Summary of PINNACLE WEST CAPITAL CORP

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION The following discussion should be read in conjunction with Pinnacle West's Consolidated Financial Statements and APS' Financial Statements and the related Notes that appear in Item 8 of this report.
OVERVIEW Pinnacle West owns all of the outstanding common stock of APS. APS is a vertically-integrated electric utility that provides retail and wholesale electric service to most of the state of Arizona, with the major exceptions of about one-half of the Phoenix metropolitan area, the Tucson metropolitan area and Mohave County in northwestern Arizona. APS has historically accounted for a substantial part of our revenues and earnings, and is expected to continue to do so.
While customer growth in APS' service territory has been an important driver of our revenues and earnings, it has significantly slowed, reflecting recessionary economic conditions both nationally and in Arizona. Customer growth averaged 3% a year for the three years 2006 through 2008. We currently expect customer growth and retail electricity sales growth (excluding the effects of weather variations) to average about 1% per year during 2009 through 2011. We currently project that our customer growth will begin to accelerate as the economy recovers.
The near-term economic conditions are reflected in the recent volatility and disruption of the credit markets, as discussed in detail under "Liquidity and Capital Resources - Pinnacle West Consolidated" below. Despite these conditions, Pinnacle West and APS currently have ample borrowing capacity under their respective credit facilities and have been able to access these facilities, ensuring adequate liquidity for each company.
Our cash flows and profitability are affected by the electricity rates APS may charge and the timely recovery of costs through those rates. APS' retail rates are regulated by the ACC and its wholesale electric rates (primarily for transmission) are regulated by the FERC. APS' capital expenditure requirements, which are discussed below under "Liquidity and Capital Resources - Pinnacle West Consolidated," are substantial because of increased costs related to environmental compliance and controls and system reliability, as well as continuing, though slowed, customer growth in APS' service territory.
APS needs timely recovery through rates of its capital and operating expenditures to maintain adequate financial health. See "Factors Affecting Our Financial Outlook" below. On March 24, 2008, APS filed a rate case with the ACC, which it updated on June 2, 2008, requesting, among other things, an increase in retail rates to help defray rising infrastructure costs, approval of an impact fee and approval of new conservation rates. See Note 3 for details regarding this rate case, including the ACC's approval of an interim base rate surcharge pending the outcome of the case.
The 2007 and 2008 financial results of SunCor, our real estate subsidiary, reflect the weak real estate market and current economic conditions, which have adversely affected SunCor's ability to access capital. SunCor's net loss in 2008 included a $53 million (pre-tax) real estate impairment charge. If conditions in the broader economy or the real estate markets worsen, or as a result of a change in SunCor's strategy, we may be required to record additional impairments (see Note 23). In addition to SunCor's Secured Revolver, under which approximately $120 million in borrowings were outstanding at December 31, 2008, SunCor had approximately $68 million of outstanding debt under other credit facilities that mature at various dates and also contain certain loan covenants. The majority of this indebtedness, except for the Secured Revolver, is due in 2009, and SunCor is in the process of renegotiating these facilities. If SunCor is unable to meet its financial covenants under the Secured Revolver or its other outstanding credit facilities, SunCor could be required to immediately repay its outstanding indebtedness under all of its credit facilities as a result of cross-default provisions. Such a debt acceleration would have a material adverse impact on SunCor's business and its financial position. The Company has not guaranteed any SunCor indebtedness. As a result, the Company does not believe that SunCor's inability to meet its financial covenants under the Secured Revolver or its other outstanding credit facilities would have a material adverse impact on Pinnacle West's cash flows or liquidity, although any resulting SunCor losses would be reflected in Pinnacle West's consolidated financial statements.

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Our other principal first tier subsidiaries, El Dorado and APSES, are not expected to have any material impact on our financial results, or to require any material amounts of capital, over the next three years.
We continue to focus on solid operational performance in our electricity generation and delivery activities. In the delivery area, we focus on superior reliability and customer satisfaction. We plan to expand long-term energy resources and our transmission and distribution systems to meet the electricity needs of our growing retail customer base and to sustain reliability.
See "Factors Affecting Our Financial Outlook" below for a discussion of several factors that could affect our future financial results.

PINNACLE WEST CONSOLIDATED - EARNINGS CONTRIBUTION BY BUSINESS SEGMENT
Pinnacle West's two reportable business segments are:
• our regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses (primarily electric service to Native Load customers) and related activities and includes electricity generation, transmission and distribution; and

• our real estate segment, which consists of SunCor's real estate development and investment activities.

The following table presents income from continuing operations for our regulated electricity and real estate segments and reconciles those amounts to net income in total for the years ended 2008, 2007, and 2006 (dollars in millions):

                                                              2008      2007      2006
   Regulated electricity segment                              $ 256     $ 274     $ 259
   Real estate segment (a)                                      (49 )      14        50
   All other (b)                                                  7        11         7

   Income from continuing operations                            214       299       316
   Income (loss) from discontinued operations - net of tax:
   Real estate segment (c)                                       23         9        10
   All other (b)                                                  5        (1 )       1

   Net income                                                 $ 242     $ 307     $ 327

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(a) SunCor's net loss in 2008 included a $32 million after-tax real estate impairment charge (see Note 23).

(b) Includes activities related to marketing and trading, APSES, Silverhawk and El Dorado. Income from discontinued operations for 2008 is primarily related to the resolution of certain tax issues associated with the sale of Silverhawk in 2005. The 2007 loss is primarily related to an APSES project. None of these segments is a reportable segment.

PINNACLE WEST CONSOLIDATED - RESULTS OF OPERATIONS 2008 Compared with 2007
Our consolidated net income decreased approximately $65 million, to $242 million in 2008 from $307 million in 2007. The major factors that increased (decreased) our net income for the year ended December 31, 2008 compared with the prior year are summarized in the following table (dollars in millions):

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                                                                       Increase (Decrease)
                                                                    Pretax           After Tax
Regulated electricity segment:
Impacts of retail rate increase effective July 1, 2007 and
transmission rate increases:
Retail revenue increase primarily related to higher Base
Fuel Rate                                                         $      156         $       95
Decreased deferred fuel and purchased power costs related to
higher Base Fuel Rate                                                   (141 )              (86 )
Transmission rate increases (including related retail rates)              31                 19
Lower mark-to-market valuations of fuel and purchased power
contracts related to changes in market prices, net of
related PSA deferrals                                                    (14 )               (9 )
Regulatory disallowance in 2007                                           14                  8
Higher retail sales primarily due to customer growth,
excluding weather effects, partially offset by lower average
usage                                                                     21                 13
Effects of weather on retail sales                                       (43 )              (26 )
Operations and maintenance expense increases primarily due
to:
Customer service and other costs, including distribution
system reliability                                                       (30 )              (18 )
Generation costs, including more planned maintenance                     (18 )              (11 )
Employee severance costs                                                  (9 )               (5 )
Higher depreciation and amortization primarily due to
increased utility plant in service                                       (18 )              (11 )
Income tax benefits related to prior years resolved in 2008                -                 30
Income tax benefits related to prior years resolved in 2007                -                (13 )
Higher interest expense, net of capitalized financing costs,
primarily due to higher rates on certain APS pollution
control bonds and higher short-term debt balances                        (15 )               (9 )
Miscellaneous items, net                                                   1                  5

Decrease in regulated electricity segment net income                     (65 )              (18 )
Lower real estate segment income from continuing operations
primarily due to:
Real estate impairment charge (Note 23)                                  (53 )              (32 )
Lower land parcel sales resulting from the weak real estate
market                                                                   (40 )              (24 )
Lower sales of residential property resulting from the weak
real estate market                                                        (4 )               (2 )
Higher other costs                                                        (7 )               (5 )
Lower marketing and trading contribution primarily due to
lower sales volumes                                                      (16 )              (10 )
Other miscellaneous items, net                                            14                  6

Decrease in income from continuing operations                     $     (171 )              (85 )

Increase in real estate segment income from discontinued
operations primarily related to a 2008 commercial property
sale                                                                                         14
Increase in other income from discontinued operations
primarily related to the resolution in 2008 of certain tax
issues associated with the sale of Silverhawk in 2005                                         6

Decrease in net income                                                               $      (65 )

Regulated Electricity Segment Revenues
Regulated electricity segment revenues were $209 million higher for the year ended December 31, 2008 compared with the prior year primarily because of:

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• a $156 million increase in retail revenues due to a rate increase effective July 1, 2007;

• a $38 million increase in revenues from Off-System Sales due to higher prices and volumes;

• a $31 million increase due to transmission rate increases (including related retail rates);

• a $29 million increase in retail revenues primarily related to customer growth, excluding weather effects;

• a $26 million increase in revenues related to long-term traditional wholesale contracts;

• a $14 million increase in renewable energy surcharges which are offset by operations and maintenance expense;

• a $63 million decrease in retail revenue due to the effects of weather;

• a $47 million decrease in retail revenues related to recovery of PSA deferrals, which had no earnings effect because of lower amortization of the same amount recorded as fuel and purchased power expense; and

• a $25 million net increase due to miscellaneous factors.

Real Estate Segment Revenues
Real estate segment revenues were $82 million lower for the year ended December 31, 2008 compared with the prior year primarily because of:
• a $62 million decrease primarily due to lower sales of land parcels as a result of the weak real estate market;

• a $14 million decrease primarily due to lower residential property sales as a result of the weak real estate market; and

• a $6 million net decrease due to miscellaneous factors.

All Other Revenues
All other revenues were $78 million lower for the year ended December 31, 2008 compared with the prior year primarily because of planned reductions of marketing and trading activities.
2007 Compared with 2006
Our consolidated net income decreased approximately $20 million, from $327 million for 2006 to $307 million for 2007. The major factors that increased (decreased) net income for the year ended December 31, 2007 compared with the prior year are summarized in the following table (dollars in millions):

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                                                                       Increase (Decrease)
                                                                    Pretax           After Tax
Regulated electricity segment:
Higher retail sales primarily due to customer growth,
excluding weather effects                                         $       46         $       28
Effects of weather on retail sales                                        37                 23
Impacts of retail rate increase effective July 1, 2007:
Revenue increase related to higher Base Fuel Rate                        185                113
Decreased deferred fuel and purchased power costs related to
higher Base Fuel Rate                                                   (171 )             (104 )
Non-fuel rate increase                                                     6                  4
Net changes in fuel and purchased power costs related to
price:
Higher fuel and purchased power costs related to increased
commodity prices                                                        (121 )              (74 )
Increased deferred fuel and purchased power costs related to
increased prices                                                         115                 70
Mark-to-market fuel and purchased power costs, net of
related deferred fuel and purchased power costs                           18                 11
Regulatory disallowance (see Note 3)                                     (14 )               (8 )
Operations and maintenance increases primarily due to:
Increased generation costs, including increased maintenance
and overhauls and Palo Verde performance improvement plan                (25 )              (15 )
Customer service and other costs                                         (21 )              (13 )
Higher depreciation and amortization primarily due to
increased utility plant in service                                       (12 )               (7 )
Lower other income, net of expense, primarily due to lower
interest income as a result of lower investment balances and
miscellaneous asset sales in prior year                                  (15 )               (9 )
Income tax benefits resolved in 2007 related to prior years                -                 13
Income tax credits resolved in 2006 related to prior years                 -                (14 )
Miscellaneous items, net                                                   6                 (3 )

Increase in regulated electricity segment net income                      34                 15
Lower real estate segment income from continuing operations
primarily due to:
Lower sales of residential property resulting from the
continued slowdown in the western United States real estate
markets                                                                  (47 )              (29 )
Lower sales of land parcels                                              (12 )               (7 )
Higher other costs                                                        (1 )                -
Higher marketing and trading contribution primarily due to
higher mark-to-market gains resulting from changes in
forward prices and higher unit margins                                     6                  3
Other miscellaneous items, net                                            (2 )                1

Decrease in income from continuing operations                     $      (22 )              (17 )

Discontinued operations:
Increased commercial property real estate sales                                              (1 )
Other discontinued operations                                                                (2 )

Decrease in net income                                                               $      (20 )

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Regulated Electricity Segment Revenues
Regulated electricity segment revenues were $283 million higher for the year ended December 31, 2007 compared with the prior year primarily because of:
• a $191 million increase in retail revenues due to a rate increase effective July 1, 2007;

• a $60 million increase in retail revenues primarily related to customer growth, excluding weather effects;

• a $50 million increase in retail revenues due to the effects of weather;

• a $3 million increase in revenues from Off-System Sales due to higher prices and volumes;

• a $35 million decrease in retail revenues related to recovery of PSA deferrals, which had no earnings effect because of amortization of the same amount recorded as fuel and purchased power expense (see Note 3); and

• a $14 million net increase due to miscellaneous factors.

Real Estate Segment Revenues
Real estate segment revenues were $187 million lower for the year ended December 31, 2007 compared with the prior year primarily because of:
• a $167 million decrease in residential property sales due to the continued slowdown in western United States real estate markets; and

• a $20 million decrease primarily due to lower sales of land parcels.

All Other Revenues
Other revenues were $13 million higher for the year ended December 31, 2007 compared with the prior year primarily as a result of increased sales by APSES of energy-related products and services.
LIQUIDITY AND CAPITAL RESOURCES - Pinnacle West Consolidated Cash Flows
The following table presents net cash provided by (used for) operating, investing and financing activities for the years ended December 31, 2008, 2007 and 2006 (dollars in millions):

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                                                           2008       2007       2006
   Net cash flow provided by operating activities         $  814     $  658     $  394
   Net cash flow used for investing activities              (815 )     (873 )     (569 )
   Net cash flow provided by financing activities             51        185        108

   Net Increase (decrease) in cash and cash equivalents   $   50     $  (30 )   $  (67 )

2008 Compared with 2007
The increase of approximately $156 million in net cash provided by operating activities is primarily due to lower current income taxes; lower real estate investments resulting from the weak real estate market; and increased retail revenue related to higher Base Fuel Rates, partially offset by increased collateral and margin cash provided as a result of changes in commodity prices.
The decrease of approximately $58 million in net cash used for investing activities is primarily due to a real estate commercial property sale in 2008; lower levels of capital expenditures (see table and discussion below); and increased contributions in aid of construction related to changes in 2008 in APS' line extension policy (see Note 3), partially offset by lower cash proceeds from the net sales and purchases of investment securities.
The decrease of approximately $134 million in net cash provided by financing activities is primarily due to the use of the proceeds from the sale of a real estate commercial property to pay down long-term debt in 2008, partially offset by higher levels of short-term debt borrowings.
2007 Compared with 2006
The increase of approximately $264 million in net cash provided by operating activities is primarily due to a decrease in 2007 in the amount of cash collateral and margin cash returned to counterparties as a result of changes in commodity prices.
The increase of approximately $304 million in net cash used for investing activities is primarily due to the proceeds of $208 million received in 2006 from the 2005 sale of Silverhawk and an increase in cash used for capital expenditures and capitalized interest (see table and discussion below), partially offset by higher cash proceeds from the net sales and purchases of investments.
The increase of approximately $77 million in net cash provided by financing activities is primarily due to higher levels of short-term borrowings, partially offset by a decrease in net new long-term debt (issuances net of redemptions and refinancing).
Liquidity
Capital Expenditure Requirements
The following table summarizes the actual capital expenditures for 2006, 2007 and 2008 and estimated capital expenditures, net of contributions in aid of construction, for the next three years:

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                              CAPITAL EXPENDITURES
                             (dollars in millions)

                                        Actual                         Estimated
                              2006       2007       2008      2009      2010       2011
             APS
             Distribution     $ 357     $   372     $ 340     $ 276     $ 266     $   356
             Generation (a)     176         353       310       288       274         319
             Transmission       113         138       163       275        99         185
             Other (b)           16          37        43        44        37          50

             Subtotal           662         900       856       883       676         910
             SunCor (c)         201         161        41        14        70         175
             Other                7           3         7         7         3           3

             Total            $ 870     $ 1,064     $ 904     $ 904     $ 749     $ 1,088

(a) Generation includes nuclear fuel expenditures of approximately $60 million to $80 million per year for 2009, 2010 and 2011.

(b) Primarily information systems and facilities projects.

(c) Consists primarily of capital expenditures for residential, land development and retail and office building construction reflected in "Real estate investments" and "Capital expenditures" on the Consolidated Statements of Cash Flows.

Distribution and transmission capital expenditures are comprised of infrastructure additions and upgrades, capital replacements, new customer construction and related information systems and facility costs. Examples of the types of projects included in the forecast include power lines, substations, line extensions to new residential and commercial developments and upgrades to customer information systems, partially offset by contributions in aid of construction in accordance with APS' line extension policy.
Generation capital expenditures are comprised of various improvements to APS' existing fossil and nuclear plants. Examples of the types of projects included in this category are additions, upgrades and capital replacements of various power plant equipment such as turbines, boilers and environmental equipment. Environmental expenditures differ for each of the years 2009, 2010 and 2011, with the lowest year estimated at approximately $25 million, and the highest year estimated at approximately $80 million. We are also monitoring the status of certain environmental matters, which, depending on their final outcome, could require modification to our environmental expenditures. (See "Business of Arizona Public Service Company - Environmental Matters - EPA Environmental Regulation - Regional Haze Rules" and "Environmental Matters - EPA Environmental Regulation - Mercury" in Item 1.)
In early 2008, we announced and began implementing a cost reduction effort that included the elimination of approximately $200 million of capital expenditures for the years 2008 - 2012. These capital expenditure reductions are reflected in the estimates provided above. Due primarily to our reduced customer growth outlook as well as the deferral of upgrades and other capital projects, we have identified additional capital expenditure reductions of over $500 million at APS (net of the

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change in amounts collected for projected line extensions) over the years 2009 - 2011. These reductions are across all areas - distribution, generation, transmission and general plant, and are reflected in the estimates provided above. (See "Pinnacle West Consolidated - Factors Affecting Our Financial Outlook - Customer and Sales Growth" below for additional information on our growth outlook.)
Capital expenditures will be funded with internally generated cash and/or external financings, which may include issuances of long-term debt and Pinnacle West common stock.
Pinnacle West (Parent Company)
Our primary cash needs are for dividends to our shareholders and principal and interest payments on our long-term debt. The level of our common stock dividends and future dividend growth will be dependent on a number of factors including, but not limited to, payout ratio trends, free cash flow and financial market conditions.
On January 21, 2009, the Pinnacle West Board of Directors declared a . . .