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 cash flow 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 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. When amounts have been reclassified from accumulated OCI to earnings, they will be subject to deferral in accordance with the PSA. 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 11 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.

For its regulated operations, APS defers for future rate treatment 100% of the unrealized gains and losses 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 March 31, 2015, we had the following outstanding gross notional volume of derivatives, which represent both purchases and sales (does not reflect net position):



Commodity	Quantity
Power	4,186	GWh
Gas	157	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 months ended March 31, 2015 and 2014 (dollars in thousands):



	Financial Statement Location	Three Months Ended March 31,
Commodity Contracts	Financial Statement Location	2015			2014
Gain (loss) recognized in OCI on derivative instruments (effective portion)	OCI — derivative instruments	$	(327	)	$	177
Loss reclassified from accumulated OCI into income (effective portion realized) (a)	Fuel and purchased power (b)	(2,343		)	(4,439		)


(a)	During the three months ended March 31, 2015 and 2014, we had no amounts reclassified from accumulated OCI to earnings related to discontinued cash flow hedges.


(b)	Amounts are before the effect of PSA deferrals.

During the next twelve months, we estimate that a net loss of $5 million before income taxes will be reclassified from accumulated OCI 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 months ended March 31, 2015 and 2014 (dollars in thousands):



	Financial Statement Location	Three Months Ended March 31,
Commodity Contracts	Financial Statement Location	2015			2014
Net loss recognized in income	Operating revenues (a)	$	(48	)	$	(92	)
Net gain (loss) recognized in income	Fuel and purchased power (a)	(44,803		)	18,107
Total		$	(44,851	)	$	18,015


(a)	Amounts are before the effect of PSA deferrals.

Derivative Instruments in the Condensed Consolidated Balance Sheets

Our derivative transactions are typically executed under standardized or customized agreements, which include collateral requirements and, in the event of a default, would allow for the netting of positive and negative exposures associated with a single counterparty. Agreements that allow for the offsetting of positive and negative exposures associated with a single counterparty are considered master netting arrangements. Transactions with counterparties that have master netting arrangements are offset and reported net on the Condensed Consolidated Balance Sheets. Transactions that do not allow for offsetting of positive and negative positions are reported gross on the Condensed Consolidated Balance Sheets.

We do not offset a counterparty’s current derivative contracts with the counterparty’s non-current derivative contracts, although our master netting arrangements would allow current and non-current positions to be offset in the event of a default. Additionally, in the event of a default, our master netting arrangements would allow for the offsetting of all transactions executed under the master netting arrangement. These types of transactions may include non-derivative instruments, derivatives qualifying for scope exceptions, trade receivables and trade payables arising from settled positions, and other forms of non-cash collateral (such as letters of credit). These types of transactions are excluded from the offsetting tables presented below.

The significant majority of our derivative instruments are not currently designated as hedging instruments. The Condensed Consolidated Balance Sheets as of March 31, 2015 and December 31, 2014, each include gross liabilities of $4 million of derivative instruments designated as hedging instruments.

The following tables provide information about the fair value of our risk management activities reported on a gross basis, and the impacts of offsetting as of March 31, 2015 and December 31, 2014. These amounts relate to commodity contracts and are located in the assets and liabilities from risk management activities lines of our Condensed Consolidated Balance Sheets.



As of March 31, 2015: (Dollars in thousands)	Gross Recognized Derivatives (a)			Amounts Offset (b)			Net Recognized Derivatives			Other (c)			Amount Reported on Balance Sheet
Current assets	$	26,414		$	(13,382	)	$	13,032		$	626		$	13,658
Investments and other assets	23,035			(4,591		)	18,444			—			18,444
Total assets	49,449			(17,973		)	31,476			626			32,102

Current liabilities	(97,349		)	42,069			(55,280		)	(7,023		)	(62,303		)
Deferred credits and other	(106,631		)	32,804			(73,827		)	—			(73,827		)
Total liabilities	(203,980		)	74,873			(129,107		)	(7,023		)	(136,130		)
Total	$	(154,531	)	$	56,900		$	(97,631	)	$	(6,397	)	$	(104,028	)


(a)	All of our gross recognized derivative instruments were subject to master netting arrangements.


(b)	Includes cash collateral provided to counterparties of $56,900.


(c)	Represents cash collateral and margin that is not subject to offsetting. Amounts relate to non-derivative instruments, derivatives qualifying for scope exceptions, or collateral and margin posted in excess of the recognized derivative instrument. Includes cash collateral received from counterparties of $7,023 and cash margin provided to counterparties of $626.



As of December 31, 2014: (Dollars in thousands)	Gross Recognized Derivatives (a)			Amounts Offset (b)			Net Recognized Derivatives			Other (c)			Amount Reported on Balance Sheet
Current assets	$	28,562		$	(15,127	)	$	13,435		$	350		$	13,785
Investments and other assets	24,810			(7,190		)	17,620			—			17,620
Total assets	53,372			(22,317		)	31,055			350			31,405

Current liabilities	(86,062		)	33,829			(52,233		)	(7,443		)	(59,676		)
Deferred credits and other	(82,990		)	32,388			(50,602		)	—			(50,602		)
Total liabilities	(169,052		)	66,217			(102,835		)	(7,443		)	(110,278		)
Total	$	(115,680	)	$	43,900		$	(71,780	)	$	(7,093	)	$	(78,873	)


(a)	All of our gross recognized derivative instruments were subject to master netting arrangements.


(b)	Includes cash collateral provided to counterparties of $43,900.


(c)	Represents cash collateral and margin that is not subject to offsetting. Amounts relate to non-derivative instruments, derivatives qualifying for scope exceptions, or collateral and margin posted in excess of the recognized derivative instrument. Includes cash collateral received from counterparties of $7,443, and cash margin provided to counterparties of $350.

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 one counterparty for which our exposure represents approximately 94% of Pinnacle West’s $32 million of risk management assets as of March 31, 2015. This exposure relates to a long-term traditional wholesale contract with a counterparty that has a 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 March 31, 2015 (dollars in millions):



	March 31, 2015
Aggregate fair value of derivative instruments in a net liability position	$	204
Cash collateral posted	57
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 $166 million if our debt credit ratings were to fall below investment grade.