Derivative Accounting

9 Months Ended

Sep. 30, 2012

Derivative Accounting

Derivative Accounting

8.Derivative Accounting

We are exposed to the impact of market fluctuations in the commodity price and transportation costs of electricity, natural gas, coal, emissions allowances and in interest rates.  We manage risks associated with market volatility by utilizing various physical and financial derivative instruments, including futures, forwards, options and swaps.  As part of our overall risk management program, we may use derivative instruments to hedge purchases and sales of electricity and fuels.  Derivative instruments that meet certain hedge accounting criteria may be designated as cash flow hedges and are used to limit our exposure to cash flow variability on forecasted transactions.  The changes in market value of such instruments have a high correlation to price changes in the hedged transactions.  We also enter into derivative instruments for economic hedging purposes.  While we believe the economic hedges mitigate exposure to fluctuations in commodity prices, these instruments have not been designated as accounting hedges.  Contracts that have the same terms (quantities, delivery points and delivery periods) and for which power does not flow are netted, which reduces both revenues and fuel and purchased power costs in our Condensed Consolidated Statements of Income, but does not impact our financial condition, net income or cash flows.

On June 1, 2012, we elected to discontinue cash flow hedge accounting treatment for the significant majority of our contracts that had previously been designated as accounting hedges.  This discontinuation is due to changes in PSA recovery (see Note 3), which now allows for 100% deferral of the unrealized gains and losses relating to these contracts.  For those contracts that were de-designated, all changes in fair value after May 31, 2012 are no longer recorded through other comprehensive income (“OCI”), but are deferred through the PSA.  The amounts previously recorded in accumulated OCI relating to these instruments will remain in accumulated OCI, and will transfer to earnings in the same period or periods during which the hedged transaction affects earnings or sooner if we determine it is probable that the forecasted transaction will not occur.  Cash flow hedge accounting treatment will continue for a limited number of contracts that are not subject to PSA recovery.

Our derivative instruments, excluding those qualifying for a scope exception, are recorded on the balance sheet as an asset or liability and are measured at fair value; see Note 14 for a discussion of fair value measurements.  Derivative instruments may qualify for the normal purchases and normal sales scope exception if they require physical delivery and the quantities represent those transacted in the normal course of business.  Derivative instruments qualifying for the normal purchases and sales scope exception are accounted for under the accrual method of accounting and excluded from our derivative instrument discussion and disclosures below.

Hedge effectiveness is the degree to which the derivative instrument contract and the hedged item are correlated and is measured based on the relative changes in fair value of the derivative instrument contract and the hedged item over time.  We assess hedge effectiveness both at inception and on a continuing basis.  These assessments exclude the time value of certain options.  For accounting hedges that are deemed an effective hedge, the effective portion of the gain or loss on the derivative instrument is reported as a component of OCI and reclassified into earnings in the same period during which the hedged transaction affects earnings.  We recognize in current earnings, subject to the PSA, the gains and losses representing hedge ineffectiveness, and the gains and losses on any hedge components which are excluded from our effectiveness assessment.  As cash flow hedge accounting has been discontinued for the significant majority of our contracts, after May 31, 2012, effectiveness testing is no longer being performed for these contracts.

Prior to the Settlement Agreement, for its regulated operations, APS deferred for future rate treatment approximately 90% of unrealized gains and losses on certain derivatives pursuant to the PSA mechanism that would otherwise be recognized in income.  Due to the Settlement Agreement, for its regulated operations, APS now defers for future rate treatment 100% of the unrealized gains and losses for delivery periods after June 30, 2012 on derivatives pursuant to the PSA mechanism that would otherwise be recognized in income.  Realized gains and losses on derivatives are deferred in accordance with the PSA to the extent the amounts are above or below the Base Fuel Rate (see Note 3).  Gains and losses from derivatives in the following tables represent the amounts reflected in income before the effect of PSA deferrals.

As of September 30, 2012, we had the following outstanding gross notional volume of derivatives, which represent both purchases and sales (does not reflect net position):

Commodity	Quantity
Power	8,517	gigawatt hours
Gas	155	Bcfs (a)

(a)“Bcf” is Billion Cubic Feet.

Gains and Losses from Derivative Instruments

The following table provides information about gains and losses from derivative instruments in designated cash flow accounting hedging relationships during the three and nine months ended September 30, 2012 and 2011 (dollars in thousands):

	Financial Statement	Three Months Ended September 30,						Nine Months Ended September 30,
Commodity Contracts	Location	2012			2011			2012			2011
Loss Recognized in OCI on Derivative Instruments (Effective Portion)	Other comprehensive loss - derivative instruments	$	(119	)	$	(25,457	)	$	(37,513	)	$	(40,792	)
Loss Reclassified from Accumulated Other Comprehensive Income into Income (Effective Portion Realized) (a)	Fuel and purchased power	(49,478		)	(59,144		)	(86,993		)	(99,278		)
Gain (Loss) Recognized in Income (Ineffective Portion and Amount Excluded from Effectiveness Testing)	Fuel and purchased power	—			17			117			(147		)

(a)During the nine months ended September 30, 2012, we had $1.8 million of losses reclassified from accumulated other comprehensive income to earnings related to discontinued cash flow hedges.  There were no amounts reclassified in the third quarter of 2012 and in the 2011 periods related to discontinued cash flow hedges.

During the next twelve months, we estimate that a net loss of $51 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.  In accordance with the PSA, substantially all of these amounts will be recorded as either a regulatory asset or liability and have no immediate effect on earnings.

The following table provides information about gains and losses from derivative instruments not designated as accounting hedging instruments during the three and nine months ended September 30, 2012 and 2011 (dollars in thousands):

	Financial Statement	Three Months Ended September 30,					Nine Months Ended September 30,
Commodity Contracts	Location	2012		2011			2012		2011
Net Gain Recognized in Income	Operating revenues	$	258	$	81		$	19	$	1,085
Net Gain (Loss) Recognized in Income	Fuel and purchased power	12,870		(13,219		)	13,860		(25,138		)
Total		$	13,128	$	(13,138	)	$	13,879	$	(24,053	)

Fair Values of Derivative Instruments in the Condensed Consolidated Balance Sheets

The following table provides information about the fair value of our risk management activities reported on a gross basis.  Transactions with counterparties that have master netting arrangements are reported net on the Condensed Consolidated Balance Sheets.  These amounts are located in the assets and liabilities from risk management activities lines of our Condensed Consolidated Balance Sheets.  Amounts are as of September 30, 2012 (dollars in thousands):

Commodity Contracts	Designated as Hedging Instruments			Not Designated as Hedging Instruments			Margin and Collateral Provided to Counterparties		Collateral Provided from Counterparties			Other (b)			Total
Current Assets	$	—		$	57,165		$	320	$	—		$	(31,228	)	$	26,257
Investments and Other Assets	—			47,868			—		—			(9,419		)	38,449
Total Assets	—			105,033			320		—			(40,647		)	64,706
Current Liabilities	(1,092		)	(117,325		)	43,480		(13,145		)(a)	31,819			(56,263		)
Deferred Credits and Other	(4,523		)	(103,173		)	17,033		—			9,419			(81,244		)
Total Liabilities	(5,615		)	(220,498		)	60,513		(13,145		)	41,238			(137,507		)
Total	$	(5,615	)	$	(115,465	)	$	60,833	$	(13,145	)	$	591		$	(72,801	)

(a)Collateral relates to non-derivative instruments or derivative instruments that qualify for a scope exception.

(b)Other represents derivative instrument netting, option premiums, and other risk management contracts.

The following table provides information about the fair value of our risk management activities reported on a gross basis at December 31, 2011 (dollars in thousands):

Commodity Contracts	Designated as Hedging Instruments			Not Designated as Hedging Instruments			Margin and Collateral Provided to Counterparties		Collateral Provided from Counterparties			Other (b)			Total
Current Assets	$	7,287		$	76,162		$	1,630	$	—		$	(54,815	)	$	30,264
Investments and Other Assets	3,804			58,273			—		—			(12,755		)	49,322
Total Assets	11,091			134,435			1,630		—			(67,570		)	79,586
Current Liabilities	(82,195		)	(124,028		)	107,228		(11,145		)(a)	56,172			(53,968		)
Deferred Credits and Other	(68,137		)	(92,880		)	65,768		—			12,754			(82,495		)
Total Liabilities	(150,332		)	(216,908		)	172,996		(11,145		)	68,926			(136,463		)
Total Derivative Instruments	$	(139,241	)	$	(82,473	)	$	174,626	$	(11,145	)	$	1,356		$	(56,877	)

(a)Collateral relates to non-derivative instruments or derivative instruments that qualify for a scope exception.

(b)Other represents derivative instrument netting, option premiums, and other risk management contracts.

Credit Risk and Credit Related Contingent Features

We are exposed to losses in the event of nonperformance or nonpayment by counterparties.  We have risk management contracts with many counterparties, including two counterparties for which our exposure represents approximately 82% of Pinnacle West’s $65 million of risk management assets as of September 30, 2012.  This exposure relates to long-term traditional wholesale contracts with counterparties that have high credit quality.  Our risk management process assesses and monitors the financial exposure of all counterparties.  Despite the fact that the great majority of trading counterparties’ debt is 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.

Certain of our derivative instrument contracts contain credit-risk-related contingent features including, among other things, investment grade credit rating provisions, credit-related cross default provisions, and adequate assurance provisions.  Adequate assurance provisions allow a counterparty with reasonable grounds for uncertainty to demand additional collateral based on subjective events and/or conditions.  For those derivative instruments in a net liability position, with investment grade credit contingencies, the counterparties could demand additional collateral if our debt credit rating were to fall below investment grade (below BBB- for Standard & Poor’s or Fitch or Baa3 for Moody’s).

The following table provides information about our derivative instruments that have credit-risk-related contingent features at September 30, 2012 (dollars in millions):

	September 30, 2012
Aggregate Fair Value of Derivative Instruments in a Net Liability Position	$	226
Cash Collateral Posted	60
Additional Cash Collateral in the Event Credit-Risk Related Contingent Features were Fully Triggered (a)	104

(a)This amount is after counterparty netting and includes those contracts which qualify for scope exceptions, which are excluded from the derivative details above.

We also have energy related non-derivative instrument contracts with investment grade credit-related contingent features which could also require us to post additional collateral of approximately $183 million if our debt credit ratings were to fall below investment grade.