APS 2013 Annual Report Download - page 137

Table of Contents
PINNACLE WEST CAPITAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Risk Management Activities — Derivative Instruments
Exchange traded commodity contracts are valued using unadjusted quoted prices. For non-exchange traded commodity contracts, we calculate fair
value based on the average of the bid and offer price, discounted to reflect net present value. We maintain certain valuation adjustments for a number of risks
associated with the valuation of future commitments. These include valuation adjustments for liquidity and credit risks. The liquidity valuation adjustment
represents the cost that would be incurred if all unmatched positions were closed out or hedged. The credit valuation adjustment represents estimated credit
losses on our net exposure to counterparties, taking into account netting agreements, expected default experience for the credit rating of the counterparties and
the overall diversification of the portfolio. We maintain credit policies that management believes minimize overall credit risk.
Certain non-exchange traded commodity contracts are valued based on unobservable inputs due to the long-term nature of contracts or the unique
location of the transactions. Our long-dated energy transactions consist of observable valuations for the near-term portion and unobservable valuations for the
long-term portions of the transaction. We rely primarily on broker quotes to value these instruments. When our valuations utilize broker quotes, we perform
various control procedures to ensure the quote has been developed consistent with fair value accounting guidance. These controls include assessing the quote
for reasonableness by comparison against other broker quotes, reviewing historical price relationships, and assessing market activity. When broker quotes
are not available, the primary valuation technique used to calculate the fair value is the extrapolation of forward pricing curves using observable market data
for more liquid delivery points in the same region and actual transactions at more illiquid delivery points.
Option contracts are primarily valued using a Black-Scholes option valuation model, which utilizes both observable and unobservable inputs such
as broker quotes, interest rates and price volatilities.
When the unobservable portion is significant to the overall valuation of the transaction, the entire transaction is classified as Level 3. Our
classification of instruments as Level 3 is primarily reflective of the long-term nature of our energy transactions and the use of option valuation models with
significant unobservable inputs.
Our energy risk management committee, consisting of officers and key management personnel, oversees our energy risk management activities to
ensure compliance with our stated energy risk management policies. We have a risk control function that is responsible for valuing our derivative commodity
instruments in accordance with established policies and procedures. The risk control function reports to the chief financial officer’s organization.
Investments Held in our Nuclear Decommissioning Trust
The nuclear decommissioning trust invests in fixed income securities and equity securities. Equity securities are held indirectly through commingled
funds. The commingled funds are valued based on the concept of NAV, which is a value primarily derived from the quoted active market prices of the
underlying equity securities. We may transact in these commingled funds on a semi-monthly basis at the NAV, and accordingly classify these investments as
Level 2. The commingled funds, which are similar to mutual funds, are maintained by a bank and hold investments in accordance with the stated objective
of tracking the performance of the S&P 500 Index. Because the commingled fund
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