ML17305B106

1989 Annual Rept,Arizona Public Svc Co.

ML17305B106
Person / Time
Site:	Palo Verde
Issue date:	12/31/1989
From:	Snell R ARIZONA PUBLIC SERVICE CO. (FORMERLY ARIZONA NUCLEAR
To:
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ML17305B105	List: ML17305B104 ML17305B106 ML17305B107 ML17305B108 ML17305B109 ML20059N661 ML20059N663
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NUDOCS 9010170088
Download: ML17305B106 (42)

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1989 ANNUAL REPORT 90iOi70088 90i005 PDR ADOCK 05000528 I PDC

ABOUT THE COMPANY Arizona Public Service Company (the "Company" or "APS") is engaged principally in the generation and sale of electricity. APS, a successor to a series of small utility operations originating in 1886, was incorporated in 1920 under the laws of Arizona and has operated under its present name since 1952. The Company's electric service reaches approximately 1,629,000 people, or about 45 percent of the state's population, in an area that includes all or part of ll of Arizona's 15 counties.

, All of the outstanding shares of common stock of the Company are owned by Pinnacle West Capital Corporation ("Pinnacle West" ), which became the Company's corporate parent, effective in April 1985, pursuant to a corporate restructuring. The restructuring did not affect the Company's preferred stock or any of its outstanding debt securities, all of which remain obligations of the Company. Pursuant to a Pledge Agreement, dated as of January 31, 1990 between Pinnacle West and Citibank, N.A., as Collateral Agent (the "Pledge Agreement" ), and as part of a restructuring of substantially all of its outstanding indebtedness, Pinnacle West granted certain of its lenders a security interest in all of the Company's outstanding common stock. Until the Collateral Agent and Pinnacle West receive notice of the occurrence and continuation of an Event of Default (as defined in the Pledge Agreement), Pinnacle West is entitled to exercise or refrain from exercising any and all voting and other consensual rights pertaining to the common stock. As to matters other than the election of directors, Pinnacle West agreed not to exercise or refrain from exercising any such rights if, in the Collateral Agent's judgment, such action would have a material adverse effect on the value of the common stock.

After notice of an Event of Default, the Collateral Agent will have the right to vote the common stock.

ANNUALREPORT This report is published to provide general information concerning the Company and not in connection with any sale, offer for sale, or solicitation of an offer to buy, any securities.

ANNUALMEETING OF STOCKHOLDERS All stockholders are invited to attend the Company's seventieth annual meeting at 10:00 a.m.

on Tuesday, April 17, 1990, at the offices of the Company, 400 North Fifth Street, Phoenix, Arizona.

APS OFFICERS Jack N. Bailey, 40, Vice President, Nuclear Safety and Licensing Leslie N. Brockhurst, 43, Vice President, Human Resources William F. Conway, 59, Executive Vice President, Nuclear

0. Mark De Michele, 56, President and Chief Executive Officer Walter F. Ekstrom, 52, Executive Vice President, Engineering, Operations and Construction Karl Eller, 61, Chairman of the Executive Committee David W. Ellis, 51, Vice President, Engineering William J. Hemelt, 36, Treasurer and Assistant Secretary Russell D. Hulse, 62, Vice President, Resources Planning Charles D. Jarman, 54, Vice President, Construction James M. Levine, 40, Vice President, Nuclear Production Nancy C. Loftin, 36, Secretary and Corporate Counsel Jaron B. Norberg, 52, Executive Vice President and Chief Financial Officer William J. Post, 39, Vice President, Finance and Rates Shirley A. Richard, 43, Executive Vice President, Customer Service, Marketing and Corporate Relations E. C. Simpson, 42, Vice President, Nuclear Engineering and Construction Richard Snell, 59, Chairman of the Board (Age on Annual Meeting date, April 17, 1990)

To Our APS Preferred Shareholders:

For Arizona Public Service Company, 1989 represented a significant turning point in the Company's transition from merely an electric utility to a nuclear utility. The year started with Palo Verde's three units producing electricity at the same record-setting pace as during the previous 12 months. However, in March, all three units began experiencing a variety of equipment failures which would, in combination with subsequent regulatory action, take them out of service. Two of the units remained off line for the rest of the year.

The extended outage at Palo Verde had a significant impact on the financial fortunes of APS in 1989. Although several cost cutting actions helped to mitigate the financial downturn, the Company achieved only a 9.4% return on equity for 1989, well below the 12.5% authorized by the Arizona Corporation Commission. After payment of preferred dividends, we earned $ 180 million on revenues of $ 1.45 billion; electric sales decreased by 1.5% to 17.5 million megawatt-hours, since access to the wholesale markets was limited as a result of the Palo Verde outage.

Shortly after the units came down in March, the Nuclear Regulatory Commission ("NRC")

instructed APS to obtain NRC approval before restarting each unit. In order to meet certain NRC concerns, we accelerated our efforts to strengthen the management team at Palo Verde. To that end, in May 1989, we hired William F. Conway, a 21-year veteran of the commercial nuclear industry to direct Palo Verde operations. In the ensuing months, Mr. Conway has succeeded in filling 13 executive or senior manager positions with highly skilled individuals, all of whom possess significant nuclear industry experience.

The Company's positive and aggressive action in dealing with its management and operational issues at Palo Verde in the last half of 1989 was recognized by the NRC in its annual Systematic Assessment of Licensee Performance (or SALP) Report. In that SALP Report, the NRC states that "overall performance has generally been improving during the last six months (May through October) of the assessment period, and most indications are that improved performance can continue in the future." We are absolutely committed to continuing our "improved performance" at Palo Verde.

As for the units themselves, Unit 2 came back on line in June, following extensive testing, inspection and review by both the Company and the NRC. That unit came off line on February 24 for refueling. Unit 3, which was refueled while out of service, started producing electricity again on January 21, 1990 and is expected to operate on an 18-month refueling cycle. Unit 1 also and is expected back on line by the end of March for its 18-month operating cycle.

underwent'efueling One highlight for Palo Verde during the year was the issuance of the Arizona Corporation Commission's Prudence Audit Report in April. That audit, conducted by the national accounting firm of Ernst & Whinney under the direction of the Commission, took over four years to complete, at a cost to APS of over $ 35 million, and examined millions of pages of documents relating to all aspects surrounding the construction of the plant.

The final result represents a significant achievement for the Company, its management and the thousands of men and women who worked on Palo Verde during its construction period. Of the total $ 5.9 billion construction cost of Palo Verde, the audit documented only $ 60 million of expenditures it deemed to be imprudently incurred. That amount is about 1% of the cost of the plant, and is far and away the best result of a construction prudence audit in the country.

Additionally, however, Ernst & Whinney pointed out that exceptional management performance during the construction of Palo Verde resulted in a quantifiable savings of approximately $ 300 million.

Obviously, with the operating difficulties experienced by Palo Verde in 1989, the Company and its employees had to heighten their commitment to provide exceptional customer service.

Particularly through the hot summer months, the Company had to replace Palo Verde

generation by relying more heavily on our coal-fired facilities like Four Corners and Cholla, bringing the smaller, more costly oil- and gas-fired units back into service, and purchasing power from other utilities in the western United States.

That effort demanded extraordinary cooperation among plant engineers, operators and system controllers. But the results, despite the hottest summer on record, were exceptional.

Through the four peak-demand months of June-September, the equivalent availability of the company's coal-fired plants averaged 94.06 percent. For the year overall the figure was 85.65 percent, the highest availability in the Company's history and well above the industry average.

As a result of this performance, matched at the Company's gas- and oil-fired peaking plants and combined-cycle turbines, purchases of high-priced interchange energy from neighboring utilities were minimized. More importantly, during one of Arizona's hottest and most demanding summers, not a single customer's service had to be curtailed.

Our Company's serious financial challenges have underscored the need for the rate increases which we filed with the Arizona Corporation Commission this past January. Our filing asks for approval of three 6.8% rate increases, to take effect in 1991, 1992 and 1993, respectively. Though our request refiects a commitment, made in 1987, not to raise rates until 1991, increases are needed to recover expenses associated with continued customer growth, including additions to transmission and distribution systems and increases in property taxes, as well as construction and operation of Palo Verde Unit 3 and Cholla Unit 4.

As we wrote last year, we are also striving to become more innovative, more entrepreneurial and market-driven. Our overriding goal is "ServicePlus," or exceptional service. We are convinced that providing such service is the key to maintaining a positive relationship with our customers and helping us compete in a rapidly changing, increasingly competitive business environment.

To encourage our employees to be more Qexible and responsive to customer needs and perceptions, we have launched a Company-wide program called "ServicePlus Partnership." This program provides a formalized process by which employees identify their customers internal and external then focus their energies and resources on breaking down barriers and making the decisions that can improve both their service to customers and their overall productivity.

Our ServicePlus approach recently earned national recognition by being spotlighted in The Service Edge (Zemke and Schaff, New American Library). APS was described by the book's authors as providing "light and warmth that can'. be measured by a meter," and was the only investor-owned utility and the only Arizona firm among the 101 U.S. companies profiled.

We have also taken a leadership role in the State of Arizona's economic recovery effort. In 1989, our economic development department spearheaded efforts to attract or expand industry and to assist communities in rural or metropolitan areas in this effort. The department has also taken the lead in organizations such as the Greater Phoenix Economic Council and others across the region.

We invite you to study the detailed financial information in the following pages and to attend our Annual Meeting of Stockholders on April 17 in Phoenix.

Richard Snell O. Mark De Michele Chairman of the Board President and Chief Executive Officer

ARIZONA PUBLIC SERVICE COMPANY SELECTED FINANCIALDATA 1989 1988 1987 1986 1985 (Thousands of Dollars)

Electric Operating Revenues... $ 1 447 154 $ 1 442 023 $ 1 322 930 $ 1 255 057 $ 1 183 784 Electric Operating Expenses:

Operation and maintenance .. 641,702 594,041 596,353 546,253 457,267 Depreciation and amortization 202,409 194,334 160,298 139,541 99,221 Taxes 296,887 318,047 323,204 305,909 320,312 Palo Verde cost deferral ~.... ~68 989) ~67 479) ~84 289) ~25 526)

Total 1 072 009 1 038 943 995 566 966 177 876 800 Operating Income 375,145 403,080 327,364 288,880 306,984 Other Income* ............. 56,965 71,694 126,456 173,847 190,047 Interest Deductions - Net..... 219 756 203 563 156 057 188 607 171 608 Income Before Cumulative Effect of Accounting Change....... 212,354 271,211 297,763 274,120 325,423 Cumulative Effect of Accounting Change - Net of Tax'et 16 110 Income 212,354 271,211 313,873 274,120 325,423 Preferred Stock Dividend Requirements............. 32 302 38 319 32 950 39 279 44 412 Earnings for Common Stock ... $ 180 052 $ 237 892 $ 280 923 $ 234 841 $ 281 011 Total Assets . $ 6,299,885 $ 5,990,964 $ 5,818,588 $ 5,595,883 $ 5,251,327 Long-term Debt and Redeemable Preferred Stock .. $ 2,510,360 $ 2,455,880 $ 2,503,928'2,107,219 $ 2,425,361

'ederal and state income taxes are included in Taxes, Other Income and Cumulative Effect of Accounting Change. Total income tax expense was as follows 1989, $ 145,678,000; 1988,

$ 183,897,000; 1987, $ 197,314,000; 1986, $ 156,820,000; 1985, $ 165,279,000. Palo Verde cost deferral included in Other Income for 1989, 1988, 1987 'and 1986 was $ 72,861,000, $ 79,432,000,

$ 71,961,000 and $ 38,262,000, respectively; there was no such deferral in 1985.

OTHER FINANCIALAND OPERATING STATISTICS 1989 1988 1987 1986 1985 (Dollars in Thousands, Except Pcr Hour Amounts)

Capitalization:

Common e(Iuity $ 1,901,615 $ 1,932,419 $ 1,905,577 $ 1,835,616 $ l)811,405 Non-redeemable preferred stock . ..~ 168,561 168,561 168,561 218,561 218,561 Redeemable preferred stock 204,021 212,948 221,978 178,728 219,421 Long-term debt .... 2 806 389 2 242 932 2 281 950 1 928 491 2 205 940 Total........... $ 4 580 586 $ 4 556 860 $ 4 578 066 $ 4 161 396 $ 4 455 327 Utilityplant gross... $ 6,668,644 $ 6,414)655 $ 6,229,446 $ 5,880,435 $ 5,712,507 Utilityplant net .... $ 5,168,730 $ 5,112,648 $ 5,093,035 $ 4,904,325 $ 4,873,823 Number of employees at year-end .......... 8,181 8,135 8,926 16.09 8,966 15.23 8,324 14.48 Average wage per hour $ 17.97 $ 17.02 $ $ $

Electric resources (kw) 4,575,300 4,311,800 3,925,600 3,592,100 3,570,800 Peak load (kw) 3,645,600 3,371,600 3,159,300 3,194,600 3,197,800 Electric sales total (mwh) 17,488,551 17,760,896 15,404,312 14,180,458 14,348,204 Number of customers at year-end .......... 594,820 582,003 566,384 545,018 521,567 OPERATING REVENUES 1989 1988 1987 1986 1985 (Thousands of Dollars)

Electric Residential..... $ 559,755 $ 545,082 $ 505,525 $ 466,816 438,265 Commercial 521,665 501,666 467,643 441,236 401,439 Industrial 172,556 166,346 146,925 141,729 135,254 Irrigation 14,424 14,989 16,641 21,547 22,853 Other......... 112 613 114 180 88 630 85 816 107 010 Total........ 1,381,013 1,342,263 1,225,364 1,157,144 1,104,821 Transmission for others........... 14,117 17,187 14,254 19,692 16,602

- Miscellaneous services 52 024 82 573 83 312 78 221 62 361 Total operating revenues .......... $ 1 447 154 $ 1 442 023 $ 1 322 930 $ 1 255 057 $ 1 188 784

THIS PAGE LEFT BLANKINTENTIONALLY MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Company's liquidity is affected primarily by construction expenditures and by capital requirements relating to debt and preferred stock redemptions and repurchases. The capital resources available to meet these requirements include internal cash generation and external financings.

Although its plans are subject to change, the Company does not presently intend to construct any new major baseload generating units until the end of the century. Utility construction expenditures for the years 1990 through 1992 are therefore expected to consist primarily of the cost of updating and expanding the electric transmission system and utility distribution systems.

During 1990, 1991 and 1992, the Company expects to incur construction expenditures of $ 318 million, $ 309 million and $ 300 million, respectively. These amounts include nuclear fuel expenditures, but omit capitalized property taxes and allowance for funds used during construction ("AFC"). The Company conducts a continuing review of its construction program.

This program and the above"estimates are subject to periodic revisions based upon changes in assumptions as to system load growth, rates of "inflation, the availability and timing of environmental and other regulatory approvals, the availability and costs of outside sources of capital and changes in project construction schedules. During the years 1987 through 1989, the Company incurred approximately $ 837 million in construction expenditures and approximately

$ 138 million in additional capitalized items.

The Company has a degree of flexibility in adjusting its construction program to its financing capability; however, that flexibility is somewhat limited and its long-term liquidity will depend on its access to the capital markets, which in turn will depend on sufficiency of rates to provide adequate coverages on senior securities and an adequate rate of return on common stock equity. Adequate earnings and coverages are critical to the maintenance of satisfactory credit ratings on the Company's senior securities and, as calculated in accordance with the Company's mortgage bond indenture and articles of incorporation, are prerequisite to the Company's legal ability to issue such securities (see below).

The Company's other major cash requirements include payments of long-term debt and preferred stock maturities, redemptions and repurchases (together, approximately $ 120 million,

$ 174 million and $ 233 million, for the years 1990, 1991 and 1992, respectively) and annual lease payments of approximately $ 44 million for the Company's leasehold interest in a portion of Unit 2 of the Palo Verde Nuclear Generatin~gS ation ("Palo Verde" ). The Company notified the beneficial owners of its $ 12.90 Cumulative Preferred Struck, Series N (the "Series N Stock" ), and its $ 11.50 Cumulative Preferred Stock, Series R (the "Series R Stock" ), of its intent to repurchase such 'stock on December 1, 1989; however, pursuant to existing agreements with the Company, the beneficial owners denied the Company its options to repurchase at that time. In the event that the beneficial owners have the right to rescind these denials, the Company may be required to repurchase the Series N Stock and/or the Series R Stock for an aggregate repurchase price of approximately $ 77 million, which amount is not included in the requirements=

set forth above for the years 1990 through 1992. In addition, the Company may be required to indemnify the beneficial owners of the Series N Stock and the Series R Stock in the aggregate amount of up to $ 58 million (before income taxes) if certain Internal Revenue Service ("IRS")

claims are sustained regarding the taxable nature of distributions in respect of such stock and the beneficial owners'osition with respect to indemnification is upheld. The Company believes there are meritorious defenses to the IRS claims.

In 1989, the Company financed approximately 39% of its capital expenditures generated funds (after the payment of dividends), decreasing from approximately with'nternally

83% and 45% in 1988 and 1987, respectively. The decline in 1989 resulted primarily"from higher fuel, purchased power, and operation and maintenance costs attributable to the. unscheduled outages during 1989 at Palo Verde. The increase in 1988 over 1987 resulted primarily from increased revenues attributable to a retail rate increase granted effective April 1, 1988 in the Palo Verde Unit 2 rate decision. The Company expects to finance more than one-half of its capital expenditures internally (after the payment of dividends) in the period 1990 through 1992. This situation may deterio'rate, however, if the Company does not receive adequate rate relief with respect to Palo Verde Unit 3, Unit 4 of the Cholla Plant ("Cholla 4"), and other cost of service increases. (See "ACC Matters" below.)

In 1989, the Company provided for its external capital requirements primarily through the issuance of $ 100 million aggregate principal amount of first mortgage bonds, short-term borrowings (principally issuances of. commercial paper and bank borrowings) and internal cash generation. During 1989, the Company redeemed approximately $ 45 million in aggregate principal amount of its first mortgage bonds and purchased or optionally redeemed shares of, various series of its cumulative preferred stock having an aggregate par value of approximately

$ 9 million.

Provisions in the Company's mortgage bond indenture and articles of incorporation restrict the Company from issuing additional first mortgage bonds or preferred stock, respectively, unless the Company's earnings (as defined) cover by at least the prescribed number of times the amount of interest (as to bonds) and the amount of interest plus preferred stock dividend requirements (as to preferred stock) on the securities to be outstanding after completion of the new issue. Operation of the latter such provision has at times in the past limited the Company's ability to issue preferred stock. In addition, the mortgage bond indenture limits the amount of additional bonds which may be issued to a percentage of net "property additions" and property previously pledged as, security for certain bonds that have been redeemed or retired. As of December 31, 1989, the Company estimates that the mortgage bond indenture and the articles of incorporation would have allowed the Company to issue approximately $ 1.185 billion of additional first mortgage bonds based on property additions and property pledged as security for certain bonds that have been redeemed or retired (as compared to approximately $ 1.4 billion on the basis of coverages) and $ 248 million of preferred stock, respectively. Minimum required coverages are 2.0 for bonds and 1.5 for preferred stock. Actual coverages afforded by earnings (as defined) were as follows:

Year Ended December 31 1989 1988 1987 Bonds 3.93 4.90 4.73 Preferred Stock . 1.68 1.91 1.91 Provisions in certain financing agreements of the Company's parent, Pinnacle West Capital Corporation ("Pinnacle West" ), limit the aggregate amount of, additional long- term indebtedness that may be incurred by Pinnacle West and its subsidiaries, including the Company, to a specified percentage of, consolidated capitalization (as defined). At December 31, 1989, the amount of additional long-term indebtedness that could be incurred in accordance with these provisions was approximately $ 285 million. Pinnacle West is currently contractually prohibited from incurring additional indebtedness. Based on certain assumptions regarding consolidated earnings and the amount of long-term indebtedness to be incurred by Pinnacle West's subsidiaries other than the Company, it is not expected that these provisions will limit the Company's ability to meet its capital requirements.

By Arizona statute, the Company's short-term borrowings may not exceed 7% of its total capitalization without the consent of the Arizona Corporation Commission (the "ACC"). Such borrowings are an important source of funds, particularly between permanent financings, and

the statute could from time to time limit the Company's financing flexibility. However, the Company's own general policy relating to short-term borrowings is consistent with that of the statute.

Moody's Investors Service, Inc. ("Moody's"), Standard & Poor's Corporation ("S&P"), and Duff & Phelps, Inc. ("DufF & Phelps" ) establish ratings on certain of the Company's securities and lowered. such ratings on November 6, 1989, January 30, 1990 and February 14, 1990; respectively. In their decision to lower ratings, these companies cited the regulatory uncertainty regarding matters pending before the ACC, the potential for decreasing financial flexibilityat the Company because of the continuing liquidity problems of Pinnacle West, deteriorating cash flow and earnings measures, due in part to the extended Palo Verde outages discussed below (see "Operating Results Fuel Expenses" ) and Pinnacle West's dependence on the Company's common stock dividends. The table below reflects the Company's current ratings by Moody's, S&P and Duff & Phelps.

Duff 8:

Moody's S&P Phelps Security Ratings Ratings Ratings First Mortgage Bonds and Baa3 .

BBB- BBB-Secured Pollution Control Bonds Eurodebentures Bal BB+ Not rated Preferred Stock bal BB BB+

Commercial Paper P-3 A-3 DufF 3 Secured Lease Obligation Bonds Baa3 BB+ BBB-(PVNGS Funding Corp., Inc.)

The Company expects that the downgradings by the rating agencies may adversely affect the Company's ability to access the financial markets and will raise the cost of external capital.

Although its plans are subject to change for reasons which would include market conditions, rate relief, and limitations imposed by the Company's mortgage bond indenture, articles of incorporation and certain Pinnacle West financing agreements (see above), the Company intends to sell in 1990 up to $ 225 million in long-term debt (presumably first mortgage bonds) and up to $ 100 million in aggregate par value of preferred stock. As of December 31, 1989, the Company had credit commitments from various banks totalling approximately $ 302 million (which were available either to support-the issuance of additional commercial paper or to be used for additional bank borrowings), under which borrowings totalling $ 210 million were outstanding.

The Company's capital structure at December 31, 1989 consisted of 50% long-term debt (excluding current maturities), 4% preferred stock with mandatory redemption requirements, 4% preferred stock without mandatory redemption requirements and 42% common stock equity.

During 1986, the Company entered. into sale and leaseback transactions under which it sold and leased back approximately 42% of its 29.1% ownership interest in Palo Verde Unit 2. The leases are accounted for as operating leases and, accordingly, are not reflected in the Company's capitalization (see Note 8 of Notes to Financial Statements).

Operating Results Su$ )senary. Net income decreased in 1989 to $ 212,354,000 compared to $ 271,211,000 and

$ 313,873,000 in 1988 and 1987, respectively.

Year 1989'988 Ended December 31, (Thousands of Dollars) 1987 Operating Revenues $ 1,447,154 $ 1,442,023 $ 1,322,930 Net Income $ 212,354 $ 271,211 $ 313,873 The decline in net income in 1989 as compared to 1988 was primarily due to higher fuel and purchased power costs incurred as a result of the extended Palo Verde outages. Also, higher operation and maintenance costs in 1989 were in large part due to these outages. Several other factors contributed to the decrease in 1989 net income. Depreciation expense and property taxes were higher due to additional facilities being placed in service. Property taxes also increased due to higher tax rates. Interest costs increased as a result of greater average debt balances outstanding combined with higher interest rates.

The decrease in net income for 1988 as compared to 1987 was primarily attributable to the Company not accruing an equity return on Palo Verde Unit 2 and Unit 3 cost deferrals in accordance with Statement of Financial Accounting Standards No. 92, "Regulated Enterprises-Accounting for Phase-in Plans" ("SFAS No. 92"). Another significant factor was the change in method of accounting for revenues, which resulted in a one-time earnings increase in January 1987. Also contributing to the earnings decline in 1988 was the Company's allowed rate of return on equity being reduced from 14.0% to 12.5% effective April 1, 1988 in the Palo Verde Unit 2 rate decision. The above impacts were somewhat offset by the net income effect of increased revenues, which were largely due to customer growth and increased sales per customer in 1988. The following paragraphs discuss these issues in more detail.

ELectric Operating Revenues. Total operating revenues include the effects of rate increases and adjustment clauses on prices of units sold. Operating revenues also refiect volume changes in unit sales. The foregoing factors contributed to annual increases (decreases) in electric operating revenues over the preceding calendar year as follows:

Year Ended December 31, 1989 1988>> 1987>>

(Thousands of Dollars)

Energy related:

Volume increases (1) $ 44,690 $ 90,439 $ 90,843 Revenue per kilowatt-hour increases (decreases) (2) (18,392) 29,732 (21,030)

Non-energy related:

Revenue (decreases) (3)

Total increase

............. ~21 167) ~1078) ~1940)

$ 5 131 $ 119 093 $ 67 873

• Certain prior year items have been reclassified to conform to 1989 presentation.

(1) Calculated by summing the results of multiplying the year-to-year increases in units sold in each customer class by the weighted average of the applicable rate levels in effect for the prior year.

(2) Calculated by summing the results of multiplying the year-to-year increases in the weighted average of rate levels in each customer class times the applicable number of units sold in the current year.

10

(3) Includes revenues for miscellaneous services, transmission for others and a termination settlement with one wholesale customer.

In 1989, the volume-related increases occurred in the residential and business customer classes. The increases were largely due to customer growth and increased sales per customer. In 1988, the volume-related increases occurred in the residential, business and resale customer classes. The increases were largely due to customer growth,.increased sales per customer as a result of warmer summer weather, increased sales to copper mines and increased sales for resale.

In 1987, the volume-related increases in electric revenues were primarily due to increased customers and sales per customer in the residential and commercial classes. The increase in residential sales per customer was largely due to colder weather conditions in the winter months of 1987. Price-related revenue increases and decreases reflect the timing and amounts of base rate changes, the operation of the Company's Purchased Power and Fuel Adjustment Mechanism ("PPFAM"), the incentive for customers to migrate over time to that rate which produces the lowest bill and the effect of weather and seasonal rates on annual average revenue per kilowatt-hour. The year-to-year changes in non-energy related electric revenues reflect changes in the revenues collected for the capacity sold to other utilities. The decrease in 1989 is primarily due to the partial expiration of a layoff agreement for capacity sold from Cholla 4 (see "ACC Matters" below), which is partially offset by a termination settlement with one wholesale customer.

Fuel Expenses. Fuel expenses increased in 1989 due to increased fossil generation resulting from the extended unscheduled outages experienced by all three Palo Verde units during 1989.

Units 2 and 3 have returned to commercial operation. The Company may not restart Unit 1 without Nuclear Regulatory Commission ("NRC") approval. The Company is undertaking corrective actions relating to Unit 1 and currently estimates that it will request NRG approval to restart that unit during the first quarter of 1990. Unit 2's next refueling outage is scheduled for late February 1990. Fuel expenses increased in 1988 and 1987 as increased system energy requirements more than offset lower unit fuel costs resulting from increased nuclear generation attributable to Palo Verde Units 2 and 3.

Variations in purchased power expense reflect contractual commitments with other utilities for purchasing power as a means of augmenting the Company's own generating sources from time to time. As a result of the extended Palo Verde outages, the Company incurred additional replacement power costs totalling approximately $ 58 million, before income taxes, during 1989.

The decreases in purchased power in 1988 and 1987 were primarily due to decreased purchases as a result of increased nuclear generation.

Until 1989, nearly all of the Company's purchased power and fuel costs were either recovered currently or deferred to the extent allowed by the ACC pursuant to the PPFAM and, accordingly, did not materially affect earnings. On April 13, 1989 the ACG issued an order eliminating the PPFAM. Without the PPFAM, actual purchased power and fuel costs incurred are reflected currently in earnings. The order requires the Company to seek recovery of any changes in fuel and purchased power costs along with changes in other elements of cost of service in a general rate request. The Company recently requested that the ACC approve an expedited procedure for the reflection in rates of significant changes in fuel and purchased power costs. See "ACC Matters Application for Retail Rate Increase" below.

Other Income. Net income reflects accounting practices unique to regulated public utilities and represents a composite of cash and noncash items, including AFC and the cost deferrals associated with Palo Verde Units 2 and 3 (see "Statements of Cash Flows" ).

Palo Verde Unit 2 commenced commercial operation on September 19, 1986. The Company began expensing the costs of operating and maintaining Unit 2 and ceased accruing AFC on such investment at that time. Pursuant to an ACC accounting and ratemaking order, the Company deferred Unit 2 operating costs (excluding fuel) and accrued a carrying charge on

such deferrals until April 1, 1988, the effective date of new rates to cover the costs relating to Unit 2. As a result, earnings were not significantly affected by the increased costs and reduced AFC. In accordance with SFAS No. 92, between January 1, 1988 and April 1, 1988, the Company did not accrue, for financial reporting purposes, an equity return on Unit 2 cost deferrals, the net income effect of which was approximately $ 8 million.

Palo Verde Unit 3 commenced commercial operation on January 8, 1988. The Company began expensing the cost of operating and maintaining Unit 3 and ceased" accruing AFC on such investment at that time. A rate application designed to recover Unit 3 costs has been filed with the ACC (see "ACC Matters" below). On April 6, 1988, the ACC issued. an accounting and ratemaking order that allows the Company, 'or ACG purposes, to defer and capitalize substantially all Unit 3 operating costs (excluding fuel) and to accrue a carrying charge on its ownership interest in Unit 3 and one-third of the facilities common to all three Palo Verde units (collectively, the "Unit 3 Cost Deferrals"). The ACC ordered the period for accumulating such deferrals to commence on January 8, 1988, and to continue until the later of December 31, 1989, or the date that the ACC rules on the application for an extension of the deferral period which was filed by the Company on June 30, 1989 (the "Extension Application"). The application requests an extension of the deferral period until such time as the ACC includes Unit 3 in the Company's rate base.

'n September 22, 1989, a procedural order was issued scheduling an ACC hearing to commence on April 2, 1990 to consider the Extension Application. The procedural order stated that the issues of excess capacity and the recent Palo Verde Unit 3 outages are relevant in determining the propriety of continued deferrals. On February 20, 1990, a procedural order was issued vacating the previous procedural schedule and indefinitely continuing the hearing. Unit 3 Cost Deferrals totalled approximately $ 195 million net of income taxes at December 31, 1989.

The Company estimates that Unit 3 Cost Deferrals are currently accruing in the amount of approximately $ 7 million per month, net of income taxes. If the ACC rules unfavorably on the Extension Application, recoverability of Unit 3 plant costs or deferrals could be limited and/or deferrals could be discontinued, either of which would have an adverse impact on earnings.

Accounting Matters. Effective January 1, 1987, the Company changed its method of recording revenues to include revenue related to electricity delivered to customers but not yet billed at year-end. The cumulative effect as of January 1, 1987 of the change, net of income taxes, was $ 16.1 million and is reported as a separate component of 1987 net income. See Note le of Notes to Financial Statements for further discussion.

ACC Matters The Company's future financial condition and results of operations may be significantly affected by the following ACC matters.

Application for Retail Bate Increase. Palo Verde Unit 3 and Cholla 4 are not currently refiected in the Company's retail rates. The Company's investment in Palo Verde Unit, 3 as of December 31, 1989 was approximately $ 1.2 billion, including cost deferrals. The Company's investment in 'Cholla 4 as of December 31, 1989 was approximately $ 245 million. On January ll, 1990, the Company filed an application with the ACC for a permanent increase in annual retail rates of approximately $ 271 million to become effective in three annual 6.8% increments commencing January 1, 1991. The proposed rate increase seeks to recover the costs of Palo Verde Unit 3 and Cholla 4, as well as costs incident to the increase in retail customers and in the cost of service since 1986 (the prior test year). The rate application includes requests to (1) remove the "interim" designation for revenues collected under certain previous rate orders (see "Interim or Temporary Revenues" below); (2) approve an expedited procedure for the refiection in rates of significant changes in fuel and purchased power costs (see "Operating Results-Fuel Expenses" above); and (3) approve a property tax adjustment clause allowing the Company to recover in rates certain increases in property taxes. The proposed phase-in is expressly premised upon 12

(1) the ACC continuing the accounting and ratemaking order relating to Palo Verde Unit 3 (see "Operating Results-Other Income" above); and (2) the ACC issuing an order relating to Cholla 4, as requested by the Company (see below). Hearings on the rate application have not yet been scheduled. The ultimate outcome of this rate case cannot presently be determined.

The Company is operating under a layofF agreement with Southern California Edison Company ("SCE") for capacity sold from Cholla 4. At present, approximately 200 megawatts are being sold under the agreement, which expires June 1, 1990. A portion of the agreement (covering approximately 150 additional megawatts) expired on June 1, 1989. On January ll, 1990, the Company filed an application with the ACC requesting an order that would allow the Company, for ACC purposes, to defer and capitalize the costs of owning and operating Cholla 4 that will no longer be recovered by the SCE agreement for the period of time between June 1, 1989 and the effective date of new rates recognizing such costs. The application requests deferrals of approximately $ 2 million per month, net of income taxes, from June 1, 1989 through May 31, 1990, and approximately $ 3.5 million per month, net of income taxes, for each month thereafter until the effective date of new rates to cover Cholla 4 costs. Hearings in this matter have not yet been scheduled. On January 24, 1990, the ACC staff filed a motion seeking dismissal of the Cholla 4 application on grounds that, among other things, the Company's request is inequitable and inconsistent with the ACC's regulatory policies. The Company has filed a response opposing this motion.

Palo Verde Prudnice Aiidit. On March 24, 1989, Ernst & Whinney released its report on the prudence audit of Palo Verde. The report identified approximately $ 60 million, excluding AFC and property taxes, for the entire project that were unreasonable. Of this amount, the Company's share is approximately $ 18 million. The report also identified certain areas that were found to exceed the standard of reasonableness and to have had a positive impact on the project, including built-in separation of electrical equipment, design replication of the three units at Palo Verde, certain aspects of the regulatory (licensing) management function, and certain labor and contractual arrangements. The report estimated that the potential direct cost savings of the identified areas in which performance exceeded the standard of reasonableness were approximately $ 300 million for the entire project (excluding AFC and property taxes), of which the Company's share is approximately $ 85 million. A procedural framework has not been established within which the ACC would formally, consider the results of the report or the reasonableness of Palo Verde costs.

Interim or Temporary Revenves. Pursuant to an order issued by the ACC in April 1988, the Company estimates that up to $ 211 million in revenues collected through December 31, 1989 are 'o be deemed interim or temporary pending results of the prudence audit and further action of the gCC. In the opinion of management, the amount, if any, of such revenues to be refunded will not be material to the Company's financial statements. See "ACC Matters Application for Retail Rate Increase."

ACC Revieiv of Dividend Payments. On June 23, 1989, the ACC issued an order requiring the ACC Hearing Division to schedule a hearing "to determine whether the [ACC] should limit or otherwise restrict either or both APS'ividend payments to Pinnacle West or APS'nvestment in non-utility operations or consider any other action that may be appropriate to prevent the uneconomic extraction of capital from APS to Pinnacle West or any its subsidiaries." On August 15, 1989, as a result of a negotiated settlement (the "Settlement Agreement" ), the Company agreed that it will not, without prior ACC approval, transfer any funds to Pinnacle West or any of its subsidiaries, directly or indirectly, except for regular quarterly dividend payments not in excess of that declared and paid immediately prior to July 13, 1989, and for reasonable amounts for the payment of services historically rendered to the Company by Pinnacle West or any of its subsidiaries. By its terms, the Settlement Agreement will remain in effect until the sooner of March 1, 1990, or such time as Pinnacle West resolves its present difficulties with MeraBank, A Federal Savings Bank, a subsidiary of Pinnacle West. The ACC 13

may, however, initiate proceedings during the term of the Settlement Agreement to effectuate changes in the Company's dividend policy if, and only if, catastrophic and disastrous events occur which could significantly adversely affect the Company's financial condition or prevent the Company from financing at reasonable costs its capital requirements necessary to meet customer service needs. In such event, however, the Company and Pinnacle West would be free to challenge any such action by the ACC.

14

ARIZONA PUBLIC SERVICE COMPANY STATE)CLIENTS OF INCOME Year Ended December 31, 1989 1988 1987 (Thousands of Dollars)

Electric Operating Revenues . $ 1 447 154 $ 1 442 023 $ 1 322 930 Fuel Expenses:

Fuel for electric generation ,, 235,854 207,387 180,597 Purchased power ..

Deferred fuel (Note 1) .

Total ..

~31 65,125 901) 269 078

~4) 33,592 240 975 44,773 55 154 2SO 524 Operating Revenues Less Fuel Expenses........"....'. 1 178 076 1 201 048 1 042 406 Other Operating Expenses:

Operations excluding fuel expenses .. 251,985, 244,913 213,510 Maintenance .. 120,639 '108,153 102,319 Depreciation and amortization 202,409 194,334 160,298 Income taxes (Note 9) 122,674 157,350 178,850 Other taxes (Note 12) 174,213 160,697 144,354 Palo Verde cost deferral (Note 2) ~68 989) 67 479) ~84 2S9)

Total .. 802 931 797 968, 715 042 Operating Income 375 145 403 080 327 364 Other Income (Deductions):

Allowance for equity funds used during construction ... 5,954 12,069 59,015 Palo Verde cost deferral (Note 2) ,72,861. 79,432 71,961

,Income taxes (Note 9) (23,004) (26,547) (6,004)

Other - net; .. 1 154 6 740 1 484 Total .. 56 965 71 694 126 456 Income Before Interest Deductions 432 110 474 774 453 820 Interest Deductions:

Interest on long-term debt . 213,710 202,173 190,587 Interest on short-term borrowings . 10,533 4 988 5 122

'ebt discount, premium and expense 5,967 6,251 6,781 Allowance for borrowed funds used during construction ~10 454) 9849) ~46438)

Total .. 219 756 203563 '56057 Income Before Cumulative Effect of Accounting Change . 212,354 271,211 297,763 Cumulative Effect as of January 1, 1987 of Accruing Unbilled Revenues, Net of Income Taxes of

$ 12,460,000 (Note 1) 16 110 Net Income 212,354 271,211 818,873 Preferred Stock Dividend Requirements 32 802 33 319 32 950 Earnings for Common Stock $ 180 052 $ 237 892 $ 280 923 See Notes to Financial Statements.

15

ARIZONA PUBLIC SERVICE COMPANY BALANCE SHEETS ASSETS December 3L 1989 1988 (Thousands of Dollars)

UtilityPlant (Notes 5, 7 and 8):

Electric plant in service and held for future use $ 6,213,656 $ 61008,411 Less accumulated depreciation and amortization..........' 1 399 365 1 218 699 Total 4,814,291 4,789,712 Construction work in progress . 248,207 251,223 Nuclear fuel, net of amortization of $ 100,549,000 and

$ 83,308,000 106 232 71 718 UtilityPlant net 5 168 730 5 112 648 Investments and Other Assets (at cost) 58 535 51 193 Current Assets:

Cash and marketable securities 48,923 7,876 Temporary cash investments .. 25,000 Accounts receivable:

Service customers 91,258 87,839 Other 31,307 22,985 Allowance for doubtful accounts ..: . (2,774) (2,840)

Accrued utility revenues (Note 1) 42,418 41,024 Materials and supplies (at average cost) 89,505 79,686 Fossil fuel (at average cost) 24,427 25,278 Other . 14 667 9 968 Total Current Assets .. 864 731 271 816 Deferred Debits:

Deferred income taxes 134,698 121,724 Palo Verde cost deferral (Note 2) 495,818 361,042 Unamortized costs of reacquired debt .. 29,318 25,996 Unamortized debt issue costs .. 15,947 16,570 Other . 32 108 29 975 Total Deferred Debits . 707 889 555 307 Total $ 6299885 $ 5990964 See Notes to Financial Statements.

16

ARIZONA PUBLIC SERVICE COMPANY BALANCESHEETS LIABILITIES December 31, 1989 1988 (Thousands of Dollars)

Capitalization (Notes 3, 4 and 5):

Common stock $ 178,162 $ 178,162 Premiums and expenses net 1,034,346 1,034,258 Retained earnings 689 107 719 999 Common stock equity 1,901,615 1,932,419 Non-redeemable preferred stock .. 168,561 168,561 Redeemable preferred stock 204,021 212,948 Long-term debt less current maturities 2 306 339 2 242 932 Total Capitalization 4 580 536 4 556 860

'urrent Liabilities:

Notes payable to banks (Note 6) 240,000 15,000 Commercial paper . 34,500 Current maturities of long-terrII debt (Note 5) 26,193 37,985 Accounts payable 87,253 74,127

'ccrued taxes . V6,084 V4,914 Accrued interest 60,652 53,440 Deferred fuel . 33,543

'ther .. 44 088 35 509 Total Current Liabilities 534 265 359 018 Deferred Credits and Other:

Deferred income taxes (Note 9) 771,573 650,V39 Deferred investment tax credit ... 185,976 192>135 Unamortized gain sale of utility plant (Note 8) 119,850 126,120 Unamortized credit related to sale of tax benefits........ ~ . 36,895 38,583 Customers'dvances for construction 26,138 26,044 Other .. p 44 652 41 465 Total Deferred Credits and Other 1 185 084 1 075 086 Commitments and Contingencies (Notes 2 and 11)

Total $ 6 299 885 $ 5 990 964

ARIZONA PUBLIC SERVICE COMPANY STATEMENTS OF RETAINED EARNINGS Year Ended December 31, 1989 1988 1987 (Thousands of Dollars)

Retained earnings at beginning of year $ 719,999 $ 693,051 $ 617,370 Add Net income 212 354 271 211 313 873 Total 932 353 964 262 981 243 Deduct Dividends:

Common stock (Notes 3,4 and 5) . 210,944 210,944 205,242 Preferred stock (see below) .. 32 302 33 319 32 950 Total 243 246 244 263 238 192 Retained earnings at end of year $ 689 107 $ 719 999 $ 693 051 Dividends on preferred stock:

$ 1.10 preferred .. $ 172 $ 172 $ 172

$ 2,50 preferred .. 258 258 258

$ 2.36 preferred .. 94 94 94

$ 4,35 preferred ... 326 326 . 326 Serial preferred:

$ 2.40 Series A 576 576 576

$ 2.625 Series C . 630 630 630

$ 2.275 Series D 455 455 , 455

$ 3.25 Series E 1,040 1,040 1,040

$ 10.00 Series H 513 674 .833

$ 8.32 Series J .. 4,160 4,160 4,160

$ 8.80 Series K 2,083 2 372 2,686

$ 9.70 Series L 858

$ 12.90 Series N 3,953 4,561 4,835

$ 3.58 Series 0 .. 2,983 Adjustable Rate Series P 315 Adjustable Rate Series Q 3,442, 3,538 ,,3,263

$ 11.50 Series R . 6,110 5,973 5,824

$ 8.48 Series S .. 4,240 4,240 2,544

$ 8.50 Series T .. 4 250 4 250 1 098 Total $ 32 302 $ 33 319 $ 32 950 See Notes to Financial Statements.

18

ARIZONA PUBLIC SERVICE COMPANY STATEMENTS OF CASH FLOWS Year Ended December 3L 1989 1988 1987 (Thousands of Dollars)

Cash Flows from Operations:

Income before cumulative effect of accounting change $ 212,354 $ 271,211 $ 297,763 Items not requiring cash:

Depreciation and amortization . 202,409 194,334 160,298 Nuclear fuel amortization 17,241 51,165 31,722 Allowance for equity funds used during construction .. (5,954) (12,069) (59,015) "

Deferred income taxes net .. 107,860 118,606 131,009 Deferred investment tax credit net (6,159) (9,107) (1,824)

Deferred fuel (33,543) (58) 57,595 Palo Verde cost deferral (141,850) (146,911) (156,250)

Changes in certain current assets and liabilities:

Accounts receivable net . (3,177) 8,644 (6,990)

Utilityrevenues accrued (1,394) (6,029) (34,995)

Materials, supplies and fossil fuel (8,968) (8,605) 1,650 Other current assets (4,699) 3,842 161,462 Accounts payable .. 18,322 (7,836) 13,735 .

Taxes accrued 1,170 10,851 (27,729)

Interest accrued 7,212 1,278 (386)

Other current liabilities 8,095 (133) (12,819)

Other net ~ 7 215 18 187 13 102 Total 376,134 487,370 568,378 Cumulative effect of accounting change ............. 16 110 Net cash provided 376 184 487 870 584 488 Cash Flows from Financing:

Preferred stock 99,562 Long-term debt . 98,625 11,668 388,318 Short-term borrowings net.... 190,500 49,500 . (37,000)

Dividends paid on common stock .. (210,944) (210,944) (205,242)

Dividends paid on preferred stock (31,828) (33,003) (38,136)

Repayment of preferred stock (8,927) (9,080) (106,750)

Repayment and reacquisition of long-term debt .. '..... ~54 528) ~31 406) ~328 156)

Net cash used ~17 097) ~223 215) ~227 404)

Cash Flows from Investing:

Capital expenditures . (300,847) (277,228) (403,488)

Allowance for equity funds used during construction 5,954 12,069 59,015 Sale of property 8,745 Other ~7842) ~4763) ~5788)

Net cash used ~292 990) ~269 922) ~350 211)

Net increase (decrease) in cash and marketable securities . 66,047 (5,767) 6,873 Cash and marketable securities at beginning of period... ~ 7 876 18 643 6 770 Cash and marketable securities at end of period .. ~..... ~ 8 78923 8 7876 8 13643 Supplemental Disclosure of Cash Flow Information:

Cash paid during the year for:

Interest (excluding capitalized interest) ..... ~..... $ 205,646 $ 193,289 $ 156,760 Income taxes .. $ 51,686 $ 67,575 $ 93,156 See Notes to Financial Statements.

19

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS

1. Summary of Significant Accounting Policies.

a. System of accounts The accounting records of Arizona Public Service Company (the "Company" ) are maintained in accordance with the uniform system of accounts prescribed by the Federal Energy Regulatory Commission ("FERC").

b. All of the outstanding shares of common stock of the Company are owned by Pinnacle West Capital Corporation ("Pinnacle West" ).

c. Statements of Cash Flows For purposes of the statements of cash Qows, the Company considers all temporary cash investments and marketable securities to be cash equivalents.

Temporary cash investments and marketable securities have maturities or put dates of three months or less.

d.'lant and depreciation Property is stated at original cost as defined for regulatory purposes. The cost of additions to utility plant and replacements of retirement units is capitalized. Replacements of minor items of property are charged to expense as incurred. In addition to direct costs, capitalized items include the present value of certain future lease payments (see Note 5), research and development expenditures pertaining to construction projects, indirect charges for engineering, supervision, transportation and similar costs, and an allowance for funds used during construction. Costs of depreciable units of plant retired are eliminated from plant accounts and such costs plus removal expenses less salvage are charged to accumulated depreciation. Contributions in aid of construction are credited to plant cost.

Depreciation on utility property is provided on a straight-line basis at rates authorized by the Arizona Corporation Commission (the "ACC") annually. The applicable rates for 1987 through 1989 ranged from 0.68% to 10.27%.

Decommissioning costs for the Company's interest in the Palo Verde Nuclear Generating Station ("Palo Verde" ) are charged to depreciation expense and are being deposited in external trust funds until the decommissioning of the nuclear facilities takes place. At December 31, 1989 the balance in the trust accounts, $ 10,464,000, is included in the Company's Investments and Other Assets. Total decommissioning costs for all three Palo Verde units are estimated at approximately $ 760 million (in 1989 dollars), of which the Company's 29.1% share is approximately $ 221 million.

e. Revenues and fuel costs Effective January 1, 1987, the Company changed its method of recording revenues. Prior to that date, the Company recorded revenues as billed to its customers on a monthly cycle billing basis. The unbilled revenue for those kilowatt-hours delivered to customers after meter reading dates became part of operating revenues in the following month.

In order to better match revenues with expenses, the Company changed its method of accounting to accrue an estimate of revenue for sales unbilled at the end of each month. This change also serves to conform the Company's accounting treatment with the treatment of unbilled revenues as taxable under the Tax Reform Act of 1986. The cumulative effect as of January 1, 1987 of the change, net of income taxes, is $ 16.1 million and is reported as a separate component of 1987 net income.

Until 1989 nearly all of the Company's purchased power and fuel costs were either recovered currently or deferred to the extent allowed by the ACC pursuant to the Purchased Power and Fuel Adjustment Mechanism ("PPFAM") and, accordingly, did not materially affect earnings.

On April 13, 1989 the ACC issued an order eliminating the PPFAM. Without the PPFAM, actual purchased power and fuel costs incurred are rellected currently in earnings.

Allowance for funds used during construction In accordance'ith the regulatory accounting practice prescribed by the FERC and the ACC, the Company capitalizes an allowance for the cost of funds used to finance its construction program ("AFC"). AFC, which does not 20

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEiiIENTS (continued) represent current cash earnings, is defined as the cost of borrowed funds and a reasonable rate of return on equity funds used during construction. The calculated amount is capitalized as a part of the cost of utility plant AFC has been calculated using composite rates of 11.20% for 1987; 11.25%,for 1988; and 10.50% for 1989. The Company compounds AFC semiannually and ceases to accrue AFC when construction is completed and the property is placed in service.

g. Income taxes The Company uses accelerated depreciation methods for income tax purposes. As prescribed by the ACC, deferred income taxes are provided for certain timing differences arising from the recording, for income tax and financial reporting purposes, of depreciation of property placed in service after January 1,1977. In accordance with an ACC order, the Company defers amounts equal to the change in income taxes arising from substantially all other timing difFerences, which prior to October 1983 were reflected currently in income. At December 31, 1989 the Company had flowed through to income currently approximately $ 200 million of income tax benefits arising from income tax timing difFerences for which deferred taxes have not been provided.

In compliance with an ACC order, the Company defers amounts equal to the reduction in federal income taxes arising from investment tax credits and amortizes these amounts to other income over the estimated life of the related assets.

In 1981, the Company sold to another corporation certain federal income tax benefits in exchange for cash. The Company, pursuant to an order of the ACC, has recorded the proceeds of the sale as a deferred credit and is amortizing the amount of such proceeds on a straight-line basis over approximately 30 years.

The Company is included in the consolidated income tax returns of Pinnacle West. Income taxes are allocated to the Company based on its separate company taxable income or loss. Income taxes paid to Pinnacle West amounted to $ 51,686,000, $ 67,575,000 and $ 93,156,000 in 1989, 1988 and 1987, respectively.

h. Research and development costs The Company expenses research and development costs on a current basis, except that costs which may result in additions to utility plant are deferred for subsequent inclusion in plant or to be written ofF if the applicable project is abandoned.

i. Reacquired debt costs In accordance with the regulatory accounting practices prescribed by the ACC, the Company defers the excess of the reacquisition price of reacquired debt over the net carrying amount and amortizes these amounts to expense over the remainder of the original "life of the issues reacquired.

j. Nuclear fuel Nuclear fuel is charged to fuel expense using the'unit of production method under which the number of units of thermal energy produced in the current period is related to the total thermal units expected to be produced over the remaining 'life of the fuel.

Pursuant to the Nuclear Waste Policy Act of 1982, as amended (the "Act"), contracts have been entered into with the U.S. Department of Energy for disposal of spent nuclear fuel. The Act provides for an assessment of $ 0.001 per kilowatt-hour of nuclear generation. This amount is charged to nuclear fuel expense and recovered through rates.

2. ACC and Related Matters.

II Application for Betail Bate Increase Palo Verde Unit 3 and Unit 4 of the Cholla Power Plant {"Cholla 4") are not currently reflected in the Company's retail rates. The Company's investment in Palo Verde Unit 3 as of December 31, 1989 was approximately $ 1.2 billion, including cost deferrals. The Company's investment in Cholla 4 as of December 31, 1989 was approximately $ 245 million. On January 11, 1990, the Company filed an application with the ACC for a permanent increase in annual retail 21

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued) rates of approximately $ 271 million to become effective in three annual 6.8% increments commencing January 1, 1991. The proposed rate increase seeks to recover the costs of Palo Verde Unit 3 and Cholla 4, as well as costs incident to the increase in retail customers and in the cost of service since 1986 (the prior test year). The rate application includes requests to (1) remove the "interim" designation for revenues collected under certain previous rate orders (see below);

(2) approve an expedited procedure for the reflection in rates of significant changes in fuel and purchased power costs; and (3) approve a property tax adjustment clause allowing the Company to recover in rates certain increases in property taxes. The proposed phase-in is expressly premised upon (1) the ACC continuing the accounting and ratemaking order relating to Palo Verde Unit 3 (see below); and (2) the ACC issuing an order relating to Cholla 4, as requested by the Company (see below). Hearings on the rate application have not yet been scheduled. Any costs of assets disallowed by the ACC for inclusion in the Company's rates will be recognized as a loss by the Company at such time as it becomes probable that the costs will be disallowed for ratemaking purposes, The ultimate outcome of this rate case cannot presently be determined.

Palo Verde Unit 8 Cost Deferrals On April 6, 1988, the ACC issued an accounting and ratemaking order that allows the Company, for ACC purposes, to defer and capitalize substantially all Unit 3 operating costs (excluding fuel) and to accrue a carrying charge on its ownership interest in Unit 3 and one-third of the facilities common to all three Palo Verde units (collectively, the "Unit 3 Cost Deferrals"). The ACC ordered the period for accumulating such deferrals to commence on January 8, 1988, and to continue until the later of December 31, 1989, or the date that the ACC rules on the application for an extension of the deferral period which was filed by the Company on June 30, 1989 (the "Extension Application"). The application requests an extension of the deferral period until such time as the ACC includes Unit 3 in the Company's rate base.

On September 22, 1989, a proced'ural order was issued scheduling an ACC hearing to commence on April 2, 1990 to consider the Extension Application. The procedural order stated that the issues of excess capacity and the recent Palo Verde Unit 3 outages are relevant in determining the propriety of continued deferrals. On February 20, 1990, a procedural order was issued vacating the previous procedural schedule and indefinitely continuing the hearing. Unit 3 Cost Deferrals totalled approximately $ 195 million net of income taxes at December 31, 1989.

The Company estimates that Unit 3 Cost Deferrals are currently accruing in the amount of approximately $ 7 million per month net of income taxes. If the ACC rules unfavorably on the Extension Application, recoverability of Unit 3 plant costs or deferrals could be limited and/or deferrals could be discontinued, either of which would have an adverse impact on earnings.

Cholla g The Company is operating under a layofF agreement with Southern California Edison Company ("SCE") for capacity sold from Unit 4 of the Cholla Power Plant. At present, approximately 200 megawatts are being sold under the agreement, which expires June 1, 1990.

A portion of the agreement (covering approximately 150 additional megawatts) expired on June 1, 1989. On January ll, 1990, the Company filed an application with the ACC requesting an order that would allow the Company, for ACC purposes, to defer and capitalize the costs of owning and operating Cholla 4 that will no longer be recovered by the SCE agreement for the period of time between June 1, 1989 and the effective date of new rates recognizing such costs.

The application requests deferrals of approximately $ 2 million per month, net of income taxes, from June 1, 1989 through May 31, 1990, and approximately $ 3.5 million per month, net of income taxes, for each month thereafter until the effective date of new rates to cover Cholla 4 costs. Hearings in this matter have not yet been scheduled. On January 24, 1990, the ACC Staff 22

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS. (continued) filed a motion seeking dismissal of the Cholla 4 application on the grounds that, among other things, the Company's request is inequitable and inconsistent with, the ACC's regulatory policies. The Company has filed:a response opposing this motion.

Prudence Audit On March 24, 1989, Ernst & Whinney released its report on the prudence audit of Palo Verde. The report identified approximately $ 60 million, excluding AFC and property taxes, for

'he entire project that were unreasonable; Of this amount, the Company's share is approximately $ 18 million. The report also identified certain areas that were found to exceed the standard of reasonableness and to have a positive impact on the project, including built-in separation of electrical equipment, design replication'of the three units at Palo Verde, certain aspects of the regulatory (licensing) management function, and certain labor and contractual arrangements. The report estimated that the potential direct cost savings of the identified areas in which performance exceeded the standard of reasonableness were approximately $ 300 million for the entire, project (excluding AFC and'property taxes), of which the Company's share is approximately $ 85 million. A procedural framework has not been established within which the ACC would formally consider the results of the report or the reasonableness of Palo Verde costs.

Interim or Temporary Revenues Pursuant to an order issued by the ACC in April 1988, the Company estimates that up to

$ 211 million of revenues collected through December 31, 1989 are to be deemed interim or temporary pending the results of the prudence audit and further action of the ACC. In the opinion of management, the amount, if any, of such revenues to be refunded will not be material to the Company's financial statements.

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

3. Common and Non-redeemable Preferred Stock.

The balances at December 31, 1989 and 1988 of common stock and of preferred stock, which is not redeemable except pursuant to call by the Company at its option, are as follows.

Number of Shares Par Value Call Outstanding at . Outstanding at Price December 31, Pcr December 31, Per Authorized 1989 1988 Share 1989 1988 Share(a)

(Thousands of Dollars)

Common Stock 100,000,000 71 264 947 71 264 947 $ 2.50 $ 178 162 $ 178 162 Non-redeemable Preferred Stock (cumulative):

$ 1.10 preferred ............. 160,000 155,945 155,945 $ 25.00 3,898 $ 3,898 $ 27.50

$ 2.50 preferred ............. 105,000 103,254 103,254 50.00 5,163 5,163 51.00

$ 2.36 preferred ............. 120,000 40,000 40,000 50.00 2,000 2,000 51.00

$ 4.35 preferred ............. 150,000 75,000 75,000 100.00 7,500 7,500 102.00 Serial preferred 1,000,000

$ 2.40 Series A.... 240,000 240,000 50.00 12,000 12,000 50.50

$ 2.625 Series C ........ 240,000 240,000 50.00 12,000 12,000 51.00

$ 2.2'75 Series D........... 200,000 200,000 50.00 10,000 10,000 50.50

$ 3.25 Series E........... 320,000 320,000 50.00 16,000 16,000 51.00 Serial preferred 4,000,000(b)

$ 8.32 Series J ........ 500,000 500,000 100.00 50,000 50,000 (c)

Adjustable rate Series Q .......... 500,000 500,000 100.00 50,000 50,000 ((I)

Serial preferred 10,000,000 25.00 Total . 2 374 199 2 374 199 $ 168 561 $ 168 561 (a) In each case plus accrued dividends.

(b) This authorization also covers outstanding redeemable preferred shares shown in Note 4, as well as the non-redeemable shares indicated above.

(c) At $ 103.00 through August 31, 1992; and at $ 101.00 thereafter.

(d) Bears dividends at a rate, adjusted on a quarterly basis, 2% below the rate borne by certain United States Treasury securities, but in no event less than 6% per annum or greater than 12% per annum. Redeemable at the option of the Company at $ 103.00 through February 28, 1993; and at $ 100.00 thereafter.

The holders of preferred stock are entitled to one vote for each share held of record. Special requirements'for favorable votes of holders of preferred stock, voting by the classes respectively prescribed for the several purposes, pertain to (i) certain conversions or exchanges of outstanding preferred stock, (ii) the authorization of any stock ranking prior to the preferred stock, (iii) making any change in the terms and provisions of preferred stock that would adversely affect the rights and preferences of the holders thereof, (iv) the issuance of any additional shares of preferred stock except under prescribed circumstances or (v) a merger, consolidation or sale of substantially all the assets of the Company. The foregoing voting rights attach to both redeemable and non-redeemable preferred stock, as do the rights that would arise out of dividend arrearages as discussed in Note 4.

24

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

Changes in common and non-redeemable preferred stock and premiums and expenses during each of the three years in the period ended December 31, 1989 are as follows (dollars in thousands):

Non-redeemable Preferred Stock Premiums Common Stock (cumulative) and h

Number Par Value Number I'ar Value Expenses Description of Shares Amount of Shares Amount Net0 Balance, December 31, 1986 71)264,947 $ 178,162 4,374,199,. $ 218,561 $ 1,040,084

$ 3.58 Series 0 .. (2,000,000) (50,000)

Premiums and Expenses - Net ~5720)

Balance, December 31, 1987 71,264,947 178,162 2,374,199 168,561 1,034,364 Premium and Expenses - Net ~106)

Balance, December 31, 1988 71)264,947 178,162 2,374)199 168,561 1,034,258 Premium and Expenses - Net 88 Balance, December 31, 1989 71 264 947 $ 178 162 2 374 199 $ 168 561 $ 1 034 346

'Premiums and expenses net also includes those of redeemable preferred stock issues (see Note 4).

4. Redeemable Preferred Stock.

The balances at December 31, 1989 and 1988 of preferred stock which is redeemable pursuant to sinking fund obligations, in addition to being callable by the Company, are as follows:

Number of Shares Par Value Call Outstanding at Outstanding at Price December 31, Pcr December 31, Per 1989 1988 Share 1989 1988 Share(a)

(Thousands of Dollars)

Redeemable Preferred Stock (cumulative)

Serial preferred: (b)

$ 10.00 Series H 40)677 56,677 $ 100.00 $ 4,068 $ 5,668, . (c)

$ 8.80 Series K 233,136 254,600 100.00 23,313 25)460 (d)

$ 12.90 Series N 266,400 318,200 100.00 26,640 31,820 (e)

$ 11.50 Series R........ 500,000 500,000 100.00 50,000 50,000 (f)

$ 8.48 Series S . (g)

$ 8.50 Series T .

500,000 500 000 500,000 500 000 100.00 100.00 50,000 50 000 50,000 50000 'll)

Total 2 040 213 2 129 477 204 021 ~212 948 (a) In each case plus accrued dividends.

(b) See Note 3 for authorized number of shares.

(c) Redeemable at $ 104.68 through September 1, 1990, and thereafter declining by $ 0.36 per year to par after September 1, 2002. Applicable sinking fund provisions re(Iuire the redemption of 16,000 shares at par annually (represeriting annual payments of $ 1,600,000).

25

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

(d) Redeemable at $ 103.00 through February 28, 1994; and at $ 101.00 thereafter.

Applicable sinking fund provisions require the redemption of 22,500 shares at par annually (representing annual payments of $ 2,250,000). The Company may, but is not required to, redeem an additional 22,500 shares at par on March 1 in any year.

(e) Redeemable after June 1, 1992 at the option of the Company at $ 106.11 through June 1, 1993, declining by $ 0.68 per year to $ 100.00 after June 1, 2001. Applicable sinking fund provisions require the redemption at par value between 1988 and 2002 of all shares according to a predetermined schedule. P (f) Redeemable after June 1, 1994 at the option of the Company at $ 105.45, declining each year by a predetermined amount to $ 100.00 after June 1, 2004.'Applicable sinking fund provisions require the redemption at par value between 1990 and 2004 of all shares according to a predetermined schedule.

(g) Not redeemable prior to June 1, 1992 with the proceeds of borrowed funds or stock issues having a lower cost of money than this Series'ividend rate. Otherwise,'redeemable at the option of the Company at $ 108.48 per share prior to June 1, 1992, at $ 104.24 prior to June 1, 1993, at $ 102,12 prior to June 1, 1994 and at $ 100.00 per share thereafter. A'pplicable sinking fund provisions require the redemption at par of 100,000 shares annually beginning June 1, 1993.

(h) All outstanding shares to be redeemed at par on September 1, 1994.

If there were to be any arrearage in dividends on any of its preferred stock or in the sinking fund requirements applicable to any of its redeemable preferred, stock (each such dividend being cumulative and of equal ranking with other such dividends, and each such requirement being cumulative and of equal ranking with other such requirements), the Company could not pay dividends on its common stock or acquire any shares thereof for consideration. If any such dividend arrearage were to equal six or more quarterly dividends, the holders of preferred stock, in addition to their other voting rights and voting by the classes prescribed for this purpose, could elect a total of six directors (all series of serial preferred stock, regardless of par value and whether redeemable or non-redeemable, comprising one such class and being entitled to elect two of the six directors). See Note 3 in regard to other voting rights of holders of preferred stock.

The combined aggregate amount of redemption requirements for the above issues each year through 1994 are as follows: $ 7,727,000 in 1990; $ 9,873,000 in 1991; $ 9,173,000 in 1992; $ 18,273,000 in 1993 and $ 68,273,000 in 1994.

26

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

Redeemable preferred stock transactions during each of the three years in the period ended December 31, 1989 are as'follows (dollars in thousands):

Number Par Value Description of Shares Amount Balance, December 31, 1986 1,787,277 $ 178,728 Issuances:

$ 8.48 Series S 500,000 50,000

$ 8.50 Series T 500,000 50,000 Retirements:

$ 10.00 Series H (16,000) (1,600)

$ 8.80 Series K (67,500) (6,750)

$ 9.70 Series L (384,000) (38,400)

$ 12.50 Series P . ~100 000) ~10 000)

Balance, December 31, 1987 2,219,777 221,978 Retirements:

$ 10.00 Series H (16,000) (1,600)

$ 8.80Series K ...... (22,500) (2,250)

$ 12.90 Series N ~51 800) ~5180)

Balance, December 31, 1988 2,129,477 212,948 Retirements:

$ 10.00 Series H (16,000) (1,600)

$ 8.80Series K .. (21,464) (2,147)

$ 12.90 Series N ~51 800) ~5180)

Balance, December 31, 1989 2 040 213 $ 204 021 27

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEillENTS (continued)

5. Long- Term Debt.

Details of long-term debt outstanding at December 31, 1989 and 1988 are as follows:

December 31, 1989 1988 (Thousands of Dollars)

First Mortgage Bonds:

Maturing through 1994:

4.7% due March 1, 1989 $ 20,000 4.8% due November 1, 1991 35,000 35,000 4.45% due June 1, 1992 25>000 25,000 4.40% due December 1, 1992 .. 25,000 25,000 4.5% due September 1, 1993 .. 15,000 15,000 Maturing 1995 through 1999 - 6.25% to 12% . 500,000 500,000 Maturing 2000 through 2004 - 6.2% to 12.875% .. 322,394 346,979 Maturing 2005 through 2009 - 6% to 13.25% . 127,000 127,000 Maturing 2015 through 2019 - 9% to 11.5% .. 550,000 450,000 Unamortized discount and premium ~5550) ~4402)

Total first mortgage bonds . 1 593 844 1 539 577 Pollution Control Indebtedness:

Maturing August 1, 2009 (a) 106,980 106,980 Maturing December 1, 2009 (b) 147,000 147,000 Maturing May 1, 2013 (b) 65,750 65,750 Maturing May 1, 2014 (c) 55,200 55,200 Maturing February 1,2015 (a) .. 49 400 49 400 Total pollution control indebtedness 424 330 424 330 12.5% guaranteed debentures due February 15, 1992 75,000 75,000 Revolving credit agreements (d) 120,000 120,000 Term loan due June 1990 and 1992 (LIBOR plus V4%) ..... 80,000 80,000 Capitalized lease obligation (e) 39,358 41,458 Other 552 Total long-term debt 2 332 532 2 230 917 Less current maturities:

4.7% first mortgage bonds due March 1, 1989 . 20,000 Sinking fund requirements on first mortgage bonds... 15,933 15,333 Term loan due June 1990 (LIBOR plus V4%) 8,000 Capitalized lease obligation (e) .. 2,260 2,100 Other 552 Total current maturities . 26 193 37 985 Total long-term debt less current maturities ..... $ 2 306 389 $ 2 242 932 (a) Adjustable-rate annual tender pollution control revenue refunding bonds supported by a long-term irrevocable letter of credit issued by a bank. The bonds bear an interest rate, determined annually, which will cause the bonds to have a market value which approximates, as nearly as possible, their par value.

28

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

(b) Consisting of borrowings from a governmental authority which has funded that amount through issuance of a series of par- value demand bonds supported by a long-term irrevocable letter of credit issued by a bank. These bonds bear interest at such, rate, determined weekly, as will cause the bonds to have a market value which approximates, as nearly as possible, their par, value.

(c) On May 15, 1985 the Company borrowed from a governmental authority the proceeds of a $ 55,200,000 issue of adjustable-rate annual tender pollution control revenue refunding bonds for the purpose of refunding $ 55,200,000 in aggregate principal amount of previously issued pollution control bonds due April 1, 1986. The new issue is supported by a long-term irrevocable letter of credit issued by a bank. The bonds bear an interest rate, determined annually, which will cause the bonds to have a market value which approximates, as nearly as possible, their par value.

(d) Represents domestic commercial paper and borrowings under a $ 120,000,000 Eurocommercial paper program agreement among the Company and various financial institutions that is supportedby a revolving credit agreement which, expires in 1991. At December 31, 1989, the outstanding 'balance consisted entirely of borrowings under, the Eurorevolver portion of the agreement At December 31, 1988, the outstanding balance consisted of $ 89,500,000 of Eurocommercial paper and $ 30,500,000 of domestic commercial paper.

Commercial paper interest rates are negotiated at the time of borrowing. Interest rates applicable to borrowings under the revolving credit agreement are LIBOR plus 0.30%o to 0.45%,

with commitment fees of 0.15% on the unused credit line.

(e) Represents the present value of future lease payments (discounted at the interest rate of 7.48%) on a combined cycle plant sold and leased back from the independent owner-trustee formed to own the facility. The lease requires semiannual payments of $ 2,582,000 through June 2001, and includes renewal and purchase options based on fair market value. This plant is included in plant in service at its original cost of $ 54,405,000; accumulated depreciation at December 31, 1989 was $ 30,418,000.

Aggregate annual payments due on long-term debt and for sinking fund requirements through 1994 are as follows: 1990, $ 26,193,000; 1991, $ 173,365,000; 1992, $ 215,551,000; 1993,

$ 34,551,000 and 1994, $ 20,190,000. See Note 4 for sinking fund requirements and redemptions of redeemable preferred stock.

Substantially all utility plant (other than nuclear fuel, transportation equipment and the combined cycle plant mentioned above) is subject to the lien of the first mortgage bonds. The indenture respecting the first mortgage bonds includes provisions which would restrict the payment of dividends on common stock under certain conditions which did not exist at December 31, 1989.

29

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

6. Lines of Credit.

The Company's committed lines of credit at December 31, 1989 and 1988 are summarized below. At December 31, 1989, $ 240 million of short-term debt was outstanding including $ 210 million under the $ 300 million revolving credit facility and $ 30 million under other uncommitted bank lines of credit. At December 31, 1988, no amounts were outstanding under the committed lines of credit.

1989 1988 (Thousands of Dollars)

Revolving credit facility . $ 300,000, $ 300,000 Other bank lines 2000 2000 Total . $ 302 000 $ 302 000 The commitment fees for the revolving credit facility and virtually all of the other bank lines were 3/16% per annum in 1989 and 1988.

By Arizona statute, the Company's short-term borrowings cannot exceed 7% of total capitalization without the consent of the ACC.

30

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

7. Jointly-Owned Facilities.

At December 31, 1989, the Company-owned interests in jointly-owned electric generating and transmission facilities are as follows (dollars in thousands):

Pcrccnt Net Construction owned by Plant in Accumulated Plant in Work in Company Service Depreciation Service Progress Generating Facilities:

Palo Verde Nuclear Generating Station-Units 1,2and3 ..... (a) $ 2,431,171 $ 225,455 $ 2,205,716 $ 27,306 Four Corners Steam Generating Plant-Units4and5.... ~ .. 15.0% 131,942 33,159 98,783 5,865 Navajo Steam Generating Plant-Units1,2and3 ..... 14.0% 126,882 54,280 721602 3,160 Transmission Facilities:

ANPP 500KV Transmission System . 35.8%(b) 61,852 7,294 54,558 52 Navajo Southern Transmission System . 31.4%(c) 27,899 12,672 15,227 155 Palo Verde- Yuma 500KV System 28.9%(6) 11 334 1 '154 9 580 1 Total ............ $ 2791080 $ 334 614 $ 2 456 466 $ 86 539 (a) The Company owns 29.1% of Units 1 and 3 and approximately 17%of Unit 2 (see Note 8).

(b) Weighted average of interests varying from 34.6% to 43.95%.

(c) Weighted average of interests varying from 14% to 100%.

(d) Weighted average of interests varying from 11% to 100%.

The foregoing dollar amounts correlate to the Company's percentage interest in each facility. The Company's share of related operating and maintenance expenses is included in Operating Expenses.

8. Leases.

In 1986, the Company entered into sale and leaseback transactions under which it sold approximately 42% of its 29.1% share of Palo Verde Unit 2 resulting in net proceeds of $ 487,296,000.

The resulting gain of approximately $ 140,220,000 has been deferred and is being amortized to operations expense over the original lease term. The leases require semiannual payments of approximately $ 22,061,000 through December 1996, $ 23,605,000 through June 1997 and $ 26,963,000 through Deceinber 2015, and include options to renew the leases for two additional years and to purchase the property at fair market value at the end of the lease terms. The leases are being accounted for as operating leases. Lease expense for 1989, 1988 and 1987 amounted to $ 45,458,000,

$ 45,458,000 and $ 43,445,000, respectively, of which $ 10,312,000 and $ 39,421,000 were deferred in 1988'and 1987, respectively, as allowed by an order'from the ACC. Lease expense for 1988 was deferred until April 1, 1988 when Unit 2 rates became effective.

31

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

9. Income Tax Expense.

The components of income tax expense for each of the three years in the period ended December 31, 1989 are as follows:

Year Ended December 31, 1989 1988 1987 (Thousands of Dollars)

Currently payable:

Federal $ 37,788 $ 63,457 $ 50,073 State 7,662 12,254 3,428 Other 235 Total current 45 450 75 711 53 736 Deferred:

Depreciation net 75,611 72,709 86,128 Palo Verde cost deferral 47,654 49,178 45,279 Alternative mimimum tax (25,652) (7,570) (4,247)

Other net 8,774 2,976 18,242 Investment tax credit net ~6159) ~9107) ~1824)

Total deferred . 100 223 108 186 143 578 Total $ 145 678 $ 183 897 $ 197 314 The difFerence between income tax expense and the amount obtained by multiplying income before income taxes by the statutory federal income tax rate for each of the three years in the period ended December 31, 1989 are as follows:

Year Ended December 31, 1989 1988 1987 (Thousands of Dollars)

Federal income tax expense at statutory rate (34% in 1989 and 1988, and 40% in 1987).............. $ 121,731 $ 154,737 $ 204,475 Increases (reductions) in tax expense resulting from:

Tax under book depreciation 15,870 22,316 30,935 Allowance for funds used during construction ... (2,024) (4,103) (27,430)

Palo Verde cost deferral (4,114) (4,815) (20,965)

Investment tax credit amortization (6,946) (8,287) (8,273)

State income tax net of federal income tax benefit . 19,988 23,429 18,481 Other 1 173 620 91 Total provision for federal and state income tax expense $ 145 678 $ 183 897 ~197 314 In December 1987, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" ("SFAS No. 96").

SFAS No. 96 retains the concept of comprehensive interperiod tax allocation; however, the way in which deferred income taxes are computed has changed from the existing "deferred" method to a liability method. Adjustments to balances of accumulated deferred income taxes will have to.-be made to record income tax rate changes, allowance for funds used during construction,'investment tax credits and other temporary differences not previously deferred.

It is expected that the additional deferred income tax assets and liabilities will be offset primarily by regulatory assets and liabilities representing the expected future revenue requirement impact of these adjustments.

32

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

The new statement was to have been effective beginning in 1990; however, the FASB has moved the effective date to 1992, although earlier adoption is encouraged. SFAS No. 96 will be implemented by recording a cumulative effect adjustment as of the beginning of the year in which the new standard is first adopted. The Company has not yet made a determination as to the timing of implementation.

10. Pension Plan and Other Benefits.

The Company's pension plan, a defined benefit plan, covers virtually all employees. The benefits are based on years of service and compensation utilizing the final average pay plan benefit formula. It is the Company's policy to fund the plan on a current basis to the extent deductible under existing tax regulations. Pension cost, including administrative cost, for 1989, 1988, and 1987 was approximately $ 3,657,000, $ 4,368,000, and $ 1,484,000, respectively, of which approximately $ 1,655,000, $ 1,899,000, $ 601,000, respectively was charged to expense; the remainder was either capitalized as a component of construction costs or billed to participants of jointly-owned facilities. Plan assets consist primarily of domestic and international common stocks and bonds, and real estate.

Net periodic pension cost (income) included the following (thousands of dollars):

1989 1988 Service cost-benefits earned during the period . $ 12,920 $ 12,589 Interest cost on projected benefit obligation... 24,910 22,945 Return on plan assets (61,314) (48,832)

Net amortization and deferral 24 322 15 547 Net periodic pension cost $ 838 $ 2 249 The following table sets forth the plan's funded status" and amounts recognized in the Company's Balance Sheets (thousands of dollars):

1989 1988 Actuarial present value of benefit obligation, including vested benefits of $ 182,409 and $ 148,824 $ 204,954 $ 178,019 Effect of projected future compensation increases,...,.. 112 389 92 202 Projected benefit obligation .. 317,343 270,221 Plan assets, at fair value 380 893 333 840 Plan assets in excess of projected benefit obligation.... 63,550 63,619 Unrecognized net (gain) loss from past experience different from that assumed . (25,689) (21,686)

Unrecognized prior service cost 7,152 7,135 Unrecognized net asset at January 1, 1986 being recognized over 20.2 years ~52 108) ~55 325)

Accrued pension liability included in other deferred credits .. ~$ 7 095) ~$

257) 33

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued) 1989 1988 Principal actuarial assumptions used were:

Discount rate 8.5% 9.0%

Rate of increase in compensation levels 6.5% 6.5%

Expected long-term rate of return on assets 10.44% 10.44%

In addition to providing pension benefits, the Company provides certain health care and life insurance benefits for active and retired employees. Life insurance benefits are provided through an insurance company whereas health care costs are paid as expenses are incurred under a self-insured plan. The cost of providing those benefits for both active and retired employees amounted to approximately $ 24,332,000, $ 21,991,000 and $ 22,721,000, of which approximately $ 10,172,000, $ 8,564,000 and $ 8,922,000, were charged to expense in 1989, 1988 and 1987, respectively. Remaining amounts were either capitalized as a component of construction costs or billed to participants of jointly-owned facilities. The cost of providing such benefits solely to retired employees is not significant.

11. Commitments and Contingencies.

Nuclear Insurance The Palo Verde participants have insurance for public liability payments 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 $ 200 million and the balance by an industrywide retrospective assessment program. The maximum assessment per reactor under the retrospective rating program, for each nuclear incident is approximately $ 66 million, subject to an annual limit of $ 10 million per incident.

Based upon the Company's 29.1% interest in the three Palo Verde units, the Company's maximum potential assessment per incident is approximately $ 58 million, with an annual payment limitation of $ 8.73 million. The insureds under this liability insurance include the Palo Verde participants and "any other person or organization with respect to his legal responsibility for damage caused by the nuclear energy hazard."

The Palo Verde participants maintain "all risk" (including nuclear hazards) insurance for nuclear property damage to, and decontamination of, property at Palo Verde in the aggregate amount of $ 2.035 billion, a substantial portion of which inust first be applied to decontamination.

The Company has also secured insurance against portions of any increased cost of generation or purchased power resulting from the accidental outage of any of the three units if the outage exceeds 21 weeks. The Palo Verde outages during 1989 and the current outage of Palo Verde Unit 1 are not covered by this insurance.

Litigation The Company is a party to various claims, legal actions and complaints arising in the ordinary course of business, including a lawsuit seeking to invalidate the Company's contract with various municipalities for the purchase of efHuent to be used as cooling water for Palo Verde. In the opinion of management, the ultimate disposition of these matters will not have a material adverse eEect on the operations or financial position of the Company.

Construction Program Expenditures in 1990 for the Company's continuing construction program have been estimated at $ 318 million.

34

ARIZONA PUBLIC SERVICE COMPANY NOTES TO FINANCIALSTATEMENTS (continued)

12. Supplementary Income Statement Information.

Other taxes charged to operations during each of the three years in the period ended December 31, 1989 are as follows:-

Year Ended December 31.

1989 1988 1987 (Thousands of Dollars)

Property .. $ 92,522 $ 79,730 $ 71,357 Sales . 70,866 69,107 62,783 Other 10 825 11 860 10 214 Total other taxes $ 174 2 13 $ 160 697 $ 144 354

13. Selected Quarterly Financial Data (Unaudited).

Operating Operating Net Earnings for Revenues Income Income Common Stock Q uarter (Thousands of Dollars) 1989 First $ 332,449 $ 92,630 , $ 54,435 $ 46,258 Second 359,807 92,964 52,788 44,692 Third 458,793 136,398 94,219 -

86,270 Fourth 296,105 53,153 10,912 2,832 1988 First $ 313,389 $ 83,142 $ 57,168 $ 48,719 Second 336,723 92,333 57,294 48,936 Third 469,092 157,827 125,466 117,177 Fourth 322,819 69,778 31,283 23,060

THIS PAGE LEFT BLANKINTENTIONALLY INDEPENDENT AUDITORS'EPORT Arizona Public Service Company:

i We have audited the accompanying balance sheets of Arizona Public Service Company as of December 31, 1989 and 1988 and the related statements of income, retained earnings and cash flows for each of the three years in the period ended December 31, 1989. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 1989 and 1988 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1989 in conformity with generally accepted accounting principles.

As discussed under Application for Retail Rate Increase in Note 2 to the financial statements, the Company has filed an application with the Arizona Corporation Commission for an increase in retail rates relating to its investments in Unit 3 of the Palo Verde Nuclear Generating Station and Unit 4 of the Cholla Power Plant, and other costs. Until the level of rate relief ultimately granted by the Commission is determined, an uncertainty exists as to the eventual full recovery of the cost of these assets, the outcome of which cannot presently be determined. i As discussed in Note 1 to the financial statements, in 1987 the Company changed its method of accounting for unbilled revenues.

Phoenix, Arizona February 22, 1990 37

THIS FAGE LEFT BLANKINTENTIONALLY 38

APS DIRECTORS Joe Acosta, 66, Robert C. Acosta, P.C. (certified public accountants), Phoenix, Arizona Dino DeConcini, 56, attorney at law, Phoenix, Arizona

0. Mark De Michele, 56, president and chief executive officer of the Company, Phoenix,

'Arizona Karl Eller, 61, chairman of the board, The Circle K Corporation, Phoenix, Arizona Marianne Moody Jennings, 36, professor of business law, College of Business Administration, Arizona Sate University, Tempe, Arizona.

Jack M. Morgan, 66, attorney at law, Farmington, New Mexico Marvin R. Morrison, 66, farmer, cattle feeder and dairyman, Morrison Brothers Ranch,

'Higley, Arizona Jaron B. Norberg, 52, executive vice president and chief financial officer of the Company, Phoenix, Arizona John R. Norton III, 61, chairman and chief executive officer, J. R. Norton Company (agricultural production), Phoenix, Arizona Donald M. Riley, 46, president and general manager, Gilpin's Enterprises, Inc. (general contractor), Yuma, Arizona Wilma W. Schwada, 63, civic leader and homemaker, Tempe, Arizona Verne D. Seidel, 64, managing partner of HMS Properties (property management),

FlagstafF, Arizona Richard Snell, 59, chairmkn of the board of the Company; chairman of the board, president and chief executive officer, Pinnacle West Capital Corporation; and chairman of the board, Aztar Corporation (gaming business), Phoenix, Arizona Keith L. Turley, 66, member of the board of directors of the Company and of Pinnacle West Capital Corporation, Phoenix, Arizona. Mr. Turley was chairman of the board of the Company and chairman of the board, president and chief executive officer of Pinnacle West Capital Corporation until February 1990.

Morrison F. Warren, 66, formerly professor emeritus of education (retired June 1988),

Arizona State University, Tempe, Arizona Ben F. Williams, Jr., 60, attorney at law, Douglas, Arizona Thomas G. Woods, Jr., 63, consultant to the Company; formerly executive vice president of the Company for the Arizona Nuclear Power Project (retired February 1985), Phoenix, Arizona (Age on Annual Meeting date, April 17, 1990)

Member of the Executive Committee.

39

SHAREHOLDER INFORMATION Stock Listing The Adjustable Rate Cumulative Preferred Stock, Series Q (Symbol ARPQ) is listed for trading on the New York Stock Exchange. The 'common stock'of the Company is wholly-owned by Pinnacle West and as a result is not listed for trading on any stock exchange. Prior to April 29, 1985 the Company's common stock was publicly held and was traded on the New York and Pacific Stock Exchanges. At the close of business on April 28, 1985 the Company's common stock was held by 123,776 shareholders.

The chart below sets forth the dividends per share paid on the Company's common stock for each of the four quarters of 1989 and 1988.

Common Stock Dividends Per Share Quarter 1989 1988 1st Quarter $ 0.74 $ 0.74 2nd Quarter 0.74 0.74 3rd Quarter 0.74 0.74 4th Quarter 0.74 0.74 Transfer Agent and Registrar Pinnacle West Capital Corporation Stock Transfer Department P.O. Box 52134 Phoenix, Arizona 85072-2134 (602) 222-6951 The First National Bank of Boston Shareholder Services P.O. Box 1865 Boston Massachusetts 02105-1865 (617) 575-2555 (common stock only)

General Counsel Snell & Wilmer Phoenix, Arizona Auditors Deloitte & Touche Phoenix, Arizona Pinnacle West Capital Corporation Stock Purchase and Dividend Iieinvestnient Plan A Prospectus describing this plan is available upon request. Write: Office of the Secretary, Station 9068, at the address below.

Form 10-K A copy of our Annual Report to the Securities and Exchange Commission, Form 10-K, will be available after March 31, 1990, without charge, upon written request of shareholders. Write:

Once of the Secretary, Station 9068, at the address below.

MAILINGADDRESS:

P.O. Box 53999 Phoenix, Arizona 85072-3999 40