WE’RE RE-ENGAGING WITH VERTICALLY INTEGRATED REGULATION

Last year in my letter to shareholders, I wrote that our company was starting to become a new kind of integrated utility, tempered by competitive forces, relying on our own generation as well as market resources.

We’re making the transition to a new regulatory platform – working closely with the Arizona Corporation Commission – and we’re moving forward with steady success. In April 2005, we received our first rate increase since 1991 and, perhaps even more important, we gained approval for our first fuel and purchased power adjustor since 1989. With our greater reliance on natural gas, the market price of which we clearly cannot control, the fuel adjustor will greatly reduce our financial risk profile given volatile fuel markets. This reduces uncertainty for our investors and long-term costs for our customers.

That’s been and will continue to be one of our strongest themes – reducing uncertainty by aggressively tackling issues. We knew a fuel adjustor would be fundamental due to our increased reliance on natural gas and purchased power, and we achieved that goal.

After a decade of price decreases, made possible by operational excellence, employee productivity and technological advances, we’re now in an era of high natural gas fuel prices. Price pressures have compounded the implementation of the adjustor as well as the transition to vertically integrated regulation. However, we are making progress toward a strong regulatory platform for the future.

As we continue to move out of our transitional regulatory structure, we’ll stay focused on Arizona’s energy future, engaging regulators cooperatively on the best approach to new energy sources as we enter a new resource cycle. To achieve timely resolution of resource issues and preserve our momentum toward greater reliability, working together with our regulators early in the cycle will be vital.

OUR OPERATIONS ARE SOUND

Despite an extended outage for a steam generator replacement on Unit 1, the Palo Verde Nuclear Generating Station produced more electricity than any other single power plant in the United States for the 14th consecutive year. Over the last decade, Palo Verde has provided an outstanding hedge against rising fuel costs. Our average unit production cost over the last 10 years was 25 percent below the nuclear industry average. This means our costs over that period were about $450 million lower than what they would have been had Palo Verde’s unit operating costs been at industry averages. This has translated into significant savings for our customers.

Yet Palo Verde’s performance last year fell behind our own high standards and the results we’ve produced over the last decade. Frankly, we’re not accustomed to anything less than stellar performance, and we have in place a comprehensive performance improvement plan to return Palo Verde to the top rank of nuclear plants.

In 2005, our coal units achieved their highest capacity factor ever. Over the last decade, our coal units have improved from a capacity factor of 69 percent in 1996 to better than 87 percent in 2005. That’s an increase of more than 2.5 billion kilowatt-hours of low-cost, reliable coal generation to meet the growing needs of our customers.

Construction is a big part of our job to meet customer growth and improve reliability. In 2005, we added 900 miles of distribution and transmission lines as well as eight new substations. While our construction workload continues to grow, so does our productivity. For example, using new work methods and techniques, APS employees can now build an average substation in half the time it took a little over a decade ago.

Customer service increasingly means much more than just keeping the lights on; it also means providing swift, accurate and useful information. In the last decade, we successfully reduced our staffing through applied technology tailored to our business, and there’s more to come. Intelligent metering, new clean coal technologies, advancements in renewable generation, conservation improvements through applied technologies, information system enhancements and other high-tech applications will transform our industry. In the next decade our focus is to modify our core business through technology – to expand customer value in addition to improving productivity.

While we’ve improved customer service, we’ve also increased the number of customers served per employee from 167 to 220 over the last decade. While increasing their productivity, our employees have achieved the highest J.D. Power customer satisfaction rating of any investor-owned utility in the West (we’re third in the U.S. as a whole). While we’re using every technological means at our disposal to control costs and improve service, our dedicated and creative employees remain our most important assets in this effort.

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