PINNACLE WEST CAPITAL CORPORATION INTRODUCTION
The following discussion should be read in conjunction with Pinnacle West's
Condensed Consolidated Financial Statements and APS's Condensed Consolidated
Financial Statements and the related Combined Notes that appear in Item 1 of
this report. For information on factors that may cause our actual future
results to differ from those we currently seek or anticipate, see
"Forward-Looking Statements" at the front of this report and "Risk Factors" in
Part 1, Item 1A of the 2019 Form 10-K, Part II, Item 1A of the 2020 1st Quarter
10-Q and Part II, Item 1A of this report.
OVERVIEWBusiness Overview
Pinnacle West is an investor-owned electric utility holding company based inPhoenix, Arizona with consolidated assets of about$19 billion . For over 130 years, Pinnacle West and our affiliates have provided energy and energy-related products to people and businesses throughoutArizona . Pinnacle West derives essentially all of our revenues and earnings from our principal subsidiary, APS. APS isArizona's largest and longest-serving electric company that generates safe, affordable and reliable electricity for approximately 1.3 million retail customers in 11 ofArizona's 15 counties. APS is also the operator and co-owner ofPalo Verde - a primary source of electricity for the southwestUnited States and the largest nuclear power plant inthe United States . COVID-19 Pandemic The COVID-19 pandemic continues to be a rapidly evolving situation. It has led to economic disruption and volatility in financial markets worldwide. The Company is operating under long-standing crisis and business continuity plans that exist to address situations including pandemics like COVID-19. We are focused on ensuring the health and safety of our employees, contractors and the general public by helping limit spread of this virus and ensuring continued, safe and reliable electric service for APS customers. We have identified business-critical positions in both our operations and support organizations and identified backup personnel who are intended to provide support if needed to maintain operations with a reduced workforce. Essential planned work and capital investments are continuing during the pandemic but certain non-essential planned work has been postponed to later in 2020. The Company conducted a contract review to confirm adequacy of needed summer resources and has measures in place to continue to monitor resource needs and supply chain adequacy. At this time, the Company does not believe it has any material supply chain risks due to COVID-19 that would impact its ability to serve customers' needs. The Company's operations and maintenance expenses, exclusive of bad debt expense, increased by approximately$9 million for the six months endedJune 30, 2020 due to costs for personal protective equipment and other health and safety-related costs related to COVID-19. We expect the Company's operation and maintenance expenses will continue to be impacted for the remainder of 2020 by the need for additional personal protective equipment and other health and safety-related costs related to COVID-19. While the total expected impact of COVID-19 on future sales is currently unknown, APS has experienced higher electric residential sales and lower electric commercial and industrial sales since the outset of the pandemic. FromMarch 13th through July 28, 2020 , the cumulative impact in weather-normalized usage was negative 1%. During that period, APS's retail electric residential weather-normalized sales increased 4%, 72 -------------------------------------------------------------------------------- and its retail electric commercial and industrial weather-normalized sales decreased 5% in the aggregate. APS expects the reduction in electric demand from commercial and industrial customers and increased demand from residential customers to continue in the near term. Based on past experience, a 1% variation in our annual kWh sales projections under normal business conditions can result in increases or decreases in annual net income of approximately$20 million . OnMarch 31, 2020 , a stay at home order became effective for the state ofArizona and remained in effect untilMay 16, 2020 , when it was lifted andArizona began reopening. InJune 2020 ,Arizona saw an increase in the number of COVID-19 cases, hospitalizations, and deaths. Accordingly, onJune 29, 2020 , the governor ofArizona closed bars, indoor gyms and fitness clubs or centers, indoor movie theaters and water parks and tubing operators untilJuly 27, 2020 as a partial reversal of the state's reopening and to mitigate the spread of COVID-19. OnJuly 23, 2020 , the governor ofArizona extended these closures and they will remain in place and continue to be reviewed for repeal or revision every two weeks. We cannot predict the impact of the increased spread of COVID-19 inArizona and the partial reclosure will have on our financial position, results of operations or cash flows and we are continuing to monitor the impacts. As a result of the COVID-19 pandemic, inmid-March 2020 the commercial paper markets failed to function normally and we were unable to utilize commercial paper as our primary method of acquiring short-term capital, which resulted in us drawing on our revolving credit facilities during the first quarter of 2020. Inmid-April 2020 , we were again able to utilize the commercial paper market and we have paid down the entire amount of the revolving credit facilities that were utilized as a result of the commercial paper market failure. The Coronavirus Aid, Relief, and Economic Security (CARES) Act allows employers to defer payments of the employer share ofSocial Security payroll taxes that would have otherwise been owed fromMarch 27, 2020 throughDecember 31, 2020 . We are deferring the cash payment of the employer's portion ofSocial Security payroll taxes for the periodJuly 1, 2020 throughDecember 31, 2020 that we expect will be in the range of$15 million to$20 million . We will pay half of this cash deferral byDecember 31, 2021 and the remainder byDecember 31, 2022 . OnJune 30, 2020 ,FERC issued an order granting a waiver request related to the existing AFUDC rate calculation beginningMarch 1, 2020 throughFebruary 28, 2021 . The order provides a simplified approach that companies may elect to implement in order to minimize the significant distorted effect on the AFUDC formula resulting from increased short-term debt financing during the COVID-19 pandemic. APS has adopted this simplified approach to computing the AFUDC composite rate by using a simple average of the actual historical short-term debt balances for 2019, instead of current period short-term debt balances, and has left all other aspects of the AFUDC formula composite rate calculation unchanged. This change impacts the AFUDC composite rate in 2020, but does not impact prior years. Furthermore, the change in the composite rate calculation does not impact our accounting treatment for these costs. The change will not have a material impact on our financial statements. See Note 1 in our 2019 Form 10-K for information on the accounting treatment for AFUDC. Due to the COVID-19 pandemic, APS voluntarily suspended disconnections of customers for nonpayment beginningMarch 13, 2020 . In addition, APS waived all late payment fees during this current suspension period. APS currently estimates that the Summer Disconnection Moratorium (see Note 4), the suspension of disconnections during the COVID-19 pandemic and the increased bad debt expense associated with both events will result in a negative impact to its 2020 operating results of approximately$20 million to$30 million pre-tax above the impact of disconnections on its operating results for years that did not have the Summer Disconnection Moratorium or COVID-19 pandemic. APS is anticipating an increase in bad debt expense associated with the COVID-19 pandemic, but it still believes that costs associated with the Summer Disconnection Moratorium and the COVID-19 disconnection suspensions and related bad debt expense with both events will fall within this estimated$20 million to$30 million range. These estimated impact amounts 73 -------------------------------------------------------------------------------- depend on certain assumptions, including, but not limited to, customer behaviors, population and employment growth, and the impacts of COVID-19 on the economy. Additionally, due to COVID-19, APS delayed the reset of the EIS adjustor and suspended the discontinuation of TEAM Phase II to the first billing cycle inMay 2020 rather thanApril 2020 (see Note 4 ). OnApril 17, 2020 , APS filed an application with the ACC requesting a COVID-19 emergency relief package to provide additional assistance to its customers. OnMay 5, 2020 , the ACC approved APS returning$36 million that had been collected through the DSM Adjustor Charge, but not allocated for current DSM programs, directly to customers through a bill credit inJune 2020 (see Note 4). As ofJune 30, 2020 , APS had refunded approximately$40 million to customers. The additional$4 million over the approved amount was the result of the kWh credit being based on historic consumption which was different than actual consumption in the refund period. This difference was recorded to the DSM balancing account and will be addressed in subsequent DSM filings. APS has committed in total approximately$8 million to assist customers and local non-profits and community organizations to help with the impact of the COVID-19 pandemic. OnMay 5, 2020 , APS voluntarily committed to the ACC to contribute$5.3 million of non-ratepayer funds to provide assistance to residential and non-residential customers that have been impacted by the COVID-19 pandemic ("Customer COVID Assistance"). As part of this Customer COVID Assistance, APS has established a$2.3 million program to assist extra small and small non-residential customers that have a delinquency of two or more months with a one-time credit of$1,000 on each such customer's bill. The other$3 million of the Customer COVID Assistance has not yet been assigned to specific programs. Beyond the Customer COVID Assistance, APS has also provided$1.5 million to assist customers with a one-time credit of$100 on their bill, with a priority given to customers on limited-income service plans, and$1.25 million to assist local non-profits and community organizations working to mitigate the impacts of the COVID-19 pandemic. More detailed discussion of the impacts and future uncertainties related to the COVID19 pandemic can be found throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations and the Combined Notes to Pinnacle West's and APS's financial statements that appear in Item 1of this report and "Risk Factors" in Part II, Item 1A of the 2020 1st Quarter 10-Q and Part II, Item 1A of this report.
Strategic Overview
Our strategy is to deliver shareholder value by creating a sustainable energy
future for
Clean Energy Commitment
We are committed to doing our part to make the future clean and carbon-free. Our vision for APS andArizona presents an opportunity to engage with customers, communities, employees, policymakers, shareholders and others to achieve a shared, sustainable vision forArizona . This goal is based on sound science and supports continued growth and economic development while maintaining reliability and affordable prices for APS's customers. APS's new clean energy goals consist of three parts: •A 2050 goal to provide 100% clean, carbon-free electricity; • A 2030 target of achieving a resource mix that is 65% clean energy, with 45% of the generation portfolio coming from renewable energy; and
•A commitment to end APS's use of coal-fired generation by 2031.
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APS's ability to successfully execute its clean energy commitment is dependent
upon a number of important external factors, some of which include a supportive
regulatory environment, sales and customer growth, development of clean energy
technologies and continued access to capital markets.
2050 Goal: 100% Clean, Carbon-Free Electricity. Achieving a fully clean, carbon-free energy mix by 2050 is our aspiration. The 2050 goal will involve new thinking and depends on improved and new technologies.
2030 Goal: 65% Clean Energy. APS has an energy mix that is already 50% clean with existing plans to add more renewables and energy storage before 2025. By building on those plans, APS intends to attain an energy mix that is 65% clean by 2030, with 45% of APS's generation portfolio coming from renewable energy. "Clean" is measured as percent of energy mix which includes carbon-free resources like nuclear and demand-side management, and "renewable" is expressed as a percent of retail sales. This target will serve as a checkpoint for our resource planning, investment strategy, and customer affordability efforts as APS moves toward 100% clean, carbon-free energy mix by 2050. APS understands that closing its coal-fired power plants will significantly impact employees as well as the surrounding communities. APS will continue to engage in meaningful dialogue with these stakeholders in order to explore, better understand and prepare to address a range of potential effects, including environmental, social and economic impacts. 2031 Goal: End APS's Use of Coal-Fired Generation. The commitment to end APS's use of coal-fired generation by 2031 will require APS to cease use of coal-generation at Four Corners. APS has permanently retired more than 1,000 MW of coal-fired electric generating capacity. These closures and other measures taken by APS have resulted in a total reduction of carbon emissions of 26% since 2005. In addition, APS has committed to end the use of coal at its remaining Cholla units by 2025.
Renewables. APS intends to strengthen its already diverse energy mix by increasing its investments in carbon-free resources. Its near-term actions include competitive solicitations to procure clean energy resources such as solar, wind, energy storage, demand response and DSM resources, all of which lead to a cleaner grid.
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APS has a diverse portfolio of existing and planned renewable resources,
including solar, wind, geothermal, biomass and biogas. APS's clean energy
strategy includes executing purchased power contracts for new facilities,
ongoing development of distributed energy resources and procurement of new
facilities to be owned by APS. The following table summarizes the resources in
APS's renewable energy portfolio that are in operation and under development as
of June 30, 2020 . Agreements for the development and completion of future
resources are subject to various conditions, including successful siting,
permitting and interconnection of the projects to the electric grid.
Net Capacity in Operation Net Capacity Planned / Under
(MW) Development (MW)
Total APS Owned: Solar 244 -
Purchased Power Agreements:
Solar 310 -
Solar + Energy Storage - 50
Wind 289 -
Geothermal 10 -
Biomass 14 -
Biogas 3 -
Total Purchased Power
Agreements 626 50
Total Distributed Energy:
Solar (a) 1,019 29 (b)
Total Renewable Portfolio 1,889 79
(a) Includes rooftop solar facilities owned by third parties. Distributed
generation is produced in Direct Current and is converted to AC for reporting
purposes.
(b) Applications received by APS that are not yet installed and online.
APS has developed and owns solar resources through the ACC-approved AZ Sun
Program. APS also issued two Requests for Proposal ("RFP") in September 2019 .
The first RFP seeks competitive proposals for up to 150 MW of APS-owned solar
resources to be in service by 2021. This solar generation will be designed with
the flexibility to add energy storage as a future option. A second RFP requests
up to 250 MW of wind resources to be in service as soon as possible, but no
later than 2022.
Palo Verde . Palo Verde , the nation's largest carbon-free, clean energy resource,
will continue to be a foundational part of APS's resource portfolio. The plant
supplies nearly 70% of our clean energy and provides the foundation for the
reliable and affordable service for APS customers. Palo Verde is not just the
cornerstone of our current clean energy mix, it also is a significant provider
of clean energy to the southwest United States . The plant's continued operation
is important to a carbon-free and clean energy future for Arizona and the
region, as a reliable, continuous, affordable resource and as a large
contributor to the local economy.
Affordable
We believe it is APS's responsibility to deliver electric services to customers in the most cost-effective manner. SinceJanuary 2018 throughJune 2020 , the average residential bill decreased by 7.3% or$10.95 . Building upon existing cost management efforts, APS launched a customer affordability initiative in 2019. The initiative was implemented company-wide to thoughtfully and deliberately assess our business processes and organizational approaches to completing high-value work and internal efficiencies. Through the initiative and existing cost management practices, APS identified$20 million in possible cost savings for 2020. 76 -------------------------------------------------------------------------------- Participation in the EIM continues to be an effective tool for creating savings for our customers from the real-time, voluntary market. As ofJune 30, 2020 , the EIM has delivered approximately$158 million in gross benefits to APS customers since APS began participating in EIM in 2016. APS is in discussions with the EIM operator, CAISO, and other EIM participants about the feasibility of creating a voluntary day-ahead market to achieve more cost savings and use the region's renewable resources more efficiently.
Reliable
While our energy mix evolves, the obligation to deliver reliable service to our customers remains. Excluding voluntary outages and proactive fire mitigation efforts, APS finished 2019 with its best score for frequency of customer power outages. Planned investments will support operating and maintaining the grid, updating technology, accommodating customer growth and enabling more renewable energy resources. Our advanced distribution management system allows operators to locate outages, control line devices remotely and helps them coordinate more closely with field crews to safely maintain an increasingly dynamic grid. The system also integrates a new meter data management system that increases grid visibility and gives customers access to more of their energy usage data. Wildfire safety remains a critical focus for APS and other utilities. We increased investment in fire mitigation efforts to clear defensible space around our infrastructure, build partnerships with government entities and first responders and educate customers and communities. These programs contribute to customer reliability, responsible forest management and safe communities. The new units at our modernized Ocotillo power plant provide cleaner-running and more efficient units. They support reliability by responding quickly to the variability of solar generation, and delivering energy in the late afternoon and early evening, when solar production declines as the sun sets and customer demand peaks.
Customer-Focused
Customers are at the core of what APS does every day and APS is committed to providing options that make it easier for its customers to do business with them. In 2019, APS launched its redesigned aps.com website and mobile app, giving customers upgraded access to their energy usage data and billing information. APS's Customer Care team is using speech analytics to enrich advisors' interactions with customers over the telephone, and customers can also communicate with APS through an online chat.
APS expanded financial help for its most vulnerable customers in 2019,
allocating
APS continues to develop and deploy innovative programs that connect customers with advanced technologies to help them manage their bills and encourage energy use during midday, when solar power is most abundant. Three energy storage programs incorporating smart thermostats, connected water heaters and batteries are helping customers shift energy use to times when they can take advantage of low-cost, abundant energy and reduce peak demand on APS's system.
In 2020, APS is convening an advisory panel of customers to gain a deeper understanding of the customer experience through their individual perspectives. A group of customer service advisors, in
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conjunction with local human services agencies, will resume providing in-person
customer support in communities APS serves once it is safe to do so because of
the COVID-19 pandemic.
APS is also providing assistance to residential and business customers that have
been impacted by the COVID-19 pandemic. See "COVID-19 Pandemic" above for more
information about pandemic relief.
Emerging Technologies
Energy Storage
APS deploys a number of advanced technologies on its system, including energy storage. Storage can provide capacity, improve power quality, be utilized for system regulation, integrate renewable generation, and in certain circumstances, be used to defer certain traditional infrastructure investments. Energy storage can also aid in integrating higher levels of renewables by storing excess energy when system demand is low and renewable production is high and then releasing the stored energy during peak demand hours later in the day and after sunset. APS is utilizing grid-scale energy storage projects to benefit customers, to increase renewable utilization, and to further our understanding of how storage works with other advanced technologies and the grid. We are preparing for additional energy storage in the future. In early 2018, APS entered into a 15-year power purchase agreement for a 65 MW solar facility that charges a 50 MW solar-fueled battery. Service under this agreement is scheduled to begin in 2021. In 2018, APS issued an RFP for approximately 106 MW of energy storage to be located at up to five of itsAZ Sun sites. Based upon our evaluation of the RFP responses, APS decided to expand the initial phase of battery deployment to 141 MW by adding a sixthAZ Sun site. InFebruary 2019 , we contracted for the 141 MW and originally anticipated such facilities could be in service by mid-2020. InApril 2019 , a battery module in APS's McMicken battery energy storage facility experienced an equipment failure, which prompted an internal investigation to determine the cause. APS has completed its investigation of the McMicken battery incident and is continuing to determine the timing of future deployment of batteries on APS's system. Due to the McMicken battery incident, APS is working with the counterparty for theAZ Sun sites to determine appropriate timing and path forward for such facilities. Additionally, inFebruary 2019 , APS signed two 20-year power purchase agreements for energy storage totaling 150 MW. Service under these power purchase agreements is also dependent on the results of the McMicken battery incident investigation and requires approval from the ACC to allow for recovery of these agreements through the PSA. We currently plan to install at least 850 MW of energy storage by 2025, including the 150 MW of energy storage projects under power purchase agreements described above. The additional 700 MW of energy storage is expected to be made up of the retrofits associated with ourAZ Sun sites as described above, along with current and future RFPs for energy storage and solar plus energy storage projects. Given theApril 2019 event, we continue to evaluate the appropriate timing and path forward to support the overall capacity goals for our system and associated energy storage requirements. Currently, APS is pursuing an RFP for battery-ready solar resources up to 150 MW with results expected in the second half of 2020. Electric Vehicles APS plans to make electric vehicle charging more accessible for its customers and helpArizona businesses, schools and governments electrify their fleets. In 2019, APS implemented its Take Charge AZ Pilot Program. The program provides charging equipment, installation, and maintenance to business customers, government agencies, and multifamily housing communities. Rates are designed to encourage charging overnight and during daytime off-peak hours when solar energy is abundant. 78 -------------------------------------------------------------------------------- The ACC ordered the state's public service corporations, including APS, to develop a long-term, comprehensive Statewide Transportation Electrification Plan ("TE Plan") forArizona . The TE Plan is intended to provide a roadmap for Transportation Electrification inArizona , focused on realizing the associated air quality and economic development benefits for all residents in the state along with understanding the impact of electric vehicle charging on the grid. APS is actively participating in this process, which is scheduled to be completed by the end of 2020 and submitted to the ACC for review and approval. Hydrogen ProductionPalo Verde , in partnership withIdaho National Laboratory and two other utilities, has been chosen by theDOE's Office of Nuclear Energy to participate in a hydrogen production project with the goal to improve the long-term economic competitiveness of the nuclear power industry. The project, planned for 2020 through 2022, will look at how hydrogen produced fromPalo Verde energy may be used as energy storage for use in reverse-operable electrolysis or peaking gas turbines during times of the day when photovoltaic solar energy sources are unavailable and energy reserves in the southwestUnited States are low. It could also be used to support a rapidly increasing hydrogen transportation fuel market. Experience from the pilot project will offer insights into methods for flexible transitions between electricity and hydrogen generation in solar-dominated electricity markets, and demonstrate how hydrogen may be used as energy storage to provide electricity during operating periods when solar is not available.
Carbon Capture
Carbon capture technologies can isolate CO2 and either sequester it permanently in geologic formations or convert it for use in products. Currently, almost all existing fossil fuel generators do not control carbon emissions the way they control emissions of other air pollutants such as sulfur dioxide or oxides of nitrogen. Carbon capture technologies are still in the demonstration phase and while they show promise, they are still being tested in real-world conditions. These technologies could offer the potential to keep in operation existing generators that otherwise would need to be retired. APS will continue to monitor this emerging technology. Regulatory Overview OnOctober 31, 2019 , APS filed an application with the ACC seeking an annual increase in retail base rates of$69 million . This amount includes recovery of the deferral and rate base effects of the Four Corners SCR project that is currently the subject of a separate proceeding (see "SCR Cost Recovery" in Note 4). It also reflects a net credit to base rates of approximately$115 million primarily due to the prospective inclusion of rate refunds currently provided through the TEAM. The proposed total revenue increase in APS's application is$184 million . The average annual customer bill impact of APS's request is an increase of 5.6% (the average annual bill impact for a typical APS residential customer is 5.4%).
The principal provisions of APS's application are:
• a test year comprised of twelve months ended
described below;
• an original cost rate base of $8.87 billion , which approximates theACC-jurisdictional portion of the book value of utility assets, net of
accumulated depreciation and other credits;
• the following proposed capital structure and costs of capital:
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Capital Structure Cost of Capital
Long-term debt 45.3 % 4.10 %
Common stock equity 54.7 % 10.15 %
Weighted-average cost of capital 7.41 %
• a 1% return on the increment of fair value rate base above APS's
original cost rate base, as provided for by Arizona law;
• authorization to defer until APS's next general rate case the increase
or decrease in its Arizona property taxes attributable to tax rate
changes after the date the rate application is adjudicated;
• a number of proposed rate and program changes for residential
customers, including:
? a super off-peak period during the winter months for APS's
time-of-use with demand rates;
? additional $1.25 million in funding for APS's limited-income
crisis bill program; and
? a flat bill/subscription rate pilot program;
• proposed rate design changes for commercial customers, including an
experimental program designed to provide access to market pricing for
up to 200 MW of medium and large commercial customers;
• recovery of the deferral and rate base effects of the construction and
operating costs of the Ocotillo modernization project (see Note 4
discussion of the 2017 Settlement Agreement); and
• continued recovery of the remaining investment and other costs related
to the retirement and closure of the Navajo Plant (see Note 4 for
details related to the resulting regulatory asset).
APS requested that the increase become effective December 1, 2020 . The hearing
for this rate case was delayed, at the request of ACC Staff and RUCO, and is
currently scheduled to begin December 14, 2020 . APS cannot predict the outcome
of its request.
See Note 4 for information regarding additional regulatory matters.
Financial Strength and Flexibility
Pinnacle West and APS currently have ample borrowing capacity under their respective credit facilities, and may readily access these facilities ensuring adequate liquidity for each company. Capital expenditures will be funded with internally generated cash and external financings, which may include issuances of long-term debt and Pinnacle West common stock.
Other Subsidiaries
Bright Canyon Energy. OnJuly 31, 2014 , Pinnacle West announced its creation of a wholly-owned subsidiary, BCE. BCE's strategy is to develop, own, operate and acquire energy infrastructure in a manner that leverages the Company's core expertise in the electric energy industry. In 2014, BCE formed a 50/50 joint venture withBHE U.S. Transmission LLC , a subsidiary ofBerkshire Hathaway Energy Company . The joint venture, named TransCanyon, is pursuing independent transmission opportunities within the eleven states that comprise theWestern Electricity Coordinating Council , excluding opportunities related to transmission service that would otherwise be provided under the tariffs of the retail service territories of the venture partners' utility affiliates. OnDecember 20, 2019 , BCE acquired minority ownership positions in two wind farms under development byTenaska , the 242MW Clear Creek wind farm inMissouri ("Clear Creek ") and the 250 MW Nobles 2 wind farm inMinnesota ("Nobles 2").Clear Creek achieved commercial operation inMay 2020 and Nobles 2 is expected to achieve commercial operation in 2020 and deliver power later this year. Both wind 80 --------------------------------------------------------------------------------
farms deliver power under long-term power purchase agreements. BCE indirectly
owns 9.9% of
El Dorado .El Dorado is a wholly-owned subsidiary of Pinnacle West.El Dorado owns debt investments and minority interests in several energy-related investments andArizona community-based ventures.El Dorado committed to a$25 million investment in theEnergy Impact Partners fund, which is an organization that focuses on fostering innovation and supporting the transformation of the utility industry. The investment will be made byEl Dorado as investments are selected by theEnergy Impact Partners fund.
Key Financial Drivers
In addition to the continuing impact of the matters described above, many factors influence our financial results and our future financial outlook, including those listed below. We closely monitor these factors to plan for the Company's current needs, and to adjust our expectations, financial budgets and forecasts appropriately. Electric Operating Revenues. For the years 2017 through 2019, retail electric revenues comprised approximately 95% of our total operating revenues. Our electric operating revenues are affected by customer growth or decline, variations in weather from period to period, customer mix, average usage per customer and the impacts of energy efficiency programs, distributed energy additions, electricity rates and tariffs, the recovery of PSA deferrals and the operation of other recovery mechanisms. These revenue transactions are affected by the availability of excess generation or other energy resources and wholesale market conditions, including competition, demand and prices. Actual and Projected Customer and Sales Growth. Retail customers in APS's service territory increased 2.3% for the six-month period endedJune 30, 2020 compared with the prior-year period. For the three years 2017 through 2019, APS's customer growth averaged 1.8% per year. We currently project annual customer growth to be 1.5 - 2.5% for 2020 and for 2020 through 2022 based on our assessment of steady population growth inArizona . Retail electricity sales in kWh, adjusted to exclude the effects of weather variations, decreased 0.3% for the six-month period endedJune 30, 2020 compared with the prior-year period. While steady customer growth was offset by energy savings driven by customer conservation, energy efficiency, and distributed renewable generation initiatives, the main driver of declining sales for this period was the impact of business closures due to COVID-19. Though the total expected impact of COVID-19 on future sales is currently unknown, APS has experienced higher electric residential sales and lower electric commercial and industrial sales since the outset of the pandemic. FromMarch 13th through July 28, 2020 , the cumulative impact in weather-normalized usage was negative 1%. During that period, APS's retail electric residential weather-normalized sales increased 4%, and its retail electric commercial and industrial weather-normalized sales decreased 5% in the aggregate. APS expects the reduction in electric demand from commercial and industrial customers and increased demand from residential customers to continue in the near term. For the three years 2017 through 2019, annual retail electricity sales were about flat, adjusted to exclude the effects of weather variations. We currently project that annual retail electricity sales in kWh will be flat to negative 1.0% for 2020 and increase on average in the range of 0.5 - 1.5% during 2020 through 2022, including the effects of customer conservation, energy efficiency and distributed renewable generation initiatives, but excluding the effects of weather variations and the impacts of several new large data centers opening operations in Metro Phoenix. The impact of new large data centers could raise the range of expected annual sales growth rate over the 2020 to 2022 period, but demand from these customers remains uncertain at this time. These estimates could be further impacted by slower than expected growth of theArizona economy or acceleration of the expected effects of customer conservation, energy efficiency, distributed renewable 81 --------------------------------------------------------------------------------
generation initiatives, or customer and sales growth and the economy that is being impacted by COVID-19 not normalizing in 2020.
Actual sales growth, excluding weather-related variations, may differ
from our projections as a result of numerous factors, such as economic
conditions, customer growth, usage patterns and energy conservation, impacts of
energy efficiency programs and growth in distributed generation, and responses
to retail price changes. Based on past experience, a 1% variation in our annual
kWh sales projections attributable to such economic factors under normal
business conditions can result in increases or decreases in annual net income of
approximately $20 million .
Weather. In forecasting the retail sales growth numbers provided above, we
assume normal weather patterns based on historical data. Historically, extreme
weather variations have resulted in annual variations in net income in excess of
$25 million . However, our experience indicates that the more typical variations
from normal weather can result in increases or decreases in annual net income of
up to $15 million .
Fuel and Purchased Power Costs. Fuel and purchased power costs included on our
Condensed Consolidated Statements of Income are impacted by our electricity
sales volumes, existing contracts for purchased power and generation fuel, our
power plant performance, transmission availability or constraints, prevailing
market prices, new generating plants being placed in service in our market
areas, changes in our generation resource allocation, our hedging program for
managing such costs and PSA deferrals and the related amortization.
Operations and Maintenance Expenses. Operations and maintenance expenses are
impacted by customer and sales growth, power plant operations, maintenance of
utility plant (including generation, transmission, and distribution facilities),
inflation, unplanned outages, planned outages (typically scheduled in the spring
and fall), renewable energy and demand side management related expenses (which
are offset by the same amount of operating revenues) and other factors.
Depreciation and Amortization Expenses. Depreciation and amortization expenses
are impacted by net additions to utility plant and other property (such as new
generation, transmission, and distribution facilities), and changes in
depreciation and amortization rates. See "Liquidity and Capital Resources"
below for information regarding the planned additions to our facilities.
Property Taxes. Taxes other than income taxes consist primarily of property
taxes, which are affected by the value of property in-service and under
construction, assessment ratios, and tax rates. The average property tax rate
in Arizona for APS, which owns essentially all of our property, was 10.9% of the
assessed value for 2019, 11.0% for 2018 and 11.2% for 2017. We expect property
taxes to increase as we add new generating units and continue with improvements
and expansions to our existing generating units and transmission and
distribution facilities.
Pension and other postretirement non-service credits - net. Pension and other
postretirement non-service credits can be impacted by changes in our actuarial
assumptions. The most relevant actuarial assumptions are the discount rate used
to measure our net periodic costs/credit, the expected long-term rate of return
on plan assets used to estimate earnings on invested funds over the long-term,
the mortality assumptions and the assumed healthcare cost trend rates. We review
these assumptions on an annual basis and adjust them as necessary.
Interest Expense. Interest expense is affected by the amount of debt
outstanding and the interest rates on that debt (see Note 3). The primary
factors affecting borrowing levels are expected to be our capital expenditures,
long-term debt maturities, equity issuances and internally generated cash flow.
An allowance for
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--------------------------------------------------------------------------------borrowed funds used during construction offsets a portion of interest expense while capital projects are under construction. We stop accruing AFUDC on a project when it is placed in commercial operation.
Income Taxes. Income taxes are affected by the amount of pretax book income, income tax rates, certain deductions and non-taxable items, such as AFUDC. In addition, income taxes may also be affected by the settlement of issues with taxing authorities. OnDecember 22, 2017 , the Tax Act was enacted and was generally effective onJanuary 1, 2018 . Changes impacting the Company include a reduction in the corporate tax rate to 21%, revisions to the rules related to tax bonus depreciation, limitations on interest deductibility and an associated exception for certain public utilities, and requirements that certain excess deferred tax amounts of regulated utilities be normalized. (See Note 15 for details of the impacts on the Company as ofJune 30, 2020 .) In APS's 2017 rate case decision, the ACC approved a Tax Expense Adjustor Mechanism which will be used to pass through the income tax effects to retail customers of the Tax Act. (See Note 4 for details of the TEAM.) RESULTS OF OPERATIONS Pinnacle West's only reportable business segment is our regulated electricity segment, which consists of traditional regulated retail and wholesale electricity businesses (primarily sales supplied under traditional cost based rate regulation) and related activities and includes electricity generation, transmission and distribution.
Operating Results - Three-month period ended
Our consolidated net income attributable to common shareholders for the three months endedJune 30, 2020 was$194 million , compared with consolidated net income attributable to common shareholders of$144 million for the prior-year period. The results reflect an increase of approximately$48 million for the regulated electricity segment primarily due to higher revenue driven by the effects of weather, lower operations and maintenance expense and higher pension and other postretirement non-service credits, partially offset by higher income taxes. Weather had a significant impact on our result of operations due to the hotter than normal weather in 2020 compared to the milder than normal weather in the same 2019 period. 83
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The following table presents net income attributable to common shareholders by business segment compared with the prior-year period:
Three Months Ended
June 30,
2020 2019 Net Change
(dollars in millions)
Regulated Electricity Segment:
Operating revenues less fuel and purchased
power expenses $ 690 $ 626 $ 64
Operations and maintenance (218 ) (227 ) 9
Depreciation and amortization (152 ) (147 ) (5 )
Taxes other than income taxes (57 ) (55 ) (2 )
Pension and other postretirement non-service
credits - net 14 6 8
All other income and expenses, net 19 16 3
Interest charges, net of allowance for borrowed
funds used during construction (58 ) (53 ) (5 )
Income taxes (41 ) (17 ) (24 )
Less income related to noncontrolling interests
(Note 6) (5 ) (5 ) -
Regulated electricity segment income 192 144 48
All other 2 - 2
Net Income Attributable to Common Shareholders
Operating revenues less fuel and purchased power expenses. Regulated electricity segment operating revenues less fuel and purchased power expenses were$64 million higher for the three months endedJune 30, 2020 compared with the prior-year period. The following table summarizes the major components of this change: Increase (Decrease) Fuel and Operating purchased revenues power expenses Net change (dollars in millions) Effects of weather $ 84 $ 20 $ 64 Refunds due to tax reform (Note 4) 14 - 14 Changes in net fuel and purchased power costs, including off-system sales margins and related deferrals (18 ) (18 ) - Lower renewable energy regulatory surcharges, partially offset by operations and maintenance costs (3 ) - (3 ) Lower retail revenue due to the impacts of energy efficiency, distributed generation and changes in customer usage patterns, including the impacts of COVID-19, partially offset by higher customer growth (17 ) (2 ) (15 ) Miscellaneous items, net - (4 ) 4 Total $ 60 $ (4 ) $ 64 84
-------------------------------------------------------------------------------- Operations and maintenance. Operations and maintenance expenses decreased$9 million for the three months endedJune 30, 2020 compared with the prior-year period primarily because of: • A decrease of$13 million primarily related to an increased recovery from contributions of administrative and general costs fromPalo Verde owners;
• A decrease of
• A decrease of
energy and similar regulatory programs, which are partially offset in
operating revenues and purchased power;
• An increase of
• An increase of$4 million related to customer bad debt expenses primarily related to the Summer Disconnection Moratorium and COVID-19 disconnect suspensions (see Note 4);
• An increase of
equipment and other health and safety-related costs for COVID-19
response; and
• A decrease of
Depreciation and amortization. Depreciation and amortization expenses were$5 million higher for the three months endedJune 30, 2020 compared to the prior-year period primarily due to increased plant in service of$8 million , partially offset by the regulatory deferrals for the Ocotillo modernization project of$3 million . Pension and other postretirement non-service credits, net. Pension and other postretirement non-service credits, net were$8 million higher for the three months endedJune 30, 2020 compared to the prior-year period primarily due to higher market returns in 2019. Interest charges, net of allowance for borrowed funds used during construction. Interest charges, net of allowance for borrowed funds used during construction were$5 million higher for the three months endedJune 30, 2020 compared to the prior-year period primarily due to higher debt balances in the current period.
Income taxes. Income taxes were
85
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Operating Results - Six-month period ended
Our consolidated net income attributable to common shareholders for the six months endedJune 30, 2020 was$224 million , compared with consolidated net income attributable to common shareholders of$162 million for the prior-year period. The results reflect an increase of approximately$59 million for the regulated electricity segment primarily due to lower operations and maintenance expense, higher revenue driven by the effects of weather and higher pension and other postretirement non-service credits, partially offset by higher depreciation expense. Weather had a significant impact on our result of operations due to the hotter than normal weather in 2020 compared to the milder than normal weather in the same 2019 period.
The following table presents net income attributable to common shareholders by business segment compared with the prior-year period:
Six Months Ended June 30,
2020 2019 Net Change
(dollars in millions)
Regulated Electricity Segment:
Operating revenues less fuel and purchased power
expenses $ 1,162 $ 1,135 $ 27
Operations and maintenance (439 ) (472 ) 33
Depreciation and amortization (307 ) (296 ) (11 )
Taxes other than income taxes (113 ) (110 ) (3 )
Pension and other postretirement non-service
credits - net 28 11 17
All other income and expenses, net 34 30 4
Interest charges, net of allowance for borrowed
funds used during construction (113 ) (107 ) (6 )
Income taxes (21 ) (19 ) (2 )
Less income related to noncontrolling interests
(Note 6) (10 ) (10 ) -
Regulated electricity segment income 221 162 59
All other 3 - 3
Net Income Attributable to Common Shareholders
162 $ 62
86-------------------------------------------------------------------------------- Operating revenues less fuel and purchased power expenses. Regulated electricity segment operating revenues less fuel and purchased power expenses were$27 million higher for the six months endedJune 30, 2020 compared with the prior-year period. The following table summarizes the major components of this change: Increase (Decrease) Fuel and Operating purchased revenues power expenses Net change (dollars in millions) Effects of weather $ 67 $ 15 $ 52 Changes in net fuel and purchased power costs, including off-system sales margins and related deferrals (53 ) (56 ) 3 Lower renewable energy regulatory surcharges, partially offset by operations and maintenance costs (7 ) - (7 ) Refunds due to tax reform (Note 4) (9 ) - (9 ) Lower retail revenue due to the impacts of energy efficiency, distributed generation and changes in customer usage patterns, including the impacts of COVID-19, partially offset by higher customer growth (15 ) - (15 ) Miscellaneous items, net (2 ) (5 ) 3 Total $ (19 ) $ (46 ) $ 27
Operations and maintenance. Operations and maintenance expenses decreased
• A decrease of
from contributions of administrative and general costs from Palo Verde
owners;
• A decrease of $9 million in fossil generation costs primarily due to
lower planned outages and lower operating costs due to the Navajo Plant
closure (see Note 4);
• A decrease of
energy and similar regulatory programs, which are partially offset in
operating revenues and purchased power;
• A decrease of
• A decrease of
• An increase of
• An increase of$5 million related to customer bad debt expenses primarily related to the Summer Disconnection Moratorium and COVID-19 disconnect suspensions (see Note 4); 87
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• An increase of
equipment and other health and safety-related costs for COVID-19
response; and
• A decrease of $9 million for corporate resources and other
miscellaneous factors.
Depreciation and amortization. Depreciation and amortization expenses were $11
million higher for the six months ended June 30, 2020 compared to the prior-year
period primarily due to increased plant in service of $22 million , partially
offset by the regulatory deferrals for the Ocotillo modernization project and
the Four Corners SCR project of $11 million .
Pension and other postretirement non-service credits, net. Pension and other
postretirement non-service credits, net were $17 million higher for the six
months ended June 30, 2020 compared to the prior-year period primarily due to
higher market returns in 2019.
Interest charges, net of allowance for borrowed funds used during construction.
Interest charges, net of allowance for borrowed funds used during construction
were $6 million higher for the six months ended June 30, 2020 compared to the
prior-year period primarily due to higher debt balances in the current period.
Income taxes. Income taxes were $2 million higher for the six months ended June
30, 2020 compared with the prior-year period primarily due to higher pre-tax net
income, partially offset by the amortization of excess deferred taxes (see Note
15).
LIQUIDITY AND CAPITAL RESOURCES
Overview
Pinnacle West's primary cash needs are for dividends to our shareholders and
principal and interest payments on our indebtedness. The level of our common
stock dividends and future dividend growth will be dependent on declaration by
our Board of Directors and based on a number of factors, including our financial
condition, payout ratio, free cash flow and other factors.
Our primary sources of cash are dividends from APS and external debt and equity
issuances. An ACC order requires APS to maintain a common equity ratio of at
least 40%. As defined in the related ACC order, the common equity ratio is
defined as total shareholder equity divided by the sum of total shareholder
equity and long-term debt, including current maturities of long-term debt. At
June 30, 2020 , APS's common equity ratio, as defined, was 52%. Its total
shareholder equity was approximately $5.9 billion , and total capitalization was
approximately $11.5 billion . Under this order, APS would be prohibited from
paying dividends if such payment would reduce its total shareholder equity below
approximately $4.6 billion , assuming APS's total capitalization remains the
same. This restriction does not materially affect Pinnacle West's ability to
meet its ongoing cash needs or ability to pay dividends to shareholders.
APS's capital requirements consist primarily of capital expenditures and maturities of long-term debt. APS funds its capital requirements with cash from operations and, to the extent necessary, external debt financing and equity infusions from Pinnacle West.
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