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 March 31, 2006

OR

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

     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 o		No þ

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.

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

     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 May 3, 2006: 99,197,295
ARIZONA PUBLIC SERVICE COMPANY		Number of shares of common stock, $2.50 par value, outstanding as of May 3, 2006: 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			61
Item 4.		Controls and Procedures			61
Part II					62
Item 1.		Legal Proceedings			62
Item 1A.		Risk Factors			62
Item 5.		Other Information			62
Item 6.		Exhibits			63
Signatures					65
Exhibit 12.1
Exhibit 12.2
Exhibit 12.3
Exhibit 31.1
Exhibit 31.2
Exhibit 31.3
Exhibit 31.4
Exhibit 32.1
Exhibit 32.2
Exhibit 99.1
Exhibit 99.2

GLOSSARY

ACC – Arizona Corporation Commission

ADEQ – Arizona Department of Environmental Quality

ALJ – Administrative Law Judge

APB – Accounting Principles Board

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

APS Energy Services – APS Energy Services Company, Inc., a subsidiary of the Company

Clean Air Act – Clean Air Act, as amended

Company – Pinnacle West Capital Corporation

Credit Agreement – Pinnacle West’s $300 million Amended and Restated Credit Agreement, dated as of December 9, 2005

DOE – United States Department of Energy

EITF – FASB’s Emerging Issues Task Force

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

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

IRS – United States Internal Revenue Service

kWh – kilowatt-hour

Moody’s – Moody’s Investors Service

MWh – megawatt-hours, one million watts per hour

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

NPC – Nevada Power Company

NRC – United States Nuclear Regulatory Commission

OCI – other comprehensive income

Off-System Sales – sales of electricity from generation owned 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

PRP – potentially responsible party

PSA – power supply adjustor

PWEC Dedicated Assets – the following power plants, each of which was transferred by Pinnacle West Energy to APS on July 29, 2005: Redhawk Units 1 and 2, West Phoenix Units 4 and 5 and Saguaro Unit 3

Retail Fuel and Power Costs – fuel and purchased power costs eligible to be deferred under the PSA

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

SEC – United States Securities and Exchange Commission

SFAS – Statement of Financial Accounting Standards

Silverhawk – Silverhawk Power Station, a 570-megawatt, natural gas-fueled, combined-cycle electric generating facility located 20 miles north of Las Vegas, Nevada

Standard & Poor’s – Standard & Poor’s Corporation

SunCor – SunCor Development Company, a subsidiary of the Company

Sundance Plant – 450-megawatt generating facility located approximately 55 miles southeast of Phoenix, Arizona

Superfund – Comprehensive Environmental Response, Compensation and Liability Act

Trading – energy-related activities entered into with the objective of generating profits on changes in market prices

2005 Form 10-K – Pinnacle West/APS Annual Report on Form 10-K for the fiscal year ended December 31, 2005

VIE – variable interest entity

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

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

		Three Months Ended
		March 31,
		2006				2005
OPERATING REVENUES
Regulated electricity segment		$	466,126			$	416,030
Marketing and trading segment			85,002				89,257
Real estate segment			107,854				69,936
Other revenues			11,224				10,135
Total			670,206				585,358
OPERATING EXPENSES
Regulated electricity segment fuel and purchased power			157,395				78,423
Marketing and trading segment fuel and purchased power			74,175				70,809
Operations and maintenance			178,427				155,084
Real estate segment operations			71,330				55,334
Depreciation and amortization			87,621				90,944
Taxes other than income taxes			35,573				34,565
Other expenses			8,522				8,374
Total			613,043				493,533
OPERATING INCOME			57,163				91,825
OTHER
Allowance for equity funds used during construction			3,801				2,603
Other income (Note 14)			5,467				1,726
Other expense (Note 14)			(4,541	)			(5,309	)
Total			4,727				(980	)
INTEREST EXPENSE
Interest charges			47,526				45,965
Capitalized interest			(4,024	)			(3,289	)
Total			43,502				42,676
INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES			18,388				48,169
INCOME TAXES			6,793				18,570
INCOME FROM CONTINUING OPERATIONS			11,595				29,599
INCOME (LOSS) FROM DISCONTINUED OPERATIONS
Net of income tax expense (benefit) of $557 and $(3,320) (Note 17)			860				(5,151	)
NET INCOME		$	12,455			$	24,448
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING – BASIC			99,115				91,962
WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING – DILUTED			99,449				92,045
EARNINGS PER WEIGHTED – AVERAGE COMMON SHARE OUTSTANDING
Income from continuing operations – basic		$	0.12			$	0.32
Net income – basic			0.13				0.27
Income from continuing operations – diluted			0.12				0.32
Net income – diluted			0.13				0.27
DIVIDENDS DECLARED PER SHARE		$	1.00			$	0.95

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

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

		March 31,				December 31,
		2006				2005
ASSETS
CURRENT ASSETS
Cash and cash equivalents		$	314,855			$	154,003
Customer and other receivables			379,730				502,681
Allowance for doubtful accounts			(4,596	)			(4,979	)
Materials and supplies (at average cost)			112,350				109,736
Fossil fuel (at average cost)			22,145				23,658
Assets from risk management and trading activities (Note 10)			501,871				827,779
Assets held for sale (Note 17)			—				202,645
Other current assets			83,406				75,869
Total current assets			1,409,761				1,891,392
INVESTMENTS AND OTHER ASSETS
Real estate investments – net			427,297				390,702
Assets from long-term risk management and trading activities (Note 10)			385,100				597,831
Decommissioning trust accounts			305,096				293,943
Other assets			119,264				111,931
Total investments and other assets			1,236,757				1,394,407
PROPERTY, PLANT AND EQUIPMENT
Plant in service and held for future use			10,838,110				10,727,695
Less accumulated depreciation and amortization			3,672,003				3,622,884
Total			7,166,107				7,104,811
Construction work in progress			307,950				327,172
Intangible assets, net of accumulated amortization			109,435				90,916
Nuclear fuel, net of accumulated amortization			61,806				54,184
Net property, plant and equipment			7,645,298				7,577,083
DEFERRED DEBITS
Deferred fuel and purchased power regulatory asset (Note 5)			169,486				172,756
Other regulatory assets			167,155				151,123
Other deferred debits			127,671				135,884
Total deferred debits			464,312				459,763
TOTAL ASSETS		$	10,756,128			$	11,322,645

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

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

		March 31,				December 31,
		2006				2005
LIABILITIES AND COMMON STOCK EQUITY
CURRENT LIABILITIES
Accounts payable		$	259,149			$	377,107
Accrued taxes			326,948				289,235
Accrued interest			48,828				31,774
Dividends payable			49,588				—
Short-term borrowings			10,603				15,673
Current maturities of long-term debt			384,055				384,947
Customer deposits			64,242				60,509
Deferred income taxes			32,160				94,710
Liabilities from risk management and trading activities (Note 10)			490,460				720,693
Other current liabilities (Note 10)			130,888				297,425
Total current liabilities			1,796,921				2,272,073
LONG-TERM DEBT LESS CURRENT MATURITIES			2,782,227				2,608,455
DEFERRED CREDITS AND OTHER
Deferred income taxes			1,202,226				1,225,253
Regulatory liabilities			571,939				592,494
Liability for asset retirements			273,238				269,011
Pension liability			285,735				264,476
Liabilities from long-term risk management and trading activities (Note 10)			230,629				256,413
Unamortized gain – sale of utility plant			44,613				45,757
Other			357,869				363,749
Total deferred credits and other			2,966,249				3,017,153
COMMITMENTS AND CONTINGENCIES (Notes 5, 12, 13 and 15)
COMMON STOCK EQUITY
Common stock, no par value			2,075,157				2,067,377
Treasury stock			(895	)			(1,245	)
Total common stock			2,074,262				2,066,132
Accumulated other comprehensive income (loss) (Note 11):
Minimum pension liability adjustment			(97,277	)			(97,277	)
Derivative instruments			126,775				262,397
Total accumulated other comprehensive income			29,498				165,120
Retained earnings			1,106,971				1,193,712
Total common stock equity			3,210,731				3,424,964
TOTAL LIABILITIES AND COMMON STOCK EQUITY		$	10,756,128			$	11,322,645

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

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

		Three Months Ended
		March 31,
		2006				2005 (a)
CASH FLOWS FROM OPERATING ACTIVITIES
Net Income		$	12,455			$	24,448
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization including nuclear fuel			95,072				99,556
Deferred fuel and purchased power			(14,538	)			—
Deferred fuel amortization			17,808				—
Allowance for equity funds used during construction			(3,801	)			(2,603	)
Deferred income taxes			1,757				(4,281	)
Change in mark-to-market valuations			9,305				(18,557	)
Changes in current assets and liabilities:
Customer and other receivables			129,940				117,132
Materials, supplies and fossil fuel			4,186				(9,967	)
Other current assets			(7,537	)			(10,265	)
Accounts payable			(124,577	)			(179,467	)
Accrued taxes			37,713				31,768
Other current liabilities			24,940				22,113
Proceeds from the sale of real estate assets			7,884				19,427
Real estate investments			(28,670	)			(13,797	)
Change in risk management and trading – assets			67,984				(1,198	)
Change in risk management and trading – liabilities			(66,096	)			37,707
Collateral			(170,690	)			32,946
Change in other long-term assets			(2,247	)			(1,676	)
Change in other long-term liabilities			12,169				19,064
Net cash flow provided by operating activities			3,057				162,350
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures			(167,367	)			(121,120	)
Proceeds from the sale of Silverhawk			207,620				—
Capitalized interest			(4,024	)			(3,289	)
Purchases of investment securities			(269,526	)			(343,525	)
Proceeds from sale of investment securities			269,526				424,700
Proceeds from nuclear decommissioning trust sales			33,743				39,777
Investment in nuclear decommissioning trust			(38,929	)			(42,638	)
Proceeds from real estate investments			2,138				1,869
Other			(1,484	)			8,999
Net cash flow provided by (used for) investing activities			31,697				(35,227	)
CASH FLOWS FROM FINANCING ACTIVITIES
Issuance of long-term debt			206,848				163,999
Short-term borrowings and payments – net			(70	)			(7,778	)
Dividends paid on common stock			(49,608	)			(43,666	)
Repayment of long-term debt			(39,587	)			(264,805	)
Common stock equity issuance			5,065				12,649
Other			3,450				21,228
Net cash flow provided by (used for) financing activities			126,098				(118,373	)
NET INCREASE IN CASH AND CASH EQUIVALENTS			160,852				8,750
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD			154,003				163,366
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	314,855			$	172,116
Supplemental disclosure of cash flow information
Cash paid during the period for:
Income taxes paid, net of refunds		$	(40	)		$	15,230
Interest paid, net of amounts capitalized		$	25,526			$	33,891

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 wholly-owned subsidiaries: APS, Pinnacle West Energy, APS Energy Services, SunCor and El Dorado. All significant 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. We have reclassified certain prior year amounts to conform to the current year presentation.

     In the second quarter of 2005, Pinnacle West revised the presentation of its statements of cash flows to include the cash flows from discontinued operations within the categories of operating, investing, and financing activities. A summary of the effects of the change in presentation on the Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2005 is as follows (dollars in millions):

		Three Months Ended
		March 31, 2005
Net cash flows from operating activities as previously reported		$	196
Change in net cash flows from discontinued operations			(34	)
Net cash flows from operating activities as currently reported		$	162
Net cash flows used for investing activities as previously reported		$	(40	)
Change in net cash flows used for discontinued operations			5
Net cash flows used for investing activities as currently reported		$	(35	)
Net cash flows used for financing activities as previously reported		$	(147	)
Change in net cash flows used for discontinued operations			29
Net cash flows used for financing activities as currently reported		$	(118	)

2. Condensed Consolidated Financial Statements

     Our unaudited condensed consolidated financial statements reflect all adjustments which we believe are necessary for the fair presentation of our financial position, results of operations and cash flows for the periods presented. We suggest that these condensed consolidated financial statements and notes to condensed consolidated financial statements be read along with the consolidated financial statements and notes to consolidated financial statements included in our 2005 Form 10-K.

3. Quarterly Fluctuations

     Weather conditions cause significant seasonal fluctuations in our revenues. In addition, real estate and trading and wholesale marketing activities can have significant impacts on our results for

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

interim periods. For these reasons, results for interim periods do not necessarily represent results to be expected for the year.

4. Changes in Liquidity

      In January 2006, Pinnacle West infused into APS $210 million of the proceeds from the sale of Silverhawk. See “Equity Infusions” in Note 5 for more information.

     On February 28, 2006, Pinnacle West entered into an Uncommitted Master Shelf Agreement with Prudential Investment Management, Inc. (“Prudential”) and certain of its affiliates. The agreement provides the terms under which Pinnacle West may offer up to $200 million of its senior notes for purchase by Prudential affiliates at any time prior to December 31, 2007. The maturity of notes issued under the agreement cannot exceed five years. Pursuant to the agreement, on February 28, 2006, Pinnacle West issued and sold to Prudential affiliates $175 million aggregate principal amount of its 5.91% Senior Notes, Series A, due February 28, 2011 (the “Series A Notes”).

     On April 3, 2006, Pinnacle West repaid $300 million of its 6.40% Senior Notes due April 2006. Pinnacle West used the proceeds of the Series A Notes, cash on hand and commercial paper proceeds to repay these notes.

     The following table shows principal payments due on Pinnacle West’s and APS’ total long-term debt and capitalized lease requirements (dollars in millions) as of March 31, 2006:

Year		Pinnacle West				APS
2006		$	386			$	85
2007			2				1
2008			112				1
2009			10				1
2010			228				224
Thereafter			2,439				2,262

5. Regulatory Matters

APS General Rate Case

     On January 31, 2006, APS filed with the ACC updated financial schedules, testimony and other data in the general rate case that APS originally filed on November 4, 2005. As requested by the ACC staff, the updated information uses the twelve months ended September 30, 2005 as the test period instead of the test year ended December 31, 2004 used in APS’ original filing. As a result of the updated filing, APS is requesting a 21.3%, or $453.9 million, increase in its annual retail electricity revenues effective no later than December 31, 2006. The original filing requested a 19.9%, or $409.1 million, retail rate increase.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

     The updated requested rate increase is designed to recover the following (dollars in millions):

		Updated Filing								Original Filing
		(January 31, 2006)								(November 4, 2005)
		Annual								Annual
		Revenue				Percentage				Revenue				Percentage
		Increase				Increase				Increase				Increase
Increased fuel and purchased power		$	299.0				14.0	%		$	246.8				12.0	%
Capital structure update			98.3				4.6	%			96.8				4.7	%
Rate base update, including acquisition of Sundance Plant			46.2				2.2	%			42.5				2.1	%
Pension funding			41.3				1.9	%			41.2				2.0	%
Other items			(30.9	)			(1.4	)%			(18.2	)			(0.9	)%
Total increase		$	453.9				21.3	%		$	409.1				19.9	%

     The request is based on (a) a rate base of $4.4 billion as of September 30, 2005; (b) a base rate for fuel and purchased power costs of $0.031904 per kilowatt-hour based on estimated 2006 prices; and (c) a proposed capital structure of 45% long-term debt and 55% common stock equity, with a weighted-average cost of capital of 8.73% (5.41% for long-term debt and 11.50% for common stock equity). The requested increase in annual retail electricity revenues from the original filing is based solely on increased fuel and purchased power costs, slightly offset by other items (see the above chart). If the ACC approves the requested base rate increase for fuel and purchased power costs (see clause (b) of this paragraph), subsequent PSA rate adjustments and/or PSA surcharges would be reduced because more of such costs would be recovered in base rates.

     The updated request does not include the PSA annual adjustor rate increase of approximately 5% that took effect February 1, 2006 or the pending application for a PSA surcharge that APS filed on February 2, 2006. See “Power Supply Adjustor” below.

Interim Rate Increase

     On January 6, 2006, APS filed with the ACC an application requesting an emergency interim rate increase of $299 million, or approximately 14%, to be effective April 1, 2006. APS later reduced this request to $232 million, or approximately 11%, due to a decline in expected 2006 natural gas and wholesale power prices. The purpose of the emergency interim rate increase is solely to address APS’ under-collection of higher annual fuel and purchased power costs. On May 2, 2006, the ACC approved an order in this matter that, among other things:

•

authorizes an interim PSA adjustor, effective May 1, 2006, that will result in an interim retail rate increase of approximately 8.3% designed to recover approximately $138 million of fuel and purchased power costs during 2006 (this interim adjustor, combined with the $15 million PSA surcharge approved by the ACC (see “Application for PSA Surcharges” below), will result in a rate increase of

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

			approximately 9.0% designed to recover approximately $149 million of fuel and purchased power costs during 2006);
	•		provides that amounts collected through the interim PSA adjustor “remain subject to a prudency review at the appropriate time” and that “all unplanned Palo Verde outage costs for 2006 should undergo a prudence audit by [the ACC] Staff” (PSA deferrals related to these outages are estimated to be about $32 million during the quarter ended March 31, 2006);
	•		encourages parties to APS’ general rate case to “propose modifications to the PSA that will address on a permanent basis, the issues with timing of recovery when deferrals are large and growing”;
	•		affirms APS’ ability to defer fuel and purchased power costs above the prior annual cap of $776.2 million until the ACC decides the general rate case; and
	•		encourages APS to diversify its resources “through large scale, sustained energy efficiency programs, [using] low cost renewable energy resources as a hedge against high fossil fuel costs.”

The interim PSA adjustor accelerates recovery of the fuel and purchased power component of APS’ general rate case and is not an additional increase.

Power Supply Adjustor

     PSA Provisions

     The PSA approved by the ACC in April 2005 as part of APS’ 2003 rate case provides for adjustment of retail rates to reflect variations in retail fuel and purchased power costs. On January 25, 2006, the ACC modified the PSA in certain respects. The PSA, as modified, is subject to specified parameters and procedures, including the following:

	•		APS will record deferrals for recovery or refund to the extent actual retail fuel and purchased power costs vary from the base fuel amount (currently $0.020743 per kWh);
	•		the deferrals are subject to a 90/10 sharing arrangement in which APS must absorb 10% of the retail fuel and purchased power costs above the base fuel amount and may retain 10% of the benefit from the retail fuel and purchased power costs that are below the base fuel amount;
	•		amounts to be recovered or refunded through the PSA adjustor are limited to a)  a cumulative plus or minus $0.004 per kWh from the base fuel amount over the life of the PSA and b) a maximum plus or minus $0.004 change in the adjustor rate in any one year;

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

	•		the recoverable amount of annual retail fuel and purchased power costs through current base rates and the PSA was originally capped at $776.2 million; however, the ACC has removed the cap pending the ACC’s final ruling on APS’ pending request in the general rate case to have the cap eliminated or substantially raised;
	•		the PSA will remain in effect for a minimum five-year period, but the ACC may eliminate the PSA at any time, if appropriate, in the event APS files a rate case before the expiration of the five-year period (which APS did by filing the general rate case noted above) or if APS does not comply with the terms of the PSA; and
	•		APS is prohibited from requesting PSA surcharges until after the PSA annual adjustor rate has been set each year. The amount available for potential PSA surcharges will be limited to the amount of accumulated deferrals through the prior year-end, which are not expected to be recovered through the annual adjustor or any PSA surcharges previously approved by the ACC.

     2006 PSA Annual Adjustor The effective date of the PSA’s annual adjustor is February 1, and the adjustor rate was set at the maximum $0.004 per kilowatt-hour effective February 1, 2006. The change in the adjustor rate represents a retail rate increase of approximately 5% designed to recover $110 million of deferred fuel and purchased power costs over the twelve-month period beginning February 1, 2006, of which $18 million was recorded as revenue and fuel and purchased power costs during the quarter ended March 31, 2006.

     Application for PSA Surcharges On February 2, 2006, APS filed with the ACC an application for two separate surcharges under the PSA. The surcharges would recover approximately $60 million in retail fuel and purchased power costs deferred by APS in 2005 under the PSA. The combined surcharges would represent a temporary rate increase of approximately 2.6% during the overlapping portion of the twelve-month recovery periods for the two surcharges. The other component of the 2005 PSA deferrals is being recovered under the 2006 PSA annual adjustor discussed in the preceding paragraph. The first surcharge would recover approximately $15 million over a twelve-month period, representing a temporary rate increase of approximately 0.7%, proposed to begin with the date of the ACC’s decision in APS’ emergency interim rate case. The second requested surcharge would recover approximately $45 million over a twelve-month period, representing a temporary rate increase of approximately 1.9%, proposed to begin no later than the ACC’s completion of its inquiry regarding the unplanned 2005 Palo Verde outages. The $45 million of PSA deferrals represents replacement power costs associated with these outages. On April 12, 2006, the ACC issued an order approving the $15 million surcharge request. As a result of the ACC’s decision described under “Interim Rate Increase” above, this temporary rate increase became effective May 1, 2006. The second surcharge request is still pending.

     Proposed Modifications to PSA (Requested In General Rate Case)

     In its pending general rate case, APS has requested the following modifications to the PSA:

•

The cumulative plus or minus $0.004 per kWh limit from the base fuel amount over the life of the PSA would be eliminated, while the maximum plus or minus $0.004 limit to changes in the adjustor rate in any one year would remain in effect;

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

	•		The $776.2 million annual limit on the retail fuel and purchased power costs under APS’ current base rates and the PSA would be removed or increased (although APS may defer fuel and purchased power costs above $776.2 million per year pending the ACC’s final ruling on APS’ pending request to have the cap eliminated or substantially raised);
	•		The current provision that APS is required to file a surcharge application with the ACC after accumulated pretax PSA deferrals equal $50 million and before they equal $100 million would be eliminated, thereby giving APS flexibility in determining when a surcharge filing should be made;
	•		The costs of renewable energy and capacity costs attributable to purchased power obtained through competitive procurement would be excluded from the existing 90/10 sharing arrangement under which APS absorbs 10% of the retail fuel and purchased power costs above the base fuel amount and retains 10% of the benefit from retail fuel and purchased power costs that are below the base fuel amount; and
	•		10% of any realized gains or losses resulting from APS’ hedges of Retail Fuel and Power Costs would be retained or absorbed by APS before being subject to the 90/10 sharing provision under the PSA.

APS 2003 Rate Case

     On April 7, 2005, the ACC issued an order in the rate case that APS filed on June 27, 2003. In addition to the ACC’s approval of the PSA discussed under “Power Supply Adjustor” above, certain key financial components of the order include:

	•		APS received an annual retail rate increase of approximately 4.2%, which was effective as of April 1, 2005. This increase does not include the impact of the PSA.
	•		APS was authorized to acquire the PWEC Dedicated Assets from Pinnacle West Energy, with a net carrying value of approximately $850 million, and to rate base the PWEC Dedicated Assets at a rate base value of $700 million, which resulted in a mandatory rate base disallowance of approximately $150 million. Due to depreciation and other miscellaneous factors, the actual disallowance was $139 million at December 31, 2005. This transfer was completed on July 29, 2005. As a result, for financial reporting purposes, APS recognized a one-time, after-tax net plant regulatory disallowance of approximately $84 million in the third quarter of 2005.
	•		Effective April 1, 2005, APS adopted longer service lives for certain depreciable assets. This change reduced annual depreciation expense for financial reporting purposes by approximately $30 million. APS also adopted longer service lives for the PWEC Dedicated Assets, which reduced annual depreciation expense for financial reporting purposes by approximately $10 million.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Equity Infusions

     On November 8, 2005, the ACC approved Pinnacle West’s request to infuse more than $450 million of equity into APS during 2005 or 2006. These infusions consist of about $250 million of the proceeds of Pinnacle West’s common equity issuance on May 2, 2005 and about $210 million of the proceeds from the sale of Silverhawk in January 2006 (see Note 17). Pinnacle West has made these equity infusions into APS.

Federal

     Price Mitigation Plan

     In July 2002, the FERC adopted a price mitigation plan that constrains the price of electricity in the wholesale spot electricity market in the western United States. The FERC adopted a price cap of $250 per MWh for the period subsequent to October 31, 2002. Sales at prices above the cap must be justified and are subject to potential refund.

     FERC Order

     On August 11, 2004, Pinnacle West, APS, Pinnacle West Energy, and APS Energy Services (collectively, the “Pinnacle West Companies”) submitted to the FERC an update to its 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’ market-based rate authority in the APS control area (the “FERC Order”). The FERC found that the Pinnacle West Companies failed to provide the necessary information about the APS control area to allow the FERC to make a determination about the 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.

     As a result of the FERC Order, the Pinnacle West Companies must charge cost-based rates, rather than market-based rates, in the APS control area, with an effective date of February 27, 2005. The Pinnacle West Companies will be required to refund any over-collection of rates from February 27, 2005.

     The Pinnacle West Companies will seek rehearing of the FERC Order on or before May 17, 2006. Based upon an analysis of the FERC Order and preliminary calculations of the refund obligations, at this time, neither Pinnacle West nor APS believes that the FERC Order has a material adverse effect on its financial position, results of operations or cash flows.

     In addition, the FERC Order revoked a previously-granted FERC order allowing Pinnacle West to issue securities or incur long-term debt without FERC approval. On May 3, 2006, the FERC issued an order approving Pinnacle West’s April 20, 2006 application to borrow funds under the Credit Agreement and to issue a broad range of other debt and equity securities.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

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 months ended March 31, 2006 and 2005. 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								Three Months
		Ended								Ended
		March 31,								March 31,
		2006				2005				2006				2005
Service cost-benefits earned during the period		$	15			$	12			$	7			$	6
Interest cost on benefit obligation			29				23				13				9
Expected return on plan assets			(30	)			(24	)			(13	)			(8	)
Amortization of:
Transition (asset) obligation			—				(1	)			1				1
Prior service cost			1				1				—				—
Net actuarial loss			7				5				3				2
Net periodic benefit cost		$	22			$	16			$	11			$	10
Portion of cost charged to expense		$	9			$	7			$	5			$	4
APS’ share of costs charged to expense		$	8			$	6			$	4			$	4

Contributions

     The contribution to our pension plan in 2006 is estimated to be approximately $50 million, $14 million of which was contributed on April 14, 2006. The contribution to our other postretirement benefit plans in 2006 is estimated to be approximately $29 million. APS’ share is approximately 97% of both plans.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

7. Business Segments

     We have three principal business segments (determined by products, services and the regulatory environment):

	•		our regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses (primarily electricity service to Native Load customers) and related activities and includes electricity generation, transmission and distribution;
	•		our real estate segment, which consists of SunCor’s real estate development and investment activities; and
	•		our marketing and trading segment, which consists of our competitive energy business activities, including wholesale marketing and trading and APS Energy Services’ commodity-related energy services.

     Financial data for the three months ended March 31, 2006 and 2005 and at March 31, 2006 and December 31, 2005 by business segment is provided as follows (dollars in millions):

		Three Months Ended
		March 31,
		2006				2005
Operating Revenues:
Regulated electricity		$	466			$	416
Real estate			108				70
Marketing and trading			85				89
Other			11				10
Total		$	670			$	585
Net Income (Loss):
Regulated electricity		$	(12	)		$	14
Real estate			21				9
Marketing and trading			2				—
Other			1				1
Total		$	12			$	24

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		As of					As of
		March 31, 2006					December 31, 2005
Assets:
Regulated electricity		$	9,756				$	9,732
Real estate			517					483
Marketing and trading			452					1,070
Other			31					38
Total		$	10,756				$	11,323

8. Stock-Based Compensation

     Pinnacle West offers stock-based compensation plans for officers and key employees of Pinnacle West and our subsidiaries.

     The 2002 Long-Term Incentive Plan (“2002 Plan”) allows Pinnacle West to grant performance shares, stock ownership incentive awards and non-qualified and performance-accelerated stock options to key employees. We have reserved 6 million shares of common stock for issuance under the 2002 plan. No more than 1.8 million shares may be issued in relation to performance share awards and stock ownership incentive awards. The plan also provides for the granting of new non-qualified stock options at a price per share not less than the fair market value of the common stock at the time of grant. The stock options vest over three years, unless certain performance criteria are met, which can accelerate the vesting period. The term of the option cannot be longer than 10 years and the option cannot be repriced during its term.

     Generally, each recipient of performance shares is entitled to receive shares of common stock at the end of a three-year period based upon PinnacleWest’s earnings per share growth rate during that three-year period compared to the earnings per share growth rate of all relevant companies in a specified utilities index. The number of shares of common stock a recipient is entitled to receive is determined by Pinnacle West’s relative percentile ranking during the three-year period.

     The 1994 Long-Term Incentive Plan (“1994 Plan”) includes outstanding options but no new options may be granted under the plan. Options vest one-third of the grant per year beginning one year after the date the option is granted and expire ten years from the date of the grant. The 1994 Plan also provided for the granting of any combination of shares of restricted stock, stock appreciation rights or dividend equivalents.

     In the third quarter of 2002, we began applying the fair value method of accounting for stock-based compensation, as provided for in SFAS No. 123, “Accounting for Stock-Based Compensation.” In accordance with the transition requirements of SFAS No. 123, we applied the fair value method prospectively, beginning with 2002 stock grants. In prior years, we recognized stock compensation expense based on the intrinsic value method allowed in APB No. 25, “Accounting for Stock Issued to Employees.”

     Effective January 1, 2006, we adopted SFAS No. 123(R), “Share-Based Payment,” using the modified prospective application transition method. Because the fair value recognition provisions of both SFAS No. 123 and SFAS No. 123(R) are materially consistent with respect to our stock-based

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

compensation plans, the adoption of SFAS No. 123(R) did not have a material impact on our financial statements.

     The compensation cost that has been charged against income for share-based compensation plans was $2.9 million and $0.6 million for the quarters ended March 31, 2006 and 2005, respectively. The total income tax benefit recognized in the condensed consolidated income statement for share-based compensation arrangements was $1.1 million and $0.2 million for the quarters ended March 31, 2006 and 2005, respectively.

     The following table is a summary of option activity under our equity incentive plans as of March 31, 2006 and changes during the quarter ending on that date:

										Weighted-
										Average				Aggregate
						Weighted-				Remaining				Intrinsic Value
			Shares			Average Exercise				Contractual Term				(dollars in
Options		(in thousands)					Price				(Years)				thousands)
Outstanding at January 1, 2006			1,696			$	39.65
Granted			—				—
Exercised			(2	)			32.29
Forfeited or expired			(6	)			43.29
Outstanding at March 31, 2006			1,688				39.64				4.9			$	2,930
Exercisable at March 31, 2006			1,682				39.65				4.9				2,923

     There were no options granted during the quarters ended March 31, 2006 and 2005. The intrinsic value of options exercised during the quarters ended March 31, 2006 and 2005 was not material.

     The following table is a summary of the status of stock compensation awards, other than options, as of March 31, 2006 and changes during the quarter ending on that date:

		Shares				Weighted-Average Grant-Date
Nonvested shares		(in thousands)				Fair Value
Nonvested at January 1, 2006			528			$	38.23
Granted			274				41.50
Vested			(13	)			44.13
Forfeited			(217	)			35.96
Nonvested at March 31, 2006			572				40.52

     As of March 31, 2006, there was $10.4 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the plan. That cost is expected to be recognized over a weighted-average period of 2 years. The total fair value of shares vested during the quarters ended March 31, 2006 and 2005 was $0.5 million and $2.9 million, respectively.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

     Cash received from options exercised under our share-based payment arrangements for the quarter ended March 31, 2006 was $0.1 million and for the quarter ended March 31, 2005 was $4.0 million. The actual tax benefit realized for the tax deductions from option exercises of the share-based payment arrangements was immaterial for the three months ended March 31, 2006 or 2005.

     Pinnacle West has a current policy of issuing new shares to satisfy share requirements for stock compensation plans and does not expect to repurchase any shares during 2006.

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 March 31, 2006, APS would have been required to assume approximately $234 million of debt and pay the equity participants approximately $185 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 fuel, electricity and emission allowances and credits, as well as interest rate risk associated with long-term debt. As of March 31, 2006, we hedged exposures to the price variability of the power and gas commodities for a maximum of 3.25 years. The changes in market value of such contracts have a high correlation to price changes in the hedged transactions. In addition, subject to specified risk parameters monitored by the ERMC, we engage in marketing and trading activities intended to profit from market price movements.

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 months ended March 31, 2006 and 2005 are comprised of the following (dollars in thousands):

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		Three Months Ended
		March 31,
		2006				2005
Gains (losses) on the ineffective portion of derivatives qualifying for hedge accounting		$	(178	)		$	7,324
Gains (losses) from the change in options’ time value excluded from measurement of effectiveness			(18	)			858
Gains from the discontinuance of cash flow hedges			434				385

     During the next twelve months ending March 31, 2007, we estimate that a net gain of $73 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 (see Note 5).

     Our assets and liabilities from risk management and trading activities are presented in two categories, consistent with our business segments.

     The following table summarizes our assets and liabilities from risk management and trading activities at March 31, 2006 and December 31, 2005 (dollars in thousands):

March 31, 2006

						Investments								Deferred
		Current				and Other				Current				Credits and				Net Asset
		Assets				Assets				Liabilities				Other				(Liability)
Regulated electricity:
Mark-to-market		$	381,639			$	194,319			$	(350,517	)		$	(121,356	)		$	104,085
Margin account and options			45				—				(58,224	)			—				(58,179	)
Marketing and trading:
Mark-to-market			118,925				178,740				(58,668	)			(108,466	)			130,531
Options and emission allowances – at cost			1,262				12,041				(23,051	)			(807	)			(10,555	)
Total		$	501,871			$	385,100			$	(490,460	)		$	(230,629	)		$	165,882

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2005

						Investments								Deferred
		Current				and Other				Current				Credits and				Net Asset
		Assets				Assets				Liabilities				Other				(Liability)
Regulated electricity:
Mark-to-market		$	516,399			$	228,873			$	(335,801	)		$	(74,787	)		$	334,684
Margin account and options			1,814				—				(124,165	)			—				(122,351	)
Marketing and trading:
Mark-to-market			307,883				291,122				(236,922	)			(181,417	)			180,666
Options and emission allowances – at cost			1,683				77,836				(23,805	)			(209	)			55,505
Total		$	827,779			$	597,831			$	(720,693	)		$	(256,413	)		$	448,504

     We maintain a margin account with a broker to support our risk management and trading activities. The margin account was a liability of $57 million at March 31, 2006 and $123 million at December 31, 2005 and is included in the margin account in the table above. 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.

     Cash or other assets may be required to serve as collateral against our open positions on certain energy-related contracts. Collateral provided to counterparties was $10 million at March 31, 2006 and $6 million at December 31, 2005, and is included in other current assets on the Condensed Consolidated Balance Sheets. Collateral provided to us by counterparties was $46 million at March 31, 2006 and $216 million at December 31, 2005, and is included in other current liabilities on the Condensed Consolidated Balance Sheets.

Fair Value Hedges

     On January 29, 2004, we entered into two fixed-for-floating interest rate swap transactions on our $300 million 6.4% Senior Notes. The purpose of these hedges was to protect against significant fluctuations in the fair value of our debt. These interest rate swaps were considered to be fully effective with any resulting gains or losses on the derivative offset by a similar loss or gain amount on the underlying fair value of our debt. The fair value of the interest rate swaps was a loss of approximately $1.7 million at March 31, 2006 and is included in other current liabilities with the corresponding offset in current maturities of long-term debt on the Condensed Consolidated Balance Sheets. These interest rate swaps were settled in April 2006.

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 10% of Pinnacle West’s $887

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

million of risk management and trading assets as of March 31, 2006. Our risk management process assesses and monitors the financial exposure of this and all other counterparties. Despite the fact that the great majority of trading counterparties’ securities are rated as investment grade by the credit rating agencies, including the counterparty discussed above, there is still a possibility that one or more of these companies could default, resulting in a material impact on consolidated earnings for a given period. Counterparties in the portfolio consist principally of financial institutions, major energy companies, municipalities and local distribution companies. We maintain credit policies that we believe minimize overall credit risk to within acceptable limits. Determination of the credit quality of our counterparties is based upon a number of factors, including credit ratings and our evaluation of their financial condition. To manage credit risk, we employ collateral requirements, standardized agreements that allow for the netting of positive and negative exposures associated with a single counterparty and credit default swaps. Valuation adjustments are established representing our estimated credit losses on our overall exposure to counterparties.

11. Comprehensive Income (Loss)

     Components of comprehensive income (loss) for the three months ended March 31, 2006 and 2005 are as follows (dollars in thousands):

		Three Months Ended
		March 31,
		2006				2005
Net income		$	12,455			$	24,448
Other comprehensive income (loss):
Net unrealized gains (losses) on derivative instruments (a)			(204,983	)			159,644
Net reclassification of realized gains to income (b)			(17,530	)			(5,919	)
Net income tax benefit (expense) related to items of other comprehensive income (loss)			86,891				(60,306	)
Total other comprehensive income (loss)			(135,622	)			93,419
Comprehensive income (loss)		$	(123,167	)		$	117,867

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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 2010 and it does not intend to begin accepting spent nuclear fuel prior to that date. 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 currently estimates it will incur $147 million (in 2005 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 March 31, 2006, APS had a regulatory asset of $4 million that represents amounts spent for on-site interim spent fuel storage net of amounts recovered in rates per the ACC rate order that was effective April 1, 2005.

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. The FERC is still considering the evidence and refund amounts have not yet been finalized. However, on September 6, 2005, the Ninth Circuit issued a decision, concluding that the FERC may not order refunds from entities that are not within the FERC’s jurisdiction. Because a number of the entities owing refunds under the FERC’s calculations are not within the FERC’s jurisdiction, this order may affect the level of recovery of refunds due in this proceeding. In addition, on August 8, 2005, the FERC issued an order allowing sellers in the California markets to demonstrate that its refund methodology results in an overall revenue shortfall for their transactions in the relevant markets over a specified time frame. More than twenty sellers made such cost recovery filings on September 14, 2005. On January 26, 2006, the FERC conditionally accepted thirteen of these filings, reducing the refund liability for these sellers. Correspondingly, this will reduce the recovery of total refunds in the California markets. We currently believe the refund claims at FERC will have no material adverse impact on our financial position, results of operations, cash flow or liquidity.

     On March 19, 2002, the State of California filed a complaint with the FERC alleging that wholesale sellers of power and energy, including the Company, failed to properly file rate information at the FERC in connection with sales to California from 2000 to the present under

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

market-based rates. The complaint requests the FERC to require the wholesale sellers to refund any rates that are “found to exceed just and reasonable levels.” This complaint was dismissed by the FERC and the State of California appealed the matter to the Ninth Circuit Court of Appeals. In an order issued September 9, 2004, the Ninth Circuit upheld the FERC’s authority to permit market-based rates, but rejected the FERC’s claim that it was without authority to consider retroactive refunds when a utility has not strictly adhered to the quarterly reporting requirements of the market-based rate system. On September 9, 2004, the Ninth Circuit remanded the case to the FERC for further proceedings. Several of the intervenors in this appeal filed a petition for rehearing of this decision on October 25, 2004. The petition for rehearing has not been acted upon, and the outcome of the further proceedings cannot be predicted at this time.

     The FERC also ordered an evidentiary proceeding to discuss and evaluate possible refunds for 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 has now been appealed to the Ninth Circuit Court of Appeals. Although the FERC ruling in the Pacific Northwest matter is being appealed and the FERC has not yet calculated the specific refund amounts due in California, we do not expect that the resolution of these issues, as to the amounts alleged in the proceedings, will have a 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 have sought rehearing of this order, and that request is pending.

FERC Order

     See “FERC Order” in Note 5 for a discussion of an order issued by the FERC on April 17, 2006.

Natural Gas Supply

     Pursuant to the terms of a comprehensive settlement entered into in 1996 with El Paso Natural Gas Company, the rates charged for natural gas transportation were subject to a rate moratorium through December 31, 2005.

     On July 9, 2003, the FERC issued an order that altered the capacity rights of parties to the 1996 settlement but maintained the cost responsibility provisions agreed to by parties to that settlement. On December 28, 2004, the D.C. Court of Appeals upheld the FERC’s authority to alter the capacity rights of parties to the settlement. With respect to the FERC’s authority to maintain the cost responsibility provisions of the settlement, a party has sought appellate review and is seeking to reallocate the costs responsibility associated with the changed contractual obligations in a way that would be less favorable to APS and Pinnacle West Energy than under the FERC’s July 9, 2003 order.

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Should this party prevail on this point, APS and Pinnacle West Energy’s annual capacity cost could be increased by approximately $3 million after income taxes for the period September 2003 through December 2005. This appeal has been stayed pending further consideration by the FERC.

     Consistent with its obligations under the 1996 settlement, El Paso filed a new rate case on June 30, 2005, which proposed new rates and new services to become effective on January 1, 2006. The FERC allowed the new rates to take effect on January 1, 2006, but made the rates subject to refund pending the outcome of a hearing. On March 23, 2006, the FERC issued an order approving El Paso’s proposed new services. APS has sought rehearing of this order. On March 29, 2006, El Paso filed a partial settlement that postpones the implementation and the associated cost impact of the new services until June 1, 2006. As part of this settlement, El Paso will accept bids for new services that will be evaluated and awarded on a net present value, first-come, first-serve basis. APS will be able to evaluate the cost impact of these new services once it has been notified of the services contracts it has been awarded. APS cannot currently predict the outcome of this matter; however, APS believes most of these increased costs would be eligible for recovery under the PSA (see Note 5).

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. Because the litigation is in preliminary stages, APS cannot currently predict the outcome of this matter.

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 jointly and severally, liable for clean-up. On September 3, 2003, the EPA advised APS that the EPA considers APS to be a PRP in the Motorola 52^nd Street Superfund Site, Operable Unit 3 (OU3) in Phoenix, Arizona. APS has facilities that are within this superfund site. APS and Pinnacle West have agreed with the EPA to perform certain investigative activities of the APS facilities within OU3. Because

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

the investigation has not yet been completed and ultimate remediation requirements are not yet finalized, neither APS nor Pinnacle West can currently estimate the expenditures which may be required.

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, cash flows or liquidity.

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 programs exceed the accumulated funds, APS could be assessed retrospective premium adjustments. The maximum assessment per reactor under the program for each nuclear incident is approximately $101 million, subject to an annual limit of $15 million per incident, to be periodically adjusted for inflation. Based on APS’ interest in the three Palo Verde units, APS’ maximum potential assessment per incident for all three units is approximately $88 million, with an annual payment limitation of approximately $13 million.

     The Palo Verde participants maintain “all risk” (including nuclear hazards) insurance for property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $2.75 billion, a substantial portion of which must first be applied to stabilization and decontamination. APS has also secured insurance against portions of any increased cost of generation or purchased power and business interruption resulting from a sudden and unforeseen accidental outage of any of the three units. The property damage, decontamination, and replacement power coverages are provided by Nuclear Electric Insurance Limited (NEIL). APS is subject to retrospective assessments under all NEIL policies if NEIL’s losses in any policy year exceed accumulated funds. The maximum amount of retrospective assessments APS could incur under the current NEIL policies totals $17.8 million. The insurance coverage discussed in this and the previous paragraph is subject to certain policy conditions and exclusions.

14. Other Income and Other Expense

     The following table provides detail of other income and other expense for the three months ended March 31, 2006 and 2005 (dollars in thousands):

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		Three Months Ended
		March 31,
		2006				2005
Other income:
Interest income		$	4,905			$	1,320
Asset sales			361				241
SunCor (a)			166				(28	)
Miscellaneous			35				193
Total other income		$	5,467			$	1,726
Other expense:
Non-operating costs (b)		$	(3,719	)		$	(3,098	)
Asset sales			(196	)			(64	)
Investment losses – net			(31	)			(1,249	)
Miscellaneous			(595	)			(898	)
Total other expense		$	(4,541	)		$	(5,309	)

15. Guarantees

     We have issued parental guarantees and letters of credit and obtained surety bonds on behalf of one of our unregulated subsidiaries. Our credit support instruments enable APS Energy Services to offer commodity energy and energy-related products. Non-performance or non-payment under the original contract by our unregulated subsidiary would require us to perform 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 its subsidiary. Our guarantees have no recourse or collateral provisions to allow us to recover amounts paid under the guarantees. At March 31, 2006, we had a guarantee of $18 million with a term of one year and a surety bond of $65 million with a term of one year for APS Energy Services.

     At March 31, 2006, Pinnacle West had approximately $4 million of letters of credit related to workers’ compensation expiring in 2006. These letters of credit were subsequently extended and expire in 2007. We intend to provide from either existing or new facilities for the extension, renewal or substitution of the letters of credit to the extent required.

     APS has entered into various agreements that require letters of credit for financial assurance purposes. At March 31, 2006, 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 of such debt obligations and expire in 2010. APS has also entered into approximately $93 million of letters of credit to support certain equity lessors in the Palo Verde sale leaseback transactions (see Note 9 for further details on the Palo Verde sale leaseback transactions). These letters of credit expire in 2010. Additionally, APS has approximately $5 million of letters of credit related to counterparty collateral requirements expiring

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

in 2006. 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. 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 months ended March 31, 2006 and 2005:

		Three Months Ended
		March 31,
		2006				2005
Basic earnings per share:
Income from continuing operations		$	0.12			$	0.32
Income (loss) from discontinued operations			0.01				(0.05	)
Earnings per share – basic		$	0.13			$	0.27
Diluted earnings per share:
Income from continuing operations		$	0.12			$	0.32
Income (loss) from discontinued operations			0.01				(0.05	)
Earnings per share – diluted		$	0.13			$	0.27

     Dilutive stock options and performance shares increased average common shares outstanding by approximately 334,000 shares and 83,000 shares for the three months ended March 31, 2006 and March 31, 2005, respectively.

     Options to purchase 747,874 shares for the three-month period ended March 31, 2006 were outstanding but were not included in the computation of earnings per share because the options’ exercise prices were greater than the average market price of the common shares. Options to purchase shares of common stock that were not included in the computation of diluted earnings per share for that same reason were 868,934 shares for the three-month period ended March 31, 2005.

17. Discontinued Operations

     Silverhawk (marketing and trading segment) – In June 2005, we entered into an agreement to sell our 75% interest in the Silverhawk Power Station to NPC. The sale was completed on

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

January 10, 2006. The marketing and trading segment discontinued operations amounts in the chart below are the revenues and expenses related to the operations of Silverhawk.

     SunCor (real estate segment) – In 2005 and 2006, SunCor sold commercial properties, which 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 provides revenue and income (loss) before income taxes and after income taxes classified as discontinued operations on Pinnacle West’s Condensed Consolidated Statements of Income for the three months ended March 31, 2006 and 2005 (dollars in millions):

		Three Months Ended
		March 31,
		2006				2005
Revenue:
Silverhawk		$	1			$	28
SunCor – commercial operations			1				4
Total revenue		$	2			$	32
Income (loss) before taxes:
Silverhawk (a)		$	—			$	(10	)
SunCor – commercial operations			1				2
Total income (loss) before taxes		$	1			$	(8	)
Income (loss) after taxes:
Silverhawk		$	—			$	(7	)
SunCor – commercial operations			—				1
Total income (loss) after taxes		$	—			$	(6	)

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 debt 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, APS has recorded the offsetting amount of unrealized gains (losses) on investment securities in other regulatory liabilities/assets. The following table summarizes the fair value of APS’ nuclear decommissioning trust fund assets at March 31, 2006 and December 31, 2005 (dollars in millions):

PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

						Total				Total
						Unrealized				Unrealized
		Fair Value				Gains				Losses
March 31, 2006
Equity securities		$	160			$	56			$	—
Debt securities			145				1				2
Total		$	305			$	57			$	2
December 31, 2005
Equity securities		$	150			$	50			$	—
Debt securities			144				3				1
Total		$	294			$	53			$	1

     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 March 31,
		2006				2005
Realized gains		$	1			$	1
Realized losses			(1	)			(1	)
Proceeds from the sale of securities			34				40

     The fair value of debt securities, summarized by contractual maturities, at March 31, 2006 is as follows:

		March 31,
Fair Value (in millions)		2006
Less than one year		$	10
1 year - 5 years			36
5 years - 10 years			38
Greater than 10 years			61
Total		$	145

ARIZONA PUBLIC SERVICE COMPANY
CONDENSED STATEMENTS OF INCOME
(unaudited)
(dollars in thousands)

		Three Months Ended
		March 31,
		2006				2005
ELECTRIC OPERATING REVENUES
Regulated electricity		$	467,222			$	418,434
Marketing and trading			9,647				22,858
Total			476,869				441,292
OPERATING EXPENSES
Regulated electricity fuel and purchased power			158,274				81,914
Marketing and trading fuel and purchased power			1,368				28,302
Operations and maintenance			173,353				142,294
Depreciation and amortization			86,311				82,214
Income taxes			(3,029	)			16,380
Other taxes			35,548				31,445
Total			451,825				382,549
OPERATING INCOME			25,044				58,743
OTHER INCOME (DEDUCTIONS)
Income taxes			236				(837	)
Allowance for equity funds used during construction			3,801				2,603
Other income (Note S-3)			4,806				6,161
Other expense (Note S-3)			(3,680	)			(3,860	)
Total			5,163				4,067
INTEREST DEDUCTIONS
Interest on long-term debt			34,250				35,517
Interest on short-term borrowings			2,026				1,191
Debt discount, premium and expense			1,173				1,004
Allowance for borrowed funds used during construction			(1,721	)			(1,947	)
Total			35,728				35,765
NET INCOME (LOSS)		$	(5,521	)		$	27,045

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements and Supplemental Notes to Arizona Public Service Company’s Condensed Financial Statements.

ARIZONA PUBLIC SERVICE COMPANY
CONDENSED BALANCE SHEETS
(unaudited)
(dollars in thousands)

		March 31,				December 31,
		2006				2005
ASSETS
UTILITY PLANT
Electric plant in service and held for future use		$	10,793,563			$	10,682,999
Less accumulated depreciation and amortization			3,665,740				3,616,886
Total			7,127,823				7,066,113
Construction work in progress			292,893				314,584
Intangible assets, net of accumulated amortization			108,922				90,327
Nuclear fuel, net of accumulated amortization			61,806				54,184
Utility plant – net			7,591,444				7,525,208
INVESTMENTS AND OTHER ASSETS
Decommissioning trust accounts			305,096				293,943
Assets from long-term risk management and trading activities (Note S-1)			198,329				234,372
Other assets			65,612				64,128
Total investments and other assets			569,037				592,443
CURRENT ASSETS
Cash and cash equivalents			76,645				49,933
Customer and other receivables			304,569				421,621
Allowance for doubtful accounts			(3,192	)			(3,568	)
Materials and supplies (at average cost)			112,350				109,736
Fossil fuel (at average cost)			22,145				23,658
Assets from risk management and trading activities (Note S-1)			387,426				532,923
Other current assets			10,229				14,639
Total current assets			910,172				1,148,942
DEFERRED DEBITS
Deferred fuel and purchased power regulatory asset (Note 5)			169,486				172,756
Other regulatory assets			167,155				151,123
Unamortized debt issue costs			24,630				25,279
Other deferred debits			87,291				91,690
Total deferred debits			448,562				440,848
TOTAL ASSETS		$	9,519,215			$	9,707,441

See Notes to Pinnacle West’s Condensed Consolidated Financial Statements and Supplemental Notes to Arizona Public Service Company’s Condensed Financial Statements.

ARIZONA PUBLIC SERVICE COMPANY
CONDENSED BALANCE SHEETS
(unaudited)
(dollars in thousands)

		March 31,				December 31,
		2006				2005
CAPITALIZATION AND LIABILITIES
CAPITALIZATION
Common stock		$	178,162			$	178,162
Additional paid-in capital (Note 5)			2,063,098				1,853,098
Retained earnings			770,154				860,675
Accumulated other comprehensive income (loss):
Minimum pension liability adjustment			(86,132	)			(86,132	)
Derivative instruments			73,974				179,422
Common stock equity			2,999,256				2,985,225
Long-term debt less current maturities			2,479,689				2,479,703
Total capitalization			5,478,945				5,464,928
CURRENT LIABILITIES
Current maturities of long-term debt			85,018				85,620
Accounts payable			149,529				215,384
Accrued taxes			391,080				360,737
Accrued interest			35,262				25,003
Dividends payable			42,500				—
Customer deposits			57,192				55,474
Deferred income taxes			8,682				64,210
Liabilities from risk management and trading activities (Note S-1)			413,299				480,138
Other current liabilities (Note S-1)			97,012				227,398
Total current liabilities			1,279,574				1,513,964
DEFERRED CREDITS AND OTHER
Deferred income taxes			1,205,489				1,215,403
Regulatory liabilities			571,939				592,494
Liability for asset retirements			273,238				269,011
Pension liability			253,298				233,342
Customer advances for construction			62,248				60,287
Unamortized gain – sale of utility plant			44,613				45,757
Liabilities from long-term risk management and trading activities (Note S-1)			129,029				83,774
Other			220,842				228,481
Total deferred credits and other			2,760,696				2,728,549
COMMITMENTS AND CONTINGENCIES (Notes 5, 12, 13, 15 and S-4)
TOTAL CAPITALIZATION AND LIABILITIES		$	9,519,215			$	9,707,441