Derivative Accounting

6 Months Ended

Jun. 30, 2011

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 these market fluctuations by utilizing various derivative instruments, including futures, forwards, options and swaps.  As part of our overall risk management program, we may use such instruments to hedge purchases and sales of electricity, fuels, and emissions allowances and credits.  Derivative instruments that are designated as cash flow hedges are used to limit our exposure to cash flow variability on forecasted transactions.  The changes in market value of such contracts have a high correlation to price changes in the hedged transactions. We may also invest in derivative instruments for trading purposes; however, for the period ended June 30, 2011, there was no material trading activity.

Our derivative instruments are accounted for at fair value; see Note 14 for a discussion of fair value measurements.  Derivative instruments for the physical delivery of purchase and sale quantities transacted in the normal course of business qualify for the normal purchase and sales scope exception and are accounted for under the accrual method of accounting.  Due to the scope exception, these derivative instruments are excluded from our derivative instrument discussion and disclosures below.

We also enter into derivative instruments for economic hedging purposes.  While we believe the economic hedges mitigate exposure to fluctuations in commodity prices, some of these instruments may not meet the specific hedge accounting requirements and are not designated as accounting hedges.  Economic hedges not designated as accounting hedges are recorded at fair value on our balance sheet with changes in fair value recognized in the statement of income as incurred.  These instruments are included in the “non-designated hedges” discussion and disclosure 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 accumulated other comprehensive income (“AOCI”) 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 of June 30, 2011, we hedged the majority of certain exposures to the price variability of commodities for a maximum of 39 months.

In the electricity business, some contracts to purchase energy are netted against other contracts to sell energy.  This is called “book-out” and usually occurs in contracts that have the same terms (quantities and delivery points) and for which power does not flow.  We net these book-outs, which reduces both revenues and fuel and purchased power costs in our Condensed Consolidated Statements of Income, but this does not impact our financial condition, net income or cash flows.

For its regulated operations, APS defers 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.  Realized gains and losses on derivatives are deferred in accordance with the PSA to the extent the amounts are above or below the portion of APS’s base rates attributable to fuel and purchased power costs (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 June 30, 2011, we had the following outstanding gross notional amount of derivatives, which represent both purchases and sales (does not reflect net position):

Commodity	Quantity
Power	13,226,728	megawatt hours
Gas	145,891,520	MMBTU (a)

(a) “MMBTU” is one million British thermal units.

Derivative Instruments in Designated Accounting Hedging Relationships

The following table provides information about gains and losses from derivative instruments in designated accounting hedging relationships and their impact on our Condensed Consolidated Statements of Income during the three and six months ended June 30, 2011 and 2010 (dollars in thousands):

	Financial Statement	Three Months Ended June 30,						Six Months Ended June 30,
Commodity Contracts	Location	2011			2010			2011			2010
Amount of Loss Recognized in AOCI on Derivative Instruments (Effective Portion)	Accumulated other comprehensive loss-derivative instruments	$	(16,324	)	$	(8,588	)	$	(15,335	)	$	(100,255	)
Amount of Loss Reclassified from AOCI into Income (Effective Portion Realized)	Regulated electricity segment fuel and purchased power	(25,287		)	(29,143		)	(40,133		)	(42,329		)
Amount of Gain (Loss) Recognized in Income from Derivative Instruments (Ineffective Portion and Amount Excluded from Effectiveness Testing) (a)	Regulated electricity segment fuel and purchased power	(176		)	11,899			(164		)	1,432

(a) During the three and six months ended June 30, 2011 and 2010, we had no amounts reclassified from AOCI to earnings related to discontinued cash flow hedges.

During the next twelve months, we estimate that a net loss of $89 million before income taxes will be reclassified from AOCI as an offset to the effect of market price changes for the related hedged transactions.  Approximately 90% of the amounts related to derivatives subject to the PSA will be recorded as either a regulatory asset or liability and have no effect on earnings.

Derivative Instruments Not Designated as Accounting Hedges

The following table provides information about gains and losses from derivative instruments not designated as accounting hedging instruments and their impact on our Condensed Consolidated Statements of Income during the three and six months ended June 30, 2011 and 2010 (dollars in thousands):

		Three Months Ended June 30,						Six Months Ended June 30,
Commodity Contracts	Financial Statement Location	2011			2010			2011			2010
Amount of Net Gain (Loss) Recognized in Income from Derivative Instruments	Regulated electricity segment revenue	$	(503	)	$	426		$	1,004		$	595
Amount of Net Loss Recognized in Income from Derivative Instruments	Regulated electricity segment fuel and purchased power expense	(2,892		)	(29,260		)	(11,919		)	(64,228		)
Total		$	(3,395	)	$	(28,834	)	$	(10,915	)	$	(63,633	)

Fair Values of Derivative Instruments in the Condensed Consolidated Balance Sheets

The following table provides information about the fair value of our derivative instruments, margin account and cash collateral 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 June 30, 2011 (dollars in thousands):

Commodity Contracts	Current Assets			Investments and Other Assets		Current Liabilities			Deferred Credits and Other			Total Assets (Liabilities)
Derivatives designated as accounting hedging instruments:
Assets	$	329		$	—	$	11,730		$	3,011		$	15,070
Liabilities	(550		)	—		(90,187		)	(57,209		)	(147,946		)
Total hedging instruments	(221		)	—		(78,457		)	(54,198		)	(132,876		)
Derivatives not designated as accounting hedging instruments:
Assets	24,607			43,173		31,946			10,365			110,091
Liabilities	(869		)	—		(94,294		)	(82,903		)	(178,066		)
Total non-hedging instruments	23,738			43,173		(62,348		)	(72,538		)	(67,975		)
Total derivatives	23,517			43,173		(140,805		)	(126,736		)	(200,851		)
Margin account	2,137			—		11,087			3,862			17,086
Collateral provided to counterparties (a)	10,000			—		81,669			65,801			157,470
Collateral provided from counterparties (a)	—			—		(12,145		)	—			(12,145		)
Prepaid option premiums and other	3,243			—		1,510			—			4,753
Balance Sheet Total	$	38,897		$	43,173	$	(58,684	)	$	(57,073	)	$	(33,687	)

(a) Amounts represent collateral relating to non-derivatives and derivative instruments, including those that qualify for scope exceptions.

The following table provides information about the fair value of our derivative instruments, margin account and cash collateral reported on a gross basis at December 31, 2010 (dollars in thousands):

Commodity Contracts	Current Assets			Investments and Other Assets			Current Liabilities			Deferred Credits and Other			Total Assets (Liabilities)
Derivatives designated as accounting hedging instruments:
Assets	$	1,234		$	142		$	9,062		$	4,913		$	15,351
Liabilities	(602		)	(1,933		)	(107,784		)	(71,109		)	(181,428		)
Total hedging instruments	632			(1,791		)	(98,722		)	(66,196		)	(166,077		)
Derivatives not designated as accounting hedging instruments:
Assets	36,831			40,927			27,322			19,886			124,966
Liabilities	(312		)	(33		)	(112,535		)	(85,473		)	(198,353		)
Total non-hedging instruments	36,519			40,894			(85,213		)	(65,587		)	(73,387		)
Total derivatives	37,151			39,103			(183,935		)	(131,783		)	(239,464		)
Margin account	24,579			—			997			—			25,576
Collateral provided to counterparties (a)	11,556			—			125,367			66,393			203,316
Collateral provided from counterparties (a)	(1,750		)	—			(1,250		)	—			(3,000		)
Prepaid option premiums and other	2,252			(71		)	(155		)	—			2,026
Balance Sheet Total	$	73,788		$	39,032		$	(58,976	)	$	(65,390	)	$	(11,546	)

(a) Amounts represent collateral relating to non-derivatives and derivative instruments, including those that qualify for scope exceptions.

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 64% of Pinnacle West’s $82 million of risk management assets as of June 30, 2011.  This exposure relates to long-term traditional wholesale contracts with counterparties that have very 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.  The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a liability position on June 30, 2011 was $303 million, for which we had posted collateral of $147 million in the normal course of business.

For those derivative instruments in a net liability position, with investment grade credit contingencies, the counterparties could demand additional collateral if our debt credit ratings were to fall below investment grade (below BBB- for Standard & Poor’s or Fitch or Baa3 for Moody’s).  If the investment grade contingent features underlying these agreements had been fully triggered on June 30, 2011, after off-setting asset positions under master netting arrangements we would have been required to post approximately an additional $106 million of collateral to our counterparties; this amount includes those contracts which qualify for scope exceptions, which are excluded from the derivative details in the above footnote.  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 $194 million if our debt credit ratings were to fall below investment grade.