failed auction. For the nine months ended September 30, 2008, we had nine failed auctions, which represented about 2% of all of our auctions. The average interest rate at the end of the third quarter on the auction rate securities was 9.8%. Subsequent to September 30, 2008, a significant number of our auctions have failed. We continue to closely 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.

           On September 11, 2008, APS repurchased at par two series of pollution control bonds that had no credit enhancements. These bonds were $7 million of its 1996 Series A Coconino County Pollution Control Bonds and $20 million of its 1999 Series A Coconino County Pollution Control Bonds (“Repurchased Bonds”). APS borrowed funds under its revolving lines of credit to re-purchase the bonds as permitted under the bond indenture. APS intends to keep the $27 million outstanding under its line of credit until the Repurchased Bonds are sold to third parties in the near future.

          Pinnacle West has a $300 million revolving credit facility that terminates in December 2010. Credit commitments totaling approximately $17 million from Lehman Brothers are no longer available due to its September 2008 bankruptcy filing. The remaining $283 million revolver is available to support the issuance of up to $250 million in commercial paper or to be used as bank borrowings, including issuances of letters of credit. At September 30, 2008, Pinnacle West had $127 million of borrowings under its revolving credit facility, approximately $7 million of letters of credit and $40 million of commercial paper. Pinnacle West had remaining capacity available under its revolver of approximately $109 million and had cash and investments of approximately $19 million.

          APS has two committed revolving credit facilities totaling $900 million that are available either to support the issuance of up to $250 million in commercial paper or to be used for bank borrowings, including issuances of letters of credit. The $400 million revolver terminates in December 2010 and the $500 million revolver terminates in September 2011. Credit commitments totaling about $34 million from Lehman Brothers are no longer available due to its September 2008 bankruptcy filing. At September 30, 2008, APS had borrowings of approximately $270 million and no letters of credit under its revolving lines of credit. APS had no commercial paper outstanding at September 30, 2008. At September 30, 2008, APS had remaining capacity available under its revolvers of $596 million and had cash and investments of approximately $76 million.

          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 September 30, 2008, APS’ common equity ratio, as defined, was 55%, its total common equity was approximately $3.5 billion, and its total capitalization was approximately $6.3 billion. APS would be prohibited from paying dividends if its

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

common equity falls below approximately $2.5 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 “Secured Revolver”). The Secured Revolver matures December 22, 2008, which SunCor expects to renew in the near future and which requires compliance with certain loan covenants pertaining to debt to net worth, debt service, liquidity, cash flow coverage and restrictions on debt. If SunCor were unable to renew the Secured Revolver, this would have a material impact on SunCor’s financial position. At September 30, 2008, SunCor had borrowings of approximately $112 million under this facility. In addition to the Secured Revolver, at September 30, 2008, SunCor had borrowings of approximately $70 million under other credit facilities which mature at various dates and also contain certain loan covenants.

          As of September 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 the covenants mentioned above was approximately $221 million out of a total of approximately $297 million. As a result of the restrictions under the ACC order referenced above and contained in the SunCor loan facilities, as of September 30, 2008, the restricted net assets of our subsidiaries exceeded 25% of our consolidated net assets (at September 30, 2008, our consolidated net assets were approximately $3.6 billion). These restrictions do not materially affect Pinnacle West’s ability to meet its ongoing capital requirements.

5. Regulatory Matters

     2008 General Rate Case

          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 updated request include:

	•		an increase of $264.3 million in non-fuel base rates and a net increase of $13.9 million for fuel and purchased power costs reflected in base rates, and recovery of up to $53 million of such increases through the impact fee;
	•		a rate base of $5.4 billion, which approximates the ACC-jurisdictional portion of the book value of utility assets, net of accumulated depreciation and other credits, as of December 31, 2007, which includes certain adjustments, such as the inclusion of Units 5 and 6 of the Yucca Power Plant (near Yuma in southwestern Arizona), the steam generator replacement at Palo Verde Unit 3, environmental upgrades to APS coal plants, and other plant additions under construction at the end of the test year that are currently in service or expected to go into service before the proposed rates are requested to become effective;
	•		the following proposed capital structure and costs of capital:

		Capital				Cost of
		Structure				Capital
Long-term debt			46.2	%			5.77	%
Common stock equity			53.8	%			11.50	%
Weighted-average cost of capital							8.86	%

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

	•		a Base Fuel Rate of $0.0388 per kWh based on estimated 2010 prices (an increase from the current Base Fuel Rate of $0.0325 per kWh, including the reclassification of $170 million of fuel and purchased power revenues from the PSA to base rates);
	•		an attrition adjustment of $79.3 million to address erosion in APS’ earnings and return on equity through 2010; and
	•		a new super-peak residential time-of-use rate and a commercial and industrial critical peak pricing proposal to allow eligible customers additional options to manage their electric bills, as well as other conservation-related rate design proposals.

          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 would 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. In addition, 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. A hearing on this matter was held in mid-September and we expect to receive a recommended order from the ALJ in the near future.

          The purpose of the interim surcharge is to 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, 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, and better position APS to fund customer-centered programs and needed infrastructure and access necessary capital on reasonable terms. The interim base rate surcharge would produce approximately $115 million in annual pretax retail revenues. APS cannot 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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 nine months ended September 30, 2008 and 2007 (dollars in millions):

		Nine Months Ended
		September 30,
		2008				2007
Beginning balance		$	111			$	160
Deferred fuel and purchased power costs-current period			103				198
Regulatory disallowance			—				(14	)
Interest on deferred fuel and purchased power			2				5
Amounts recovered through revenues			(158	)			(199	)
Ending balance		$	58			$	150

          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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 the difference between the originally requested amount and the amount agreed to in the settlement will be netted against the next annual rate change. The refund amount is not expected to have a material impact on our financial position, results of operations or cash flows. 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. The parties submitted their revision, which was accepted by the FERC on October 2, 2008.

          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 Approval

          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 August 6, 2008, the ACC issued an order permitting the infusion to occur on or before December 31, 2009.

Federal

          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

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 the 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.

6. Retirement Plans and Other Benefits

          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 nine months ended September 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):

		Pension Benefits																Other Benefits
		Three Months								Nine Months								Three Months								Nine Months
		Ended								Ended								Ended								Ended
		September 30,								September 30,								September 30,								September 30,
		2008				2007				2008				2007				2008				2007				2008				2007
Service cost-benefits earned during the period		$	13			$	13			$	39			$	38			$	4			$	3			$	13			$	14
Interest cost on benefit obligation			27				25				83				75				8				6				28				27
Expected return on plan assets			(30	)			(27	)			(89	)			(80	)			(10	)			(8	)			(32	)			(32	)
Amortization of:
Transition obligation			—				—				—				—				1				1				2				2
Prior service cost			1				1				2				2				—				—				—				—
Net actuarial loss			3				4				8				12				1				1				2				3
Net periodic benefit cost		$	14			$	16			$	43			$	47			$	4			$	3			$	13			$	14
Portion of cost charged to expense		$	6			$	7			$	19			$	21			$	2			$	2			$	6			$	6
APS’ share of costs charged to expense		$	6			$	7			$	18			$	20			$	2			$	2			$	5			$	6

Contributions

          We made a $35 million contribution to our pension plan in September 2008. Adjusted for this contribution, our plan was 94% funded on a cash-funded basis at plan year-end 2007, which is 2% over the minimum cash-funded status required by federal law under the Pension Protection Act of 2006. The contribution to our other postretirement benefit plans in 2008 is estimated to be approximately $11 million, of which $10

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

million has been contributed through October 2008. APS and other subsidiaries fund their share of the contributions. APS’ share is approximately 96% of the plans.

7. Business Segments

          Pinnacle West’s two reportable business segments are:

	•		our regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses (primarily electric service to Native Load customers) and related activities and includes electricity generation, transmission and distribution; and
	•		our real estate segment, which consists of SunCor’s real estate development and investment activities.

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Operating Revenues:
Regulated electricity segment		$	1,040			$	1,044			$	2,493			$	2,291
Real estate segment			19				46				103				171
All other (a)			21				115				147				301
Total		$	1,080			$	1,205			$	2,743			$	2,763
Net Income (Loss):
Regulated electricity segment		$	158			$	205			$	273			$	278
Real estate segment			(6	)			6				8				16
All other (a)			—				(2	)			—				10
Total		$	152			$	209			$	281			$	304

		As of				As of
		September 30, 2008				December 31, 2007
Assets:
Regulated electricity segment		$	10,724			$	10,356
Real estate segment			568				661
All other (a)			161				145
Total		$	11,453			$	11,162

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

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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. As a result of this settlement, we were required to reverse a portion of accelerated deductions previously claimed. Also as a result of this settlement, the favorable resolution of other various tax matters, 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 have resulted in a net decrease in uncertain tax positions of $107 million through September 30, 2008.

          As of September 30, 2008, the tax year ended December 31, 2005 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.

9. Variable-Interest Entities

          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 September 30, 2008, APS would have been required to assume approximately $188 million of debt and pay the equity participants approximately $169 million.

10. Derivative and Energy Trading Accounting

          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 power, gas and emission allowances and credits. As of September 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.

          We consider the probability of counterparty default in evaluating the effectiveness of our cash flow hedges and the expected performance of counterparties where we have elected the “normal purchases and sales” exception under FAS 133. Neither our cash flow hedges or our “normal” exception was significantly affected by changes in counterparty credit in the periods presented.

Cash Flow Hedges

          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 nine months ended September 30, 2008 and 2007 are comprised of the following (dollars in thousands):

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Gains (losses) on the ineffective portion of derivatives qualifying for hedge accounting		$	(2,483	)		$	(239	)		$	(78	)		$	1,094
Gains from the discontinuance of cash flow hedges			—				6				—				320

          During the twelve months ending September 30, 2009, we estimate that a net loss of $21 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 amounts 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.

FIN 39-1

          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):

		As originally				Reclassifications
		reported in the				as a result of the
		2007				adoption of				After adoption of
Balance Sheet - December 31, 2007		Form 10-K				FIN 39-1				FIN 39-1
Current Assets — Assets from risk management and trading activities		$	97,373			$	(39,768	)		$	57,605
Current Assets — Other current assets			34,738				(750	)			33,988
Investments and Other Assets — Assets from long-term risk management and trading activities			89,913				(40,985	)			48,928
Current Liabilities — Liabilities from risk management and trading activities			65,028				(40,518	)			24,510
Deferred Credits and Other — Liabilities from long-term risk management and trading activities			45,686				(40,985	)			4,701

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		As originally				Reclassifications
		reported in the				as a result of the
Statement of Cash Flows —		September 30,				adoption of				After adoption
Nine months ended September 30, 2007		2007 Form 10-Q				FIN 39-1				of FIN 39-1
Change in other long-term assets		$	29,877			$	(19,617	)		$	10,260
Change in margin and collateral accounts — assets			—				(50,367	)			(50,367	)
Change in risk management and trading — liabilities			(13,959	)			13,959				—
Change in other long-term liabilities			54,846				7,922				62,768	(a)
Collateral			(48,103	)			48,103				—

          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):

						Investments								Deferred
		Current				and Other				Current				Credits and				Net Asset
September 30, 2008		Assets				Assets				Liabilities				Other				(Liability)
Mark-to-market		$	14,773			$	20,507			$	(69,886	)		$	(50,554	)		$	(85,160	)
Margin account			13,019				—				20,841				3,606				37,466
Collateral provided to counterparties			543				—				4,250				—				4,793
Collateral provided from counterparties			(1,801	)			—				—				—				(1,801	)
Total		$	26,534			$	20,507			$	(44,795	)		$	(46,948	)		$	(44,702	)

						Investments								Deferred
		Current				and Other				Current				Credits and
December 31, 2007		Assets				Assets				Liabilities				Other				Net Asset
Mark-to-market		$	26,333			$	48,928			$	(30,786	)		$	(4,701	)		$	39,774
Margin account			30,650				—				6,148				—				36,798
Collateral provided to counterparties			622				—				128				—				750
Collateral provided from counterparties			—				—				—				—				—
Total		$	57,605			$	48,928			$	(24,510	)		$	(4,701	)		$	77,322

          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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Credit Risk

          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 56% of Pinnacle West’s $47 million of risk management and trading assets as of September 30, 2008. This exposure relates to a long-term traditional wholesale contract with a counterparty that has very high credit quality. 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, 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 and standardized agreements that allow for the netting of positive and negative exposures associated with a single counterparty. Valuation adjustments are established representing our estimated credit losses on our overall exposure to counterparties.

11. Comprehensive Income

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

		Three Months								Nine Months
		Ended September 30,								Ended September 30,
		2008				2007				2008				2007
Net income		$	151,586			$	208,708			$	280,975			$	304,232
Other comprehensive loss:
Net unrealized gains (losses) on derivative instruments (a)			(348,207	)			(44,715	)			12,584				(15,035	)
Net reclassification of realized (gains) losses to income (b)			(43,718	)			17,989				(82,488	)			(1,072	)
Net unrealized gains (losses) related to pension and other postretirement benefits (c)			—				605				(10,595	)			(43,968	)
Reclassification of pension and other postretirement benefits to income			1,175				1,223				3,522				1,702
Income tax benefit related to items of other comprehensive income			153,043				9,764				30,218				22,917
Total other comprehensive loss			(237,707	)			(15,134	)			(46,759	)			(35,456	)
Comprehensive income (loss)		$	(86,121	)		$	193,574			$	234,216			$	268,776

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

12. Commitments and Contingencies

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. In August 2008, the United States Court of Appeals for the Federal Circuit issued decisions in three damages actions brought by other nuclear utilities that could result in a decrease in the amount of our recoverable damages; however, additional appeals in those actions are possible and APS continues to monitor the status of those actions. A trial in the APS matter 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 September 30, 2008, APS had a regulatory liability of $20 million that represents amounts recovered in retail rates in excess of amounts spent for on-site interim spent fuel storage.

Fuel and Purchased Power Commitments

           Pinnacle West and APS are parties to various fuel and purchased power contracts that include required purchase provisions. Pinnacle West estimates the contract requirements to be approximately $468 million in 2008; $426 million in 2009; $357 million in 2010; $307 million in 2011; $400 million in 2012; and $6.2 billion thereafter. APS estimates the contract requirements to be approximately $425 million in 2008; $426 million in 2009; $357 million in 2010; $307 million in 2011; $400 million in 2012; and $6.2 billion thereafter. However, these amounts may vary significantly pursuant to certain provisions in such contracts that permit us to decrease required purchases under certain circumstances. These amounts have increased since the 2007 Form 10-K primarily due to contingent obligations related to renewable energy contracts, primarily the 280MW solar project described in “Portfolio Resources —Alternative Generation Sources” in Part I, Item 1 of the 2007 Form 10-K.

California Energy Market Issues and Refunds in the Pacific Northwest

          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

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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.

Navajo Nation Litigation

          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

          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 are jointly and severally, liable for

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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

          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.

Litigation

          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.

13. Nuclear Insurance

          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 $118 million, subject to an annual limit of $18 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 $103 million, with an annual payment limitation of approximately $15 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 approximately $21 million. The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

14. Other Income and Other Expense

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Other income:
Interest income		$	1,082			$	2,921			$	6,559			$	8,283
SunCor other income (a)			710				778				2,347				2,136
Miscellaneous			482				577				1,144				1,557
Total other income		$	2,274			$	4,276			$	10,050			$	11,976
Other expense:
Non-operating costs		$	(2,226	)		$	(3,552	)		$	(8,581	)		$	(9,207	)
Investment losses — net			(4,698	)			(2,070	)			(12,906	)			(1,128	)
Miscellaneous			(208	)			(1,122	)			(616	)			(3,350	)
Total other expense		$	(7,132	)		$	(6,744	)		$	(22,103	)		$	(13,685	)

15. Guarantees

          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 September 30, 2008 are as follows (dollars in millions):

		Guarantees								Surety Bonds
						Term								Term
		Amount				(in years)				Amount				(in years)
Parental:
Pinnacle West Marketing & Trading		$	2				1			$	—				—
APSES			14				1				9				1
APS			4				1				—				—
Total		$	20							$	9

          At September 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.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

          APS has entered into various agreements that require letters of credit for financial assurance purposes. At September 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 $78 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. 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.

16. Earnings Per Share

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

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Basic earnings per share:
Income from continuing operations		$	1.49			$	2.01			$	2.59			$	2.97
Income from discontinued operations			0.01				0.07				0.20				0.07
Earnings per share — basic		$	1.50			$	2.08			$	2.79			$	3.04
Diluted earnings per share:
Income from continuing operations		$	1.49			$	2.00			$	2.58			$	2.95
Income from discontinued operations			0.01				0.07				0.20				0.07
Earnings per share — diluted		$	1.50			$	2.07			$	2.78			$	3.02

          Dilutive stock options and performance shares (which are contingently issuable) increased average common shares outstanding by approximately 268,000 shares and 505,000 shares for the three months ended September 30, 2008 and September 30, 2007, respectively, and by approximately 269,000 shares and 567,000 shares for the nine months ended September 30, 2008 and 2007, respectively.

          Options to purchase 679,000 shares of common stock for the three-month period and 600,778 shares for the nine-month period ended September 30, 2008 were outstanding but were excluded from the computation of diluted earnings per share because the options’ exercise prices were higher than the average market price of the common shares. Options to purchase 610,250 shares of common stock for the three-month period and 115,200 shares for the nine-month period ended September 30, 2007 were outstanding but were excluded from the computation of diluted earnings per share because the options’ exercise prices were higher than the average market price of the common shares.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

17. Discontinued Operations

          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 nine months ended September 30, 2008 and 2007 (dollars in millions):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Revenue		$	1			$	1			$	1			$	4
Income before income taxes			2				12				34				11
Income after income taxes			1				7				21				7

18. Nuclear Decommissioning Trust

          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 September 30, 2008 and December 31, 2007 (dollars in millions):

						Total				Total
		Trust Fund				Unrealized				Unrealized
		Assets				Gains				Losses
September 30, 2008
Equity securities — fair value		$	143			$	37			$	(3	)
Fixed income securities — fair value			215				3				(6	)
Net receivables (a)			2				—				—
Total		$	360			$	40			$	(9	)

December 31, 2007
Equity securities — fair value		$	175			$	68			$	—
Fixed income securities — fair value			204				5				(1	)
Total		$	379			$	73			$	(1	)

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

          The costs of securities sold are determined on the basis of specific identification. The following table sets forth approximate gains and losses and proceeds from the sale of securities by the nuclear decommissioning trust funds (dollars in millions):

		Three Months Ended								Nine Months Ended
		September 30,								September 30,
		2008				2007				2008				2007
Realized gains		$	—			$	—			$	2			$	2
Realized losses			(2	)			(1	)			(4	)			(3	)
Proceeds from the sale of securities			67				70				256				203

          The fair value of fixed income securities, summarized by contractual maturities, at September 30, 2008 is as follows (dollars in millions):

Fair Value		September 30, 2008
Less than one year		$	7
1 year - 5 years			45
5 years - 10 years			41
Greater than 10 years			122
Total		$	215

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

19. New Accounting Standards

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

          See Notes 10 and S-1 for discussions of FASB Staff Position No. FIN 39-1, “Amendment of FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts” (FIN 39-1), which we adopted January 1, 2008.

          SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities,” was effective for us on January 1, 2008. This guidance provides companies with an option to report selected financial assets and liabilities at fair value. We did not elect the fair value option for any of our financial assets or liabilities. Therefore, SFAS No. 159 did not have an impact on our financial statements.

          In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities.” This guidance requires enhanced disclosures about derivative instruments and hedging activities. The Statement is effective for us on January 1, 2009. We do not expect it to have a material impact on our financial statements.

          In October 2008, the FASB issued FASB Staff Position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” This guidance clarifies the application of SFAS No 157, “Fair Value Measurements”, in a market that is not active and provides guidance on key considerations in determining the fair value of a financial asset when the market for the asset is not active. We adopted this guidance in the third quarter of 2008. It did not have a material impact on our financial statements. See Note 20 for a discussion of fair value measurements.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

20. Fair Value Measurements

          We adopted SFAS No. 157, “Fair Value Measurements,” on January 1, 2008. This new standard defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. We apply fair value measurements to derivative instruments and nuclear decommissioning trust assets. The adoption of SFAS No. 157 did not have a material impact on our financial statements.

          SFAS No. 157 requires companies to disclose the fair value of certain assets and liabilities according to a fair value hierarchy. This hierarchy ranks the quality and reliability of the inputs used to determine fair values, which are then classified and disclosed in one of three categories. The three levels of the fair value hierarchy are:

	•		Level 1 — quoted prices in active markets for identical assets or liabilities.
	•		Level 2 — quoted prices in active markets for similar assets or liabilities; quoted prices in markets that are not active; and model-derived valuations whose inputs are observable.
	•		Level 3 — model-derived valuations with unobservable inputs that are supported by little or no market activity.

          As required by SFAS No. 157, assets and liabilities are classified based on the lowest level of input that is significant to the fair value measurement. The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. The following table presents the fair value at September 30, 2008 of our assets and liabilities that are measured at fair value on a recurring basis for Pinnacle West Consolidated (substantially all of this fair value is recorded at APS) (dollars in millions):

		Quoted Prices
		in Active				Significant
		Markets for				Other				Significant
		Identical				Observable				Unobservable								Balance at
		Assets				Inputs				Inputs				Counterparty				September 30,
Pinnacle West:		(Level 1)				(Level 2)				(Level 3)				Netting				2008
Assets
Risk management and trading activities (a)		$	29			$	65			$	32			$	(91	)		$	35
Nuclear decommissioning trust (b)			33				325				—				—				358
Total		$	62			$	390			$	32			$	(91	)		$	393
Liabilities
Risk management and trading activities (a)		$	(45	)		$	(114	)		$	(52	)		$	91			$	(120	)