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    PINNACLE WEST CAPITAL CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS


    August 3, 2022 - Edgar Glimpses

     

      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 2021 Form 10-K, Part II, Item 1A of our 2022 1st Quarter 10-Q, and Part II, Item 1A of this report. OVERVIEW Business Overview Pinnacle West is an investor-owned electric utility holding company based in Phoenix, Arizona with consolidated assets of about $23 billion. For over 130 years, Pinnacle West and our affiliates have provided energy and energy-related products to people and businesses throughout Arizona. Pinnacle West derives essentially all of our revenues and earnings from our principal subsidiary, APS. APS is Arizona's largest and longest-serving electric company that generates safe, affordable and reliable electricity for approximately 1.3 million retail customers in 11 of Arizona's 15 counties. APS is also the operator and co-owner of Palo Verde - a primary source of electricity for the southwest United States and the largest nuclear power plant in the United States. COVID-19 Pandemic Essential planned work and capital investments have continued during the COVID-19 pandemic with priority given to support fire mitigation and summer storm efforts, as well as heat related outages. Raw material shortages, rising inflation, COVID-19 related work force disruptions and natural disasters are putting increased pressure on the global supply chain. APS is experiencing some delays in finished materials and tight labor markets. To date, APS has not experienced labor or material supply chain shortages that have significantly impacted its ability to serve its customers' needs. However, shortages are causing some delays and shifting of work projects based on material availability. If APS continues to experience delays in materials, it could experience an increase in purchased power costs for summer generation needs. Such increased purchased power costs would be expected to be recoverable through the PSA. See Note 4 for additional information on the PSA. APS has measures in place to continually monitor and evaluate resource needs and supply chain adequacy but cannot predict whether there will be material supply chain shortages in the future. Though the total expected impact of COVID-19 on future sales remains unknown, APS experienced higher electric residential sales and lower electric commercial and industrial sales from the outset of the pandemic through April 2021. Beginning in May 2021, electric sales to commercial and industrial customers increased to levels in line with pre-COVID sales and such sales levels have remained to date. The Coronavirus Aid, Relief, and Economic Security (CARES) Act allowed employers to defer payments of the employer share of Social Security payroll taxes that would have otherwise been owed from March 27, 2020, through December 31, 2020. We deferred the cash payment of the employer's portion of 67 -------------------------------------------------------------------------------- Table of Contents Social Security payroll taxes for the period July 1, 2020, through December 31, 2020, which was approximately $18 million. We paid half of this cash deferral by December 31, 2021, and the remainder will be paid by December 31, 2022. On June 30, 2020, the United States Federal Energy Regulatory Commission ("FERC") issued an order granting a waiver request related to the existing Allowance for Funds Used During Construction ("AFUDC") rate calculation beginning March 1, 2020 through February 28, 2021. On February 23, 2021, this waiver was extended until September 30, 2021. On September 21, 2021, it was further extended until March 31, 2022. The order provided 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 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 left all other aspects of the AFUDC formula composite rate calculation unchanged. This change impacted the AFUDC composite rate in 2021 and for the three month ended March 31, 2022. Furthermore, the change in the composite rate calculation did not impact our accounting treatment for these costs. The change did not have a material impact on our financial statements. See Note 1. 

      Strategic Overview

       Our strategy is to deliver shareholder value by creating a sustainable energy future for Arizona by serving our customers with clean, reliable and affordable energy. Clean Energy Commitment We are committed to doing our part to make the future clean and carbon-free. As Arizona stewards, we do what is right for the people and prosperity of Arizona. Our vision is to create a sustainable energy future for Arizona through providing clean, affordable, and reliable energy. We can accomplish our visions through collaboration with customers, communities, employees, policymakers, shareholders, and other stakeholders. Our clean energy 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 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.

       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 all carbon-free resources like nuclear and demand- 68 -------------------------------------------------------------------------------- Table of Contents 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. 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 33% since 2005. In addition, APS has committed to end the use of coal at its remaining Cholla units by 2025. APS understands that the transition away from coal-fired power plants toward a clean energy future will pose unique economic challenges for the communities around these plants. We worked collaboratively with stakeholders and leaders of the Navajo Nation to consider the impacts of ceasing operation of APS coal-fired power plants on the communities surrounding those facilities to propose a comprehensive Coal Community Transition ("CCT") plan. The proposed framework provided substantial financial and economic development support to build new economic opportunities and addresses a transition strategy for plant employees. We are committed to continuing our long-running partnership with the Navajo Nation in other areas as well, including expanding electrification and developing tribal renewable projects. Our proposed CCT plan supported the Navajo Nation, where Four Corners is located, the communities surrounding the Cholla Power Plant and the Hopi Tribe, which is impacted by closure of the Navajo Plant. On November 2, 2021, the ACC approved an amended 2019 Rate Case ROO that will require (i) equal payments over a three-year period that total $10 million to the Navajo Nation, (ii) a $1 million one-time payment to the Hopi Tribe within 60 days of the 2019 Rate Case decision, (iii) a $500,000 one-time payment to the Navajo County communities within 60 days of the 2019 Rate Case decision, (iv) up to $1.25 million for electrification of homes and businesses on the Hopi reservation and (v) up to $1.25 million for the electrification of homes and businesses on the Navajo Nation reservation. The payments and expenditures are attributable to the future closures of Four Corners and Cholla, along with the prior closure of the Navajo Plant. All ordered payments and expenditures would be recoverable through rates. Consistent with the 2019 Rate Case decision, as of April 2022, APS has completed the following payments that will be recoverable through rates related to the CCT: (i) $3.33 million to the Navajo Nation; (ii) $500,000 to the Navajo County communities; and (iii) $1 million to the Hopi Tribe. Consistent with APS's commitment to the impacted communities, APS has also completed the following payments: (i)$500,000 to the Navajo Nation for CCT; (ii) $1.1 million to the Navajo County Communities for CCT and economic development; and (iii) $1.25 million to the Hopi Tribe for CCT and economic development. Expenditure of the recoverable funds for electrification of homes and businesses on the Navajo Nation and the Hopi reservations is contingent upon completion of a census of the unelectrified homes and businesses in each that are also within APS service territory. In June 2021, APS and the owners of Four Corners entered into an agreement that would allow Four Corners to operate seasonally at the election of the owners beginning in fall 2023, subject to the necessary governmental approvals and conditions associated with changes in plant ownership. Under seasonal operation, one generating unit would be shut down during seasons where electricity demand is reduced, such as the winter and spring. The other unit would remain online year-round, subject to market conditions as well as planned maintenance outages and unplanned outages. As of the end of July 2022, APS anticipates that it will elect not to begin seasonal operation in November 2023, unless market conditions change. Renewables. APS's IRP (see Note 4 for additional information) establishes the path to meeting our clean energy commitment and maintaining reliable electric service for our customers. APS intends to strengthen its already diverse energy mix by increasing its investments in carbon-free resources. Our IRP rapidly adds clean energy and storage resources while maintaining reliable and affordable service. Its near- 69 -------------------------------------------------------------------------------- Table of Contents term actions are focused on clean energy and positive customer outcomes and includes: (a) competitive solicitations to procure clean energy resources such as solar, wind, energy storage, and DSM resources, all of which lead to a cleaner grid; and (b) strategic, short-term wholesale market purchases from a combination of existing merchant natural gas units, neighboring utility systems and wholesale market participants that ensure operational reliability. APS has a diverse portfolio of existing and planned renewable resources, including solar, wind, geothermal, biomass and biogas, that supports our commitment to clean energy. That commitment has its foundation in the Palo Verde generating station, which is the nation's largest carbon-free, clean energy resource, and it provides critical reliable and affordable service for APS customers. APS's longer-term clean energy strategy includes pursuing the right mix of purchased power contracts for new facilities, procurement of new facilities to be owned by APS, and the ongoing development of distributed energy resources. This balance will ensure an appropriately diverse portfolio designed to achieve the same operational reliability and customer affordability as APS's near-term strategies. In addition, APS is actively seeking to include future facility purchase options in its PPAs that will enable investments with greater financial flexibility. APS uses competitive "all source" requests for proposal ("RFPs") to pursue market resources that meet its system needs and offer the best value for customers. APS selects projects based on cost and non-cost factors, taking into consideration timing and likelihood of successful contracting and development. Under current market conditions, APS must aggressively contract for resources that can withstand supply chain and other geopolitical pressures. Available projects are guided by IRP timelines and quantities and APS maintains a flexible approach that allows it to optimize system reliability and customer affordability through the RFP process. 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. See "Business of Arizona Public Service Company - Energy Sources and Resource Planning - Current and Future Resources - Renewable Energy Standard - Renewable Energy Portfolio" in Item 1 for details regarding APS's renewable energy resources. In September 2019, APS issued an RFP that requested up to 250 MW of wind resources to be in service as soon as possible, but no later than 2022. As a result of this RFP, APS executed a 200 MW PPA for a wind resource that went into service in January 2022. In December 2020, APS issued two additional RFPs: (i) a battery storage RFP for projects to be located at two AZ Sun sites; and (ii) an all-source RFP that solicited resources to meet our clean energy needs and capacity to maintain system reliability, and was later amended to include a request for 150 MW of solar resources to be developed on APS property and owned by APS (collectively, the "December 2020 RFPs"). As a result of the all-source RFP, APS executed two solar plus storage PPAs totaling 275 combined MWs, a PPA for a 238 MW wind resource, two energy storage PPAs for a combined 300 MWs; extended an existing natural gas tolling agreement; and also executed an engineering, procurement, and construction contract in November 2021 for a 150 MW solar resource to be owned by APS and in service in early 2023. APS continues to negotiate contracts for additional resources to be in service in late 2024 in connection with the December 2020 all-source RFP. In May 2022, APS issued an all-source RFP to address resource needs for 2025 and beyond ("2022 all-source RFP"). The 2022 all-source RFP solicits competitive proposals for approximately 1,000 MW to 1,500 MW of resources, including up to 600 MW to 800 MW of renewable resources to meet the needs of 2025 and 2026 while considering resources that can be online as late as 2027. The RFP stopped accepting bids on July 15, 2022, and APS is currently in the process of reviewing those bids. 70 -------------------------------------------------------------------------------- Table of Contents The following table summarizes the resources in APS's renewable energy portfolio that are in operation and under development as of June 30, 2022. 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 250 150 Purchased Power Agreements Renewables: Solar 310 435 Wind 399 238 Geothermal 10 - Biomass 14 - Biogas 3 - Total Purchased Power Agreements 736 673 Total Distributed Energy: Solar (a) 1,325 105 (b) Total Renewable Portfolio 2,311 928 (a) Includes rooftop solar facilities owned by third parties. Distributed generation is produced in Direct Current and is converted to Alternating Current for reporting purposes. (b) Applications received by APS that are not yet installed and online. Energy Storage. APS deploys a number of advanced technologies on its system, including energy storage. Energy storage provides capacity, improves power quality, can be utilized for system regulation and, in certain circumstances, be used to defer certain traditional infrastructure investments. Energy storage also aids in integrating renewable generation 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 meet customer reliability requirements, increase renewable utilization, and to further our understanding of how storage works with other advanced technologies and the grid. In 2018, APS issued an RFP for approximately 106 MW of energy storage to be located at up to five of its AZ Sun sites. Based upon its evaluation of the RFP responses, APS decided to expand the initial phase of battery deployment to 141 MW by adding a sixth AZ Sun site. These battery storage facilities are expected to be in service by the end of 2022. On August 2, 2021, APS executed a contract for an additional 60 MW of utility-owned energy storage to be located on APS's AZ Sun sites. This contract, with a 2023 in-service date, will complete the addition of storage on current APS-owned utility-scale solar facilities. Additionally, in February 2019, APS signed two 20-year PPAs for energy storage totaling 150 MW. These PPAs were subject to ACC approval in order to allow for cost recovery through the PSA. APS received the requested ACC approval on January 12, 2021, and service under the agreements is contracted to begin in 2022 with respect to 100 MW and in 2023 with respect to 50 MW. These agreements are facing delays and APS is currently working with the developers to determine revised in-service dates. As a result of its December 2020 RFPs, as of May 2022, APS has executed four 20-year PPAs for resources that include energy storage: (a) two PPAs for standalone energy storage resources totaling 300 MW; and (b) two PPAs totaling 275 MW solar plus storage resource. The PPAs are also subject to ACC approval to enable cost recovery through the PSA. APS received the requested ACC approval for three out of four of the projects on December 16, 2021. The remaining project was filed in February 2022 for ACC approval and on 71 -------------------------------------------------------------------------------- Table of Contents April 13, 2022, the ACC approved this application. Service under the agreements is expected to begin in 2023 and 2024. 

      APS currently plans to install more than 900 MW of energy storage by 2025, including the energy storage projects under PPAs and AZ Sun retrofits described above. The remaining energy storage is expected to be made up of resources solicited through current and future RFPs.

       The following table summarizes the resources in APS's energy storage portfolio that are in operation and under development as of June 30, 2022. Agreements for the development and completion of future resources are subject to various conditions. Net Capacity in Operation (MW) Net Capacity Planned / Under Development (MW) APS Owned: Energy Storage - 201 Purchase Power Agreements - Energy Storage - 725 Residential Energy Storage 15(a) 4 Total Energy Storage Portfolio 15 930 

      (a) This includes 14.5 MW of APS customer-owned batteries and 0.2 MW of APS-owned residential batteries.

       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 currently 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 is a critical asset to the Southwest, generating more than 32 million megawatt-hours annually - enough power for more than 4 million people. Its 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 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 through LEAN Sigma procedures to identify and develop internal efficiencies. We continue to drive this initiative by identifying opportunities to streamline our business processes to assist in mitigating cost increases, increasing employee retention, and improving customer satisfaction. Participation in the Energy Imbalance Market ("EIM") continues to be a tool for creating savings for APS's customers from the real-time, voluntary market. APS continues to expect that its participation in EIM will lower its fuel and purchased-power costs, improve situational awareness for system operations in the Western Interconnection power grid, and improve integration of APS's renewable resources. APS continues to evaluate opportunities that benefit our customers and is exploring opportunities to move to a day-ahead market with the expectation of reliably achieving incrementally greater cost savings and using the region's increasing renewable resources more efficiently. As part of that effort, APS is exploring several options. APS is in discussions with the current EIM operator, the CAISO, the Western Resource Adequacy Program, the Western Markets Exploratory Group, and the Southwest Power Pool. Each of these explorations also involve other entities and are being undertaken to evaluate the feasibility and cost/benefit of creating a voluntary day-ahead market. 72

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      Reliable

       While our energy mix evolves, the obligation to deliver reliable service to our customers remains. APS is managing through significant growth in the Phoenix metropolitan area while experiencing supply chain issues similar to other industries. 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, continue ongoing system upgrades, 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. In October of 2021, APS announced plans to evaluate regional market solutions as part of the informal Western Markets Exploratory Group ("WMEG"). As part of WMEG, APS is exploring the potential for a staged approach to new market services, including day-ahead energy sales, transmission system expansion, and other power supply and grid solutions consistent with existing state regulations. WMEG hopes to identify market solutions that can help achieve carbon reduction goals while supporting reliable, affordable service for customers. APS is unable to predict the outcome of these discussions. APS's key elements to delivering reliable power include resource planning, sufficient reserve margins, customer partnerships to manage peak demand, fire mitigation, and operational preparedness. Seasonal readiness procedures at APS also include walkdowns to ensure good material conditions and critical control system surveys. APS also plans for the unexpected by conducting emergency operations drills and coordinating on fire and emergency management with federal, state, and local agencies. 

      Customer-Focused

       Recognizing that creating customer value is inextricably linked to increasing shareholder value, APS's focus remains on its customers and the communities it serves. Accordingly, it is APS's goal to achieve an industry-leading, best-in-class customer experience, while demonstrating compassion and advocacy for its customers. This multi-year objective includes incrementally improving APS's J.D. Power ("JDP") overall customer satisfaction ratings from the fourth quartile to the first quartile of its peer set comprised of large investor-owned utilities. As previously disclosed, APS's JDP residential rankings for overall customer satisfaction rating improved in 2020 and 2021. That improvement trend continued with the latest JDP residential 2022 second-quarter results, which reflect APS's mid-year progress. Compared to 2021, APS has made quartile gains in every single driver of customer satisfaction and made significant headway that lifted the company above industry benchmarks for overall satisfaction when compared to our large investor-owned peers. APS's 73 -------------------------------------------------------------------------------- Table of Contents strongest performing drivers in the latest JDP survey were Customer Care (phone and digital), Power Quality and Reliability, and Corporate Citizenship. APS's improvement also is being recognized by its business customers, as evidenced by JDP's Business 2022 first wave results. APS was the second most improved utility in the nation, placing APS in the first quartile for business customer satisfaction. 

      Developing Clean Energy Technologies

      Electric Vehicles

       APS is making electric vehicle charging more accessible for its customers and helping Arizona businesses, schools and governments electrify their fleets. In 2021, APS continued its expansion of its Take Charge AZ Pilot Program. As of June 29, 2022, APS had installed 598 Level 2 ("L2") charging ports at customer locations, with more stations expected to be added through the remainder of 2022. The program provides charging equipment, installation, and maintenance to business customers, government agencies, non-profits, and multifamily housing communities. In addition to the L2 charging stations, APS has begun construction of DC fast charging ("DCFC") stations that will be owned and operated by APS at five locations in Arizona, with the first location opened for public use in March 2022 in Show Low, Arizona. The other four projects' locations are expected to be completed during 2022, with each location including 2-150 kilowatt and 2-350 kilowatt DCFC ports. Charging at these stations will be accessible through the Electrify America charging network. APS has a goal of 450,000 light-duty electric vehicles in its service territory by 2030. Additionally, as part of APS's DSM Plan, APS has launched an Electric Vehicle Charging Demand Management Pilot Program to proactively address the growing electric demand from electric vehicle charging as electric vehicles become more widely adopted. This program includes the APS SmartCharge data gathering program, a $250 residential electric vehicle smart charger rebate for qualifying electric vehicle chargers, and a $100 rebate to home builders for new homes to be built EV ready with 240V charging station garage outlets. The ACC ordered certain public service corporations, including APS, to develop a long-term, comprehensive statewide transportation electrification plan ("TE Plan") for Arizona. The statewide TE Plan is intended to provide a roadmap for transportation electrification in Arizona, 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 actively participated in the development of that plan, which was approved by the ACC in December 2021. In the decision, the ACC also ordered APS and another large Arizona electric public service corporation to each develop and submit for ACC approval their own TE Plans and corresponding budget for 2023. Accordingly, APS filed its first TE Annual Progress Report on March 15, 2022, and its 2023 TE Plan and budget on June 1, 2022. APS will file a supplement to the 2023 TE Plan later this year. Hydrogen Production Palo Verde, in partnership with Idaho National Laboratory ("INL"), Energy Harbor Corporation ("Energy Harbor") and Xcel Energy Incorporated ("Xcel"), was chosen by the DOE's Office of Nuclear Energy to participate in a series of hydrogen production projects with the goal to improve the long-term economic competitiveness of the nuclear power industry. The multi-phase projects began in 2020 with a series of small-scale hydrogen production demonstration projects led by Energy Harbor and Xcel, as well as a technical and economic assessment performed by INL of using electricity generated at Palo Verde to produce hydrogen. Based on the experience from Palo Verde's utility partners' small scale demonstration projects and from the Palo Verde-specific technical and economic assessment performed by INL, in April 2021, PNW Hydrogen LLC ("PNW Hydrogen"), a newly formed subsidiary of Pinnacle West, applied for DOE funding for a larger scale hydrogen production demonstration project using electricity sourced from Palo Verde. On 74 -------------------------------------------------------------------------------- Table of Contents October 7, 2021, PNW Hydrogen was notified that DOE's Office of Energy Efficiency & Renewable Energy and Office of Nuclear Energy had selected PNW Hydrogen's application for an award of $20 million in federal funding to support the hydrogen production demonstration project, subject to negotiation and execution of a definitive Cooperative Agreement funding instrument between PNW Hydrogen and DOE. PNW Hydrogen continues to work through negotiations with DOE. If a definitive agreement is not completed within the DOE allotted negotiation period, the DOE will rescind the award and make other use of the funds. 

      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. 

      Environmental, Social, and Governance ("ESG") Practices

       Pinnacle West has been integrating ESG practices into its core work for almost 30 years. As a business strategy, we seek solutions that provide "shared value," meaning solutions that address societal and environmental challenges in a way that also delivers business value. Our commitment extends beyond implementing sustainability practices; we are dedicated to working with our stakeholders to identify and address the sustainability issues that we are uniquely positioned to impact through our business. In 2020, in support of our clean energy commitment and the growing focus on ESG within our organization, we increased our efforts by dedicating a new Sustainability Department at Pinnacle West to integrating ESG best practices into the everyday work of the Company. As a first step, the Company engaged the Electric Power Research Institute ("EPRI") and leveraged input from employees, large customers, limited-income advocates, economic development groups, environmental non-governmental organizations, leading sustainability academics and other stakeholders to identify and assess the sustainability issues that matter most. In total, 23 Priority Sustainability Issues ("PSIs") were identified and prioritized. The most critical category, Integral Shared Value, includes four issues deemed most important and most able to be impacted by our actions: clean energy, customer experience, energy access and reliability and safety and health. These Integral PSIs provide the foundation for informing our strategic direction, creating a framework for incorporating best practices and driving enterprise-wide alignment and accountability. In 2021, the Company engaged EPRI for the second phase of this work, focused on benchmarking best practices within these four Integral Shared Value PSIs. We will utilize the benchmarking information to identify opportunities for further improvement in our ESG performance. In 2021, the Company established a Social Issues Committee Framework. The goal of the framework is to provide a process for considering emergent social issues, and for determining whether or how best to engage. The committee's responsibility is to determine, using a set of principles grounded in the APS Promise and the PSIs, whether engagement on specific emergent social issues is appropriate and, if so, how best to engage. In 2021, the Company finalized an ESG Strategic Framework to guide our work. The framework is based upon three foundational pillars: ESG Policy Advocacy (we advocate for policy that supports our clean energy goals); Driving Performance (improving our ESG performance in the most important areas, including our PSIs); and effectively communicating and amplifying our ESG story to our various stakeholders, including investors, customers, employees and beyond. The framework will guide and shape our ESG work moving forward. 75

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      Regulatory Overview

       On October 31, 2019, APS filed an application with the ACC (the "2019 Rate Case") seeking an increase in annual retail base rates of $69 million. This amount includes recovery of the deferral and rate base effects of the Four Corners SCR project that was the subject of a separate proceeding. See "Four Corners 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 annual 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 were:

       •a test year comprised of 12 months ended June 30, 2019, adjusted as described below; •an original cost rate base of $8.87 billion, which approximates the ACC-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: Capital Structure Cost of Capital Long-term debt 45.3 % 4.1 % 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; •a Base Fuel Rate of $0.030168 per kWh; •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 for a 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. On October 2, 2020, the ACC Staff, the Residential Utility Consumer Office ("RUCO") and other intervenors filed their initial written testimony with the ACC. The ACC Staff recommended, among other things, (i) a $89.7 million revenue increase, (ii) an average annual customer bill increase of 2.7%, (iii) a return on equity of 9.4%, (iv) a 0.3% or, as an alternative, a 0% return on the increment of fair value rate base greater than original cost, (v) the recovery of the deferral and rate base effects of the construction and operating costs of the Four Corners SCR project and (vi) the recovery of the rate base effects of the construction and ongoing consideration of the deferral of the Ocotillo modernization project. RUCO recommended, among other things, (i) a $20.8 million revenue decrease, (ii) an average annual customer bill decrease of 0.63%, (iii) a return on equity of 8.74%, (iv) a 0% return on the increment of fair value rate base, (v) the 76 -------------------------------------------------------------------------------- Table of Contents nonrecovery of the deferral and rate base effects of the construction and operating costs of the Four Corners SCR project pending further consideration, and (vi) the recovery of the deferral and rate base effects of the construction and operating costs of the Ocotillo modernization project. The filed ACC Staff and intervenor testimony include additional recommendations, some of which materially differ from APS's filed application. On November 6, 2020, APS filed its rebuttal testimony and the principal provisions which differ from its initial application include, among other things, (i) a $169 million revenue increase, (ii) average annual customer bill increase of 5.14%, (iii) return on equity of 10%, (iv) return on the increment of fair value rate base of 0.8%, (v) new cost recovery adjustor mechanism, the Advanced Energy Mechanism, to enable more timely recovery of clean investments as APS pursues its clean energy commitment, (vi) recognition that securitization is a potentially useful financing tool to recover the remaining book value of retiring assets and effectuate a transition to a cleaner energy future that APS intends to pursue, provided legislative hurdles are addressed, and (vii) the CCT plan related to the closure or future closure of coal-fired generation facilities of which $25 million would be funds that are not recoverable through rates with a proposal that the remainder be funded by customers over 10 years. The CCT plan includes the following proposed components: (i) $100 million that will be paid over 10 years to the Navajo Nation for a sustainable transition to a post-coal economy, which would be funded by customers, (ii) $1.25 million that will be paid over five years to the Navajo Nation to fund an economic development organization, which would be funds not recoverable through rates, (iii) $10 million to facilitate electrification projects within the Navajo Nation, which would be funded equally by funds not recoverable through rates and by customers, (iv) $2.5 million per year in transmission revenue sharing to be paid to the Navajo Nation beginning after the closure of the Four Corners through 2038, which would be funds not recoverable through rates, (v) $12 million that will be paid over five years to the Navajo County Communities surrounding Cholla Power Plant, which would primarily be funded by customers, and (vi) $3.7 million that will be paid over five years to the Hopi Tribe related to APS's ownership interests in the Navajo Plant, which would primarily be funded by customers. In 2021, APS committed an additional $900,000 to be paid to the Hopi Tribe related to APS's ownership interests in the Navajo Plant. On December 4, 2020, the ACC Staff and intervenors filed surrebuttal testimony. The ACC Staff reduced its recommended rate increase to $59.8 million, or an average annual customer bill increase of 1.82%. In RUCO's surrebuttal, the recommended revenue decrease changed to $50.1 million, or an average annual customer bill decrease of 1.52%. The hearing concluded on March 3, 2021, and the post-hearing briefing concluded on April 30, 2021. On August 2, 2021, the Administrative Law Judge issued a Recommended Opinion and Order in the 2019 Rate Case (the "2019 Rate Case ROO") and issued corrections on September 10 and September 20, 2021. The 2019 Rate Case ROO recommended, among other things, (i) a $111 million decrease in annual revenue requirements, (ii) a return on equity of 9.16%, (iii) a 0.30% return on the increment of fair value rate base greater than original cost, with total fair value rate of return further adjusted to include a 0.03% reduction to return on equity resulting in an effective fair value rate of return of 4.95%, (iv) the nonrecovery of the deferral and rate base effects of the operating costs and construction of the Four Corners SCR project (see "Four Corners SCR Cost Recovery" below for additional information), (v) the recovery of the deferral and rate base effects of the operating costs and construction of the Ocotillo modernization project, which includes a reduction in the return on the deferral, (vi) a 15% disallowance of annual amortization of Navajo Plant regulatory asset recovery, (vii) the denial of the request to defer until APS's next general rate case the increase or decrease in its Arizona property taxes attributable to tax rate changes, and (viii) a collaborative process to review and recommend revisions to APS's adjustment mechanisms within 12 months after the date of the decision. The 2019 Rate Case ROO also recommended that the CCT plan include the following components: (i) $50 million that will be paid over 10 years to the Navajo Nation, (ii) $5 million that will be paid over five 77 -------------------------------------------------------------------------------- Table of Contents years to the Navajo County Communities surrounding Cholla Power Plant, and (iii) $1.675 million that will be paid to the Hopi Tribe related to APS's ownership interests in the Navajo Plant. These amounts would be recoverable from APS's customers through the RES adjustment mechanism. APS filed exceptions on September 13, 2021, regarding the disallowance of the SCR cost deferrals and plant investments that was recommended in the 2019 Rate Case ROO, among other issues. On October 6, 2021 and October 27, 2021, the ACC voted on various amendments to the 2019 Rate Case ROO that would result in, among other things, (i) a return on equity of 8.70%, (ii) the recovery of the deferral and rate base effects of the operating costs and construction of the Four Corners SCR project, with the exception of $215.5 million (see "Four Corners SCR Cost Recovery" below), (iii) that the CCT plan include the following components: (a) a payment of $1 million to the Hopi Tribe within 60 days of the 2019 Rate Case decision, (b) a payment of $10 million over three years to the Navajo Nation, (c) a payment of $500,000 to the Navajo County communities within 60 days of the 2019 Rate Case decision, (d) up to $1.25 million for electrification of homes and businesses on the Hopi reservation and (e) up to $1.25 million for the electrification of homes and businesses on the Navajo Nation reservation. These payments and expenditures are attributable to the future closures of Four Corners and Cholla, along with the prior closure of the Navajo Plant and all ordered payments and expenditures would be recoverable through rates, and (iv) a change in the residential on-peak time-of-use period from 3 p.m. to 8 p.m. to 4 p.m. to 7 p.m. Monday through Friday, excluding holidays. The 2019 Rate Case ROO, as amended, results in a total annual revenue decrease for APS of $4.8 million, excluding temporary CCT payments and expenditures. On November 2, 2021, the ACC approved the 2019 Rate Case ROO, as amended. On November 24, 2021, APS filed with the ACC an application for rehearing of the 2019 Rate Case and the application was deemed denied on December 15, 2021, as the ACC did not act upon it. On December 17, 2021, APS filed its Notice of Direct Appeal at the Arizona Court of Appeals and a Petition for Special Action with the Arizona Supreme Court, requesting review of the disallowance of $215 million of Four Corners SCR plant investments and deferrals (see "Four Corners SCR Cost Recovery" below for additional information) and the 20 basis point penalty reduction to the return on equity. On February 8, 2022, the Arizona Supreme Court declined to accept jurisdiction on APS's Petition for Special Action. The appeal at the Arizona Court of Appeals is proceeding in the normal course. APS cannot predict the outcome of this proceeding. Consistent with the 2019 Rate Case decision, APS implemented the new rates effective as of December 1, 2021. On December 3, 2021, ACC Staff notified the ACC of a discrepancy between the written decision, which approved the change in time-of-use on-peak hours to 4 p.m. to 7 p.m. but did not explicitly approve the 10-months contemplated in APS's verbal testimony to implement the new time-of-use hours. On December 16, 2021, the ACC ordered APS to complete the implementation of the time-of-use peak period by April 1, 2022. On January 12, 2022, the ACC voted to extend until September 1, 2022, the deadline to complete the implementation of the new on-peak hours for residential customers. In addition, the ACC ordered extensive compliance and reporting obligations and will be continuing to explore whether penalties or rebates would be owed to certain customers. APS cannot predict the outcome of this matter. Additionally, consistent with the 2019 Rate Case decision, as of April 2022, APS has completed the following payments that will be recoverable through rates related to the CCT: (i) $3.33 million to the Navajo Nation; (ii) $500,000 to the Navajo County communities; and (iii) $1 million to the Hopi Tribe. Consistent with APS's commitment to the impacted communities, APS has also completed the following payments: (i) $500,000 to the Navajo Nation for CCT; (ii) $1.1 million to the Navajo County Communities for CCT and economic development; and (iii) $1.25 million to the Hopi Tribe for CCT and economic development. The ACC has also authorized $1.25 million to be recovered through rates for electrification of homes and businesses on both the Navajo Nation and Hopi reservation. Expenditure of the recoverable funds for electrification of homes and businesses on the Navajo Nation and the Hopi reservations is contingent upon 78 -------------------------------------------------------------------------------- Table of Contents completion of a census of the unelectrified homes and businesses in each that are also within APS service territory. 

      APS expects to file an application with the ACC for its next general retail rate case by the end of October 2022, allowing for a test year ending June 30, 2022.

      See Note 4 for information regarding additional regulatory matters.

      Four Corners SCR Cost Recovery

       As part of APS's 2019 Rate Case, APS included recovery of the deferral and rate base effects of the Four Corners SCR project. On November 2, 2021, the 2019 Rate Case decision was approved by the ACC allowing approximately $194 million of SCR related plant investments and cost deferrals in rate base and to recover, depreciate and amortize in rates based on an end-of-life assumption of July 2031. The decision also included a partial and combined disallowance of $215.5 million on the SCR investments and deferrals. APS believes the SCR plant investments and related SCR cost deferrals were prudently incurred, and on December 17, 2021, APS filed its Notice of Direct Appeal at the Arizona Court of Appeals requesting review of the $215.5 million disallowance and the appeal is proceeding in the normal course. Based on the partial recovery of these investments and cost deferrals in current rates and the uncertainty of the outcome of the legal appeals process, APS has not recorded an impairment or write-off relating to the SCR plant investments or deferrals as of June 30, 2022. If the 2019 Rate Case decision to disallow $215.5 million of the SCRs is ultimately upheld, APS will be required to record a charge to its results of operations, net of tax, of approximately $154.4 million. We cannot predict the outcome of the legal challenges nor the timing of when this matter will be resolved. See Note 4 for additional information regarding the Four Corners SCR cost recovery. 

      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. On July 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 with BHE U.S. Transmission LLC, a subsidiary of Berkshire Hathaway Energy Company. The joint venture, named TransCanyon, is pursuing independent electric transmission opportunities within the 11 states that comprise the Western 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. As of June 30, 2022, BCE had total assets of approximately $77 million. BCE has started construction on a microgrid facility in Los Alamitos, California ("Los Alamitos") featuring 31 MW of solar, 20 MW of battery storage, and 3 MW of backup generators. Supported by a long-term power purchase agreement with San Diego Gas and Electric Company, Los Alamitos will supply 20 MW of solar and battery storage capacity to the Southern California grid and provide resilient backup power in the event of a grid emergency to the Army and California National Guard at Joint Forces Training Base Los Alamitos. The Los Alamitos project is scheduled to achieve commercial operation in 2023. See Note 3 79 -------------------------------------------------------------------------------- Table of Contents regarding a credit agreement entered into by BCE to finance capital expenditures and related costs for this microgrid project. BCE and Ameresco, Inc. jointly own a special purpose entity that is sponsoring the K?pono Solar project. This project is a 42 MW solar and battery storage facility in O?ahu, Hawaii that will supply clean renewable energy and capacity under a 20-year power purchase agreement with Hawaiian Electric Company, Inc. The K?pono Solar project is expected to be completed in 2024. 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 and Arizona community-based ventures. El Dorado committed to a $25 million investment in the Energy 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 by El Dorado as investments are selected by the Energy Impact Partners fund. As of June 30, 2022, El Dorado has contributed approximately $11 million to the Energy Impact Partners fund. Additionally, El Dorado committed to a $25 million investment in invisionAZ Fund, which is a fund focused on analyzing, investing, managing and otherwise dealing with investments in privately held early stage and emerging growth technology companies and businesses primarily based in the State of Arizona, or based in other jurisdictions and having existing or potential strategic or economic ties to companies or other interests in the State of Arizona. As of June 30, 2022, El Dorado has contributed approximately $3 million to the invisionAZ 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 2019 t 
      

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