Summary of PINNACLE WEST CAPITAL CORP

Item 2. 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 Condensed Consolidated Financial Statements and Arizona Public Service Company's Condensed Financial Statements and the related Notes that appear in Item 1 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 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 to average about 1% per year during 2009 through 2011; however, we currently project that our customer growth will begin to accelerate as the economy recovers. APS' actual retail electricity sales have also slowed. For the three years 2006 through 2008, such kilowatt-hour sales grew at an average annual rate of 2.9%; adjusted to exclude the effects of weather variations, such retail sales growth also averaged 2.9% a year. We currently estimate that total retail electricity sales in kilowatt-hours will remain flat on average per year during 2009 through 2011, including the effects of APS' energy efficiency programs but excluding the effects of weather variations.
The near-term economic conditions are reflected in the recent volatility and disruption of the credit markets, as discussed in detail under "Pinnacle West Consolidated - Liquidity and Capital Resources" 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 "Pinnacle West Consolidated - Liquidity and Capital Resources," 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. On January 30, 2009, APS and other parties to the rate case began settlement discussions and, on June 12, 2009, they filed a proposed settlement agreement with the ACC. See Note 5 for details regarding this rate case, including the ACC's approval of an interim base rate surcharge pending the outcome of the case and a discussion of the Settlement Agreement and related timeline.

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During the first quarter of 2009, SunCor undertook and completed a review of its assets and strategies within its various markets as a result of the then current and anticipated continuing distressed conditions in real estate and credit markets. Based on the results of the review, on March 27, 2009, SunCor's Board of Directors authorized a series of strategic transactions to dispose of SunCor's homebuilding operations, master-planned communities, and golf courses in order to reduce SunCor's outstanding debt. This resulted in a pretax impairment charge of approximately $202 million, or $123 million after income taxes, in the first quarter of 2009. During the second quarter of 2009, SunCor reassessed market conditions and recorded an additional pretax impairment charge of approximately $6 million, or $4 million after income taxes. We believe that most of the assets to be sold do not meet the held for sale criteria as of June 30, 2009 because of the uncertainties related to the current market conditions and obtaining necessary approvals. See "Liquidity and Capital Resources - Other Subsidiaries - SunCor" below for a discussion of SunCor's outstanding debt and related matters.
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.
See "Factors Affecting Our Financial Outlook" below for a discussion of several factors that could affect our future financial results.
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.

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The following table presents income (loss) from continuing operations for our regulated electricity and real estate segments and reconciles those amounts to our consolidated net income (loss) (dollars in millions):

                                             Three Months Ended               Six Months Ended
                                                  June 30,                        June 30,
                                            2009             2008           2009            2008
Regulated electricity segment            $       78       $      121     $       58       $     114
Real estate segment (a)                          (6 )             (6 )         (149 )            (9 )
All other (b)                                    (1 )             (2 )           (6 )             1

Income (loss) from continuing
operations                                       71              113            (97 )           106
Income (loss) from discontinued
operations - net of tax:
Real estate segment (a)                          (3 )             21             (5 )            23

Net income (loss)                                68              134           (102 )           129
Less: Net loss attributable to
noncontrolling interests - real estate
segment (a)                                       -                -            (14 )             -

Net income (loss) attributable to
common shareholders                      $       68       $      134     $      (88 )     $     129

(a) We recorded an after-tax real estate impairment charge of $127 million in the six months ended June 30, 2009.

(b) Includes activities related to marketing and trading, APSES and El Dorado. None of these segments is a reportable segment.

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Operating Results - Three-month period ended June 30, 2009 compared with three-month period ended June 30, 2008
Our consolidated net income attributable to common shareholders for the three months ended June 30, 2009 was $68 million, compared with net income of $134 million for the comparable prior-year period. The major factors that increased (decreased) the net income attributable to common shareholders for the three-month comparison are summarized in the following table (dollars in millions):

                                                                 Increase (Decrease)
                                                               Pretax          After Tax
Regulated electricity segment:
Retail rate increases primarily due to the interim rate
increase effective January 1, 2009                           $       19       $        12
Effects of weather on retail sales                                   12                 7
Lower retail sales primarily due to lower per customer
usage, including the effects of the Company's energy
efficiency programs, excluding the effects of weather               (13 )              (8 )
Lower mark-to-market valuations of fuel and purchased
power contracts related to changes in market prices, net
of related PSA deferrals                                             (9 )              (5 )
Higher operations and maintenance expense primarily
related to higher generation costs, including more
planned maintenance                                                 (17 )             (10 )
Higher interest expense, net of capitalized financing
costs, primarily due to higher debt balances                         (9 )              (5 )
Income tax benefits related to prior years resolved in
2008                                                                  -               (30 )
Miscellaneous items, net                                             (5 )              (4 )

Decrease in regulated electricity segment net income                (22 )             (43 )
Decrease in other expense, net of other income, primarily
due to investment losses recorded in 2008                             5                 3
Other miscellaneous items, net                                       (3 )              (2 )

Decrease in income from continuing operations                $      (20 )             (42 )

Decrease in income from discontinued operations primarily
related to certain real estate commercial property sales
in 2008                                                                               (24 )

Decrease in net income attributable to common
shareholders                                                                  $       (66 )

Regulated Electricity Segment Revenues
Regulated electricity segment revenues were $17 million lower for the three months ended June 30, 2009 compared with the prior year period primarily because of:
• a $26 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 5);

• a $23 million decrease in retail revenues primarily related to lower usage, excluding weather effects;

• an $18 million decrease in revenues from Off-System Sales due to lower market prices;

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• a $19 million increase in retail revenues due to the effects of weather;

• a $19 million increase in retail revenues due to an interim rate increase effective January 2009 and transmission rate increases (including related retail rates);

• a $16 million increase in renewable energy and demand side management surcharges which are offset by operations and maintenance expense (see Note 5); and

• a $4 million net decrease due to miscellaneous factors.

Real Estate Segment Revenues
Real estate segment revenues were $7 million lower for the three months ended June 30, 2009 compared with the prior year period primarily because of lower residential property and parcel sales as a result of the distressed real estate market.
All Other Revenues
Other revenues were $21 million lower for the three months ended June 30, 2009 compared with the prior year period because of planned reductions of marketing and trading activities.

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Operating Results - Six-month period ended June 30, 2009 compared with six-month period ended June 30, 2008
Our consolidated net loss attributable to common shareholders for the six months ended June 30, 2009 was $88 million, compared with net income of $129 million for the comparable prior-year period. The major factors that increased (decreased) the net income attributable to common shareholders for the six-month comparison are summarized in the following table (dollars in millions):

                                                                 Increase (Decrease)
                                                               Pretax          After Tax
Regulated electricity segment:
Interim rate increase effective January 1, 2009              $       29       $        18
Transmission rate increases (including related retail
rates)                                                                9                 5
Lower mark-to-market valuations of fuel and purchased
power contracts related to changes in market prices, net
of related PSA deferrals                                            (28 )             (17 )
Lower retail sales primarily due to lower per customer
usage, including the effects of the Company's energy
efficiency programs, excluding the effects of weather               (17 )             (10 )
Higher operations and maintenance expense primarily
related to higher generation costs, including more
planned maintenance                                                 (16 )             (10 )
Higher depreciation and amortization primarily due to
increased utility plant in service                                   (7 )              (4 )
Higher interest expense, net of capitalized financing
costs, primarily due to higher debt balances                        (13 )              (8 )
Income tax benefits related to prior years resolved in
2008                                                                  -               (30 )
Miscellaneous items, net                                             (1 )               -

Decrease in regulated electricity segment net income                (44 )             (56 )
Real estate segment:
Real estate impairment charge (Note 21)                            (212 )            (134 )
Higher real estate segment costs primarily related to
employee severance                                                   (9 )              (6 )
Lower marketing and trading contributions primarily due
to lower sales volumes                                              (11 )              (7 )

Decrease in income from continuing operations                $     (276 )            (203 )

Decrease in income from discontinued operations primarily
related to certain real estate commercial property sales
in 2008                                                                               (28 )

Decrease in net income                                                               (231 )
Less: Net loss attributable to real estate noncontrolling
interests primarily due to real estate impairment                                     (14 )

Decrease in net income attributable to common
shareholders                                                                  $      (217 )

Regulated Electricity Segment Revenues
Regulated electricity segment revenues were $37 million lower for the six months ended June 30, 2009 compared with the prior year period primarily because of:
• a $48 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 5);

• a $30 million decrease in retail revenues primarily related to lower usage, excluding weather effects;

• a $21 million decrease in revenues from Off-System Sales due to lower market prices;

• a $3 million decrease in retail revenues due to the effects of weather;

• a $38 million increase in retail revenues due to an interim rate increase effective January 2009 and transmission rate increases (including related retail rates);

• a $32 million increase in renewable energy and demand side management surcharges which are offset by operations and maintenance expense (see Note 5); and

• a $5 million net decrease due to miscellaneous factors.

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Real Estate Segment Revenues
Real estate segment revenues were $15 million lower for the six months ended June 30, 2009 compared with the prior year period primarily because of lower residential property and parcel sales as a result of the distressed real estate market.
All Other Revenues
Other revenues were $52 million lower for the six months ended June 30, 2009 compared with the prior year period because of planned reductions of marketing and trading activities.

          PINNACLE WEST CONSOLIDATED - LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
The following table presents net cash provided by (used for) operating,
investing and financing activities for the six months ended June 30, 2009 and
2008 (dollars in millions):

                                                                Six Months Ended
                                                                    June 30,
                                                                2009          2008
  Net cash flow provided by operating activities              $     192      $  679
  Net cash flow used for investing activities                      (541 )      (379 )
  Net cash flow provided by (used for) financing activities         261        (259 )

The decrease of approximately $487 million in net cash provided by operating activities is primarily due to changes in collateral and margin cash balances as a result of changes in commodity prices and other changes in working capital. The increase of approximately $162 million in net cash used for investing activities is primarily due to the timing of pollution control auction rate securities redemptions (see Note 4) and lower real estate sales primarily due to a commercial property sale in 2008, partially offset by lower levels of capital expenditures (see table and discussion below).
The increase of approximately $520 million in net cash provided by financing activities is primarily due to APS' issuance of $500 million of unsecured senior notes. A portion of these proceeds were used to repay short-term borrowings. In addition, there was the issuance of $343 million of pollution control bonds, a portion of which was used to redeem $179 million of APS' existing pollution control bonds. The remaining $164 million was deposited in a restricted trust fund for bond redemption of auction rate securities in July 2009 (see Note 4).

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                              CAPITAL EXPENDITURES
                             (dollars in millions)

                            Six Months Ended            Estimated for the Year Ended
                                June 30,                        December 31,
                            2008          2009        2009            2010          2011
         APS
         Distribution     $    173       $  121     $     276       $     289       $ 381
         Generation (a)        164          131           288             274         319
         Transmission           81           93           275              99         185
         Other (b)              11           15            44              37          50

         Subtotal              429          360           883             699         935
         Other                  31            7            12               8           8

         Total            $    460       $  367     $     895       $     707       $ 943

(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.

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 "Environmental Matters - EPA Environmental Regulation - Regional Haze Rules" in Part II, Item 5 below and "Environmental Matters - EPA Environmental Regulation - Mercury" in Part II, Item 5 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2009.)

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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 July 22, 2009, the Pinnacle West Board of Directors declared a quarterly dividend of $0.525 per share of common stock, payable on September 1, 2009, to shareholders of record on August 3, 2009.
Our primary sources of cash are dividends from APS and external debt and equity financings. In addition, Pinnacle West expects to recognize approximately $100 million of cash tax benefits related to SunCor's strategic asset sales which will not be realized until the asset sale transactions are completed. Approximately $80 million of these benefits were recorded in the first quarter of 2009 as reductions to income tax expense related to the current impairment charges. The additional $20 million of tax benefits were recorded as reductions in income tax expense related to the impairment charge recorded in the fourth quarter of 2008.
An existing ACC order requires APS to maintain a common equity ratio of at least 40% and prohibits APS from paying common stock dividends if the payment would reduce its common equity below that threshold. As defined in the ACC order, the common equity ratio is common equity divided by the sum of common equity and long-term debt, including current maturities of long-term debt. At June 30, 2009, APS' common equity ratio, as defined, was approximately 48%. The credit and liquidity markets experienced significant stress beginning the week of September 15, 2008. While Pinnacle West's and APS' ability to issue commercial paper has been negatively impacted by the market stress, they have both been able to access existing credit facilities, ensuring adequate liquidity.
Pinnacle West (parent company) has a $283 million revolving credit facility that terminates in December 2010. The revolver is available to support the issuance of up to $250 million in commercial paper or to be used as bank borrowings, including issuances of letters of credit of up to $94 million. At June 30, 2009, the parent company had outstanding $177 million of borrowings under its revolving credit facility and no letters of credit. It also had no commercial paper outstanding at June 30, 2009. At June 30, 2009, the parent company had remaining capacity available under its revolver of approximately $106 million.

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Pinnacle West sponsors a qualified defined benefit and account balance pension plan and a non-qualified supplemental excess benefit retirement plan for the employees of Pinnacle West and our subsidiaries. IRS regulations require us to contribute a minimum amount to the qualified plan. We contribute at least the minimum amount required under IRS regulations, but no more than the maximum tax-deductible amount. The minimum required funding takes into consideration the value of plan assets and our pension obligation. The assets in the plan are comprised of fixed-income, equity, real estate and short-term investments. Future year contribution amounts are dependent on plan asset performance and plan actuarial assumptions. We contributed $35 million to our pension plan in 2008. In the first quarter of 2009, IRS regulations were modified to allow alternative measurement dates to determine the interest rate used to value the year-end 2008 pension liability for funding purposes for 2009. As a result of this change, we estimate our minimum pension contribution to be zero in 2009. We currently estimate that our pension contributions could average around $150 million for several years, assuming the discount rate remains at approximately current levels. The expected contribution to our other postretirement benefit plans in 2009 is estimated to be approximately $15 million. APS and other subsidiaries fund their share of the contributions. APS' share is approximately 97% of both plans.
See Note 5 for information regarding Pinnacle West's approval from the ACC regarding a potential equity infusion into APS of up to $400 million. In addition, see Note 5 for details regarding terms of the proposed retail rate case settlement under which APS would have authorization to obtain additional equity infusions.
APS
APS' capital requirements consist primarily of capital expenditures and mandatory redemptions of long-term debt. APS pays for its capital requirements with cash from operations and, to the extent necessary, equity infusions from Pinnacle West and external financings. See "Pinnacle West (Parent Company)" above for a discussion of the common equity ratio that APS must maintain in order to pay dividends to Pinnacle West.
On February 26, 2009, APS issued $500 million of 8.75% unsecured senior notes that mature on March 1, 2019. Net proceeds from the sale of the notes were used to repay short-term borrowings under two committed revolving lines of credit incurred to fund capital expenditures and for general corporate purposes. During the second quarter of 2009, APS refinanced approximately $343 million of its $539 million variable rate pollution control bonds. As a result of these refinancings, which are described in the following three paragraphs, APS no longer has any outstanding debt securities in auction rate mode. . . .