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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
Amendment No. 1
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________.
Commission Registrant; State of Incorporation; IRS Employer
File Number Address; and Telephone Number Identification Number
----------- ---------------------------------- ---------------------
1-13739 UNISOURCE ENERGY CORPORATION 86-0786732
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
1-5924 TUCSON ELECTRIC POWER COMPANY 86-0062700
(An Arizona Corporation)
One South Church Avenue, Suite 100
Tucson, AZ 85701
(520) 571-4000
Securities registered pursuant to Section 12(b) of the Act:
Name of Each Exchange
Registrant Title of Each Class on Which Registered
---------- ------------------- ------------------------
UniSource Energy Common Stock, New York Stock Exchange
Corporation no par value and Pacific Exchange
Preferred Share Purchase
Rights
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether each registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes _X_ No ___
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of each registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act).
UniSource Energy Corporation Yes _X No ___
Tucson Electric Power Company Yes __ No _X__
The aggregate market value of UniSource Energy Corporation voting
Common Stock held by non-affiliates of the registrant was $630,807,609 based on
the last reported sale price thereof on the consolidated tape on June 30, 2003.
At March 10, 2004, 34,029,653 shares of UniSource Energy Corporation
Common Stock, no par value (the only class of Common Stock), were outstanding.
At March 10, 2004, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 shares were
held by UniSource Energy Corporation.
Documents incorporated by reference: Specified portions of UniSource
Energy Corporation's Proxy Statement relating to the 2004 Annual Meeting of
Shareholders are incorporated by reference into PART III.
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EXPLANATORY NOTE
This Amendment No.1 to the Annual Report on Form 10-K for UniSource
Energy Corporation and Tucson Electric Power Company (TEP) for the year ended
December 31, 2003 is being filed for the purpose of amending and revising Part
I, Item 1 - Business, and Part II, Item 6 - Selected Consolidated Financial
Data, Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations, Item 8 - Consolidated Financial Statements and
Supplementary Data, and Item 9A - Controls and Procedures and Part IV, Item 15 -
Exhibits, Financial Statement Schedules, and Reports on Form 8-K. This Form
10-K/A is being filed in order to retroactively apply a change in unbilled
revenue estimation. While not amended, the remaining items of the Form 10-K are
included for convenience.
TEP and UniSource Energy Services, Inc. (UES) record utility operating
revenues when services are provided or commodities are delivered to customers.
Operating revenues include unbilled revenues which are earned (service has been
provided) but not billed by the end of an accounting period. During the second
quarter of 2004, we determined that TEP's existing methodology for estimating
unbilled revenues resulted in an under reporting of revenues in prior periods.
As a result, TEP changed its methodology for estimating unbilled revenues and
restated prior year financial statements to give effect to the change and
correct the under reporting of revenues in those periods. The recognition of
additional revenues in those periods also resulted in an increase in the
amortization of the Transition Recovery Asset.
As described in Note 22, Change in Unbilled Revenue Estimation
Methodology at TEP, the financial information for all periods presented reflects
the revised unbilled revenue estimation methodology.
This combined Form 10-K is separately filed by UniSource Energy
Corporation and Tucson Electric Power Company. Information contained in this
document relating to Tucson Electric Power Company is filed by UniSource Energy
Corporation and separately by Tucson Electric Power Company on its own behalf.
Tucson Electric Power Company makes no representation as to information relating
to UniSource Energy Corporation or its subsidiaries, except as it may relate to
Tucson Electric Power Company.
K-ii
Table of Contents
Definitions vi
-- PART I --
Item 1. - Business 1
Overview of Consolidated Business 1
TEP Electric Utility Operations 3
Service Area and Customers 4
Generating and Other Resources 6
Fuel Supply 8
Water Supply 10
Transmission Access 11
Rates and Regulation 12
TEP's Utility Operating Statistics 15
Environmental Matters 16
UniSource Energy Services 17
UNS Electric 17
Service Territory and Customers 17
Power Supply and Transmission 17
Rates and Regulation 17
UNS Gas 18
Service Territory and Customers 18
Gas Supply and Transmission 18
Rates and Regulation 19
Millennium Energy Holdings 19
UniSource Energy Development Company 20
Employees 20
SEC Reports available on UniSource Energy's Website 21
Item 2. - Properties 22
TEP Properties 22
UES Properties 23
Item 3. - Legal Proceedings 23
Item 4. - Submission of Matters to a Vote of Security Holders 24
-- Part II --
Item 5. - Market for Registrant's Common Equity and Related
Stockholder Matters 25
Item 6. - Selected Consolidated Financial Data 26
UniSource Energy 26
TEP 27
Non-GAAP Measures 28
Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations 32
UniSource Energy Consolidated 32
Outlook and Strategies 32
Results of Operations 33
Contribution by Business Segment 34
Liquidity and Capital Resources 35
K-iii
Tucson Electric Power Company 39
Results of Operations 39
Factors Affecting Results of Operations 42
Liquidity and Capital Resources 44
UniSource Energy Services 50
Results of Operations 50
Factors Affecting Results of Operations 51
Liquidity and Capital Resources 52
Millennium Energy Holdings, Inc. 54
Results of Operations 54
UniSource Energy Development Company 56
Results of Operations 56
Springerville Generating Station Expansion 56
Critical Accounting Policies 56
New Accounting Pronouncements 63
Safe Harbor for Forward-Looking Statements 64
Item 7A. - Quantitative and Qualitative Disclosures about Market Risk 65
Item 8. - Consolidated Financial Statements and Supplementary Data 68
Report of Independent Registered Public Accounting Firm 69
UniSource Energy Corporation
Consolidated Statements of Income 70
Consolidated Statements of Cash Flows 71
Consolidated Balance Sheets 72
Consolidated Statements of Capitalization 73
Consolidated Statements of Changes in Stockholders' Equity 74
Tucson Electric Power Company
Consolidated Statements of Income 75
Consolidated Statements of Cash Flows 76
Consolidated Balance Sheets 77
Consolidated Statements of Capitalization 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements
Note 1. Nature of Operations and Summary of Significant
Accounting Policies 80
Note 2. Proposed Acquisition of UniSource Energy 88
Note 3. Establishment of UES 88
Note 4. TEP Regulatory Matters 91
Note 5. Accounting Change: Accounting for Asset Retirement
Obligations 94
Note 6. Segment and Related Information 96
Note 7. Accounting for Derivative Instruments, Trading Activities
and Hedging Activities 98
Note 8. Millennium 99
Note 9. Utility Plant and Jointly-Owned Facilities 101
Note 10. Debt and Capital Lease Obligations 103
Note 11. Fair Value of Financial Instruments 106
Note 12. Stockholders' Equity 107
Note 13. TEP Wholesale Accounts Receivable and Allowances 108
Note 14. Springerville Expansion 109
Note 15. Commitments and Contingencies 109
Note 16. Income and Other Taxes 115
Note 17. Employee Benefit Plans 118
Note 18. Stock-Based Compensation Plans 122
Note 19. UniSource Energy Earnings Per Share 123
K-iv
Note 20. Supplemental Cash Flow Information 124
Note 21. Quarterly Financial Data (Unaudited) 126
Note 22. Change in Unbilled Revenue Estimation Methodology at TEP 129
Schedule II - Valuation and Qualifying Accounts 133
Item 9. - Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure 134
Item 9A. - Controls and Procedures 134
-- Part III --
Item 10. - Directors and Executive Officers of the Registrants 135
Item 11. - Executive Compensation 137
Item 12. - Security Ownership of Certain Beneficial Owners and Management 137
Item 13. - Certain Relationships and Related Transactions 138
Item 14. - Principal Accountant Fees and Services 138
-- Part IV --
Item 15. - Exhibits, Financial Statement Schedules, and Reports on Form 8-K 138
Signatures 140
Exhibit Index 144
K-v
DEFINITIONS
The abbreviations and acronyms used in the 2003 Form 10-K are defined below:
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ACC.............................. Arizona Corporation Commission.
ACC Holding Company Order........ The order approved by the ACC in November
1997 allowing TEP to form a holding
company.
AHMSA............................ Altos Hornos de Mexico, S.A. de C.V.
AHMSA owns 50% of Sabinas.
AMT.............................. Alternative Minimum Tax.
APS.............................. Arizona Public Service Company.
Btu.............................. British thermal unit(s).
Capacity......................... The ability to produce power; the most
power a unit can produce or the maximum
that can be taken under a contract;
measured in MWs.
CISO............................. California Independent System Operator.
Citizens......................... Citizens Communications Company.
Citizens Settlement Agreement.... An agreement with the ACC Staff dated
April 1, 2003, addressing rate case and
financing issues in the acquisition by
UniSource Energy of the Citizens'
Arizona gas and electric assets.
Common Stock..................... UniSource Energy's common stock, without
par value.
Company or UniSource Energy...... UniSource Energy Corporation.
Cooling Degree Days.............. An index used to measure the impact of
weather on energy usage calculated
by subtracting 75 from the average of
the high and low daily temperatures.
CPX.............................. California Power Exchange.
Credit Agreement................. Credit Agreement between TEP and a
syndicate of banks, dated as of November
14, 2002.
Emissions Allowance(s)........... An allowance issued by the Environmental
Protection Agency which permits
emission of one ton of sulfur dioxide
or one ton of nitrogen oxide.
These allowances can be bought and sold.
Energy........................... The amount of power produced over a given
period of time; measured in MWh.
EPA.............................. The Environmental Protection Agency.
ESP.............................. Energy Service Provider.
Express Line..................... 345-kV circuit connecting Springerville
Unit 2 to the Tucson 138-kV system.
FAS 71........................... Statement of Financial Accounting
Standards No. 71: Accounting for the
Effects of Certain Types of Regulation.
FAS 132.......................... Statement of Financial Accounting
Standards No. 132: Employers'
Disclosures about Pensions and Other
Postretirement Benefits.
FAS 133.......................... Statement of Financial Accounting
Standards No. 133: Accounting for
Derivative Instruments and Hedging
Activities.
FAS 143.......................... Statement of Financial Accounting
Standards No. 143: Accounting for Asset
Retirement Obligations.
FAS 149.......................... Statement of Financial Accounting
Standards No. 149: Amendment of
Statement 133 on Derivative Instruments
and Hedging Activities.
FERC............................. Federal Energy Regulatory Commission.
First Collateral Trust Bonds..... Bonds issued under the Indenture of Trust,
dated as of August 1, 1998, of
TEP to the Bank of New York, successor
trustee.
First Mortgage Bonds............. First mortgage bonds issued under the
Indenture, dated as of April 1, 1941,
of TEP to JPMorgan Chase Bank, successor
trustee, as supplemented and amended.
Four Corners..................... Four Corners Generating Station.
GAAP............................. Generally Accepted Accounting Principles.
Global Solar..................... Global Solar Energy, Inc., a company that
develops and manufactures thin-film
photovoltaic cells. Millennium owns 99%
of Global Solar.
IDBs............................. Industrial development revenue or
pollution control revenue bonds.
IPS.............................. Infinite Power Solutions, Inc., a company
that develops thin-film batteries.
K-vi
Millennium owns 72% of IPS.
IRS.............................. Internal Revenue Service.
ISO.............................. Independent System Operator.
ITN.............................. ITN Energy Systems, Inc. was formed to
provide research, development, and other
services. Millennium exchanged its
ownership of ITN for increased ownership
of Global Solar and currently owns no
interest in ITN.
ITC.............................. Investment tax credit.
kWh.............................. Kilowatt-hour(s).
kV............................... Kilovolt(s).
LOC.............................. Letter of Credit.
MEG.............................. Millennium Environmental Group, Inc., a
wholly-owned subsidiary of Millennium,
which manages and trades emission
allowances, coal, and related financial
instruments.
MicroSat......................... MicroSat Systems, Inc. is a company
formed to develop and commercialize
small-scale satellites. Millennium
currently owns 35%.
Millennium....................... Millennium Energy Holdings, Inc., a
wholly-owned subsidiary of UniSource
Energy.
Mimosa........................... Minerales de Monclova, S.A. de C.V., an
owner of coal and associated gas
reserves and a supplier of metallurgical
coal to the steel industry and
thermal coal to the Mexican electricity
commission. Sabinas owns 19.5% of
Mimosa.
MMBtus........................... Million British Thermal Units.
MW............................... Megawatt(s).
MWh.............................. Megawatt-hour(s).
Navajo........................... Navajo Generating Station.
NOL.............................. Net Operating Loss carryback or
carryforward for income tax purposes.
PGA.............................. Purchased Gas Adjuster, a retail rate
mechanism designed to recover the cost
of gas purchased for retail gas
customers.
PNM.............................. Public Service Company of New Mexico.
Powertrusion..................... POWERTRUSION International, Inc., a
company owned 77% by Millennium, which
manufactures lightweight utility poles.
PPFAC............................ Purchased Power and Fuel Adjustment
Clause.
PWCC................................ Pinnacle West Capital Corporation.
Revolving Credit Facility........ $60 million revolving credit facility
entered into under the Credit
Agreement between a syndicate of banks
and TEP.
RTO.............................. Regional Transmission Organization.
Rules............................ Retail Electric Competition Rules.
Sabinas.......................... Carboelectrica Sabinas, S. de R.L. de
C.V., a Mexican limited liability
company. Millennium owns 50% of Sabinas.
Saguaro Utility.................. An Arizona limited partnership, whose
general partner is Sage Mountain,
L.L.C. and whose limited partners
include investment funds affiliated with
Kohlberg Kravis Roberts & Co., L.P.,
J.P. Morgan Partners, L.L.C. and
Wachovia Capital Partners.
San Carlos....................... San Carlos Resources Inc., a wholly-owned
subsidiary of TEP.
San Juan......................... San Juan Generating Station.
Second Mortgage Bonds............ TEP's second mortgage bonds issued under
the Indenture of Mortgage and Deed
of Trust, dated as of December 1, 1992,
of TEP to the Bank of New York,
successor trustee, as supplemented.
SCE.............................. Southern California Edison Company.
SES.............................. Southwest Energy Solutions, Inc., a
wholly-owned subsidiary of Millennium.
Springerville.................... Springerville Generating Station.
Springerville Coal Handling
Facilities Leases.............. Leveraged lease arrangements relating to
the coal handling facilities
serving Springerville.
Springerville Common
K-vii
Facilities..................... Facilities at Springerville used in common
with Springerville Unit 1 and
Springerville Unit 2.
Springerville Common
Facilities Leases.............. Leveraged lease arrangements relating to
an undivided one-half interest in
certain Springerville Common Facilities.
Springerville Unit 1............. Unit 1 of the Springerville Generating
Station.
Springerville Unit 1 Lease....... Leveraged lease arrangement relating to
Springerville Unit 1 and an
undivided one-half interest in certain
Springerville Common Facilities.
Springerville Unit 2............. Unit 2 of the Springerville Generating
Station.
SRP.............................. Salt River Project Agricultural
Improvement and Power District.
Sundt Generating Station...... H. Wilson Sundt Generating Station
(formerly known as the Irvington
Generating Station).
Sundt Lease...................... The leveraged lease arrangement relating
to Sundt Unit 4.
TEP.............................. Tucson Electric Power Company, the
principal subsidiary of UniSource
Energy.
TEP Settlement Agreement......... TEP's Settlement Agreement approved by the
ACC in November 1999 that provided for
electric retail competition and
transition asset recovery.
Therm............................ A unit of heating value equivalent to
100,000 British thermal units (Btu).
Tri-State........................ Tri-State Generation and Transmission
Association.
TruePricing...................... TruePricing, Inc., a start-up company
established to market energy related
products.
UED.............................. UniSource Energy Development Company, a
wholly-owned subsidiary of UniSource
Energy, which engages in developing
generation resources and other project
development services and related
activities.
UES.............................. UniSource Energy Services, Inc., an
intermediate holding company established
to own the operating companies (UNS Gas
and UNS Electric) which acquired the
Citizens Arizona gas and electric
utility assets.
UniSource Energy................. UniSource Energy Corporation.
UNS Electric..................... UNS Electric, Inc., a wholly-owned
subsidiary of UES, which acquired the
Citizens Arizona electric utility
assets.
UNS Gas.......................... UNS Gas, Inc., a wholly-owned subsidiary
of UES, which acquired the Citizens
Arizona gas utility assets.
WestConnect...................... The proposed for-profit RTO in which TEP
is a participant.
K-viii
PART I
This Annual Report on Form 10-K contains forward-looking statements
as defined by the Private Securities Litigation Reform Act of 1995. You should
read forward-looking statements together with the cautionary statements and
important factors included in this Form 10-K. (See Item 7. - Management's
Discussion and Analysis of Financial Condition and Results of Operations, Safe
Harbor for Forward-Looking Statements.) Forward-looking statements include
statements concerning plans, objectives, goals, strategies, future events or
performance and underlying assumptions. Forward-looking statements are not
statements of historical facts. Forward-looking statements may be identified by
the use of words such as "anticipates," "estimates," "expects," "intends,"
"plans," "predicts," "projects," and similar expressions. We express our
expectations, beliefs and projections in good faith and believe them to have a
reasonable basis. However, we make no assurances that management's expectations,
beliefs or projections will be achieved or accomplished.
ITEM 1.-- BUSINESS
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OVERVIEW OF CONSOLIDATED BUSINESS
---------------------------------
UniSource Energy Corporation (UniSource Energy) is a holding company
that owns substantially all of the outstanding common stock of Tucson Electric
Power Company (TEP), and all of the outstanding common stock of UniSource Energy
Services, Inc. (UES), Millennium Energy Holdings, Inc. (Millennium), and
UniSource Energy Development Company (UED).
TEP, an electric utility, has provided electric service to the
community of Tucson, Arizona, for over 100 years. UES, through its two operating
subsidiaries, provides gas and electric service to 30 communities in northern
and southern Arizona. Millennium invests in unregulated businesses, including a
developer of thin-film batteries and a developer and manufacturer of thin-film
photovoltaic cells. UED engages in developing generating resources and other
project development activities, including facilitating the expansion of the
Springerville Generating Station. We conduct our business in these four primary
business segments -- TEP's Electric Utility Segment, UES' Gas and Electric
Utility Segment, the Millennium Businesses Segment, and the UED Segment.
UniSource Energy was incorporated in the State of Arizona on March 8,
1995 and obtained regulatory approval to form a holding company in November
1997. On January 1, 1998, TEP and UniSource Energy exchanged shares of stock
resulting in TEP becoming a subsidiary of UniSource Energy. Following the share
exchange, TEP transferred the stock of its subsidiary Millennium to UniSource
Energy. See Note 1 of Notes to Consolidated Financial Statements--Nature of
Operations and Summary of Significant Accounting Policies.
ESTABLISHMENT OF UES
On August 11, 2003, UniSource Energy completed the purchase of the
Arizona gas and electric system assets from Citizens Communications Company
(Citizens) for a total of $223 million, comprised of the base purchase price
plus other operating capital adjustments and transaction costs. UniSource Energy
formed two new operating companies called UNS Electric, Inc. (UNS Electric) and
UNS Gas, Inc. (UNS Gas) to acquire these assets, as well as UES, an intermediate
holding company that holds the common stock of the operating companies.
AGREEMENT AND PLAN OF MERGER
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
Frederick B. Rentschler is the managing member of Sage Mountain,
L.L.C., an Arizona limited liability company, and Saguaro Acquisition Corp. is a
wholly-owned indirect subsidiary of Saguaro Utility.
K-1
Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp. will merge with and into UniSource Energy. UniSource Energy will be the
surviving corporation, but will become an indirect wholly-owned subsidiary of
Saguaro Utility. Trading in our common stock on the New York Stock Exchange and
the Pacific Exchange will cease immediately as of the effective time of the
acquisition. After that time, the surviving corporation will delist our shares
from the New York Stock Exchange and the Pacific Exchange and de-register our
shares under the Securities Exchange Act of 1934, as amended. UniSource Energy's
and TEP's headquarters will remain in Tucson, and we expect that UniSource
Energy's and TEP's senior management team will remain generally in place.
Upon the closing of the acquisition, Saguaro Utility will cause the
surviving corporation to pay approximately $880 million in cash to UniSource
Energy's shareholders and holders of stock options, stock units, restricted
stock and performance shares awarded under our stock based compensation plans.
In connection with the closing of the acquisition, Saguaro Utility intends to
cause the surviving corporation (i) to repay the $95 million intercompany loan
to UniSource Energy from TEP and (ii) to contribute up to $168 million to TEP.
TEP will use a significant portion of these proceeds to retire some of its
outstanding debt.
We expect that the proceeds for all of the above mentioned payments
will come from a combination of equity contributions by the partners of Saguaro
Utility and borrowings and issuances of debt securities by another affiliate of
Saguaro Acquisition Corp. We expect the partners of Saguaro Utility to
contribute approximately $557 million to Saguaro Utility, which will contribute
the net proceeds to Saguaro Acquisition Corp. immediately prior to the
acquisition. We expect that the remaining proceeds necessary to finance this
transaction will be obtained by Saguaro Acquisition Corp.'s affiliate, at the
closing of the acquisition, through a $360 million borrowing from a syndicate of
lenders and an issuance of $300 million in notes. Saguaro Acquisition Corp. and
its affiliate obtained commitments from lenders for the $360 million in
borrowings. In addition, Saguaro Acquisition Corp. and its affiliate obtained
commitments for (i) a $50 million revolving credit facility for general
corporate purposes, (ii) a $40 million revolving credit facility for UES and
(iii) a loan to refinance TEP's existing Credit Facility. Each of these
commitments expires February 21, 2005, and is subject to various closing
conditions customary for bank commitment letters in connection with an
acquisition of this type. Saguaro Acquisition Corp. and its affiliate also
obtained a letter from a group of investment banks that they were highly
confident that they could arrange for the sale of up to $300 million in notes of
the affiliate through a private sale and/or a public offering. The letter from
the investment banks relating to the sale of the $300 million in notes is not a
commitment or undertaking by such banks to underwrite, place or purchase the
notes or otherwise provide financing.
The acquisition is subject to several closing conditions, including
without limitation, (i) the absence of any material adverse effect in the
business, properties, assets, condition, prospects or results of operations of
UniSource Energy and its subsidiaries taken together as a whole; (ii) the
receipt of the required shareholder approval; (iii) the receipt of required
regulatory approvals; (iv) that no final order with respect to any regulatory
approval necessary to effect the acquisition either (A) has or could reasonably
be expected to have a material adverse effect on us or Saguaro Utility or (B)
causes or could reasonably be expected to cause the rates of any of our utility
subsidiaries to be less favorable than the rates that were in effect on the date
of the acquisition agreement; (v) that restrictions on the ability of TEP to pay
dividends of all of its net income be effectively eliminated; and (vi) that
Saguaro Acquisition Corp. receives its financing for the acquisition on terms
and conditions that, in the reasonable judgment of Saguaro Acquisition Corp.,
are comparable to, or more favorable to Saguaro Acquisition Corp. in the
aggregate than the terms and conditions contemplated by the acquisition
agreement.
UniSource Energy's shareholders of record will formally consider a
proposal to approve the acquisition agreement at a special meeting scheduled for
March 29, 2004. The acquisition is also subject to the receipt of certain
regulatory approvals, including ACC approval, SEC approval under the Public
Utility Holding Company Act of 1935, as amended, FERC approval and approval
under federal antitrust laws. We filed an application with the ACC for approval
of the acquisition on December 29, 2003. We expect the acquisition to close in
the second half of 2004.
The acquisition agreement contains operating covenants with respect to
the operations of our business pending the consummation of the acquisition.
Generally, unless UniSource Energy obtains Saguaro Acquisition Corp.'s prior
written consent, we must carry on our business in the ordinary course consistent
with past practice and use all commercially reasonable efforts to preserve
substantially intact our present business organization and present regulatory,
business and employee relationships. In addition, the acquisition agreement
restricts
K-2
our activities, subject to the receipt of Saguaro Acquisition Corp.'s
prior written consent, including the issuance or repurchase of capital stock,
the amendment of organizational documents, acquisitions and dispositions of
assets, capital expenditures, incurrence of indebtedness, modification of
employee compensation and benefits, changes in accounting methods, discharge of
liabilities, and matters relating to UniSource Energy's investment in
Millennium. For a more complete understanding of these restrictions we encourage
you to read the acquisition agreement which UniSource Energy has previously
filed with the SEC and is publicly available.
Either UniSource Energy or Saguaro Acquisition Corp. may terminate the
acquisition agreement in certain circumstances, including if not consummated by
March 31, 2005, certain regulatory approvals are not obtained or if our
shareholders do not approve the acquisition. In certain circumstances, upon the
termination of the acquisition agreement, UniSource Energy would be required to
pay Saguaro Acquisition Corp.'s expenses and a termination fee in an aggregate
amount of up to $25 million.
As a result of the approval of the acquisition by UniSource Energy's
Board of Directors, the acquisition will not trigger the provisions of UniSource
Energy's shareholder rights plan or the restrictions on "business combinations"
or "control share acquisitions" under the Arizona Business Corporation Act.
BUSINESS SEGMENT CONTRIBUTIONS
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments, as well as parent company expenses.
Restated - See Note 22 in the Consolidated Financial Statements
2003 2002 2001
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Business Segment - Millions of Dollars -
TEP (1) $129 $ 55 $ 78
UES (2) 3 - -
Millennium (16) (16) (9)
UED 7 1 1
UniSource Energy Standalone (3) (9) (5) (6)
--------------------------------------------------------------------------------
Consolidated Net Income $114 $ 35 $ 64
================================================================================
(1) TEP results in 2003 include an after-tax gain of $67 million for
the Cumulative Effect of Accounting Change from the adoption of
Statement of Financial Accounting Standards No. 143, Accounting for
Asset Retirement Obligations (FAS 143).
(2) Results are for the period from August 11, 2003 to December 31,
2003.
(3) Primarily represents interest expense (net of tax) on the note
payable from UniSource Energy to TEP, as well as costs in 2003
associated with the Citizens acquisition and the proposed acquisition
of UniSource Energy as previously discussed.
The electric utility industry has undergone significant regulatory
change in recent years. See Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations, Outlook and Strategies, for a
discussion of our plans and strategies to remain competitive and flexible in
this changing environment and Rates and Regulation, below, for the status of
competition in Arizona.
References in this report to "we" and "our" are to UniSource Energy and
its subsidiaries, collectively.
TEP ELECTRIC UTILITY OPERATIONS
-------------------------------
TEP was incorporated in the State of Arizona on December 16, 1963. TEP
is the successor by merger as of February 20, 1964, to a Colorado corporation
that was incorporated on January 25, 1902. TEP is the principal operating
subsidiary of UniSource Energy. In 2003, TEP's electric utility operations
contributed 88% of UniSource Energy's operating revenues and comprised 86% of
its assets.
SERVICE AREA AND CUSTOMERS
TEP is a vertically integrated utility that provides regulated electric
service to more than 367,000 retail customers in Southeastern Arizona. TEP's
service territory consists of a 1,155 square mile area and includes a population
of approximately 911,000 in the greater Tucson metropolitan area in Pima County,
as well as parts of Cochise County. TEP holds a franchise to provide electric
distribution service to customers in the Cities of Tucson and South Tucson.
These franchises expire in 2026 and 2017, respectively. TEP also sells
electricity to other utilities and power marketing entities in the western U.S.
RETAIL CUSTOMERS
In 2003, TEP's number of retail customers increased by 2.2% and total
K-3
retail energy consumption increased by approximately 4%. The table below shows
the percentage distribution of TEP's energy sales by major customer class over
the last three years.
2003 2002 2001
--------------------------------------------------------------------------------
Residential 41% 40% 38%
Commercial 20% 20% 19%
Non-mining Industrial 27% 28% 27%
Mining 9% 9% 13%
Public Authority 3% 3% 3%
--------------------------------------------------------------------------------
TEP expects that its peak demand, number of retail customers and retail
energy consumption will increase 2 - 3% annually through 2007. The retail energy
consumption by customer class is expected to be similar to the 2003
distribution.
Beginning January 1, 2001, all of TEP's retail customers were eligible
to choose alternative energy providers. Even though some of TEP's retail
customers may choose other energy providers, the forecasted customer growth
rates referred to above would continue to apply to its distribution business. At
March 10, 2004, none of TEP's customers are being served by an alternative
energy provider. See Rates and Regulation, State, below.
Sales to Large Industrial Customers
TEP provides electric utility service to a diverse group of commercial,
industrial, and public sector customers. Major industries served include copper
mining, cement manufacturing, defense, health care, education, military bases
and other governmental entities. Local, regional, and national economic factors
can impact the financial condition and operations of TEP's large industrial
customers. Such economic conditions may directly impact energy consumption by
large industrial customers, and may indirectly impact residential and small
commercial sales and revenues if employment levels and consumer spending are
affected.
Two of TEP's largest retail customers are in the copper mining
industry. TEP has contracts with its two mining customers to provide electric
service at negotiated rates. These contracts expire in 2006 and 2008. TEP's
sales to mining customers depend on a variety of factors including changes in
supply and demand in the world copper market and the economics of
self-generation. Average U.S. copper prices have ranged between $0.62 and $1.00
per pound during the last five years. As a result of low copper prices in 2002
and 2003, TEP's mining customers reduced operations during those years and
correspondingly reduced energy consumption. Since October 2003, U.S. copper
prices have risen steadily and were approximately $1.19 per pound in February
2004. One of TEP's mining customers announced in January 2004, it would be
increasing its energy requirements by approximately 15 MW this year.
WHOLESALE BUSINESS
TEP's electric utility operations include the wholesale marketing of
electricity to other utilities and power marketers. Wholesale sales transactions
are made on both a firm and interruptible basis. A firm basis means that
contractually, TEP must supply the power (except under limited emergency
circumstances), while an interruptible basis means that TEP may stop supplying
power under defined conditions. See Other Purchases and Interconnections, below.
K-4
TEP typically uses its own generation to serve the requirements of its
retail and long-term wholesale customers. Generally, TEP commits to future sales
based on expected excess generating capability, forward prices and generation
costs, using a diversified portfolio approach to provide a balance between
long-term, mid-term and spot energy sales. When TEP expects to have excess
generating capacity (usually in the first, second and fourth calendar quarters),
its wholesale sales consist primarily of three types of sales:
(1) Sales under long-term contracts for periods of more than one year. TEP
currently has long-term contracts with three entities to sell firm
capacity and energy: Salt River Project Agricultural Improvement and
Power District (SRP), the Navajo Tribal Utility Authority and the
Tohono O'odham Utility Authority. TEP also has a multi-year
interruptible contract with Phelps Dodge Energy Services, which
requires a fixed contract demand of 60 MW at all times except during
TEP's peak customer energy demand period, from July through September
of each year. Under the contract, TEP can interrupt delivery of power
if TEP experiences significant loss of any electric generating
resources.
(2) Other sales include forward sales and short-term sales. Under forward
contracts, TEP commits to sell a specified amount of capacity or energy
at a specified price over a given period of time, typically for
one-month, three-month or one-year periods. Under short-term sales, TEP
sells energy in the daily or hourly markets at fluctuating spot market
prices and other non-firm energy sales.
(3) Sales of transmission service.
TEP purchases power in the wholesale markets when economic. TEP may
enter into forward contracts: (a) to purchase energy under long-term contracts
to serve retail load and long-term wholesale contracts, (b) to purchase capacity
or energy during periods of planned outages or for peak summer load conditions,
and (c) to purchase energy to resell to certain wholesale customers under load
and resource management agreements. Finally, TEP may purchase energy in the
daily and hourly markets to meet higher than anticipated demands, to cover
unplanned generation outages, or when it is more economical than generating its
own energy.
As a participant in the western U.S. wholesale power markets, TEP is
affected by changes impacting these markets and market participants. In 2001, a
significant portion of TEP's revenues and earnings resulted from its wholesale
marketing activities (including unrealized gains or losses on sales and
purchases of energy), which benefited from strong demand and high wholesale
prices in the western U.S. These market conditions were the result of a number
of factors, including power supply shortages, high natural gas prices, and
transmission and environmental constraints. During this period, these markets
experienced unprecedented price volatility, as well as payment defaults and
bankruptcies by several of its largest participants. Regulatory agencies became
concerned with the outcomes of deregulation of the electric power industry and
intervened in the operation of these markets by, among other things, imposing
price caps and initiating investigations into potential market manipulation.
Since mid-2001, conditions in the western U.S. energy markets have
changed significantly as a result of various regulatory actions, the addition of
new generation in the region and other factors. In addition, the presence of
fewer creditworthy counterparties, as well as legal, political and regulatory
uncertainties has reduced market liquidity and trading volume. Several companies
that were large market participants have either curtailed their activities or
exited the business completely. These factors placed downward pressure on
wholesale electricity prices, and resulted in significantly lower wholesale
electricity sales and revenues at TEP in 2002 and 2003.
In the first quarter of 2003, both the natural gas and western U.S.
wholesale electricity markets experienced some price spikes and volatility due
to severe winter weather. Gas and power prices remained high throughout 2003 due
to continued gas production and storage concerns. TEP cannot predict, however,
whether gas and wholesale electricity prices will remain elevated and what the
impact will be on TEP's sales and revenues in 2004.
TEP expects to continue to be a participant in the wholesale energy
markets, primarily by making sales and purchases in the short-term and forward
markets. TEP expects the market price in the western U.S. and demand for
capacity and energy to continue to be influenced by the following factors, among
others, during the next few years:
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o continued population growth;
o economic conditions in the western U.S.;
o availability of generation capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental requirements and the cost of compliance.
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Tucson Electric Power Company, Factors
Affecting Results of Operations, Western Energy Markets, for additional
discussion of TEP's wholesale marketing activities.
GENERATING AND OTHER RESOURCES
TEP GENERATING Resources
At December 31, 2003, TEP owned or leased 2,003 MW of net generating
capability as set forth in the following table:
Net
Unit Fuel Owned/ Capability Operating TEP's Share
Generating Source No. Location Type Leased MW Agent
% MW
---------------------------------------------------------------------------------------------------------------------------
Springerville Station 1 Springerville, AZ Coal Leased 380 TEP 100.0 380
Springerville Station 2 Springerville, AZ Coal Owned 380 TEP 100.0 380
San Juan Station 1 Farmington, NM Coal Owned 327 PNM 50.0 164
San Juan Station 2 Farmington, NM Coal Owned 316 PNM 50.0 158
Navajo Station 1 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 2 Page, AZ Coal Owned 750 SRP 7.5 56
Navajo Station 3 Page, AZ Coal Owned 750 SRP 7.5 56
Four Corners Station 4 Farmington, NM Coal Owned 784 APS 7.0 55
Four Corners Station 5 Farmington, NM Coal Owned 784 APS 7.0 55
Sundt Station 1 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 2 Tucson, AZ Gas/Oil Owned 81 TEP 100.0 81
Sundt Station 3 Tucson, AZ Gas/Oil Owned 104 TEP 100.0 104
Sundt Station 4 Tucson, AZ Coal/Gas Leased 156 TEP 100.0 156
Internal Combustion Turbines Tucson, AZ Gas/Oil Owned 122 TEP 100.0 122
Internal Combustion Turbines Tucson, AZ Gas Owned 95 TEP 100.0 95
Solar Electric Generation Springerville/ Solar Owned 4 TEP 100.0 4
Tucson, AZ
---------------------------------------------------------------------------------------------------------------------------
Total TEP Capacity (1) 2,003
===========================================================================================================================
(1) Excludes 486 MW of additional resources, which consist of certain capacity
purchases and interruptible retail load. At December 31, 2003, total owned
capacity was 1,467 MW and leased capacity was 536 MW.
The Springerville Generating Station, located in northeast Arizona,
consists of two coal-fired units. Springerville Unit 1 began commercial
operation in 1985 and is leased and operated by TEP. Springerville Unit 2
started commercial operation in June 1990 and is owned by TEP's wholly-owned
subsidiary, San Carlos Resources Inc. (San Carlos), and operated by TEP. These
units are rated at 380 MW for continuous operation. The Springerville Station
was originally designed for four generating units. UED currently manages the
construction of Unit 3, which will be 100% leased by a financial owner to
Tri-State Generation and Transmission Association (Tri-State). Construction of
Unit 3 began in October 2003. We expect commercial operation of Unit 3 to occur
in December 2006. TEP will operate the unit. SRP has the right to construct and
own Unit 4 at a later date. See UniSource Energy Development Company, below.
The Springerville Generating Station also includes the Springerville
Coal Handling Facilities and the Springerville Common Facilities. In 1984, TEP
sold and leased back the Springerville Coal Handling Facilities. In 1985, TEP
sold and leased back a 50% interest in the Springerville Common Facilities. The
other 50%
K-6
interest is included in the Springerville Unit 1 leases.
TEP obtains approximately 600 MW, or 30%, of its generating capacity
from jointly-owned facilities at the San Juan, Four Corners, and Navajo
Generating Stations in New Mexico and northern Arizona.
The Sundt Generating Station (Sundt) includes four units located in
Tucson, Arizona. Units 1, 2 and 3 are gas or oil burning units. Sundt Unit 4
operates primarily on coal in combination with natural gas or landfill gas, but
it is also able to operate solely on natural gas. Units 1, 2, and 3 are
wholly-owned by TEP, and Unit 4 is leased. The Sundt Generating Station and the
internal combustion turbines located in Tucson are designated as "must-run
generation" facilities. Must-run generating units are those which are required
to run in certain circumstances to maintain distribution system reliability and
meet local load requirements.
See Note 10 of Notes to Consolidated Financial Statements, and Item 7.
- Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for more information regarding the Springerville and
Sundt leases.
POWER EXCHANGE AGREEMENT
TEP and Southern California Edison Company (SCE) have a ten-year power
exchange agreement which requires SCE to provide firm system capacity of 110 MW
to TEP during the summer months. TEP is then obligated to return to SCE in the
winter months the same amount of energy that TEP received during the preceding
summer. For example, in the summer of 2003, TEP received approximately 136,000
MWh from SCE and returned the same amount during the winter months from November
2003 to February 2004. This agreement expires in February 2005. The net
incremental increase in cost due to the loss of the SCE exchange agreement is
expected to be less than $2 million annually. We expect to purchase additional
resource needs through a competitive bidding process and short-term purchases.
OTHER PURCHASES AND INTERCONNECTIONS
TEP purchases additional electric energy from other utilities and power
marketers. The amount of energy purchased varies substantially from time to time
depending on the demand for energy, the cost of purchased energy compared with
TEP's cost of generation, and the availability of such energy. TEP may also sell
electric energy in the wholesale market. See also Wholesale Business, above and
Item 7. - Management's Discussion and Analysis of Financial Condition and
Results of Operations, Tucson Electric Power Company, Factors Affecting Results
of Operations, below.
TEP is a member of various regional reserve sharing, reliability and
power sharing organizations. These relationships allow TEP to call upon other
utilities during emergencies such as plant outages and system disturbances, and
reduce the amount of reserves TEP is required to carry.
PEAK DEMAND AND RESOURCES
Peak Demand 2003 2002 2001 2000 1999
-----------------------------------------------------
-MW-
Retail Customers-Net One Hour 2,060 1,899 1,840 1,862 1,754
Firm Sales to Other Utilities 171 228 151 143 178
-------------------------------------------------------------------------------------------------------------
Coincident Peak Demand (A) 2,231 2,127 1,991 2,005 1,932
Total Generating Resources 2,003 2,002 1,999 1,904 1,904
Other Resources (1) 486 308 217 248 235
Total TEP Resources (B) 2,489 2,310 2,216 2,152 2,139
Total Margin (B) - (A) 258 183 225 147 207
Reserve Margin (% of Coincident
Peak Demand) 12% 9% 11% 7% 11%
-------------------------------------------------------------------------------------------------------------
(1) Other Resources includes firm power purchases and interruptible
retail and wholesale loads.
TEP's retail sales are influenced by several factors, including
seasonal weather patterns, competitive
K-7
conditions and the overall economic climate. The peak demand occurs during the
summer months due to the cooling requirements of TEP's retail customers. Retail
peak demand has grown at an average annual rate of approximately 4% from 1999 to
2003.
The chart above shows the relationship over a five-year period between
TEP's peak demand and its energy resources. TEP's margin is the difference
between total energy resources and coincident peak demand, and the reserve
margin is the ratio of margin to coincident peak demand. TEP maintains a minimum
reserve margin in excess of 7% to comply with reliability criteria set forth by
the Western Electricity Coordinating Council (WECC), (formerly the Western
Systems Coordinating Council). TEP's actual reserve margin in 2003 was 12%.
In 2003, TEP entered into two power purchase agreements for the period
2003 through 2006 as listed below:
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through December
2003 and will supply 75 MW from January 2004 through December 2006,
under a unit contingent contract.
o Panda Gila River generating station will supply 50 MW on-peak for the
June through September time period, from 2003 (which has been supplied)
through 2005, under a unit contingent contract between TEP and Panda
Gila River, L.P.
We believe these and other short-term purchases will provide adequate
reserve margins during the summer peak period.
Forecasted retail peak demand for 2004 is approximately 2,083 MW,
compared with actual peak demand of 2,060 MW in 2003. Except for certain peak
hours during the summer, TEP believes it has sufficient resources to meet
expected demand in 2004 with its existing generation and power purchase
agreements.
See Future Generating Resources, TEP, below and Rates and Regulation,
State, Track B, below.
FUTURE GENERATING RESOURCES -- TEP
In the past, TEP assessed its need for future generating resources
based on the premise of a continued regulatory requirement to serve customers in
TEP's retail service area. However, the ACC's electric competition rules, as
currently in effect, modified the obligation to provide generation services to
all customers. These rules and TEP's ability to retain and attract customers
will affect the need for future resources. For those customers who do not choose
other energy providers, TEP remains obligated to supply energy. However, TEP is
not obligated to supply this energy from TEP-owned generating assets. The energy
may be acquired through purchase in the wholesale markets. See Rates and
Regulation, Recent Arizona Court of Appeals Decision below and Item 7. -
Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Factors Affecting Results of
Operations, Competition, below.
TEP will continue to add peaking resources in the Tucson area as needed
based upon our forecasts of retail and firm wholesale load, as well as the
statewide transmission infrastructure. TEP currently forecasts that new peaking
resources of 75 MW may be needed in both 2008 and 2010. In conjunction with the
expansion of the Springerville Generating Station, TEP entered into a power
purchase contract with Tri-State for up to 100 MW of capacity from Tri-State's
system resources. This contract with Tri-State is for up to five years,
beginning with commercial operation of Unit 3, expected in December 2006. TEP
anticipates that any power purchased under this contract will be sold in the
wholesale markets. If power purchased under this contract is to be used by TEP
to serve its retail load, TEP must comply with the Track B competitive bidding
procedures established by the ACC. See UniSource Energy Development Company,
below and Rates and Regulation, State, Track B, below.
FUEL SUPPLY
TEP purchases coal and natural gas in the normal course of business to
fuel its generating plants. The majority of its coal supplies are purchased
under long-term contracts, which result in more predictable prices.
TEP's principal fuel for electric generation is low-sulfur coal. Fuel
information is provided below:
K-8
Average Cost per MMBtu Consumed Percentage of Total Btu Consumed
-----------------------------------------------------------------------------------------------
2003 2002 2001 2003 2002 2001
Coal (A) $1.58 $1.59 $1.63 96% 94% 90%
Gas 6.38 4.28 5.99 4 6 10
All Fuels $1.79 $1.76 $2.08 100% 100% 100%
-----------------------------------------------------------------------------------------------
(A) The average cost per ton of coal for 2003, 2002, and 2001 was $30.31,
$30.86, and $30.96, respectively.
TEP'S COAL AND GAS SUPPLY
Year Contract Average
Terminates Sulfur
Station Coal Supplier Content Coal Obtained From (A)
--------------------------------------------------------------------------------------------------------------------------
Springerville Peabody Coalsales Company 2020 0.9% Lee Ranch Coal Company
Four Corners BHP Billiton 2016 0.8% Navajo Indian Tribe
San Juan San Juan Coal Company 2017 0.8% Federal and State Agencies
Navajo Peabody Coalsales Company 2011 0.6% Navajo and Hopi Indian Tribes
Sundt Various approved suppliers 2006 - Various locations
--------------------------------------------------------------------------------------------------------------------------
(A) Substantially all of the suppliers' mining leases extend at least as long
as coal is being mined in economic quantities.
TEP Operated Generating Facilities
TEP is the sole owner (or lessee) and operator of the Springerville and
Sundt Generating Stations. The coal supplies for these plants are transported
from northwestern New Mexico and Colorado by railroad.
In October 2003, TEP amended and extended the long-term coal supply
contract for Springerville Units 1 and 2 through 2020. We expect coal reserves
to be sufficient to supply the estimated requirements for Units 1 and 2 for
their presently estimated remaining lives. We estimate future minimum annual
payments under this contract to be $45 million through 2010, the initial
contract expiration date, and $14 million in 2011 through 2020. TEP's coal
transportation contract at Springerville runs through 2011. We estimate minimum
annual payments under this contract to be $13 million through 2010 and $7
million in 2011.
In July 2002, TEP terminated the long-term coal supply contract for the
Sundt Generating Station. TEP incurred a pre-tax charge of $11 million related
to the cost of terminating this contract. The termination fee relieved TEP of up
to $3 million in annual pre-tax take-or-pay payments.
In the fourth quarter of 2003, TEP entered into agreements for the
purchase and transportation of coal to the Sundt Generating Station through
2006. The total amount paid under these agreements depends on the number of tons
of coal purchased and transported. The coal agreements require TEP to take
300,000 tons annually with estimated future minimum payments of $4 million in
2004 and $6 million in 2005 and 2006. The rail agreement requires TEP to
transport 300,000 tons with estimated future minimum payments of $2 million in
each year from 2004 through 2006.
The rail contract for the Sundt Generating Station is in effect until
the earliest of 2015 or the remaining life of Unit 4. The rail contract requires
TEP to transport at least 75,000 tons of coal per year through 2015 at an
estimated annual cost of $2 million or to make a minimum payment of $1 million.
TEP expects to use the rail contracts for at least the minimum delivery amounts
through at least 2006. See Note 15 of Notes to Consolidated Financial Statements
- Commitments and Contingencies, TEP Commitments, Purchase and Transportation
Commitments.
Generating Facilities Operated by Others
TEP also participates in jointly-owned generating facilities at Four
Corners, Navajo and San Juan, where coal supplies are under long-term contracts
administered by the operating agents. In July 2003, the Four Corners coal
contract was extended through July 2016. This contract requires TEP to purchase
minimum amounts of coal at an estimated annual cost of $5 million for the next
13 years. We expect coal reserves available to these three jointly-owned
generating facilities to be sufficient for the remaining lives of the stations.
In September 2000, TEP terminated the San Juan Generating Station's
coal supply contract and entered into a new coal supply contract, replacing two
surface mining operations with one underground operation. San Juan Coal Company,
the coal supplier to San Juan, commenced development of the underground mine in
the fourth quarter of 2000 with full station supply expected in March 2003. The
underground mine did not achieve full station supply until December 2003 due to
geological issues. PNM, TEP, and San Juan Coal Company have begun a review of
long term coal cost projections given the production issues encountered and the
experience gained from mining operations.
The contracts to purchase coal for use at the jointly-owned facilities
require TEP to purchase minimum
K-9
amounts of coal at an estimated average annual cost of $19 million for the next
five years.
Natural Gas
TEP typically uses generation from its facilities fueled by natural gas
to meet the summer peak demands of its retail customers and to meet local
reliability needs. Due to its increasing seasonal gas usage, TEP hedges a
portion of its natural gas purchases with fixed price contracts for a maximum of
three years, and purchases its remaining gas needs in the spot and short-term
markets through its supplier Southwest Gas Corporation (SWG). TEP entered into a
Gas Procurement Agreement with SWG effective June 1, 2001 with a primary term of
five years. The contract provided for a minimum volume obligation during the
first two years of 10 million MMBtu's annually. TEP negotiated new pricing and a
lower minimum annual volume obligation of 4 million MMBtu's for 2004 and TEP
expects to use more gas than this minimum requirement. In the event fewer
MMBtu's are purchased, TEP is obligated to pay only the transportation component
for any shortfall. TEP will negotiate terms for the remaining two years of the
contract in late 2004. TEP made payments under this contract of $34 million in
2003, $33 million in 2002 and $28 million in 2001.
In 2003, the average market price of natural gas at the San Juan basin
was $4.42 per MMBtu, or 68% higher than 2002, due to low gas storage levels and
reductions in gas production. The increase in the regional supply of
gas-generated energy and the completion of a 500-kV transmission connection,
however, allowed TEP to decrease use of its less efficient gas generation units
in favor of more economical purchases of energy in the wholesale market. TEP's
generation output fueled by natural gas was approximately 433,000 MWh, or 4% of
total generation in 2003, compared with approximately 720,000 MWh, or 6% of
total generation in 2002. In 2003, TEP purchased approximately 125,000 MWh of
gas-fired energy under long-term purchased power contracts. The majority of the
energy purchased under these agreements is adjusted for changes in the price of
natural gas. See Rates and Regulation, State, Track B, below for discussion of
purchased power contracts.
WATER SUPPLY
Drought conditions in the Four Corners region, combined with water
usage in upper New Mexico, have resulted in decreasing water levels in the lake
that indirectly supplies water to the San Juan and Four Corners Generating
Stations. These drought conditions may affect the water supply of the plants in
the future if adequate moisture is not received in the watershed that supplies
the area. The moisture levels in the region during the 2003-2004 winter season
have been above historic averages. TEP has a 50% ownership interest in each of
San Juan units 1 and 2 (322 MW capacity) and a 7% ownership interest in each of
Four Corners units 4 and 5 (110 MW capacity).
PNM, the operating agent for San Juan, has negotiated supplemental
water contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache
Nation to assist San Juan in meeting its water requirements in the event of a
water shortage. TEP does not believe that its operations will be materially
affected by this drought. However, TEP cannot predict the ultimate outcome of
the drought, or whether it will adversely affect the amount of power available
from the San Juan and Four Corners Generating Stations.
TRANSMISSION ACCESS
TEP has transmission access and power transaction arrangements with
over 120 electric systems or suppliers. In May 2003, TEP completed construction
of a one mile 500-kV transmission line and related substations to enhance its
distribution system link to the regional high voltage transmission system.
K-10
Tucson to Nogales Transmission Line
In January 2001, TEP and Citizens (now UES) entered into a project
development agreement for the joint construction of a 62-mile transmission line
from Tucson to Nogales, Arizona. In January 2002, the ACC approved the location
and construction of the proposed 345-kV line. TEP is currently seeking approvals
for the project from the Department of Energy (DOE), the U.S. Forest Service,
the U.S. Bureau of Land Management, and the International Boundary and Water
Commission. The DOE has completed a draft Environmental Impact Statement (EIS)
for the project which identified the ACC-approved Western Corridor route as its
preferred alternative. We expect to receive a final EIS in 2004. The DOE will
use the EIS to help it decide whether to issue a Presidential Permit that would
allow TEP to extend the line across the border into Mexico. Other federal
agencies will also use the EIS for their own permitting processes. The
construction costs to Nogales, Arizona are expected to be approximately $75
million. Through December 31, 2003, approximately $9 million in engineering and
environmental expenses have been capitalized related to this project. If the
transmission line does not proceed, these costs would be immediately expensed.
Regional and Federal Transmission Issues
In 1997, TEP and other transmission owners and users located in the
southwestern U.S. began to investigate the feasibility of forming an Independent
System Operator (ISO) for the region. In December 1999, the FERC issued FERC
Order 2000, which established timelines for all transmission owning entities to
join a Regional Transmission Organization (RTO) and defined the minimum
characteristics and functions of an RTO. TEP and three other southwestern
utilities filed agreements and operating protocols with the FERC in October 2001
to form a new, for-profit RTO to be known as WestConnect RTO, LLC (WestConnect).
WestConnect will be responsible for security, reservations, scheduling,
transmission expansion and planning, and congestion management for the regional
transmission system. It will also focus on ensuring reliability,
nondiscriminatory open-access, and independent governance. Regional transmission
owners would have the option, but not be required, to transfer ownership of
transmission assets to the RTO. At present, TEP intends to turn over only
operating control of its transmission assets to the RTO. Additionally, the RTO
may build new transmission lines in the region, which could be owned by the RTO.
In October, 2002, the FERC issued a provisional order approving, in
part, the WestConnect RTO proposal. The FERC also required WestConnect, along
with the other two RTOs in the western region (the California Independent System
Operator (CISO) and RTO West), to participate in a steering group to encourage
the development of a seamless wholesale electric energy market. WestConnect's
operation is dependent on the resolution of these issues and is also subject to
approval by state regulatory agencies. WestConnect is following a phased
approach for development that will progress from development of a regional Open
Access Same Time Information System (OASIS) to full RTO implementation in three
or four phases. The first phase includes the regional OASIS (to be called
WesTTrans) and an energy posting system that will be operational on April 1,
2004. The WesTTrans system includes the WestConnect participants as well as some
other public power entities throughout the west. WestConnect is currently
developing its phasing plans.
On July 31, 2002, the FERC issued a Notice of Proposed Rulemaking
(NOPR) proposing standard market design rules that would significantly alter the
markets for wholesale electricity and transmission and ancillary services in the
U.S. The new rules would establish a generation adequacy requirement for
"load-serving entities" and a standard platform for the sale of electricity and
transmission services. Under the new rules, Independent Transmission Providers
would administer spot markets for wholesale power, ancillary services and
transmission congestion rights, and electric utilities, including TEP, would be
required to transfer control over transmission facilities to the applicable
Independent Transmission Provider. The FERC released a white paper on the
standard market design in 2003. This effort by FERC provoked extensive response
from the industry as well as state regulators, stalling the standard market
design effort.
In late 2003, FERC issued a final rule on Standards of Conduct that
apply equally to natural gas and electricity. These rules expand on existing
requirements that utilities must follow regarding non-discriminatory treatment
of customers.
K-11
RATES AND REGULATION
The FERC and the ACC regulate portions of TEP's utility accounting
practices and electricity rates. The FERC regulates the terms and prices of
TEP's transmission services and sales of electricity at wholesale. In 1996, TEP
filed a tariff at FERC governing the rates, terms and conditions of open access
transmission services. In 1997, TEP was granted a FERC tariff to sell power at
market based rates. The ACC has authority over rates charged to retail
customers, the issuance of securities, and transactions with affiliated parties.
STATE
Historically, the ACC determined TEP's rates for retail sales of
electric energy on a "cost of service" basis, which was designed to provide,
after recovery of allowable operating expenses, an opportunity to earn a
reasonable rate of return on TEP's "fair value rate base." Fair value rate base
was generally determined by reference to the original cost and the
reconstruction cost (net of depreciation) of utility plant in service to the
extent deemed used and useful, and to various adjustments for deferred taxes and
other items, plus a working capital component. Over time, rate base was
increased by additions to utility plant in service and reduced by depreciation
and retirements of utility plant.
TEP's Settlement Agreement and Retail Electric Competition Rules
In September 1999, the ACC approved the Retail Electric Competition
Rules (Rules) that provided a framework for the introduction of retail electric
competition in Arizona. In November 1999, the ACC approved the Settlement
Agreement between TEP and certain customer groups related to the implementation
of retail electric competition in Arizona.
The Rules and TEP's Settlement Agreement required the unbundling of
electric services, with separate rates or prices for generation, transmission,
distribution, metering, meter reading, billing and collection, and ancillary
services. Generation services at market prices may be provided by Energy Service
Providers (ESPs) licensed by the ACC. Transmission and distribution services and
must-run generation facilities will remain subject to regulation on a cost of
service basis. TEP has met all conditions required by the ACC to facilitate
electric retail competition, including ACC approval of TEP's direct access
tariffs. However, ESPs and their related service providers must meet certain
conditions before they can competitively sell electricity in TEP's service
territory. Examples of these conditions include ACC certification of ESPs and
completion of direct access service agreements with TEP.
The Settlement Agreement also provided for certain retail rate
reductions from 1998 through 2000. In addition, TEP is required to file by June
1, 2004 a general rate case, including an updated cost of service study. Under
the terms of the Settlement Agreement, no rate case filed by TEP through 2008,
including the rate case to be filed by June 1, 2004, may result in a net rate
increase. Any rate decrease resulting from this rate case would be effective no
sooner than June 1, 2005.
The ACC order approving the Citizens acquisition also requires that TEP
submit as part of its June 2004 general rate case filing, a feasibility study
and consolidation plan, or in the alternative, a plan for coordination of
operations of UNS Electric's operations in Santa Cruz County with those of TEP.
During 2002, the ACC reexamined circumstances that had changed since it
approved the Rules in 1999. The outstanding issues were divided into two groups.
Track A related primarily to the divestiture of generation assets while Track B
related primarily to the competitive energy bidding process.
Track A
In September 2002, the ACC issued the Track A Order, which eliminated
the requirement in the TEP Settlement Agreement that TEP transfer its generation
assets to a subsidiary. At the same time, the ACC ordered the parties, including
TEP, to develop a competitive bidding process, and reduced the amount of power
to be acquired in the competitive bidding process to only that portion not
supplied by TEP's existing resources.
K-12
Track B
On February 27, 2003, the ACC issued the Track B Order, which defined
the competitive bidding process TEP must use to obtain capacity and energy
requirements beyond what is supplied by TEP's existing resources. For the period
2003 through 2006, TEP estimated these amounts to be 50,000 MWh of energy in
2003, or approximately 0.5% of its retail load, gradually increasing to 104,000
MWh by 2006. The Track B Order further required TEP to bid out "Economy Energy",
or short-term energy purchases, that it estimates it will make in the 2003 to
2006 period (210,000 to 181,000 MWh).
TEP was also required to bid out its Reliability Must Run (RMR)
generation requirements, which are currently met by its existing local
generation units. TEP's RMR generation requirements are estimated at 471 MW of
capacity and 37,000 MWh of energy in 2003 increasing to 687 MW of capacity and
38,000 MWh of energy in 2005. TEP does not anticipate that any near-term RMR
requirements will be met through this competitive bidding process because of the
locational and operational requirements of TEP's RMR generation as well as TEP's
belief that its existing RMR generation solutions are economically sound.
TEP is not required to purchase any power through this process that it
deems to be uneconomical, unreasonable or unreliable. The Track B bidding
process involved the ACC Staff and an independent monitor. The Track B Order
also confirmed that it is not intended to change the current retail rates for
generation services.
TEP entered into two agreements to meet its 2003 bid requirements
under the Track B Order for the period 2003 through 2006 as listed below:
o PPL Energy Plus, LLC contract for 37 MW from June 2003 through December
2003 and 75 MW from January 2004 through December 2006, under a unit
contingent contract.
o Panda Gila River generating station will supply 50 MW on-peak for the
June through September time period, from 2003 (which has been supplied)
through 2005, under a unit contingent contract between TEP and Panda
Gila River, L.P.
o No RMR bids were received.
Recent Arizona Court of Appeals Decision
On January 27, 2004, the Arizona Court of Appeals issued a decision
that resolved challenges to the ACC's Retail Electric Competition Rules. The
Court determined that certain rules established by the ACC relating to the entry
of new competitive electric service providers into the market were invalid. The
ultimate impact on TEP's Settlement Agreement is not known. A Motion for
Reconsideration was filed by Arizona Electric Power Cooperative (AEPCO) and
Duncan Valley Electric Cooperative (Duncan Valley), and a separate Motion to
Reconsider was filed by Trico Electric Cooperative (Trico). A Motion for
Reconsideration is a prerequisite to filing an appeal. AEPCO generates and
transmits electricity for its members in Arizona and California. Duncan Valley
and Trico provide electric service to rural areas in Arizona.
See Note 4 of Notes to Consolidated Financial Statements - TEP
Regulatory Matters, for more information on TEP's Settlement Agreement.
FEDERAL
During 2000 and 2001, the FERC ordered hearings and issued several
orders to mitigate volatile energy prices in the western U.S. and to address the
energy emergency in California. During 2000, the FERC established certain soft
caps on prices for power sold to the CISO. In June 2001, the FERC adopted a
price mitigation plan applicable to certain wholesale power sales in the western
U.S. This plan, which had a price cap of $91.87 per MWh, was in effect until
October 31, 2002. The FERC adopted a price cap for the period thereafter of $250
per MWh.
Market Manipulation Investigations
On June 25, 2003, the FERC alleged that 60 energy companies, including
TEP, may have engaged in manipulative practices that disrupted western energy
markets in 2001 and 2000. On January 22, 2004, FERC granted a Motion to Dismiss
all charges against TEP.
K-13
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Tucson Electric Power Company, Factors
Affecting Results of Operations, Western Energy Markets, below, for a discussion
of various FERC proceedings, including refund hearings on power sold to
California in 2000 and 2001, which may impact TEP's results.
TEP's UTILITY OPERATING STATISTICS (Restated- See Note 22 in the Consolidated
Financial Statements)
For Years Ended December 31,
2003 2002 2001 2000 1999
----------------------------------------------------------------------------------------------------------------------------
Generation and Purchased Power-kWh (000)
Remote Generation (Coal) 10,182,706 10,067,069 10,362,211 10,278,393 10,000,401
Local Tucson Generation (Oil, Gas & Coal) 1,082,058 1,402,504 1,820,783 1,667,308 1,115,277
Purchased Power 1,153,305 1,329,574 3,656,978 3,174,244 2,712,570
----------------------------------------------------------------------------------------------------------------------------
Total Generation and Purchased Power 12,418,069 12,799,147 15,839,972 15,119,945 13,828,248
Less Losses and Company Use 778,285 791,851 747,940 688,227 753,974
----------------------------------------------------------------------------------------------------------------------------
Total Energy Sold 11,639,784 12,007,296 15,092,032 14,431,718 13,074,274
============================================================================================================================
Sales-kWh (000)
Residential 3,389,744 3,181,030 3,159,504 3,041,446 2,758,260
Commercial 1,689,014 1,605,148 1,591,942 1,503,222 1,394,588
Industrial 2,245,340 2,254,174 2,297,476 2,272,285 2,238,285
Mining 701,638 692,448 1,053,152 1,145,891 1,209,609
Public Authorities 250,038 256,867 257,155 259,621 249,297
----------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 8,275,774 7,989,667 8,359,229 8,222,465 7,850,039
Electric Wholesale Sales 3,364,010 4,017,628 6,732,802 6,209,254 5,224,235
----------------------------------------------------------------------------------------------------------------------------
Total Electric Sales 11,639,784 12,007,295 15,092,031 14,431,719 13,074,274
============================================================================================================================
Operating Revenues (000)
Residential $309,807 $291,390 $285,808 $279,067 $255,763
Commercial 175,559 168,838 166,139 158,309 149,262
Industrial 160,276 161,749 162,523 162,888 161,988
Mining 28,022 28,072 41,940 48,460 49,402
Public Authorities 17,839 18,672 18,763 18,883 18,280
----------------------------------------------------------------------------------------------------------------------------
Total - Electric Retail Sales 691,503 668,721 675,173 667,607 634,695
Electric Wholesale Sales 151,030 157,108 921,280 359,814 171,219
Other Revenues 9,018 8,618 8,508 3,908 2,964
----------------------------------------------------------------------------------------------------------------------------
Total Operating Revenues $851,551 $834,447 $1,604,961 $1,031,329 $808,878
============================================================================================================================
Customers (End of Period)
Residential 334,131 326,847 318,976 311,673 303,653
Commercial 32,369 31,767 31,194 30,467 29,714
Industrial 676 695 705 711 705
Mining 2 2 2 2 4
Public Authorities 61 61 61 61 61
----------------------------------------------------------------------------------------------------------------------------
Total Retail Customers 367,239 359,372 350,938 342,914 334,137
============================================================================================================================
Average Retail Revenue per kWh Sold (cents)
Residential 9.1 9.2 9.0 9.2 9.3
Commercial 10.4 10.5 10.4 10.5 10.7
Industrial and Mining 6.4 6.4 6.1 6.2 6.1
Average Retail Revenue per kWh Sold 8.4 8.4 8.1 8.1 8.1
Average Revenue per Residential Customer $937 $902 $906 $906 $854
Average kWh Sales per Residential Customer 10,249 9,842 10,015 9,878 9,208
K-14
ENVIRONMENTAL MATTERS
TEP is subject to environmental regulation of air and water quality,
resource extraction, waste disposal and land use by federal, state and local
authorities. TEP believes that all existing generating facilities are in
compliance with all existing regulations and will be in compliance with expected
environmental regulations, except as described below.
The 1990 Federal Clean Air Act Amendments (CAAA) require reductions of
sulfur dioxide (SO2) and nitrogen oxide (NOx) emissions in two phases. TEP is
subject only to Phase II of the SO2 and NOx emission reductions, which became
effective January 1, 2000. All of TEP's generating facilities (except 142 MW of
its internal combustion turbines) are affected.
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emission Allowances based on past operational history. Each allowance gives the
owner the right to emit one ton of SO2. Beginning in 2000, generating units
subject to Phase II must hold Emission Allowances equal to the level of
emissions in the compliance year or pay penalties and offset excess emissions in
future years. TEP had sufficient Emission Allowances to comply with the Phase II
SO2 regulations for compliance year 2003. We expect to continue to have adequate
Emission Allowances until Springerville Unit 3 goes into service. At that point,
due to reduced usage of Emission Allowances at Springerville Unit 1 and Unit 2,
TEP expects to have excess Emission Allowances. Potential changes to the
regulation of SO2 emissions may impact these expectations in future years.
Title V of the CAAA requires that all of TEP's generating facilities
obtain more complex air quality permits. All TEP facilities (including those
jointly owned and operated by others) have obtained these permits. In 1999, TEP
received Title V permits for the Springerville and Sundt generating stations.
These permits are valid for five years, and, as a result, TEP has submitted a
permit renewal application. TEP must pay an annual emission-based fee for each
generating facility subject to a Title V permit. These emission-based fees are
included in the CAAA compliance expenses discussed below. The CAAA also requires
multi-year studies of visibility impairment in specified areas and studies of
hazardous air pollutants. The results of these studies will impact the
development of future regulation of electric utility generating units. Since
these activities involve the gathering of information not currently available,
TEP cannot predict the outcome of these studies.
Arizona and New Mexico have adopted regulations restricting the
emissions from existing and future coal, oil and gas-fired plants. These
regulations are in some instances more stringent than those adopted by the
Environmental Protection Agency (EPA). The principal generating units of TEP are
located relatively close to national parks, monuments, wilderness areas and
Indian reservations. Since these areas have relatively high air quality, TEP
could be subject to control standards that relate to the "prevention of
significant deterioration" of visibility and tall stack limitation rules. In
addition, the ACC mandated under the Environmental Portfolio Standard (EPS) that
TEP derive a percentage of its total retail energy sold from new solar resources
or environmentally-friendly renewable electricity technologies. The percentage
changes each year, increasing to a maximum of 1.1 percent in 2007. In 2003, the
percentage was 0.6 percent of which at least 50 percent must be derived from
solar electric generation.
The EPA has issued a determination that coal and oil-fired electric
utility steam generating units must control their mercury emissions. Final
regulations are expected to be issued in December 2004.
TEP capitalized $11 million in 2003 and $8 million in 2002 and 2001 in
construction costs to comply with environmental requirements and expects to
capitalize $6 million in 2004 and 2005. In addition, TEP recorded expenses of $8
million in 2003 and $6 million in 2002 and 2001 related to environmental
compliance, including the cost of lime used to scrub the stacks. TEP expects
environmental expenses to be $7 million in 2004 and 2005. TEP may incur
additional costs to comply with recent and future changes in federal and state
environmental laws, regulations and permit requirements at existing electric
generating facilities. Compliance with these changes may result in a reduction
in operating efficiency.
In order to meet Title V permit requirements in connection with the
construction of Springerville Unit 3, the Unit 3 project will pay for
approximately $90 million of capital expenditures related to pollution control
equipment upgrades on Springerville Unit 1 and Unit 2.
K-15
See Note 15. Commitments and Contingencies, TEP Contingencies,
Springerville Generating Station Complaint.
UNISOURCE ENERGY SERVICES
-------------------------
On August 11, 2003, UniSource Energy completed the purchase of the
Arizona gas and electric system assets from Citizens for a total of $223
million, comprised of the base purchase price plus other operating capital
adjustments and transaction costs. UES was formed to hold the common stock of
UNS Electric and UNS Gas, which operate these electric and gas system assets,
respectively.
UNS ELECTRIC
Service Territory and Customers
UNS Electric is an electric transmission and distribution company
serving approximately 81,000 retail customers in Mohave and Santa Cruz counties.
These counties had a population of approximately 212,000 in 2003.
UNS Electric's customer base is primarily residential, with some small
commercial and both light and heavy industrial customers. Peak demand for 2003
was 365 MW.
Power Supply and Transmission
UNS Electric has a full requirements power supply agreement with
Pinnacle West Capital Corporation (PWCC). The agreement expires May 31, 2008.
The agreement obligates PWCC to supply all of UNS Electric's power requirements
at a fixed price. Payments under the contract are usage based, with no fixed
customer or demand charges. UNS Electric imports the power it purchases from
PWCC into its Mohave County and Santa Cruz County service territories over the
Western Area Power Administration's (WAPA) transmission lines. UNS Electric's
transmission capacity agreement with WAPA expires in February 2008. Under the
terms of the agreement, UNS Electric's aggregate minimum fixed transmission
charges are expected to be $5 million in 2004. UNS Electric also has a long-term
electric transmission capacity agreement with WAPA that expires in 2011. Under
the terms of this contract, the aggregate minimum transmission payments are $1
million per year.
UNS Electric owns and operates the Valencia Power Plant (Valencia),
located in Nogales, Arizona. The Valencia plant consists of three gas and
diesel-fueled combustion turbine units and provides approximately 48 MW of
peaking resources. The facility is directly interconnected with the distribution
system serving the city of Nogales and the surrounding areas. Under the PWCC
agreement, Valencia will be dispatched by PWCC when needed for local reliability
or when it is economic relative to other PWCC resources.
Rates and Regulation
UNS Electric is regulated by the ACC with respect to retail electric
rates, the issuance of securities, and transactions with affiliated parties, and
by the FERC with respect to wholesale power contracts and interstate
transmission service. UNS Electric's retail electric rates include a purchase
power and fuel adjustment clause (PPFAC), which allows for adjustment to the
base rate for delivered purchase power through a separate surcharge or credit.
The ACC order and settlement agreement include the following terms
related to UNS Electric rates:
o A 22% increase in retail rates effective August 11, 2003 from the rates
previously in effect for Citizens. This reflects the implementation of
a PPFAC surcharge of $0.01825 per kWh, which combined with the current
base rate of $0.05194 per kWh, results in a new delivered purchase
power price of $0.07019 per kWh, to fully recover the cost of the
current contract with PWCC, WAPA transmission charges and the cost of
running the Valencia turbines.
K-16
o UniSource Energy must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated contract must
be allocated in a ratio of 90% to ratepayers and 10% to shareholders.
Discussions are underway relating to restructuring options, however at
March 10, 2004, no agreement had been reached.
The ACC order also requires that TEP submit in its next general rate
case filing in June 2004, a feasibility study and consolidation plan, or a plan
for coordination of operations of UNS Electric's operations in Santa Cruz County
with those of TEP.
Under the terms of the ACC order, UNS Electric may not file a general
rate increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. The settlement agreement also limits dividends
payable by UNS Electric to 75% of earnings until the ratio of common equity to
total capitalization reaches 40%. The ratio of common equity to total
capitalization for UNS Electric at December 31, 2003 was 38%.
UNS GAS
Service Territory and Customers
UNS Gas is a gas distribution company serving approximately 128,000
retail customers in Mohave, Yavapai, Coconino, and Navajo Counties in northern
Arizona, as well as Santa Cruz County in southeast Arizona. These counties
comprise approximately 50% of the territory of the state of Arizona, with a
population of approximately 702,000 in 2003.
UNS Gas' customer base is primarily residential. Total revenues derived
from residential customers were approximately 55% in the five months of
operation in 2003, while sales to other retail customer classes accounted for
approximately 29% of total revenues. Approximately 16% of total revenues in 2003
were derived from gas transportation services and a Negotiated Sales Program
(NSP). UNS Gas is supplying natural gas transportation service to the 600 MW
Griffith Power Plant located near Kingman, Arizona, under a 20-year contract
which expires in 2021. UNS Gas also supplies natural gas to some of its large
transportation customers, through an NSP approved by the ACC. One half of the
margin earned on these NSP sales is retained by UNS Gas, while the other half
benefits retail customers through a credit to the purchased gas adjustor (PGA)
mechanism which reduces the gas commodity price.
Gas Supply and Transmission
UNS Gas has a natural gas supply and management agreement with BP
Energy Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended one year on an annual basis unless either party provides
180 days notice of its intent to terminate. The market price for gas supplied by
BP will vary based upon the period during which the commodity is delivered. UNS
Gas hedges its gas supply prices by entering into fixed price forward contracts
at various times during the year to provide more stable prices to its customers.
These purchases are made up to three years in advance with the goal of hedging
at least 45% and not more than 80% of the expected monthly gas consumption with
fixed prices prior to entering into the month. UNS Gas hedged approximately 70%
of its expected monthly consumption for the 2003/2004 winter season (November
through March). Currently, UNS Gas has approximately 15% of its expected gas
consumption hedged for November and December of 2004, and 10% hedged for the
period January through March of 2005.
Most of the gas distributed by UNS Gas in Arizona is procured from the
San Juan Basin in the Four Corners region and delivered on the El Paso and
Transwestern interstate pipeline systems. UNS Gas has firm transportation
agreements with El Paso Natural Gas (EPNG) and Transwestern Pipeline Company
(Transwestern) with combined capacity sufficient to meet its load requirements.
EPNG provides gas transmission service under a full requirements contract under
which UNS Gas pays a fixed reservation charge. This contract expires in August
2011.
In July 2003, FERC required the conversion of UNS Gas' full
requirements status under the EPNG agreement to contract demand starting on
September 1, 2003. Upon conversion to contract demand status, UNS Gas will have
specific volume limits in each month and specific receipt point rights from the
available
K-17
supply basins (San Juan and Permian). These changes will reduce the amount of
less expensive San Juan gas available to UNS Gas. The impact, however, is not
expected to be material. The annual cost of the EPNG capacity after conversion
to contract demand will not change. These costs will be the same through 2005
(pending a 2006 EPNG rate case) as under UNS Gas' existing full requirements
contract. The average daily capacity rights of UNS Gas upon conversion to
contract demand will be approximately 870,000 therms per day, with an average of
1,200,000 therms per day in the winter season (November through March). UNS Gas
has capacity rights of 250,000 therms per day on the San Juan Lateral and
Mainline of the Transwestern pipeline. The Transwestern pipeline principally
delivers gas to the portion of UNS Gas' distribution system serving customers in
Flagstaff and Kingman, Arizona, and also delivers gas to UNS Gas' facilities
serving the Griffith Power Plant in Mohave County. This contract expires in
January 2007. The aggregate annual minimum transportation charges are expected
to be approximately $4 million and $3 million for the EPNG and Transwestern
contracts, respectively.
Rates and Regulation
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
The PGA mechanism is intended to address the volatility of natural gas
prices and allows UNS Gas to recover its costs through a price adjustor. The PGA
charge may be changed monthly based on an ACC approved mechanism that compares
the twelve-month rolling average gas cost to the base cost of gas, subject to
limitations on how much the price per therm may change in a twelve month period.
The difference between the actual cost of UNS Gas' gas supplies and
transportation contracts and that currently allowed by the ACC are deferred and
recovered or refunded through the PGA mechanism. When under or over recovery
reaches approximately $4 million, UNS Gas may request a PGA surcharge or
surcredit with the goal of collecting or refunding the amount deferred from or
to customers over a twelve month period.
The ACC order and settlement agreement include the following terms
related to UNS Gas rates:
o An increase in retail delivery base rates, effective August 11, 2003,
equivalent to a 20.9% increase over 2001 test year retail revenues.
o Fair value rate base of $142 million and allowed rate of return of
7.49%, based on a cost of capital of 9.05%, derived from a cost of
equity of 11.00% and a cost of debt of 7.75% (based on a capital
structure of 60% debt and 40% equity).
o Change in rate design to include an increase in the monthly residential
customer charge from $5 to $7 and an increase in the base cost of gas
to $0.400 per therm from $0.250 in northern Arizona and $0.3884 in
Santa Cruz County.
o The existing PGA rate change limit of $0.10 per therm over a
twelve-month period is increased to $0.15 through July 2004 and
thereafter will revert to $0.10.
Under the terms of the ACC order, UNS Gas may not file a general rate
increase until August 2006 and any resulting rate increase may not become
effective until August 1, 2007. The settlement agreement also limits dividends
payable by UNS Gas to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Gas at December 31, 2003 was 35%.
The PGA bank balance acquired by UNS Gas on August 11, 2003 was
approximately $7 million. On September 9, 2003, the ACC approved a new PGA
surcharge of $0.1155 per therm that took effect October 1, 2003. At December 31,
2003, the PGA bank balance was $3 million.
MILLENNIUM ENERGY HOLDINGS
--------------------------
Through affiliates, Millennium holds investments in unregulated energy
and emerging technology companies. At December 31, 2003, Millennium's assets
represented 5% of UniSource Energy's total assets. The acquisition agreement
discussed in Overview of Consolidated Businesses - Agreement and Plan of
K-18
Merger, above, limits the amount UniSource Energy may invest in Millennium.
Consequently, Millennium's ability to provide future funding for the operations
of emerging companies could be affected.
Technology Investments
GLOBAL SOLAR ENERGY, INC. (Global Solar) develops and manufactures
light weight thin-film photovoltaic cells and panels. Global Solar's target
markets have included military, space and commercial applications. In 2003,
Millennium increased its ownership in Global Solar to 99% from 87%.
INFINITE POWER SOLUTIONS, INC. (IPS) develops thin-film lithium ion
batteries. In 2003, Millennium's ownership in IPS was reduced to 72% from 77%.
MICROSAT SYSTEMS, INC. (MicroSat) develops small-scale satellites under
U.S. government contracts. In 2003, Millennium reduced its ownership in MicroSat
to 35% from 49%.
As technology developers, these entities face many challenges, such as
developing technologies that can be manufactured on an economic scale,
technological obsolescence, competitors and possible reductions in government
spending to advance technological research and development activities. See Item
7. - Management's Discussion and Analysis of Financial Condition and Results of
Operations, Millennium Energy Holdings, Inc., Results of Operations, below, for
more information regarding these entities, including research and development
activities.
Other Millennium Investments
Millennium also has the following investments:
SOUTHWEST ENERGY SOLUTIONS, INC. (SES), a wholly-owned Millennium
subsidiary, provides electrical contracting services in Arizona to commercial,
industrial and governmental customers in both high voltage and inside wiring
capacities and meter reading services to TEP.
MILLENNIUM ENVIRONMENTAL GROUP, INC. (MEG), a wholly-owned Millennium
subsidiary, established in September 2001, manages and trades emission
allowances, coal and other environmental related products including derivative
instruments.
NATIONS ENERGY CORPORATION (Nations Energy), a wholly-owned subsidiary
of Millennium established in 1995, develops and invests in independent power
projects worldwide. In 2001, Nations Energy sold its 26% equity interest in a
power project located in Curacao, Netherland Antilles. Nations Energy has one
remaining investment, a 40% equity interest in an independent power producer
that owns and operates a 43 MW power plant near Panama City, Panama. Nations
Energy intends to sell its interest in this project, which had a book value of
less than $1 million at December 31, 2003. Millennium does not intend to make
any additional investments in Nations Energy.
HADDINGTON ENERGY PARTNERS II, LP (Haddington) is a limited partnership
that funds energy-related investments. A member of the UniSource Energy Board of
Directors has an investment in Haddington and is a managing director of the
general partner of the limited partnership. Millennium committed $15 million in
capital, excluding fees, to Haddington in exchange for approximately 31% of
Haddington. At December 31, 2003 Millennium had funded $9 million of this
commitment, of which $2 million was funded in 2003. Millennium expects the
balance to be funded in the next three years.
VALLEY VENTURES III, LP (Valley Ventures) is a venture capital fund
that focuses on investments in information technology, microelectronics and
biotechnology, primarily within the southwestern U.S. A different member of the
UniSource Energy Board of Directors is a general partner of the company that
manages the fund. Millennium committed $6 million, including fees, to the fund
and owns approximately 15% of the fund. Millennium had funded approximately $1
million of this commitment through December 31, 2003 and expects the balance to
be funded by the end of 2007.
CARBOELECTRICA SABINAS, S. DE R.L. DE C.V. (Sabinas) is a Mexican
limited liability company created to develop up to 800 MW of coal-fired
generation in the Sabinas region of Coahuila, Mexico. Sabinas also owns
K-19
19.5% of Minerales de Monclova, S.A. de C.V. (Mimosa). Mimosa is an owner of
coal and associated gas reserves and a supplier of metallurgical coal to the
Mexican steel industry and thermal coal to the major electric utility in Mexico.
Millennium owns 50% of Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and
affiliates also own 50%. Also, UniSource Energy's Chairman, President and Chief
Executive Officer is a member of the Board of Directors of AMHSA. Since 1999,
both AHMSA and Mimosa are parties to a suspension of payments procedure, under
applicable Mexican law, which is the equivalent of a U.S. Chapter 11 proceeding.
Under certain circumstances, Millennium has the right to sell (a put option) its
interest in Sabinas to an AHMSA affiliate for $20 million plus an accrued
service fee. These circumstances include failure of Sabinas to reach financial
closing on the generation project within a specified time. Millennium's put
option is secured by collateral valued in excess of $20 million. In 2003
Millennium received $1 million of returned capital from the investment. At
December 31, 2003, the book value of the investment in Sabinas was approximately
$19 million.
We describe the results of Millennium's unregulated energy businesses
and other investments in Item 7. - Management's Discussion and Analysis of
Financial Condition and Results of Operations, Millennium Energy Holdings, Inc.,
Results of Operations.
UNISOURCE ENERGY DEVELOPMENT COMPANY
------------------------------------
On October 21, 2003, UED, TEP, Tri-State and SRP entered into an
Amended and Restated Joint Development Agreement (Agreement), which provides for
the development of two 400 MW coal-fired units at TEP's existing Springerville
Generating Station by parties other than TEP. Based on the Agreement, TEP
transferred the right to construct Unit 3, together with associated rights, to
Tri-State.
Springerville was originally designed for four units. Springerville
Unit 3, and if constructed Unit 4, will each consist of a 400 MW coal-fired,
base-load generating facility at the same site as Springerville Units 1 and 2.
When Unit 3 (and possibly Unit 4) is built, TEP would spread the fixed costs of
the existing common facilities over the additional generating unit (or units).
On October 21, 2003, Tri-State completed financing of Unit 3 and
immediately began construction. UED received reimbursement of its development
costs totaling $29 million, and an $11 million development fee. On October 24,
2003, part of the proceeds were used to repay UniSource Energy's $35 million
short-term bridge loan obtained to help fund the Citizens Acquisition.
Once built, Tri-State will lease 100% of Unit 3 from a financial owner
and take 300 MW of the 400 MW capacity. TEP will operate Unit 3 and will
purchase up to 100 MW of Tri-State system capacity for no more than five years
from the time the plant begins commercial operation. UED expects commercial
operation of Unit 3 to occur in December 2006. SRP will purchase 100 MW of
capacity from Unit 3 under a 30 year power purchase agreement and will have the
right to construct and own Unit 4 at a later date. If SRP decides to construct
Unit 4, TEP may be required, along with Tri-State, to exercise best efforts to
find a replacement purchaser for SRP to purchase 100 MW of capacity from Unit 3.
If TEP and Tri-State are unable to find such a replacement purchaser, TEP would
then purchase 100 MW of output from Unit 4, beginning with the commercial
operation of Unit 4.
UED will continue to manage the development of Unit 3. Upon the
completion of construction, TEP expects to receive annual pre-tax benefits of
approximately $15 million in the form of cost savings, rental payments,
transmission revenues, and other fees. TEP will also benefit from upgraded
emissions controls for Units 1 and 2, totaling approximately $90 million, which
will be paid for by the Unit 3 project.
EMPLOYEES (As of December 31, 2003)
-----------------------------------
TEP had 1,155 employees, of which approximately 58% are represented by
the International Brotherhood of Electrical Workers (IBEW) Local No. 1116. A
three-year collective bargaining agreement between the IBEW and TEP was ratified
in December 2002 and extends through 2005. Wages for bargaining unit employees
increased 3% effective January 5, 2004. Wage increases for 2005 and 2006 will be
determined annually during July and August of each preceding year.
UNS Gas had 187 employees, of which 5 employees in Santa Cruz County
are represented by IBEW Local No. 387. The existing agreement with the IBEW
Local No. 387 expires in February 2005.
K-20
UNS Electric had 152 employees, of which 34 employees in Santa Cruz
County are represented by the IBEW Local No. 387 and 53 employees in Mohave
County are represented by the IBEW Local No. 769. The existing agreement with
the IBEW Local No. 387 expires in February 2005 and the agreement with IBEW
Local No. 769 expires in June 2004.
Millennium and its wholly-owned subsidiaries, which include SES and
MEG, had 208 employees. SES had 200 employees, of which approximately 92% are
represented by unions. Of the employees represented by unions, 59% are
represented by IBEW Local No. 1116, 34% by IBEW Local 769 and 7% by IBEW Local
No. 570. The existing agreements expire as follows: IBEW Local No. 1116, October
2006; IBEW Local No. 769, March 2004 and April 2006; and IBEW Local No. 570, May
2006.
SEC REPORTS AVAILABLE ON UNISOURCE ENERGY'S WEBSITE
---------------------------------------------------
UniSource Energy and TEP make available their annual reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all
amendments to those reports as soon as reasonably practicable after they
electronically file them with, or furnish them to, the SEC. These reports are
available free of charge through UniSource Energy's website address:
http://www.unisourceenergy.com. A link from UniSource Energy's website to these
SEC reports is accessible as follows: At the UniSource Energy main page, select
Investor Relations from the menu shown at the top of the page; next select SEC
filings from the menu shown on the Investor Relations page.
Information contained at UniSource Energy's website is not part of any
report filed with the SEC by UniSource Energy or TEP.
The SEC also maintains an Internet site that contains reports, proxy
and information statements, and other information regarding issuers that file
electronically with the SEC. The SEC website address is http://www.sec.gov.
Interested parties may also read and copy any materials UniSource Energy and TEP
file with the SEC at the SEC's Public Reference Room at 450 Fifth Street, NW,
Washington, DC 20549. Information on the operation of the Public Reference Room
is available by calling the SEC at 1-800-SEC-0030.
K-21
ITEM 2.-- PROPERTIES
-------------------------------------------------------------------------------
TEP PROPERTIES
--------------
TEP's transmission facilities, located in Arizona and New Mexico,
transmit electricity from TEP's remote electric generating stations at Four
Corners, Navajo, San Juan and Springerville to the Tucson area for use by TEP's
retail customers (see Item 1. - Business - Generating and Other Resources). The
transmission system is interconnected at various points in Arizona and New
Mexico with a number of regional utilities. TEP has arrangements with
approximately 120 companies to interchange generation capacity and transmission
of energy.
As of December 31, 2003, TEP owned, or participated in, an overhead
electric transmission and distribution system consisting of:
o 512 circuit-miles of 500-kV lines;
o 1,122 circuit-miles of 345-kV lines;
o 371 circuit-miles of 138-kV lines;
o 434 circuit-miles of 46-kV lines; and
o 12,511 circuit-miles of lower voltage primary lines.
The underground electric distribution system is comprised of 7,843
cable-miles. TEP owns approximately 77% of the poles on which the lower voltage
lines are located. Electric substation capacity consisted of 197 substations
with a total installed transformer capacity of 6,011,272 kilovolt amperes.
The electric generating stations (except as noted below), operating
headquarters, warehouse and service center are located on land owned by TEP. The
electric distribution and transmission facilities owned by TEP are located:
o on property owned by TEP;
o under or over streets, alleys, highways and other public places, the
public domain and national forests and state lands under franchises,
easements or other rights which are generally subject to termination;
o under or over private property as a result of easements obtained
primarily from the record holder of title; or
o over American Indian reservations under grant of easement by the
Secretary of Interior or lease by American Indian tribes.
It is possible that some of the easements, and the property over which
the easements were granted, may have title defects or may be subject to
mortgages or liens existing at the time the easements were acquired.
Springerville is located on land parcels held by TEP under a long-term
surface ownership agreement with the State of Arizona.
Four Corners and Navajo are located on properties held under easements
from the United States and under leases from the Navajo Nation. TEP,
individually and in conjunction with Public Service Company of New Mexico (PNM)
in connection with San Juan, has acquired easements and leases for transmission
lines and a water diversion facility located on land owned by the Navajo Nation.
TEP has also acquired easements for transmission facilities, related to San
Juan, Four Corners, and Navajo, across the Zuni, Navajo and Tohono O'odham
Indian Reservations.
TEP's rights under these various easements and leases may be subject to
defects such as:
o possible conflicting grants or encumbrances due to the absence of or
inadequacies in the recording laws or record systems of the Bureau of
Indian Affairs and the American Indian tribes;
o possible inability of TEP to legally enforce its rights against adverse
claimants and the American
Indian tribes without Congressional consent; or
o failure or inability of the American Indian tribes to protect TEP's
interests in the easements and leases
K-22
from disruption by the U.S. Congress, Secretary of the Interior, or
other adverse claimants.
These possible defects have not interfered and are not expected to
materially interfere with TEP's interest in and operation of its facilities.
TEP, under separate sale and leaseback arrangements, leases the
following generation facilities (which do not include land):
o coal handling facilities at Springerville;
o a 50% undivided interest in the Springerville Common Facilities;
o Springerville Unit 1 and the remaining 50% undivided interest in
Springerville Common Facilities; and
o Sundt Unit 4 and related common facilities.
See Note 10 of Notes to Consolidated Financial Statements, and Item 7.
- Management's Discussion and Analysis of Financial Condition and Results of
Operations, Tucson Electric Power Company, Liquidity and Capital Resources,
Contractual Obligations, for additional information on TEP's capital lease
obligations.
Substantially all of the utility assets owned by TEP are subject to the
lien of the General First Mortgage and the General Second Mortgage.
Springerville Unit 2, which is owned by San Carlos, is not subject to those
liens.
UES PROPERTIES
--------------
UNS Electric
As of December 31, 2003, UNS Electric's transmission and distribution
system consisted of approximately 56 circuit-miles of 115-kV transmission lines,
234 circuit-miles of 69-kV transmission lines, and 3,116 circuit-miles of
underground and overhead distribution lines. UNS Electric also owns 39
substations having a total installed capacity of 1,161,300 kilovolt amperes and
the 48 MW Valencia plant described above.
UNS Gas
As of December 31, 2003, UNS Gas' transmission and distribution system
consisted of approximately 168 miles of steel transmission mains, 2,459 miles of
steel and plastic distribution mains, and 128,108 customer service lines.
ITEM 3.-- LEGAL PROCEEDINGS
--------------------------------------------------------------------------------
See Item 7 - Management's Discussion and Analysis of Financial
Condition and Results of Operations, Tucson Electric Power Company, Factors
Affecting Operations, for litigation related to ACC orders and retail
competition.
We discuss other legal proceedings in Note 15 of Notes to Consolidated
Financial Statements.
California Attorney General's Unfair Competition Lawsuits
Beginning in April 2002, the California Attorney General filed eleven
virtually identical actions against TEP and other wholesale electricity
suppliers or marketers in San Francisco Superior Court. The complaints seek to
impose civil penalties on defendants under California's unfair competition law
based upon allegations that defendants violated the Federal Power Act by failing
to properly file their rates with FERC and by charging "unjust and unreasonable"
rates.
Defendants removed the cases to the United States District Court for
the Northern District of California, which dismissed the California Attorney
General's complaints finding them barred by federal preemption and the filed
rate doctrine. The California Attorney General appealed the District Court's
dismissal of the complaints. A decision from the Ninth Circuit is expected in
the second or third quarter of 2004.
K-23
TEP believes these claims are without merit and intends to vigorously
contest them.
Cross-Complaints in Wholesale Electricity Antitrust Cases I and II
In late 2000, various California municipalities and citizens filed
suits against Duke Energy Trading and Marketing, L.L.C., Reliant Energy
Services, Inc. and other large suppliers of wholesale electricity alleging that
Duke, Reliant, and the other large suppliers violated antitrust laws by
colluding to effect the price of electricity in the California wholesale
electricity market. These actions were subsequently consolidated in San Diego
Superior Court in March 2002 as Wholesale Electricity Antitrust Cases I and II.
Duke and Reliant responded by filing cross-complaints against TEP and
numerous other wholesale electricity market participants in April 2002. The
cross complaints allege that cross-defendants sold power in significant amounts
at prices the antitrust plaintiffs allege were excessive, and as participants in
power sales, cross-defendants are equally liable for plaintiffs alleged damages.
The entire action was removed to the United States District Court for the
Southern District of California in May 2002. The antitrust plaintiffs responded
to the removal by filing a motion for remand, and on December 13, 2002, the
District Court remanded the case back to state court.
Duke and Reliant promptly appealed the District Court's remand order
and requested that the order be stayed pending resolution of their appeal. A
ruling on the remand order from the Ninth Circuit is expected in the second or
third quarter of 2004.
TEP believes these claims are without merit and intends to vigorously
contest them.
ITEM 4.-- SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
--------------------------------------------------------------------------------
Not applicable.
K-24
PART II
ITEM 5.-- MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
--------------------------------------------------------------------------------
Stock Trading
UniSource Energy's Common Stock is traded under the ticker symbol UNS.
It is listed on the New York Stock Exchange and the Pacific Exchange. On March
10, 2004, the closing price was $24.20, with 13,010 shareholders of record. If
UniSource Energy is acquired by Saguaro Utility, UniSource Energy will no longer
be a publicly held company, and thus its common stock will no longer be traded
on any such exchange.
Dividends
The acquisition agreement allows UniSource Energy to continue to pay
regular quarterly cash dividends until the closing of the acquisition, subject
to limitations upon our ability to increase the amount of such dividends.
UniSource Energy's Board of Directors currently expects to continue to pay
regular quarterly cash dividends on our common stock until the closing of the
acquisition, subject, however, to the directors' evaluation of our financial
condition, earnings, cash flows and dividend policy.
TEP pays dividends on its common stock after its Board of Directors
declares them. UniSource Energy is the primary shareholder of TEP's common
stock. UniSource Energy relies on dividends from its subsidiaries, primarily
TEP, to declare and pay dividends to its shareholders. See Note 12 of Notes to
Consolidated Financial Statements for a discussion of limitations on UniSource
Energy's subsidiaries ability to pay dividends to UniSource Energy. Also see
Item 1. - Business, Agreement and Plan of Merger, for a discussion on the
possible elimination of restrictions on TEP's ability to pay dividends to
UniSource Energy.
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations, UniSource Energy Consolidated, Dividends on
Common Stock.
Common Stock Dividends and Price Ranges
------------------------------------------------------------------------------------------------------------
2003 2002
Quarter: Market Price per Dividends Market Price per Dividends
Share of Common Stock (1) Declared Share of Common Stock (1) Declared
High Low High Low
-------- ------ ------- -------
First $18.10 $16.00 $ 0.150 $20.60 $16.74 $ 0.125
Second 19.27 17.05 0.150 20.75 17.91 0.125
Third 19.80 17.65 0.150 18.89 14.05 0.125
Fourth 24.90 19.01 0.150 17.90 13.69 0.125
------------------------------------------------------------------------------------------------------------
Total $ 0.600 $ 0.500
============================================================================================================
(1) UniSource Energy's Common Stock composite price on the New York Stock
Exchange.
On February 6, 2004, UniSource Energy declared a cash dividend of $0.16
per share on its Common Stock. The dividend was paid March 10, 2004 to
shareholders of record at the close of business February 17, 2004.
TEP declared and paid cash dividends of $80 million in 2003, $35
million in 2002 and $50 million in 2001.
K-25
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
(Restated - See Note 22 in the Consolidated Financial Statements)
--------------------------------------------------------------------------------
UniSource Energy 2003 2002 2001 2000 1999
- In Thousands -
Summary of Operations (except per share data)
-----------------------------------------------------------------------------------------------------------------------------
Operating Revenues (1) $972,755 $839,576 $1,613,304 $1,036,630 $819,623
Gain on Sale of NewEnergy - - - - $34,651
Loss Before Income Taxes of Millennium Energy
Businesses (2) $(26,350) $(30,702) $(14,455) $(12,059) $(11,276)
Income Before Extraordinary Item and Accounting
Change (1) $46,470 $34,928 $63,369 $43,484 $59,406
Net Income (1) (3) $113,941 $34,928 $63,839 $43,484 $82,003
Basic Earnings per Share:
Before Extraordinary Item & Accounting Change $1.38 $1.04 $1.90 $1.34 $1.84
Net Income $3.37 $1.04 $1.91 $1.34 $2.54
Diluted Earnings per Share:
Before Extraordinary Item & Accounting Change $1.35 $1.02 $1.86 $1.32 $1.83
Net Income $3.32 $1.02 $1.87 $1.32 $2.52
Shares of Common Stock Outstanding
Average 33,828 33,665 33,398 32,445 32,321
End of Year 33,788 33,579 33,502 33,219 32,349
Year-end Book Value per Share $16.47 $13.60 $13.17 $11.60 $10.32
Cash Dividends Declared per Share $0.60 $0.50 $0.40 $0.24 $0.08
-----------------------------------------------------------------------------------------------------------------------------
Financial Position
-----------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $2,069,215 $1,835,904 $1,832,164 $1,848,975 $1,860,733
Investments in Lease Debt and Equity $178,789 $191,867 $84,459 $71,639 $44,550
Other Investments and Other Property $109,570 $123,238 $98,288 $50,172 $69,933
Total Assets $3,122,302 $2,885,954 $2,925,937 $2,834,289 $2,804,490
Long-Term Debt (4) $1,286,320 $1,128,963 $802,804 $1,132,395 $1,135,820
Non-Current Capital Lease Obligations 762,968 801,611 853,793 857,829 880,427
Common Stock Equity 556,472 456,640 441,133 385,483 334,001
-----------------------------------------------------------------------------------------------------------------------------
Total Capitalization $2,605,760 $2,387,214 $2,097,730 $2,375,707 $2,350,248
-----------------------------------------------------------------------------------------------------------------------------
Selected Cash Flow Data
-----------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 259,642 $ 172,963 $ 215,379 $ 215,034 $113,228
Capital Expenditures $(137,282) $(112,706) $(121,735) $(105,996) $(92,808)
Other Investing Cash Flows (213,450) (158,184) 4,888 (7,554) (242)
-----------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $(350,732) $(270,890) $(116,847) $(113,550) $(93,050)
-----------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ 101,428 $ (39,299) $ (33,382) $ (83,768) $(20,057)
-----------------------------------------------------------------------------------------------------------------------------
(1) In 2003, Operating Revenues, Income Before Extraordinary Item and
Accounting Change and Net Income include results from UES for the
period from August 11, 2003 to December 31, 2003.
(2) Loss Before Income Taxes of Millennium Energy Businesses for 1999
excludes the Gain on Sale of NewEnergy.
(3) Net Income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting Change from the adoption of FAS 143 in 2003, $0.5
million for the Cumulative Effect of Accounting Change from the
Adoption of FAS 133 in 2001 and an Extraordinary Gain of $23 million
for the discontinued application of FAS 71 to generation operations in
1999.
(4) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs under TEP's Credit Agreement. TEP's obligations under
the Credit Agreement are collateralized with Second Mortgage Bonds. In
November 2002, TEP entered into two new LOCs for $341 million to
replace the LOCs provided under its then existing credit agreement that
would have expired on December 30, 2002. These new LOCs expire in 2006.
Accordingly, these IDBs were classified as short-term debt at December
31, 2001 and classified as long-term debt at December 31, 2002.
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations.
K-26
ITEM 6. - SELECTED CONSOLIDATED FINANCIAL DATA
(Restated - See Note 22 in the Consolidated Financial Statements)
--------------------------------------------------------------------------------
TEP 2003 2002 2001 2000 1999
------------------------------------------------------------------------
- Thousands of Dollars -
Summary of Operations
------------------------------------------------------------------------------------------------------------------------------
Operating Revenues $ 851,551 $ 834,447 $1,604,961 $1,031,329 $ 808,878
Income Before Extraordinary Item and Accounting
Change $ 61,442 $ 55,390 $ 77,308 $ 52,762 $ 53,774
Net Income (1) $ 128,913 $ 55,390 $ 77,778 $ 52,762 $ 76,371
------------------------------------------------------------------------------------------------------------------------------
Financial Position
------------------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net $1,832,156 $1,835,904 $1,832,164 $1,848,975 $1,860,733
Investments in Lease Debt and Equity $ 178,789 $ 191,867 $ 84,459 $ 69,474 $ 44,550
Other Investments and Other Property $ 41,285 $ 21,358 $ 21,416 $ 22,860 $ 23,288
Total Assets $2,766,630 $2,808,810 $2,824,555 $2,763,840 $2,748,743
Long-Term Debt (2) $1,126,320 $1,128,410 $ 801,924 $1,132,395 $1,135,820
Non-Current Capital Lease Obligations 762,323 801,508 853,447 857,519 880,111
Common Stock Equity 406,054 353,832 337,082 307,596 279,887
------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $2,294,697 $2,283,750 $1,992,453 $2,297,510 $2,295,818
------------------------------------------------------------------------------------------------------------------------------
Selected Cash Flow Data
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Operating Activities $ 257,788 $ 203,517 $ 261,169 $ 234,190 $ 139,957
Capital Expenditures $ (121,854) $ (103,307) $ (103,913) $ (98,063) $ (90,940)
Other Investing Cash Flows 11,408 (151,035) (8,861) (23,273) (24,480)
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Investing Activities $ (110,446) $ (254,342) $ (112,774) $ (121,336) $ (115,420)
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows From Financing Activities $ (137,858) $ (53,077) $ (77,427) $ (112,544) $ (54,371)
------------------------------------------------------------------------------------------------------------------------------
Ratio of Earnings to Fixed Charges 1.51 1.60 1.85 1.49 1.48
------------------------------------------------------------------------------------------------------------------------------
(1) Net Income includes an after-tax gain of $67 million for the Cumulative
Effect of Accounting Change from the Adoption of FAS 143 in 2003, $0.5
million for the Cumulative Effect of Account Change from the Adoption
of FAS 133 in 2001 and an Extraordinary Gain of $23 million for the
discontinued application of FAS 71 to generation operations in 1999.
(2) TEP's tax-exempt variable rate bonds in the amount of $329 million are
backed by LOCs under TEP's Credit Agreement. TEP's obligations under
the Credit Agreement are collateralized with Second Mortgage Bonds. In
November 2002, TEP entered into two new LOCs for $341 million to
replace the LOCs provided under its then existing credit agreement that
would have expired on December 30, 2002. These new LOCs expire in 2006.
Accordingly, these IDBs were classified as short-term debt at December
31, 2001 and classified as long-term debt at December 31, 2002.
Note: Disclosure of earnings per share information for TEP is not presented
as the common stock of TEP is not publicly traded.
See Item 7. - Management's Discussion and Analysis of Financial
Condition and Results of Operations.
K-27
NON-GAAP MEASURES
Adjusted EBITDA
---------------
Adjusted EBITDA represents EBITDA excluding the cumulative effect of
accounting change which is a non-cash item. EBITDA is earnings before interest,
taxes, depreciation and amortization. Adjusted EBITDA is presented here as a
measure of liquidity because it can be used as an indication of a company's
ability to incur and service debt and is commonly used as an analytical
indicator in our industry. Adjusted EBITDA measures presented may not be
comparable to similarly titled measures used by other companies. Adjusted EBITDA
is not a measurement presented in accordance with United States generally
accepted accounting principles (GAAP), and we do not intend Adjusted EBITDA to
represent cash flows from operations as defined by GAAP. Adjusted EBITDA should
not be considered to be an alternative to cash flows from operations or any
other items calculated in accordance with GAAP or an indicator of our operating
performance.
UniSource Energy and TEP view Adjusted EBITDA, a non-GAAP financial
measure, as a liquidity measure. The most directly comparable GAAP measure to
Adjusted EBITDA is Net Cash Flows from Operating Activities.
Adjusted EBITDA and Net Cash Flows from Operating Activities
Restated - See Note 22 in the Consolidated Financial Statements
UniSource Energy 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Adjusted EBITDA $395 $366 $419 $361
Net Cash Flows from
Operating Activities $260 $173 $215 $215
------------------------------------------------------------------------------------------------------
TEP 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Adjusted EBITDA $403 $399 $439 $383
Net Cash Flows from
Operating Activities $258 $204 $261 $234
------------------------------------------------------------------------------------------------------
K-28
Reconciliation of Adjusted EBITDA to Cash Flows from Operations
Restated - See Note 22 in the Consolidated Financial Statements
UniSource Energy 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Adjusted EBITDA (1) $395 $366 $419 $361
Amounts from the Income Statements:
Less: Income Taxes (12) (18) (49) (16)
Less: Total Interest Expense (167) (155) (159) (166)
Changes in Assets and Liabilities and Other
Non-Cash Items 44 (20) 4 36
------------------------------------------------------------------------------------------------------
Net Cash Flows from Operating Activities $260 $173 $215 $215
------------------------------------------------------------------------------------------------------
Restated - See Note 22 in the Consolidated Financial Statements
TEP 2003 2002 2001 2000
------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Adjusted EBITDA (1) $403 $399 $439 $383
Amounts from the Income Statements:
Less: Income Taxes (21) (36) (58) (28)
Less: Total Interest Expense (161) (154) (158) (166)
Changes in Assets and Liabilities and Other
Non-Cash Items 37 (5) 38 45
------------------------------------------------------------------------------------------------------
Net Cash Flows from Operating Activities $258 $204 $261 $234
------------------------------------------------------------------------------------------------------
(1) Adjusted EBITDA was calculated as follows (Restated - See Note 22 in the
Consolidated Financial Statements):
UniSource Energy 2003 2002 2001 2000
-------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Net Income $114 $ 35 $ 63 $ 43
Amounts from the Income Statements:
Less: Cumulative Effect of Accounting Change (67) - (1) -
Plus: Income Taxes 12 18 49 16
Plus: Total Interest Expense 167 155 159 166
Plus: Depreciation and Amortization 131 128 120 114
Plus: Amortization of Transition Recovery Asset 32 24 23 17
Plus: Depreciation included in Fuel and Other
O&M Expense (see Note 20 of Notes to
Consolidated Financial Statements) 6 6 6 5
-------------------------------------------------------------------------------------------------------------
Adjusted EBITDA $395 $366 $419 $361
-------------------------------------------------------------------------------------------------------------
K-29
TEP 2003 2002 2001 2000
-------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Net Income $129 $ 55 $ 78 $ 53
Amounts from the Income Statements:
Less: Cumulative Effect of Accounting Change (67) - (1) -
Plus: Income Taxes 21 36 58 28
Plus: Total Interest Expense 161 154 158 166
Plus: Depreciation and Amortization 121 124 117 114
Plus: Amortization of Transition Recovery Asset 32 24 23 17
Plus: Depreciation included in Fuel and Other
O&M Expense (see Note 20 of Notes to
Consolidated Financial Statements) 6 6 6 5
-------------------------------------------------------------------------------------------------------------
Adjusted EBITDA $403 $399 $439 $383
-------------------------------------------------------------------------------------------------------------
Net Debt and Total Debt and Capital Lease Obligations--TEP
As of December 31, 2003 2002 2001 2000
-------------------------------------------------------------------------------------
-Millions of Dollars-
Net Debt $1,761 $1,783 $1,921 $1,944
Total Debt and Capital
Lease Obligations $1,940 $1,975 $2,005 $2,013
-------------------------------------------------------------------------------------
Net Debt represents the current and non-current portions of TEP's
long-term debt and capital lease obligations less investment in lease debt. We
have subtracted investment in lease debt because it represents TEP's ownership
of its own capital lease obligations. Net Debt measures presented may not be
comparable to similarly titled measures used by other companies. Net Debt is not
a measurement presented in accordance with GAAP and we do not intend Net Debt to
represent debt as defined by GAAP. You should not consider Net Debt to be an
alternative to debt or any other items calculated in accordance with GAAP.
K-30
Reconciliation of Total Debt and Capital Lease Obligations to Net Debt
As of December 31, 2003 2002 2001 2000
-------------------------------------------------------------------------------------
-Millions of Dollars-
Long-Term Debt $1,126 $1,128 $802 $1,132
Current Portion -
Long-Term Debt 2 2 330 2
-------------------------------------------------------------------------------------
Total Debt 1,128 1,130 1,132 1,134
-------------------------------------------------------------------------------------
Capital Lease Obligations 762 802 853 858
Current Portion -
Capital Lease Obligations 50 43 20 21
-------------------------------------------------------------------------------------
Total Debt and
Capital Lease Obligations 1,940 1,975 2,005 2,013
-------------------------------------------------------------------------------------
Investment in Lease Debt (179) (192) (84) (69)
-------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------
Net Debt $1,761 $1,783 $1,921 $1,944
=====================================================================================
K-31
ITEM 7.-- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
--------------------------------------------------------------------------------
Certain information in Management's Discussion and Analysis of
Financial Condition and Results of Operations for UniSource Energy and TEP has
been restated. For further information, see Note 22 in Notes to
Consolidated Financial Statements.
Management's Discussion and Analysis explains the results of
operations, the general financial condition, and the outlook for UniSource
Energy and its four primary business segments and includes the following:
o outlook and strategy,
o operating results during 2003 compared with 2002, and 2002 compared
with 2001,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting policies.
TEP is the principal operating subsidiary of UniSource Energy and, at
December 31, 2003, represented approximately 86% of its assets.
The seasonal nature of TEP's business causes operating results to vary
significantly from quarter to quarter. UniSource Energy's results for 2003
include 143 days of operations of UES. Due to sales of both winter-peaking gas
and summer-peaking electricity, UES' consolidated operating results are expected
to be less seasonal than TEP's. Although representing approximately 5% of
UniSource Energy's total assets, net losses from Millennium's unregulated
businesses have had a significant impact on earnings reported by UniSource
Energy for 2003, 2002 and 2001. UED's unregulated business segment, which was
established in February 2001, had a significant impact on consolidated net
income and cash flows in 2003 due to the financial closing of Springerville Unit
3 which occurred on October 21, 2003. UED is not expected to significantly
impact net income or cash flows in future periods.
UNISOURCE ENERGY CONSOLIDATED
OUTLOOK AND STRATEGIES
Agreement and Plan of Merger
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp.
entered into an acquisition agreement, providing for the acquisition of all of
the common stock of UniSource Energy for $25.25 per share by an affiliate of
Saguaro Utility.
Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp. will merge with and into UniSource Energy. UniSource Energy will be the
surviving corporation, but will become an indirect wholly-owned subsidiary of
Saguaro Utility. Trading in our common stock on the New York Stock Exchange and
the Pacific Exchange will cease immediately as of the effective time of the
acquisition. After that time, the surviving corporation will delist our shares
from the New York Stock Exchange and the Pacific Exchange and de-register our
shares under the Securities Exchange Act of 1934, as amended. UniSource Energy's
and TEP's headquarters will remain in Tucson, and we expect that UniSource
Energy's and TEP's senior management team will remain generally the same.
Subject to the satisfaction of various closing conditions, including the receipt
of our shareholders' approval and required regulatory approvals, we expect the
acquisition to close in the second half of 2004.
Upon consummation of the acquisition, Saguaro Utility will cause the
surviving corporation to pay approximately $880 million in cash to UniSource
Energy's shareholders and holders of stock options, stock units, restricted
stock, and performance shares awarded under our stock-based compensation plans.
In addition, Saguaro Utility intends to cause the surviving corporation (i) to
repay the $95 million inter-company loan to UniSource Energy from TEP and (ii)
to contribute up to $168 million to TEP. TEP will use a significant portion of
these proceeds to retire some of its outstanding debt.
K-32
Operating Plans and Strategies
Our financial prospects and outlook for the next few years will be
affected by many competitive, regulatory and economic factors. Our plans and
strategies include the following:
o Obtain all necessary regulatory approvals and the required shareholder
approval and satisfy all of the other closing conditions contained in
the acquisition agreement so that the acquisition of UniSource Energy
by an affiliate of Saguaro Utility can occur in a timely manner.
o Integrate UES' businesses with UniSource Energy's other businesses to
achieve the strategic and financial objectives of the acquisition.
o Oversee the construction of Springerville Unit 3 and continue to
enhance the value of existing assets by working with SRP to facilitate
the development of Springerville Unit 4.
o Enhance the value of TEP's transmission system while continuing to
provide reliable access to generation for TEP's retail customers and
market access for all generating assets. This will include focusing on
completing the Tucson - Nogales transmission line, which could
eventually be connected to Mexico's utility system and improve
reliability for customers of UNS Electric.
o Improve the value of our existing Millennium investments.
o Improve production and sales of Global Solar's thin-film photovoltaic
cells and seek strategic partners.
o Reduce TEP's debt, using some of our excess cash flows.
o Efficiently manage TEP's generating resources and look for ways to
reduce or control our operating expenses while maintaining and
enhancing reliability and profitability.
To accomplish our goals, during 2004 we expect TEP to spend
approximately $106 million on capital expenditures and UES to spend
approximately $37 million on capital expenditures.
While we believe that our plans and strategies will continue to have a
positive impact on our financial prospects and position, we recognize that we
continue to be highly leveraged, and as a result, our access to the capital
markets may be limited or more expensive than for less leveraged companies.
RESULTS OF OPERATIONS
---------------------
UniSource Energy recorded Net Income of $114 million in 2003, including
an after-tax gain of $67 million for the Cumulative Effect of Accounting Change
from the adoption of Statement of Financial Accounting Standards No. 143,
Accounting for Asset Retirement Obligations (FAS 143). Income Before Cumulative
Effect of Accounting Change was $46 million. This compares with Net Income of
$35 million in 2002 and $64 million in 2001.
Change in Net Income, 2003 Compared With 2002
o A $133 million increase in Total Operating Revenues resulting from warm
summer weather, a 2.2% increase in TEP's number of retail customers,
and $103 million of Total Operating Revenues at UES.
o A $6 million decline in TEP's revenues from Electric Wholesale Sales is
primarily attributable to unplanned outages at several of TEP's
coal-fired generating facilities during the first half of 2003,
unfavorable wholesale opportunities for its gas generation resources
and record retail kWh demand in the third quarter. In addition, TEP
recorded a $2 million increase in reserves against receivables from
California wholesale sales in 2003.
K-33
o Purchased Energy expense, which includes purchased power and purchased
gas expense, was higher by $92 million. This resulted from $70 million
of Purchased Energy expense at UES, replacement power costs in the
first half of 2003 related to planned and unplanned outages at TEP's
generating facilities, and increased economic wholesale electric
purchases in lieu of running gas-fired generation.
o Other O&M was higher by $25 million due primarily to $15 million of O&M
at UES and increased costs resulting from planned and unplanned outages
at TEP's generating facilities.
o Higher Total Interest Expense of $12 million related to higher interest
rates under TEP's Credit Agreement, interest expense at UES, and
interest expense related to UniSource Energy's borrowing under a bridge
loan for the Citizens Acquisition.
o Despite higher Income Before Taxes and Cumulative Effect of Accounting
Change, income tax expense was $6 million less in 2003 than in 2002,
due primarily to a $15 million tax benefit resulting from guidance
issued by the IRS clarifying rules on limitations of the use of net
operating loss carry forwards.
o Expenses of $3 million related to the proposed acquisition of UniSource
Energy.
o UED's income in 2003 included an $11 million pre-tax development fee
received at the financial closing of Springerville Unit 3.
o 2002 results included a pre-tax coal contract termination fee of $11
million. TEP terminated a coal contract related to the Sundt Generating
Station, eliminating annual take-or-pay payments of approximately $3
million.
Change in Net Income, 2002 Compared With 2001
o TEP's wholesale revenues decreased by $764 million due to significantly
lower prices in the western U.S. energy markets and decreased sales
activity, partially offset by a reduction of $738 million in fuel and
purchased power expenses.
o Mild weather and lower demand from TEP's mining customers contributed
to lower retail energy sales and revenues in 2002. Despite these
factors, retail revenues fell only one percent due to continued strong
growth in number of retail customers and increased usage by residential
and commercial customers.
o TEP recorded an $11 million coal contract termination fee in the third
quarter of 2002.
o Millennium's after-tax losses were $7 million higher in 2002 than 2001
because 2001 results included a $6 million after-tax gain on the sale
of a power project.
o TEP recognized $5 million in tax benefits from the favorable settlement
of IRS audits and the recognition of tax credits in 2002, and
Millennium recognized $2 million in tax benefits from the recognition
of foreign tax losses and favorable settlement of IRS audits.
CONTRIBUTION BY BUSINESS SEGMENT
The table below shows the contributions to our consolidated after-tax
earnings by our four business segments, as well as parent company expenses.
Restated - See Note 22 in the Consolidated Financial Statements
2003 2002 2001
--------------------------------------------------------------------------------
Business Segment - Millions of Dollars -
TEP (1) $129 $ 55 $ 78
UES (2) 3 - -
Millennium (16) (16) (9)
UED 7 1 1
UniSource Energy Standalone (3) (9) (5) (6)
--------------------------------------------------------------------------------
Consolidated Net Income $114 $ 35 $ 64
================================================================================
K-34
(1) TEP results in 2003 include an after-tax gain of $67 million for
the Cumulative Effect of Accounting Change from the adoption of FAS
143.
(2) Results are for the period from August 11, 2003 to December 31,
2003.
(3) Primarily represents interest expense (net of tax) on the note
payable from UniSource Energy to TEP, as well as costs in 2003
associated with the Citizens acquisition and the proposed acquisition
of UniSource Energy as previously discussed.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UNISOURCE ENERGY CONSOLIDATED CASH FLOWS
2003 2002 2001
--------------------------------------------------------------------------------
-Millions of Dollars -
Cash provided by (used in):
Operating Activities $ 260 $ 173 $ 215
Investing Activities (351) (271) (117)
Financing Activities 101 (39) (33)
--------------------------------------------------------------------------------
Net Increase (Decrease) in Cash $ 10 $ (137) $ 65
================================================================================
UniSource Energy's consolidated cash flows are provided primarily from
retail and wholesale energy sales at TEP and UES, net of the related payments
for fuel and purchased power. Cash from operations is lowest in the first
quarter and highest in the third quarter due to TEP's summer peaking load.
We use our available cash primarily to:
o finance capital expenditures at TEP and UES;
o make investments in our technology affiliates;
o pay dividends to shareholders; and
o reduce leverage at TEP by repaying high coupon debt and investing in
lease debt.
The primary source of liquidity for UniSource Energy, the parent
company, is dividends it receives from its subsidiaries, primarily TEP, from
their cash flow from operations.
Accrued interest on UniSource Energy's promissory note to TEP of
approximately $20 million is payable every two years; the last payment of $20
million was made to TEP in December 2003. Under our tax allocation procedures
our subsidiaries make income tax payments to UniSource Energy, which makes
payments on behalf of the consolidated group.
In August 2003, UniSource Energy used approximately $50 million of its
available cash and borrowed $35 million from a financial institution in the form
of short-term debt to help finance the purchase of the Citizens Arizona electric
and gas utility assets. The funds were used as an equity contribution in the
capitalization of UES. On October 24, 2003, as required by the debt agreement,
UniSource Energy repaid the $35 million loan upon the financial close of the
Springerville Unit 3 project.
As of March 10, 2004, cash and cash equivalents available to UniSource
Energy was approximately $79 million.
In addition, as part of our ACC Holding Company Order, we must invest
at least 30% of any proceeds of UniSource Energy equity issuances in TEP until
TEP's equity reaches 37.5% of total capital (excluding capital leases).
Operating Activities
In 2003, net cash flows from operating activities increased by $87
million compared with 2002. The following factors contributed to the increase:
K-35
o receipt of $43 million in proceeds for the financial closing of the
Springerville Unit 3 project;
o a $23 million decrease in income taxes paid due primarily to lower
taxable income;
o a $22 million increase in cash receipts from retail and wholesale
energy customers, net of fuel and purchased energy costs, due to warm
summer weather, an increase in TEP's retail customers and energy sales
at UES;
o a $16 million increase in income tax refunds of taxes previously paid,
which was received in the fourth quarter of 2003;
o a $9 million increase in interest received due to interest received on
investments in lease debt; and
o a $27 million cash payment made in 2002 to terminate and amend coal
contracts; partially offset by:
o a $17 million increase in interest paid (including capital lease
interest paid), due primarily to higher letter of credit fees
under TEP's Credit Agreement;
o a $17 million deposit by TEP in 2003 with its second mortgage
trustee; and
o a $4 million increase in other taxes paid.
Investing Activities
Net cash used for investing activities was $80 million higher in 2003
than in 2002, primarily due to the following factors:
o $223 million for the acquisition of the Citizens Arizona gas and
electric utility assets; and
o a $25 million increase in capital expenditures at TEP and UES, due in
part to $10 million spent to complete a new one mile 500-kV
transmission line and related substations to enhance TEP's distribution
system link to the regional high-voltage transmission system; partially
offset by:
o a $22 million decline in investments and loans to equity
investees. In 2002, $20 million was invested in Sabinas; and
o In 2002, TEP paid $138 million to purchase Springerville Lease
debt; in 2003, TEP received principal payments related to its
investment in Springerville Lease debt of $12 million.
Financing Activities
Net cash provided by financing activities was $101 million in 2003,
compared with net cash used for financing activities of $39 million in 2002.
o In 2003, UNS Gas and UNS Electric issued $160 million aggregate
principal amount of senior unsecured notes in a private placement to
provide funding for the acquisition of the Citizens' Arizona gas and
electric utility assets.
o TEP retired $23 million more of its capital lease obligations in 2003
than in 2002.
o UniSource Energy paid $3 million more in common stock dividends in 2003
than in 2002.
As a result of the activities described above, our consolidated cash
and cash equivalents increased to $101 million at December 31, 2003, from $91
million at December 31, 2002. At March 10, 2004, our consolidated cash balance,
including cash equivalents, was approximately $79 million. We invest cash
balances in high-grade money market securities with an emphasis on preserving
the principal amounts
K-36
invested.
In the event that we experience lower cash from operations in 2004, we
will adjust our discretionary uses of cash accordingly. We believe, however,
that we will continue to have sufficient cash flow to cover our capital needs,
as well as required debt payments and dividends to shareholders. Furthermore, we
believe we will have sufficient excess cash flow to continue to make annual
discretionary debt reductions or lease debt investments at TEP in the range of
$30 - $50 million.
GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain
subsidiaries, including TEP, enter into various agreements providing financial
or performance assurance to third parties on behalf of certain subsidiaries. We
entered into these agreements primarily to support or enhance the
creditworthiness of a subsidiary on a stand-alone basis. The most significant of
these guarantees are UES' guarantee of $160 million of aggregate principal
amount of senior unsecured notes issued by UNS Gas and UNS Electric to purchase
the Citizens' Arizona gas and electric system assets, UniSource Energy's
guarantee of approximately $22 million in natural gas and supply payments and
building lease payments for UNS Gas and UES, and subsidiaries of Millennium
guarantee of approximately $5 million in commodity-related payments for MEG at
December 31, 2003. To the extent liabilities exist under the contracts subject
to these guarantees, such liabilities are included in the consolidated balance
sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale. The terms of the indemnifications provide for no
limitation on potential future payments; however, we believe that we have abided
by all tax laws and paid all tax obligations. We have not made any payments
under the terms of these indemnifications to date.
We believe that the likelihood that UniSource Energy or TEP would be
required to perform or otherwise incur any significant losses associated with
any of these guarantees is remote.
CONTRACTUAL OBLIGATIONS
The following charts display UniSource Energy's consolidated
contractual obligations by maturity and by type of obligation as of December 31,
2003.
----------------------------------------------------------------------------------------------------------------------------------
UniSource Energy's Contractual Obligations
- Millions of Dollars -
----------------------------------------------------------------------------------------------------------------------------------
Payments
Due in IDBs Pension and
Years Supported Capital Other Total
Ending by Long- Lease Purchase Postretirement Funding Contractual
December Expiring Term Obligations Operating Obligations Benefit Commitments Cash
31, LOCs(1) Debt (2) Leases (3) Obligations(4) (5) Obligations
----------------------------------------------------------------------------------------------------------------------------------
2004 $ - $ 2 $120 $ 3 $113 $ 6 $ 4 $ 248
2005 - 2 120 2 97 3 3 227
2006 329 21 123 2 95 4 3 577
2007 - 1 126 2 82 4 1 216
2008 - 89 121 1 82 5 - 298
----------------------------------------------------------------------------------------------------------------------------------
Total 2004 -
2008 329 115 610 10 469 22 11 1,566
Thereafter - 844 836 6 436 177 - 2,299
Less: Imputed
Interest - - (633) - - - - (633)
----------------------------------------------------------------------------------------------------------------------------------
Total $329 $959 $813 $16 $905 $199 $11 $3,232
==================================================================================================================================
(1) TEP's tax-exempt variable rate bonds (IDBs) in the amount of $329
million are backed by LOCs issued pursuant to TEP's Credit Agreement.
TEP's obligations under the Credit Agreement are collateralized with
Second Mortgage Bonds.
(2) See TEP's Capital Lease Obligations table in Tucson Electric Power
Company, Liquidity and Capital Resources, below.
(3) These obligations represent future minimum payments under open purchase
orders, UES' transmission and gas transportation contracts and TEP's
natural gas, coal and rail transportation contracts. The total amount
paid under these contracts depends on the quantity purchased and
transported. UES and TEP's requirements are expected to be in excess of
these minimums. TEP expects to
K-37
spend approximately $175 million annually for the purchase and
transportation of coal through 2010. TEP is unable to estimate how much
it will spend under these contracts beyond 2010 due to the impact of
the new Springerville coal contract.
UES and TEP do not have any minimum gas commodity purchase obligations,
and are unable to estimate the amounts payable under the gas and
purchase power contracts due to the variability of gas prices and
customer load and interplay of generation costs and wholesale market
prices. UniSource Energy has not included in the minimum purchase
obligations above amounts payable to PWCC as payments under this
contract are usage based with no fixed demand charges. We expect to
spend approximately $92 million annually under this contract through
May 2008. In addition, 2004 includes $10 million in contingent
transaction fees payable upon the closing of the acquisition of
UniSource Energy by Saguaro Utility.
(4) These obligations represent TEP and UES' minimum required contributions
to pension plans in 2004 and TEP's expected postretirement benefit
costs to cover medical and life insurance claims as determined by the
plans' actuaries. TEP and UES do not know and have not included pension
contributions beyond 2004 due to the significant impact that returns on
plan assets and changes in discount rates might have on such amounts.
TEP funds the postretirement benefit plan on a pay-as-you-go basis.
(5) These obligations represent Millennium's equity commitments to fund
subsidiaries (Haddington and Valley Ventures) as suitable investments
are identified.
MEG conducts its emissions and coal trading activities using certain
contracts which contain provisions whereby MEG may be required to post margin
collateral due to a change in contract values. As of December 31, 2003, MEG had
posted $0.7 million in cash collateral to its trading counterparties.
MEG has a $5 million bank line of credit for the purpose of issuing
LOCs to counterparties to support its emission allowance and coal marketing and
trading activities. As of December 31, 2003, MEG had $5 million in outstanding
LOCs. This facility expires in March 2005.
In addition, UniSource Energy has contingent obligations under various
surety bonds that total approximately $0.5 million.
We have reviewed our contractual obligations and provide the following
additional information:
o We do not have any provisions in any of our debt or lease agreements
that would cause an event of default or cause amounts to become due and
payable in the event of a credit rating downgrade.
o None of our contracts or financing structures contains provisions or
acceleration clauses due to changes in our stock price.
DIVIDENDS ON COMMON STOCK
On February 6, 2004, UniSource Energy declared a cash dividend of $0.16
per share on its Common Stock. The dividend, totaling approximately $5 million,
was paid March 10, 2004 to shareholders of record at the close of business
February 17, 2004. During 2003, UniSource Energy paid quarterly dividends to its
shareholders of $0.15, totaling approximately $20 million. In 2002, we paid
quarterly dividends of $0.125 per share, totaling approximately $17 million.
The acquisition agreement allows UniSource Energy to continue to pay
regular quarterly cash dividends until the closing of the acquisition, subject
to limitations upon our ability to increase the amount of such dividends.
UniSource Energy's Board of Directors currently expects to continue to pay
regular quarterly cash dividends on UniSource Energy's Common Stock until the
closing of the acquisition, subject, however, to its evaluation of our financial
condition, earnings, cash flows and dividend policy.
INCOME TAX POSITION
At December 31, 2003, UniSource Energy and TEP had, for federal and
state income tax filing purposes, the following carryforward amounts (Restated -
See Note 22 in the Consolidated Financial Statements):
UniSource Energy TEP
-------------------------------------------------------------
Amount Expiring Amount Expiring
-------------------------------------------------------------
-Millions -Millions
of Dollars- Year of Dollars- Year
--------------------------------------------------------------------------------
Net Operating Losses $ 55 2006-2023 $ 32 2006-2009
Investment Tax Credit 8 2004-2023 8 2004-2023
AMT Credit 88 - 85 -
--------------------------------------------------------------------------------
K-38
Of the $55 million in NOL carryforwards, $18 million is subject to
limitation. Due to a reorganization of certain Millennium entities in December,
2002, $18 million of Federal and State net operating losses are subject to
limitation. The future utilization of these losses is dependant upon the
generation of sufficient future taxable income at the separate company level.
See Critical Accounting Policies, Deferred Tax Valuation - TEP and Millennium,
below.
TUCSON ELECTRIC POWER COMPANY
RESULTS OF OPERATIONS
---------------------
The financial condition and results of operations of TEP are currently
the principal factors affecting the financial condition and results of
operations of UniSource Energy on an annual basis. The following discussion
relates to TEP's utility operations, unless otherwise noted.
UTILITY SALES AND REVENUES
Customer growth, weather and other consumption factors affect retail
sales of electricity. Electric wholesale revenues are affected by market prices
in the wholesale energy market, availability of TEP generating resources, and
the level of wholesale forward contract activity.
The table below provides trend information on retail sales by major
customer class and electric wholesale sales made by TEP in the last three years.
Restated - See Note 22 in the Consolidated Financial Statements
Sales Operating Revenue
2003 2002 2001 2003 2002 2001
-------------------------------------------------------------------------------------------------------------
- Millions of kWh - - Millions of Dollars -
Electric Retail Sales:
Residential 3,390 3,181 3,160 $ 310 $ 291 $ 286
Commercial 1,689 1,605 1,592 176 169 166
Industrial 2,245 2,254 2,297 160 162 162
Mining 702 693 1,053 28 28 42
Public Authorities 250 257 257 18 19 19
-------------------------------------------------------------------------------------------------------------
Total Electric Retail Sales 8,276 7,990 8,359 692 669 675
-------------------------------------------------------------------------------------------------------------
Electric Wholesale Sales Delivered:
Long-term Contracts 1,199 982 1,218 31 29 24
Other Sales 2,165 3,035 5,515 115 125 705
Transmission - - - 6 4 4
Net Unrealized Gain (Loss) on
Forward Sales of Energy - - - (1) (1) 188
-------------------------------------------------------------------------------------------------------------
Total Electric Wholesale Sales 3,364 4,017 6,733 151 157 921
-------------------------------------------------------------------------------------------------------------
Total 11,640 12,007 15,092 $ 843 $ 826 $1,596
=============================================================================================================
2003 Compared with 2002
Total retail kWh sales in 2003 increased by 4% compared with 2002. Hot
summer weather and a 2.2% increase in the number of retail customers more than
offset mild weather during the first six months of 2003. Cooling degree days
increased by 9% in 2003 compared with 2002, and were up 8% compared with the
10-year average. Kilowatt-hour sales to residential customers were up 7% and kWh
sales to commercial customers were up 5% in 2003, resulting from customer growth
and warmer weather compared with a year ago. Revenue from sales to retail
customers increased by 3% in 2003, reflecting higher kWh demand.
Electric wholesale revenues delivered decreased by 4% in 2003. The 4%
decline in wholesale revenues is not as large as the 16% decline in wholesale
kWh sales due to higher average power prices. Average-around-the-clock energy
prices based on the Dow Jones Palo Verde Index for 2003 were $42 per MWh
compared with $27 per MWh during 2002, reflecting higher gas prices. Planned and
unplanned outages at
K-39
TEP's coal-fired generating plants, particularly in the
first six months of 2003, reduced opportunities to sell excess power in the
wholesale markets. In addition, the increase in the regional supply of
gas-generated energy caused TEP to decrease use of its less efficient gas
generation units for wholesale market opportunities.
In addition, wholesale revenues were reduced by a $2 million reserve
for doubtful accounts recorded in the first quarter related to wholesale sales
made to the California Independent System Operator (CISO) and the California
Power Exchange (CPX) in 2001 and 2000. See Payment Defaults and Allowances for
Doubtful Accounts, below.
2002 Compared with 2001
TEP's average number of retail customers increased by 2.4%, while kWh
sales to retail customers decreased by 4%. This decrease in kWh energy sales was
primarily due to a 33% reduction in sales to mining customers. KWh sales to
residential, commercial and industrial customers as a group remained relatively
flat in 2002, despite milder temperatures.
Electric wholesale sales decreased by 33% while revenues decreased by
83%. A decline in sales activity and market prices were contributing factors.
The average market price for around-the-clock energy decreased $67 per MWh,
compared with 2001. Factors contributing to the lower market prices included
more generation online in the western U.S., lower natural gas prices, increased
hydropower supply, and weaker demand. Sales and revenues from forward contracts
experienced the largest declines. Short-term sales were higher, however, due to
sales of excess energy in the daily and hourly markets.
OPERATING EXPENSES
2003 Compared with 2002
Fuel and Purchased Power Expense
Fuel expense at TEP's generating plants was approximately $210 million
in both 2003 and 2002. Despite running its gas-fired generation less in 2003,
fuel expense remained the same due to higher gas prices and higher output from
TEP's coal-fired generation.
The table below shows the average cost per kWh for TEP's generating
plants by fuel type.
2003 2002 2001
------------------------------------------------------
-cents per kWh-
Coal 1.65 1.65 1.65
Gas 7.40 4.45 7.05
All fuels 1.87 1.83 2.13
-------------------------------------------------------
The increase in the regional supply of new gas-generated energy and the
completion of a 500-kV transmission connection allowed TEP to decrease use of
its older, less efficient gas generation units in favor of more economical
purchases of energy in the wholesale market. TEP's Purchased Power expense
increased approximately $22 million, or 51%, in 2003. In addition to energy
purchases made during the third quarter of 2003, TEP purchased replacement power
during the first half of 2003 due to planned and unplanned outages at some of
its generating facilities.
Other Operating Expenses
Other Operations and Maintenance expense increased by $6 million, or
4%, in 2003 primarily attributable to unplanned outages and longer-than-expected
planned outages at some of TEP's generating facilities during the first quarter
of 2003.
Depreciation and Amortization expense decreased $3 million in 2003. The
adoption of FAS 143 in the first quarter of 2003 resulted in a $6 million
decrease because asset retirement costs are no longer recorded as
K-40
a component of depreciation expense. See Critical Accounting Policies,
Accounting for Asset Retirement Obligations, below.
Amortization of the Transition Recovery Asset (TRA) increased $7
million in 2003 compared with 2002. Amortization of the TRA is the result of the
1999 Settlement Agreement (TEP Settlement Agreement) with the ACC, which changed
the accounting method for TEP's generation operations. This item reflects the
recovery, through 2008, of transition recovery assets which were previously
regulatory assets of the generation business. The amount of amortization is a
function of the TRA balance and total kWh consumption by TEP's distribution
customers.
The table below shows estimated TRA amortization and unamortized TRA
balances for 2004-2008.
Restated - See Note 22 in the Consolidated Financial Statements
Future Estimated Unamortized
TRA Amortization TRA Balance
-Millions of Dollars-
------------------------------------------------------------
2004 $ 49 $ 225
2005 57 168
2006 66 102
2007 76 26
2008 26 -
------------------------------------------------------------
Other Income (Deductions)
TEP's income statement includes inter-company Interest Income of $10
million for 2003, and $9 million for 2002. This represents Interest Income on
the promissory note TEP received from UniSource Energy in exchange for the
transfer to UniSource Energy of its stock in Millennium in 1998. On UniSource
Energy's Consolidated Statement of Income, this Interest Income, as well as
UniSource Energy's related interest expense, is eliminated as an inter-company
transaction. Interest Income remained unchanged between 2003 and 2002.
Interest Expense
Long-Term Debt Interest Expense increased by $11 million, or 17%, in
2003 due to higher Letter of Credit fees under TEP's Credit Agreement entered
into in November, 2002. Interest on Capital Leases decreased $4 million in 2003
due to scheduled repayments of lease debt.
Income Tax Expense
Income Tax Expense, before Cumulative Effect of Accounting Change,
decreased $15 million in 2003 compared with 2002, due primarily to a $15 million
tax benefit resulting from guidance issued by the IRS clarifying rules on
limitations of the use of net operating loss carry forwards.
Cumulative Effect of Accounting Change
TEP adopted FAS 143 on January 1, 2003 and recorded a one-time $67
million after-tax gain. Upon adoption of FAS 143, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1 million;
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $113 million of costs previously accrued for final removal recorded in
accumulated depreciation, and reversed previously recorded deferred tax assets
of $44 million. Adopting FAS 143 results in a reduction to depreciation expense
charged throughout the year as well because asset retirement costs are no longer
recorded as a component of depreciation expense. For the year 2003, the
reduction in depreciation expense is approximately $6 million. See Critical
Accounting Policies, Accounting for Asset Retirement Obligations, below.
K-41
2002 Compared with 2001
Fuel and Purchased Power Expense
Fuel expense at TEP's generating plants decreased by $49 million, or
19%, in 2002 primarily attributable to lower wholesale demand, which resulted in
decreased natural gas usage for generation. Contributing to higher fuel expense
in 2001 was approximately $9 million in costs associated with two gas swap
agreements entered into in May 2001 to hedge the risk of price fluctuation. Fuel
expense in 2002 included $2.3 million related to an arbitration ruling that
increased the price of coal purchased between 1997 and May 2002 for the Navajo
Generating Facility. See Item 7A. - Quantitative and Qualitative Disclosures
about Market Risk, below.
Purchased Power expense decreased by $688 million, or 94%, due
principally to decreased volume of wholesale forward contract activity and
significantly lower wholesale prices. In 2001, TEP incurred approximately $12
million in additional costs from several forward purchase contracts that were
entered into in May 2001 to assure service reliability in the summer months. TEP
paid an average price of $186 per MWh for those forward contracts in 2001. TEP
entered into similar contracts in 2002 at an average price of $37 per MWh.
Forward purchase contract activity decreased corresponding with the reduction in
forward sales activity discussed above.
Other Operating Expense
TEP recorded an $11 million (pre-tax) charge in the third quarter of
2002 as a result of terminating the Sundt long-term coal supply agreement. This
expense is off-set by the elimination of future take-or-pay payments of up to $3
million annually.
Other Operations and Maintenance expense increased by $5 million, or
3%, in 2002 due primarily to a $2 million increase in pension and
post-retirement medical benefit costs and maintenance at the Four Corners and
Springerville generating stations.
Depreciation and Amortization expense increased by $7 million, or 6%,
in 2002 compared with 2001. Depreciation expense increased due to depreciation
of solar generating facilities and a $125 million increase in the depreciable
asset base, which represents: (i) new line extensions to support new business,
(ii) the addition of a 75 MW gas turbine placed in-service in June 2001, and
(iii) routine improvements to TEP's system. These increases were partially
offset by reduced depreciation resulting from a change in the second quarter of
2002 to increase the estimated useful lives of gas-fired generating units and
internal combustion turbines located in Tucson. See Note 9 of Notes to
Consolidated Financial Statements - Utility Plant and Jointly-Owned Facilities.
TRA amortization increased by $2 million in 2002 compared with 2001.
Other Income (Deductions)
TEP's income statement for both 2002 and 2001 includes interest income
of $9 million on its promissory note from UniSource Energy.
Interest Income was $8 million higher in 2002 due to interest received
on TEP's additional $132 million investment in Springerville lease debt in 2002.
Interest Expense
Interest Expense was $5 million, or 3% lower in 2002 than in 2001 due
to lower average interest rates on variable rate tax-exempt debt and lower debt
balances.
Income Tax Expense
Income taxes decreased $21 million in 2002 compared with 2001 due
primarily to lower pre-tax income, a $1 million tax benefit from the reduction
of the valuation allowance and the favorable settlement of an IRS audit in the
third quarter of 2002, and $4 million in tax credits recognized in 2002.
K-42
See Note 15 of Notes to Consolidated Financial Statements - Commitments
and Contingencies.
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
COMPETITION
The electric utility industry has undergone significant regulatory
change in the last few years designed to encourage competition in the sale of
electricity and related services. However, the recent experience in California
with deregulation has caused many states, including Arizona, to re-examine the
viability of retail electric deregulation.
As of January 1, 2001, all of TEP's retail customers are eligible to
choose an alternate energy supplier. Although there is one Energy Service
Provider (ESP) certified to provide service in TEP's retail service area,
currently none of TEP's retail customers are receiving service from this ESP.
TEP has met all conditions required by the ACC to facilitate electric retail
competition, including ACC approval of TEP's direct access tariffs. ESPs must
meet certain conditions before electricity can be sold competitively in TEP's
service territory. Examples of these conditions include ACC certification of
ESPs, and execution of and compliance with direct access service agreements with
TEP.
On January 27, 2004, the Arizona Court of Appeals issued a decision
that resolved challenges to the ACC's Retail Electric Competition Rules. The
Court determined that certain rules established by the ACC relating to the entry
of new competitive electric service providers into the market were invalid. The
ultimate impact on TEP's Settlement Agreement is not known. A Motion for
Reconsideration was filed by Arizona Electric Power Cooperative (AEPCO) and
Duncan Valley Electric Cooperative (Duncan Valley), and a separate Motion for
Reconsideration was filed by Trico Electric Cooperative (Trico). A Motion for
Reconsideration is a prerequisite to filing an appeal. AEPCO generates and
transmits electricity for its members in Arizona and California. Duncan Valley
and Trico provide electric service to rural areas in Arizona.
TEP competes against gas service suppliers and others that provide
energy services. Other forms of energy technologies may provide competition to
TEP's services in the future, but to date, are not financially viable
alternatives for its retail customers. Self-generation by TEP's large industrial
customers could also provide competition for TEP's services in the future, but
has not had a significant impact to date.
In the wholesale market, TEP competes with other utilities, power
marketers and independent power producers in the sale of electric capacity and
energy.
WESTERN ENERGY MARKETS
As a participant in the western U.S. wholesale power markets, TEP is
directly and indirectly affected by changes in market conditions and market
participants. TEP competes with other utilities, power marketers and independent
power producers in the sale of electric capacity and energy at market-based
rates in the wholesale market.
As of the end of 2003, electric generating capacity in Arizona has
grown to approximately 25,000 MW; an increase of more than 60% since 2000. A
majority of the growth over the last three years is the result of 19 new or
upgraded gas-fired generating units with a combined capacity of approximately
9,300 MW. In addition, the presence of fewer creditworthy counterparties, as
well as legal, political and regulatory uncertainties, has reduced market
liquidity and trading volume.
Market Prices
The average market price for around-the-clock energy based on the Dow
Jones Palo Verde Index increased in 2003 compared with 2002, as did the average
price for natural gas based on the San Juan Index. Average market prices for
around-the-clock energy began to rise in February 2003 due to increased demand
and higher natural gas prices resulting from low gas storage levels resulting
from colder temperatures in other regions of the U.S. and reduced gas
production. Reduced hydropower supply in the western U.S. also contributed to
the higher market prices. As a result of all these factors, TEP's natural gas
and purchased power expenses were higher in 2003 than in 2002. Prices have
continued in this range to date; however, we cannot
K-43
predict whether these higher prices will continue, or whether changes in
various factors that influence demand and supply will cause prices to fall
during 2004.
Average Market Price for Around-the-Clock Energy $/MWh
------------------------------------------------------------------ -------------
Quarter ended December 31, 2003 $38
Quarter ended December 31, 2002 32
12 months ended December 31, 2003 41
12 months ended December 31, 2002 27
------------------------------------------------------------------ -------------
Average Market Price for Natural Gas $/MMBtu
------------------------------------------------------------------ -------------
Quarter ended December 31, 2003 $4.05
Quarter ended December 31, 2002 3.31
12 months ended December 31, 2003 4.42
12 months ended December 31, 2002 2.63
------------------------------------------------------------------ -------------
TEP typically uses its generation from its facilities fueled by natural
gas to meet the summer peak demands of its retail customers and to meet local
reliability needs. Due to its increasing seasonal gas usage, TEP hedges a
portion of its natural gas purchases with fixed price contracts for a maximum of
three years, and purchases its remaining gas needs in the spot and short-term
markets through its supplier Southwest Gas Corporation (SWG). TEP entered into a
Gas Procurement Agreement with SWG effective June 1, 2001 with a primary term of
five years. The contract provided for a minimum volume obligation during the
first two years of 10 million MMBtus annually. TEP negotiated new pricing and a
lower minimum annual volume obligation of 4 million MMBtus for 2004 and expects
to burn more gas than this minimum requirement. TEP will negotiate terms for the
remaining two years of the contract in late 2004. TEP made payments under this
contract of $34 million in 2003, $33 million in 2002 and $28 million in 2001.
We expect the market price and demand for capacity and energy to
continue to be influenced by factors including:
o weather;
o continued population growth in the western U.S.;
o economic conditions in the western U.S.;
o availability of generating capacity throughout the western U.S.;
o the extent of electric utility industry restructuring in Arizona,
California and other western states;
o the effect of FERC regulation of wholesale energy markets;
o the availability and price of natural gas;
o availability of hydropower;
o transmission constraints; and
o environmental regulations and the cost of compliance.
Payment Defaults and Allowances for Doubtful Accounts
See Critical Accounting Policies, TEP- Payment Defaults and Allowances
for Doubtful Accounts, below.
LIQUIDITY AND CAPITAL RESOURCES
TEP CASH FLOWS
TEP's capital requirements consist primarily of capital expenditures
and optional and mandatory redemptions of long-term debt and capital lease
obligations. As shown in the chart below, during the last three years, TEP had
sufficient cash available after capital expenditures, scheduled debt payments
and capital lease obligations to provide for other investing and financing
activities:
K-44
2003 2002 2001
--------------------------------------------------------------------------------
-Millions of Dollars -
Cash from Operations $ 258 $ 204 $ 261
Capital Expenditures (122) (103) (104)
Debt Maturities (2) (2) (2)
Retirement of Capital Lease Obligations (43) (20) (26)
--------------------------------------------------------------------------------
Net Cash Flows Available after Required Payments $ 91 $ 79 $ 129
================================================================================
During 2004, TEP expects to generate sufficient internal cash flows to
fund its operating activities, construction expenditures, required debt
maturities, and to pay dividends to UniSource Energy. However, TEP's cash flows
may vary due to changes in wholesale revenues, changes in short-term interest
rates, and other factors. TEP currently has $60 million available under its
Revolving Credit Facility which it may borrow if cash flows fall short of
expectations or if monthly cash requirements temporarily exceed available cash
balances.
Operating Activities
In 2003, net cash flows from operating activities at TEP were $258
million, up $54 million from 2002, primarily due to the following factors:
o a $24 million decrease in income taxes paid due primarily to lower
taxable income;
o a $20 million receipt of interest related to the inter-company note to
UniSource Energy;
o a $16 million increase in income tax refunds of taxes previously paid,
which was received in the fourth quarter of 2003; and
o a $27 million cash payment made in 2002 to terminate and amend coal
contracts; partially offset by:
o a $17 million increase in interest paid (including capital
lease interest paid), due primarily to higher letter of
credit fees under TEP's Credit Agreement; and
o a deposit of $17 million in 2003 with TEP's second mortgage
trustee.
Investing Activities
Net cash used for investing activities was $144 million lower in 2003
compared with 2002, primarily due to the following factors:
o In 2002, TEP paid $138 million to purchase Springerville Lease
Debt; in 2003, TEP received principal payments related to its
investment in Springerville Lease Debt of $12 million.
o TEP paid $15 million in 2002 to purchase a combustion turbine from
UniSource Energy Development.
The decrease in cash used for investing activities was partially offset
by a $19 million increase in capital expenditures. Part of this increase
resulted from $10 million spent on completing a new one mile 500-kV transmission
line and related substations to enhance TEP's distribution system link to the
regional high voltage transmission system.
K-45
Investments in Springerville Lease Debt and Equity
Principal Average Coupon
Date Amount Debt Purchased Rate
--------------------------------------------------------------------------------
January 2002 $ 96 million Springerville Coal Handling Lease Debt 14.3%
May 2002 3 million Springerville Unit 1 Lease Debt 10.7%
September 2002 33 million Springerville Unit 1 Lease Debt 10.6%
--------------------------------------------------------------------------------
In March of 2004, TEP purchased approximately $4 million principal
amount of Springerville Unit 1 Lease Debt with an average coupon of 10.7%. As of
March 10, 2004, TEP's total investment in Springerville Lease Debt was
approximately $175 million, at yields ranging from 8.9% to 12.7%.
In December 2001, TEP purchased a 13% equity ownership interest in the
Springerville Coal Handling Facilities Leases for $13 million. In March 2002,
TEP terminated the lease related to its equity interest and cancelled the
associated debt that TEP held. As a result of the lease termination, TEP
recorded a $21 million reduction to the capital lease obligation, a $27 million
reduction of its investment in lease debt, and a $6 million increase in the
capital lease asset, which represents the residual value of TEP's interest in
the leased asset and is carried at cost.
See Note 10 of Notes to Consolidated Financial Statements - Debt and
Capital Lease Obligations.
Capital Expenditures
TEP's forecasted construction expenditures for the next five years are:
$106 million in 2004, $119 million in 2005, $162 million in 2006, $123 million
in 2007, and $135 million in 2008. These estimated capital expenditures for
2004-2008 break down in the following categories:
o $351 million for transmission, distribution and other facilities in the Tucson
area; o $146 million for production facilities; o $28 million for renewable
energy projects, including expansion of solar generation portfolio; o $44
million for new production facility for a 75 MW combustion turbine; o $10
million for environmental projects; and o $66 million for a proposed 345-kV
transmission line to Nogales, Arizona.
These estimated expenditures include costs for TEP to comply with
current federal and state environmental regulations. All of these estimates are
subject to continuing review and adjustment. Actual construction expenditures
may be different from these estimates due to changes in business conditions,
construction schedules, environmental requirements, and changes to TEP's
business arising from retail competition. TEP plans to fund these expenditures
through internally generated cash flow.
As of December 31, 2003, approximately $9 million in engineering and
environmental expenses have been capitalized related to the Nogales transmission
line. If the required environmental permits are not obtained and the project
does not proceed, these costs would be immediately expensed. See Item 1.
Business, Tucson Electric Utility Operations, Transmission Access, Tucson to
Nogales Transmission Line.
In addition to TEP's forecasted construction expenditures, TEP's other
capital requirements include its required debt maturities and capital lease
obligations. See Note 10 of Notes to Consolidated Financial Statements - Debt
and Capital Lease Obligations.
Financing Activities
Net cash used for financing activities was $85 million higher in 2003
compared with 2002, due primarily to the following factors:
o a $45 million increase in dividends paid from TEP to UniSource Energy;
and
o a $23 million increase in scheduled payments for capital lease
obligations.
K-46
Bond Issuance and Redemption
During 2003, TEP purchased and retired $0.4 million of its 8.50% First
Mortgage Bonds due in 2009 and made required sinking fund payments of $2
million. During 2002, TEP purchased and retired $0.4 million of its 8.50% First
Mortgage Bonds due in 2009 and made required sinking fund payments of $2
million.
TEP Credit Agreement
TEP's $401 million Credit Agreement consists of a $60 million Revolving
Credit Facility and two letter of credit (LOC) facilities (Tranche A and Tranche
B) totaling $341 million. The Revolving Credit Facility is used to provide
liquidity for general corporate purposes. The LOC Facilities support $329
million aggregate principal amount of tax-exempt variable rate debt obligations.
The Revolving Credit Facility is a 364-day facility that expires on November 11,
2004. The Tranche A letters of credit, totaling $135 million, expire in January
2006, and the Tranche B letters of credit, totaling $206 million, expire in
November 2006.
The facilities are secured by $401 million in aggregate principal
amount of Second Mortgage Bonds issued under TEP's General Second Mortgage
Indenture. The Credit Agreement contains a number of restrictive covenants,
including restrictions on additional indebtedness, liens, sale of assets,
mergers and sale-leasebacks. The Credit Agreement also contains several
financial covenants including: (a) a minimum Consolidated Tangible Net Worth,
(b) a minimum Cash Coverage Ratio, and (c) a maximum Leverage Ratio. Under the
terms of the Credit Agreement, TEP may pay dividends so long as it maintains
compliance with the Credit Agreement; however, dividends and certain investments
in affiliates may not exceed 65% of TEP's net income so long as the Tranche B
LOCs are outstanding. The Credit Agreement also provides that under certain
circumstances, certain regulatory actions could result in a required reduction
of the commitments. As of December 31, 2003, TEP was in compliance with these
financial covenants.
If TEP borrows under the Revolving Credit Facility, the borrowing costs
would be at a variable interest rate consisting of a spread over LIBOR or an
alternate base rate. The spread is based upon a pricing grid tied to TEP's
credit ratings. Also, TEP pays a commitment fee on the unused portion of the
Revolving Credit Facility, and a fee on the LOC Facilities. The chart below
shows the per annum rates and fees in effect on TEP's Credit Facilities as of
December 31, 2003, based on its credit ratings, as well as the possible range of
rates and fees if TEP's credit ratings were to change.
Current Rate / Range of
Fee Rates / Fees
--------------------------------------------------------------------------------
Revolving Credit Facility
o Commitment Fee 0.35% 0.25% to 0.40%
o Borrowing Rate (spread over LIBOR) 4.00% 3.50% to 4.25%
Tranche A LOCs (including LOC Fronting Fee) 4.25% 3.75% to 4.50%
Tranche B LOCs (including LOC Fronting Fee) 5.75% 5.75%
--------------------------------------------------------------------------------
At December 31, 2003, there were no outstanding borrowings under the
Revolving Credit Facility. In January 2004, TEP borrowed $20 million under its
Revolving Credit Facility and repaid it within 30 days.
Springerville Common Facilities Leases
In 1985, TEP sold and leased back its undivided one-half ownership
interest in the common facilities at the Springerville Generating Station. Under
the terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. TEP was
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2003 or the leases would have been terminated and
TEP would have been required to repurchase the facilities for $125 million.
TEP finalized the arrangements for the refinancing of $70 million of
lease debt on June 26, 2003 and the special event of loss date was reset for
June 30, 2006. TEP incurred a total of $0.3 million in debt costs related to the
refinancing. These costs were deferred and are being amortized over a three year
period. Interest on the new debt is payable at LIBOR plus 4.25%. The LIBOR rate
is reset every six months and the
K-47
rate in effect on December 31, 2003 was 0.99%, which resulted in a total
interest rate on the lease debt of 5.24% at year end. Prior to the refinancing,
the interest rate was LIBOR plus 2.50%.
Tax-Exempt Local Furnishing Bonds
TEP has financed a substantial portion of utility plant assets with
industrial development revenue bonds issued by the Industrial Development
Authorities of Pima County and Apache County. The interest on these bonds is
excluded from gross income of the bondholder for federal tax purposes. This
exclusion is allowed because the facilities qualify as "facilities for the local
furnishing of electric energy" as defined by the Internal Revenue Code. These
bonds are sometimes referred to as "tax-exempt local furnishing bonds." To
qualify for this exclusion, the facilities must be part of a system providing
electric service to customers within not more than two contiguous counties. TEP
provides electric service to retail customers in the City of Tucson and certain
other portions of Pima County, Arizona and to Fort Huachuca in contiguous
Cochise County, Arizona.
TEP has financed the following facilities, in whole or in part, with
the proceeds of tax-exempt local furnishing bonds: Springerville Unit 2, Sundt
Unit 4, a dedicated 345-kV transmission line from Springerville Unit 2 to TEP's
retail service area (the Express Line), and a portion of TEP's local
transmission and distribution system in the Tucson metropolitan area. As of
December 31, 2003, TEP had approximately $584 million of tax-exempt local
furnishing bonds outstanding. Approximately $331 million in principal amount of
such bonds financed Springerville Unit 2 and the Express Line. In addition,
approximately $59 million of remaining lease debt related to the Sundt Unit 4
lease obligation was issued as tax-exempt local furnishing bonds.
Various events might cause TEP to have to redeem or defease some or all
of these bonds:
o formation of an RTO or ISO;
o asset divestiture;
o changes in tax laws; or
o changes in system operations.
TEP believes that its qualification as a local furnishing system should
not be lost so long as (1) the RTO or ISO would not change the operation of the
Express Line or the transmission facilities within TEP's local service area, (2)
the RTO or ISO allows pricing of transmission service such that the benefits of
tax-exempt financing continue to accrue to retail customers, and (3) energy
produced by Springerville Unit 2 and by TEP's local generating units continues
to be consumed in TEP's local service area. However, there is no assurance that
such qualification can be maintained. Any redemption or defeasance of tax-exempt
local furnishing bonds would likely require the issuance and sale of higher cost
taxable debt securities in the same or a greater principal amount.
Mortgage Indentures
TEP's first mortgage indenture and second mortgage indenture create
liens on and security interests in most of TEP's utility plant assets.
Springerville Unit 2, which is owned by San Carlos, is not subject to these
liens and security interests. TEP's mortgage indentures allow TEP to issue
additional mortgage bonds on the basis of: (1) a percentage of net utility
property additions and/or (2) the principal amount of retired mortgage bonds.
The amount of bonds that TEP may issue is also subject to a net earnings test
under each mortgage indenture.
TEP's Credit Agreement contains limits on the amount of First and
Second Mortgage Bonds that may be outstanding. The Credit Agreement allows no
more than $222 million of First Mortgage Bonds to be outstanding, and no more
than a total of $623 million in First and Second Mortgage Bonds to be
outstanding. At December 31, 2003, TEP had $220 million of First Mortgage Bonds
and a total of $621 million in First and Second Mortgage Bonds outstanding.
Although the first and second mortgage indentures would allow TEP to issue
additional bonds based on property additions and/or retired bond credits, the
limits imposed by the Credit Agreement are more restrictive and are currently
the governing limitations.
TEP also has the ability to release property from the liens of the
mortgage indentures on the basis of net property additions and/or retired bond
credits. The Credit Agreement also limits the amount of property that can be
released from the second mortgage indenture to $25 million. As a result, TEP
deposited $17 million in cash with the second mortgage trustee in the fourth
quarter of 2003 in conjunction with the release of $42 million in property from
its mortgage indentures related to the Springerville Unit 3 transaction.
K-48
CONTRACTUAL OBLIGATIONS
The following charts display TEP's contractual obligations as of
December 31, 2003 by maturity and by type of obligation, and provide additional
detail on TEP's capital lease obligations.
--------------------------------------------------------------------------------------------------------------------
Payments
Due in Pension
Years IDBs Capital and Other Total
Ending Supported by Long- Lease Purchase Postretirement Contractual
December Expiring Term Obligations Operating Obligations Benefit Cash
31, LOCs (1) Debt (2) Leases (3) Obligations Obligations
--------------------------------------------------------------------------------------------------------------------
2004 $ - $ 2 $ 120 $ 1 $ 91 $ 5 $ 219
2005 - 2 120 1 90 3 216
2006 329 21 122 1 87 4 564
2007 - 1 127 1 77 4 210
2008 - 29 120 1 77 5 232
--------------------------------------------------------------------------------------------------------------------
Total 2004 - 329 55 609 5 422 21 1,441
2008
Thereafter - 744 836 1 424 177 2,182
Less: Imputed - - (633) - - - (633)
Interest
--------------------------------------------------------------------------------------------------------------------
Total $329 $ 799 $ 812 $ 6 $ 846 $ 198 $ 2,990
====================================================================================================================
See UniSource Energy Consolidated, Liquidity and Capital Resources, Contractual
Obligations, above, for a description of these obligations.
TEP's Capital Lease Obligations
- Millions of Dollars -
--------------------------------------------------------------------------------------------------------------------
Springerville Total Capital
Payments Due in Years Springerville Coal Sundt Unit Springerville Rail Car Lease
Ending December 31, Unit 1 Handling 4 Common Lease Obligations
--------------------------------------------------------------------------------------------------------------------
2004 $ 86 $ 16 $ 13 $ 4 $ 1 $ 120
2005 86 17 12 5 - 120
2006 85 22 10 5 - 122
2007 85 24 12 6 - 127
2008 85 18 12 5 - 120
--------------------------------------------------------------------------------------------------------------------
Total 2004 - 2008 427 97 59 25 1 609
Thereafter 521 129 27 159 - 836
Less: Imputed Interest (464) (97) (15) (57) - (633)
--------------------------------------------------------------------------------------------------------------------
Total $ 484 $ 129 $ 71 $ 127 $ 1 $ 812
====================================================================================================================
We have no other commercial commitments to report.
We have reviewed our contractual obligations and provide the following
additional information:
o TEP's Credit Agreement contains pricing tied to a grid based on the
ratings of TEP's Credit Facilities. A change in TEP's credit rating can
cause an increase or decrease in the amount of interest and fees TEP
pays for these facilities.
o TEP's Credit Agreement contains certain financial and other restrictive
covenants, including interest coverage, leverage and net worth tests.
Failure to comply with these covenants would entitle the lenders to
accelerate the maturity of all amounts outstanding. At December 31,
2003, TEP was in compliance with these covenants. See TEP Credit
Agreement, above.
o TEP conducts its wholesale trading activities under the Western Systems
Power Pool Agreement (WSPP) which contains provisions whereby TEP may
be required to post margin collateral due to a change in credit rating
or changes in contract values. As of December 31, 2003, TEP has not
been required to post such collateral.
K-49
DIVIDENDS ON COMMON STOCK
TEP declared and paid dividends of $80 million in 2003, $35 million in
2002, and $50 million in 2001. UniSource Energy is the primary holder of TEP's
common stock.
TEP can pay dividends if it maintains compliance with the TEP Credit
Agreement and certain financial covenants, including a covenant that requires
TEP to maintain a minimum level of net worth. As of December 31, 2003, the
required minimum net worth was $326 million. TEP's actual net worth at December
31, 2003 was $406 million, and was $376 million as defined for the purposes of
the Credit Agreement. As of December 31, 2003, TEP was in compliance with the
terms of the Credit Agreement. Under the terms of the Credit Agreement,
dividends and certain investments in affiliates may not exceed 65% of TEP's net
income, so long as the Tranche B LOCs are outstanding. See Financing Activities
- TEP Credit Agreement, above.
The ACC Holding Company Order stated that TEP may not pay dividends to
UniSource Energy in excess of 75% of its earnings until TEP's common equity
equals 37.5% of total capitalization (excluding capital lease obligations). The
Citizens Settlement Agreement, as approved by the ACC, modified this dividend
limitation so that it will remain in place until TEP's common equity equals 40%
of total capitalization (excluding capital lease obligations). As of December
31, 2003, TEP's common equity (as determined by the ACC for the purpose of this
limitation) equaled 26% of total capitalization (excluding capital lease
obligations).
In connection with the proposed acquisition, Saguaro Utility intends to
cause the surviving corporation (i) to repay the $95 million intercompany loan
to UniSource Energy from TEP and (ii) to contribute up to $168 million to TEP.
TEP will use a significant portion of these proceeds to retire some of its
outstanding debt. We expect these transactions to improve TEP's common equity
(as determined by the ACC) to 40% of total capitalization (excluding capital
lease obligations).
In addition to these limitations, the Federal Power Act states that
dividends shall not be paid out of funds properly included in capital accounts.
Although the terms of the Federal Power Act are unclear, we believe that there
is a reasonable basis to pay dividends from current year earnings. Therefore,
TEP declared its 2003 dividends from its current year earnings since TEP had an
accumulated deficit, rather than positive retained earnings.
UNISOURCE ENERGY SERVICES
RESULTS OF OPERATIONS
---------------------
UniSource Energy formed two operating companies, UNS Gas and UNS
Electric, to acquire the Arizona electric and gas assets from Citizens, as well
as an intermediate holding company, UES, to hold the common stock of UNS Gas and
UNS Electric. Results of operations for UNS Electric and UNS Gas cover the
period from August 11, 2003, the date the assets were acquired from Citizens, to
December 31, 2003.
UES' net income for the period was approximately $3 million. Similar to
TEP's operations, we expect UNS Electric's operations to be seasonal in nature,
with peak energy demand occurring in the summer months. We also expect
operations at UNS Gas to vary with the seasons, with peak energy usage occurring
in the winter months.
UNS Electric
The table below shows UNS Electric's kWh sales and revenues for the
period August 11, 2003 to December 31, 2003.
K-50
Sales Operating Revenue
------------------------------------------------------------------------------------------------
For the Period August 11 - December 31, 2003 2003
------------------------------------------------------------------------------------------------
Electric Retail Sales: -Millions of kWh- -Millions of Dollars-
Residential 302 $30
Commercial 153 16
Industrial 59 4
Other 47 5
-------------------------------------------------------------------------------------------------
Total Electric Retail Sales 561 $55
=================================================================================================
UNS Gas
The table below shows UNS Gas' therm sales and revenues for the period
August 11, 2003 to December 31, 2003.
Sales Operating Revenue
------------------------------------------------------------------------------------------------
For the Period August 11 - December 31, 2003 2003
------------------------------------------------------------------------------------------------
Retail Therm Sales: -Millions of Therms- -Millions of Dollars-
Residential 25 $25
Commercial 12 11
Industrial 1 1
Public Authority 3 2
------------------------------------------------------------------------------------------------
Total Retail Therm Sales 41 39
Transport - 1
Negotiated Sales Program (NSP) 13 7
------------------------------------------------------------------------------------------------
Total 54 $47
================================================================================================
Through a Negotiated Sales Program (NSP) approved by the ACC, UNS Gas
supplies natural gas to some of its large transportation customers.
Approximately one half of the margin earned on these NSP sales is retained by
UNS Gas, while the remainder benefits retail customers through a credit to the
Purchased Gas Adjustor (PGA) mechanism which reduces the gas commodity price.
FACTORS AFFECTING RESULTS OF OPERATIONS
---------------------------------------
COMPETITION
As required by the ACC order approving UniSource Energy's acquisition
of the Citizens' Arizona gas and electric assets, on November 3, 2003, UNS
Electric filed with the ACC a plan to open its service territories to retail
competition by December 31, 2003. The plan addresses all aspects of
implementation. It includes UNS Electric's unbundled distribution tariffs for
both standard offer customers and customers that choose competitive retail
access, as well as Direct Access and Settlement Fee schedules. UNS Electric
direct access rates for both transmission and ancillary services will be based
upon its FERC Open Access Transmission Tariff. The plan is subject to review and
approval by the ACC. As a result of the court decisions concerning the ACC's
Retail Electric Competition Rules, we are unable to predict when and how the ACC
will address this plan. See Tucson Electric Power Company, Factors Affecting
Results of Operations, Competition, above for information regarding the recent
Arizona Court of Appeals decision.
RATES AND REGULATION
ACC Order on Citizens Acquisition
On July 3, 2003, the ACC issued an order approving the acquisition of
Citizens Arizona gas and electric assets. Concurrent with the closing of the
acquisition, retail rate increases for customers of both UNS Electric and UNS
Gas went into effect on August 11, 2003. Key provisions of the order include:
K-51
UNS Gas
o 20.9% overall increase in retail rates through a base rate increase.
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Gas to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
UNS Electric
o 22% overall increase in retail rates through its Purchased Power Fuel
Adjustor Clause (PPFAC).
o UNS Electric must file a plan with the ACC to open its service
territories to retail competition by no later than December 31, 2003
(which was filed by UNS Electric on November 3, 2003).
o Restricts the filing of a general rate case until August 2006 and any
resulting rate increase shall not become effective prior to August 1,
2007.
o Limits dividends payable by UNS Electric to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization
reaches 40%.
o Requires UNS Electric to enter into negotiations with Pinnacle West
Capital Corporation (PWCC) to seek to reduce the cost of its purchased
power contract with PWCC.
Energy Cost Adjustment Mechanisms
UNS Gas
UNS Gas' retail rates include a PGA mechanism intended to address the
volatility of natural gas prices and allows UNS Gas to recover its costs through
a price adjustor. The PGA charge may be changed monthly based on an ACC approved
mechanism that compares the twelve-month rolling average gas cost to the base
cost of gas, subject to limitations on how much the price per therm may change
in a twelve month period. The difference between the actual cost of UNS Gas' gas
supplies and transportation contracts and that currently allowed by the ACC are
deferred and recovered or repaid through the PGA mechanism. When under or over
recovery trigger points are met, UNS Gas may request a PGA surcharge or
surcredit with the goal of collecting or returning the amount deferred from or
to customers over a twelve month period.
On September 9, 2003, the ACC approved a new PGA surcharge of $0.1155
per therm that took effect October 1, 2003.
UNS Electric
UNS Electric's retail rates include a PPFAC, which allows for a
separate surcharge or surcredit to the base rate for delivered purchased power
to collect or return under or over recovery of costs. As part of the July 3,
2003 ACC Order, a new PPFAC surcharge of $0.01825 per kWh was approved to fully
recover the cost of the current full-requirements power supply agreement with
PWCC. UNS Electric is required to enter into negotiations with PWCC to
potentially reduce the cost of this purchased power contract; 90% of any savings
from the negotiations is to be passed on to UNS Electric rate payers.
LIQUIDITY AND CAPITAL RESOURCES
-------------------------------
UES' capital requirements consist primarily of capital expenditures. In
the nearly five months of operation during 2003, capital expenditures were
approximately $13 million. During 2004, UES expects to generate sufficient
internal cash flows to fund its operating activities and its construction
expenditures.
UES' forecasted construction expenditures for the next five years are:
$37 million in 2004, $41 million in 2005, $54 million in 2006, $40 million in
2007, and $40 million in 2008.
Senior Unsecured Notes
On August 11, 2003, UNS Gas and UNS Electric issued a total of $160
million of aggregate principal amount of senior unsecured notes in a private
placement. Proceeds from the note issuance were paid to Citizens to purchase the
Arizona gas and electric system assets. UNS Gas issued $50 million of 6.23%
Notes
K-52
due in 2011 and $50 million of 6.23% Notes due in 2015. UNS Electric issued $60
million of 7.61% Notes due in 2008. The notes are guaranteed by UES.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants, including restrictions on transactions with
affiliates, mergers, liens to secure indebtedness, restricted payments,
incurrence of indebtedness, and minimum net worth. Consolidated Net Worth, as
defined by the note purchase agreements for both UNS Gas and UNS Electric, is
approximately equal to the balance sheet line item, Common Stock Equity. The
table below outlines the actual and required minimum net worth levels of UES,
UNS Gas, and UNS Electric, at December 31, 2003.
Required Actual
Company Net Worth Net Worth
-------------------------------------------------------------
-Millions of Dollars-
UES $50 $90
UNS Gas 43 53
UNS Electric 26 37
-------------------------------------------------------------
The incurrence of indebtedness covenant requires each of UNS Gas and
UNS Electric to meet certain tests before additional indebtedness may be
incurred. These tests include:
o A ratio of Consolidated Long-Term Debt to Consolidated Total
Capitalization of no greater than 0.67 to 1.00 prior to September
30, 2004, and no greater than 0.65 to 1.00 after September 30,
2004.
o An Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00.
However, UNS Gas and UNS Electric may, without meeting these tests,
refinance indebtedness and incur short-term debt in an amount not to exceed $7
million in the case of UNS Gas, and $5 million in the case of UNS Electric.
Neither UNS Gas, nor UNS Electric, may declare or make distributions or
dividends (restricted payments) on their common stock unless (a) immediately
after giving effect to such action no default or event of default would exist
under such company's note purchase agreement and (b) immediately after giving
effect to such action, such company would be permitted to incur an additional
dollar of indebtedness under the debt incurrence test for such company.
CONTRACTUAL OBLIGATIONS
The following section includes UES' significant contractual obligations or
other commercial commitments:
UNS Gas Supply Contracts
UNS Gas has a natural gas supply and management agreement with BP
Energy Company (BP). Under the contract, BP manages UNS Gas' existing supply and
transportation contracts and its incremental requirements. The initial term of
the agreement extends through August 31, 2005. The term of the agreement is
automatically extended one year on an annual basis unless either party provides
180 days notice of its intent to terminate. Prices for incremental gas supplied
by BP will vary based upon the period during which the gas is delivered. UNS Gas
hedges its gas supply prices by entering into fixed price forward contracts at
various times during the year to provide more stable prices to its customers.
These purchases are made up to three years in advance with the goal of hedging
at least 45% and not more than 80% of the expected monthly gas consumption with
fixed prices prior to entering into the month. Currently, UNS Gas has
approximately 15% of its expected monthly consumption hedged for November
through December 2004 and 10% for January through March 2005.
UNS Gas has firm transportation agreements with El Paso Natural Gas
(EPNG) and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements. EPNG provides gas transmission service
under a full requirements contract under which UNS Gas pays a fixed reservation
charge. This contract expires on September 1, 2011. In July 2003, FERC required
the conversion of UNS Gas' full requirements status under the EPNG agreement to
contract demand starting on September 1, 2003. Upon conversion to contract
demand status, UNS Gas now has specific volume limits in each month and
K-53
specific receipt point rights from the available supply basins (San Juan and
Permian). These changes will reduce the amount of less expensive San Juan gas
available to UNS Gas. The impact, however, is not expected to be material. The
annual cost of the EPNG capacity after conversion to contract demand will not
change. The Transwestern contract expires on March 1, 2007. The aggregate annual
minimum transportation charges are expected to be approximately $3.5 million and
$3.0 million for the EPNG and Transwestern contracts, respectively.
UNS Electric Power Supply and Transmission Contracts
UNS Electric has a full requirements power supply agreement with PWCC.
The agreement expires May 31, 2008. The agreement obligates PWCC to supply all
of UNS Electric's power requirements at a fixed price per MWh. Payments under
the contract are usage based, with no fixed customer or demand charges.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. Under the terms of the agreements, UNS Electric's aggregate
minimum fixed transmission charges are expected to be approximately $6 million
in 2004 and $1 million in 2005 through 2011.
DIVIDENDS ON COMMON STOCK
The Citizens Settlement Agreement, as approved by the ACC, limits
dividends payable by UNS Gas and UNS Electric to 75% of earnings until the ratio
of common equity to total capitalization reaches 40%. At December 31, 2003, the
ratio of common equity to total capitalization for UNS Gas was 35% and for UNS
Electric was 38%.
The note purchase agreements for both UNS Gas and UNS Electric contain
restrictive covenants including restrictions on dividends. According to the note
purchase agreements, neither UNS Gas, nor UNS Electric, may declare or make
distributions or dividends (restricted payments) on their common stock unless,
(a) immediately after giving effect to such action no default or event of
default would exist under such company's note purchase agreement and (b)
immediately after giving effect to such action, such company would be permitted
to incur an additional dollar of indebtedness under the debt incurrence test for
such company.
MILLENNIUM ENERGY HOLDINGS, INC.
RESULTS OF OPERATIONS
---------------------
Millennium accounts for its investments under the consolidation method
and the equity method. In some cases, Millennium is an investment's sole
provider of funding. When this is the case, Millennium recognizes 100% of an
investment's losses, because as sole provider of funds it bears all of the
financial risk. To the extent that an investment becomes profitable and
Millennium has recognized losses in excess of its percentage ownership,
Millennium will recognize 100% of an investment's net income until Millennium's
recognized losses equal its ownership percentage of losses.
The table below provides a breakdown of the net income and losses
recorded by Millennium for the last three years. These results exclude sales and
related costs to TEP.
K-54
2003 2002 2001
---------------------------------------------------------------------------------------------------------
-Millions of Dollars -
Technology Investments
Global Solar and IPS
Research & Development Contract Revenues from Third Parties $ 1 $ 1 $ 2
Research & Development Contract Expenses & Losses (5) (2) (5)
Research & Development - Internal Development Expenses (2) (7) (4)
Depreciation & Amortization Expense (3) (3) (2)
Administrative & Other Costs (8) (11) (9)
Income Tax Benefits 7 9 7
---------------------------------------------------------------------------------------------------------
Total Global Solar and IPS Net Loss (10) (13) (11)
MicroSat and ITN Energy Systems Inc. Net Loss (1) (1) (3)
---------------------------------------------------------------------------------------------------------
Total Technology Investments Net Loss (11) (14) (14)
Nations Energy and Other Millennium Investments Net (Loss) Income (5) (2) 5
---------------------------------------------------------------------------------------------------------
Total Millennium Loss, after-tax $ (16) $ (16) $ (9)
=========================================================================================================
Technology Investments
Millennium accounts for Global Solar under the consolidation method and
recognizes 100% of Global Solar's losses. In 2003 Millennium funded debt and
equity contributions of $10 million to Global Solar. Global Solar recognizes
expense when funding is used for research, development and administrative costs.
Millennium has no remaining funding commitments to Global Solar.
Millennium also accounts for IPS under the consolidation method. In
2003, Millennium provided IPS funding of $3 million. Dow Corning Enterprises,
Inc. (DCEI) continued to support IPS through 2003 with preferred equity and debt
contributions totaling $2 million. IPS recognizes expense when funding is used
for research, development and administrative costs. At December 31, 2003,
Millennium had less than $1 million of unfunded commitments to IPS. In early
2004 these funds were drawn by IPS.
Millennium's after-tax losses relating to MicroSat and ITN Energy
Systems Inc. (ITN) related to the development of small-scale satellites and
other research and development activities. Millennium accounts for MicroSat
under the equity method. In 2003, Millennium made no contributions to MicroSat.
As sole funder, Millennium recognizes 100% of MicroSat's net losses. Millennium
has no further funding commitments to MicroSat. ITN results are included at 100%
of ITN's losses only through June 2003, when Millennium exchanged its ITN shares
for shares of Global Solar.
As technology developers, these entities face many challenges, such as
developing technologies that can be manufactured on an economic scale,
technological obsolescence, competitors and possible reductions in government
spending to advance technological research and development activities.
Nations Energy and Other Millennium Investments
Results from Nations Energy and Other Millennium Investments in 2003
include an after-tax loss of less than $2 million from each of Powertrusion and
TruePricing, Inc. (TruePricing) and less than $1 million each from Nations
Energy, SES and MEG.
Results from Nations Energy and Other Millennium Investments in 2002
include an after-tax loss of $2 million from Powertrusion. Powertrusion produces
and sells lightweight utility pole products. Nations Energy had income of less
than $1 million. MEG, SES and TruePricing, each recorded after-tax losses of
less than $1 million. These losses were offset by earned interest and a tax
benefit from final resolution of IRS audits.
In 2001, Nations Energy sold its investment in a power project in
Curacao, resulting in an after-tax gain of $6 million. Nations Energy received a
promissory note as part of the sale. See Item 7A. - Quantitative and Qualitative
Disclosures about Market Risk, Credit Risk, below.
Millennium consolidates the results of SES, MEG, Powertrusion and
Nations Energy. Millennium uses the equity method to reflect its investment in
Haddington, Valley Ventures, and Sabinas. Sabinas, however,
K-55
accounts for its investment in Mimosa under the cost method.
Millennium Commitments
Millennium is currently finalizing possible future commitments to each
of its investments to help insure that these investments conform to Millennium's
business plans. Millennium's funding levels and share ownership are subject to
change in the future. Millennium's outstanding equity commitments are currently
limited to $6 million to Haddington and $5 million to Valley Ventures.
Millennium's only outstanding debt commitment at December 31, 2003, to IPS, was
funded in early 2004.
Global Solar and MicroSat have commitments to incur future expenses
relating to government contracts. The following is a table of remaining
government contract commitments at:
December 31,
2003 2002 2001
------------------------------------------------------------------
-Millions of Dollars-
Global Solar $ 1 $ 3 $ -
MicroSat - 6 8
------------------------------------------------------------------
Total $ 1 $ 9 $ 8
==================================================================
UNISOURCE ENERGY DEVELOPMENT COMPANY
RESULTS OF OPERATIONS
---------------------
UED recorded net income of $7 million in 2003 compared with $1 million
in 2002. UED's income in 2003 primarily represents an $11 million pre-tax
development fee received at the financial closing of the Springerville Unit 3
Project. See Springerville Generating Station Expansion, below.
UED's net income in 2002 represented rental income (less expenses)
under an operating lease of the 20 MW North Loop turbine to TEP. The rental
income was eliminated from UniSource Energy's consolidated after-tax earnings as
an inter-company transaction. TEP purchased the turbine from UED in September
2002.
SPRINGERVILLE GENERATING STATION EXPANSION
------------------------------------------
On October 21, 2003, Tri-State completed financing of Unit 3 and
immediately began construction. UED received reimbursement of its development
costs totaling $29 million, and an $11 million development fee. On October 24,
2003, UniSource Energy used the proceeds to repay a $35 million short-term
bridge loan.
UED will continue to manage the development of Unit 3. Upon the
completion of construction in December 2006, TEP expects to receive annual
pre-tax benefits of approximately $15 million in the form of cost savings,
rental payments, transmission revenues, and other fees. TEP will also benefit
from upgraded emissions controls for Units 1 and 2, totaling approximately $90
million, which will be paid for by the Unit 3 project.
CRITICAL ACCOUNTING POLICIES
----------------------------
In preparing financial statements under Generally Accepted Accounting
Principles (GAAP), management exercises judgment in the selection and
application of accounting principles, including making estimates and
assumptions. UniSource Energy and TEP consider Critical Accounting Policies to
be those that could result in materially different financial statement results
if our assumptions regarding application of accounting principles were
different. UniSource Energy and TEP describe their Critical Accounting Policies
below. Other significant accounting policies and recently issued accounting
standards are discussed in Note 1 of Notes to Consolidated Financial Statements
- Nature of Operations and Summary of Significant Accounting Policies.
K-56
ACCOUNTING FOR RATE REGULATION
TEP and UES generally use the same accounting policies and practices
used by unregulated companies for financial reporting under GAAP. However,
sometimes these principles, such as Statement of Financial Accounting Standards
No. 71, Accounting for the Effects of Certain Types of Regulation (FAS 71),
issued by the Financial Accounting Standards Board (FASB), require special
accounting treatment for regulated companies to show the effect of regulation.
For example, in setting TEP's and UES' retail rates, the ACC may not allow TEP
or UES to currently charge its customers to recover certain expenses, but
instead requires that these expenses be charged to customers in the future. In
this situation, FAS 71 requires that TEP and UES defer these items and show them
as regulatory assets on the balance sheet until TEP and UES are allowed to
charge their customers. TEP and UES then amortize these items as expense to the
income statement as those charges are recovered from customers. Similarly,
certain revenue items may be deferred as regulatory liabilities, which are also
eventually amortized to the income statement as rates to customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates below
the rates set by the regulator.
TEP
In November 1999, upon approval by the ACC of the TEP Settlement
Agreement relating to recovery of TEP's transition costs and standard retail
rates, TEP discontinued application of FAS 71 to its generation operations.
TEP's transmission and distribution regulatory assets, net of regulatory
liabilities, total $285 million at December 31, 2003, $21 million of which is
not presently included in the rate base and consequently is not earning a return
on investment.
TEP continues to apply FAS 71 to its regulated business, distribution
and transmission, and continues to assess whether it can apply FAS 71 to these
operations. If TEP stopped applying FAS 71 to its remaining regulated
operations, it would write off the related balances of its regulatory assets as
an expense and would write off its regulatory liabilities as income on its
income statement. Based on regulatory asset and liability balances at December
31, 2003, if TEP had stopped applying FAS 71 to its remaining regulated
operations, it would have recorded an extraordinary loss, after-tax, of
approximately $172 million. While regulatory orders and market conditions may
affect TEP's cash flows, its cash flows would not be affected if it stopped
applying FAS 71 unless a regulatory order limited its ability to recover the
cost of that regulatory asset.
UES
UES' regulatory assets, net of regulatory liabilities, total $1 million
at December 31, 2003. If UES stopped applying FAS 71 to its regulated
operations, it would write off the related balances of its regulatory assets as
an expense and would write off its regulatory liabilities as income on its
income statement. Based on the balances of regulatory assets and liabilities at
December 31, 2003, if UES had stopped applying FAS 71 to its regulated
operations, it would have recorded an extraordinary loss, after-tax, of
approximately $1 million. UES' cash flows would not be affected if it stopped
applying FAS 71 unless a regulatory order limited its ability to recover the
cost of that regulatory asset.
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
FAS 143, issued by the FASB in June 2001, requires entities to record
the fair value of a liability for a legal obligation to retire an asset in the
period in which the liability is incurred. A legal obligation is a liability
that a party is required to settle as a result of an existing or enacted law,
statute, ordinance or contract. When the liability is initially recorded, the
entity should capitalize a cost by increasing the carrying amount of the related
long-lived asset. Over time, the liability is adjusted to its present value by
recognizing accretion expense as an operating expense in the income statement
each period, and the capitalized cost is depreciated over the useful
K-57
life of the related asset. Upon settlement of the liability, an entity either
settles the obligation for its recorded amount or incurs a gain or loss if the
actual costs differ from the recorded amount.
TEP
Prior to adopting FAS 143, costs for final removal of all owned
generation facilities were accrued as an additional component of depreciation
expense. Under FAS 143, only the costs to remove an asset with legally binding
retirement obligations will be accrued over time through accretion of the asset
retirement obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station. TEP has estimated that its share of the cost to remove the Navajo and
Four Corners facilities and settle the San Juan environmental obligations will
be approximately $38 million at the date of retirement. No other legal
obligations to retire generation plant assets were identified. As of December
31, 2002, TEP had accrued $113 million for the final decommissioning of its
generating facilities. This amount has been reclassified from accumulated
depreciation to an accrued asset retirement obligation. As discussed below, this
amount was reversed for 2002 and included as part of the cumulative effect of
accounting change adjustment when FAS 143 was adopted on January 1, 2003.
TEP has various transmission and distribution lines that operate under
land leases and rights of way that contain end dates and restorative clauses.
TEP operates its transmission and distribution lines as if they will be operated
in perpetuity and would continue to be used or sold without land remediation. As
a result, TEP is not recognizing the costs of final removal of the transmission
and distribution lines in the financial statements. As of December 31, 2003, TEP
had accrued $60 million for the net cost of removal for the interim retirements
from its transmission, distribution and general plant. As of December 31, 2002,
TEP had accrued $55 million for these removal costs. The amount has been
reclassified from accumulated depreciation to a regulatory liability.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $113 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets by
$44 million and recognized the cumulative effect of accounting change as a gain
of $112 million ($67 million net of tax). Adopting FAS 143 has resulted in a
reduction to current depreciation expense charged throughout the year as well
because asset retirement costs are no longer recorded as a component of
depreciation expense. For the year ended December 31, 2003 and future years, the
annual reduction in depreciation expense is approximately $6 million.
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets have been determined pursuant to the TEP Settlement
Agreement.
UES, MILLENNIUM AND UED
UES has various transmission and distribution lines that operate under
land leases and rights of way that contain end dates and restorative clauses.
UES operates its transmission and distribution lines as if they will be operated
in perpetuity and would continue to be used or sold without land remediation. As
a result, UES is not recognizing the cost of final removal of the transmission
and distribution lines in the financial statements. As of December 31, 2003, UES
had accrued $0.6 million for the net cost of removal for interim retirements
from
K-58
its transmission, distribution and general plant. The amount has been
reclassified from accumulated depreciation to a regulatory liability.
Millennium and UED have no asset retirement obligations.
TEP - PAYMENT DEFAULTS AND ALLOWANCES FOR DOUBTFUL ACCOUNTS
We record an allowance for doubtful accounts when we determine that an
account receivable will not be collected. As a result of payment defaults made
by market participants in California, TEP's collection shortfall from the CPX
and CISO was approximately $9 million for sales made in 2000 and $7 million for
sales made in 2001. Prior to 2003 and since December 31, 2001, TEP had an
allowance for doubtful accounts recorded for $8 million, or 50% of these
uncollected amounts based on the amount TEP believed would be collected. In the
first quarter of 2003, as a result of a FERC order, TEP estimated that $6
million of its $16 million receivable will be collected. Therefore, in the first
quarter of 2003, TEP increased its reserve for sales to the CPX and the CISO by
$2 million by recording a reduction of wholesale revenues. The amount that TEP
ultimately collects would have an impact on earnings if the amount received is
more or less than the $6 million TEP has on its balance sheet. If TEP collects
all of the $16 million, pre-tax income will increase by $10 million. If TEP does
not collect any of the $16 million, pre-tax income will decrease by $6 million.
In addition, TEP has cash collateral of approximately $1 million on deposit in
an escrow account with the CPX, which is currently unavailable to TEP due to the
CPX's bankruptcy stay.
At December 31, 2003 and December 31, 2002, TEP's reserve for electric
wholesale accounts receivable on its balance sheet was approximately $11 million
and $8 million, respectively.
PENSION AND OTHER POSTRETIREMENT BENEFIT PLAN ASSUMPTIONS
We record plan assets, obligations, and expenses related to pension and
other postretirement benefit plans based on actuarial valuations. These
valuations include key assumptions on discount rates, expected returns on plan
assets, compensation increases and health care cost trend rates. These actuarial
assumptions are reviewed annually and modified as appropriate. The effect of
modifications is generally recorded or amortized over future periods. We believe
that the assumptions used in recording obligations under the plans are
reasonable based on prior experience, market conditions and the advice of plan
actuaries.
TEP
TEP discounted its future pension plan obligations using a rate of
6.25% at December 31, 2003, compared with 6.75% at December 31, 2002. TEP
discounted its other postretirement plan obligations using a rate of 5.5% at
December 31, 2003, compared with 6.75% at December 31, 2002. TEP determines the
discount rate annually based on the rates currently available on high-quality,
long-term bonds. TEP looks to bonds that receive one of the two highest ratings
given by a recognized rating agency and are expected to be available during the
period to maturity of the pension benefits. In selecting the appropriate rate,
TEP also considers the durations of plan obligations.
The pension liability and future pension expense both increase as the
discount rate is reduced. A decrease in the discount rate results in an increase
in the Projected Benefit Obligation (PBO) and the service cost component of
pension expense. Additionally, the recognized actuarial loss is significantly
impacted by a reduction in the discount rate. Since the PBO increases with the
decrease in discount rate, the obligation is that much larger than would
normally occur due to normal growth of the plan. This leads to an actuarial loss
(or a greater actuarial loss than would occur in the absence of the discount
rate change), which is amortized over future periods leading to a greater
expense. The resulting change in the interest cost component of pension expense
is dependent on the effect that the change in the discount rate has on the PBO
and will vary based on employee demographics. The effect of the lower rate used
to calculate the interest cost is offset to some degree by a larger obligation.
The relative magnitude of these two changes determines whether interest cost
will increase or decrease. For TEP's pension plans, a 25 basis point decrease in
the discount rate would increase the accumulated benefit obligation (ABO) by
approximately $5 million and the related plan expense for 2004 by approximately
$1 million. A similar increase in the discount rate would decrease the ABO by
approximately $4 million and the related plan expense for 2004 by approximately
$1 million. For TEP's plan for other postretirement benefits, a 25 basis point
change in the discount rate would increase or decrease the
K-59
accumulated postretirement benefit obligation (APBO) by approximately $2
million. A 25 basis point change in the discount rate would not have a
significant impact on the related plan expense for 2004.
TEP calculates the market-related value of plan assets using the fair
value of plan assets on the measurement date. At December 31, 2003 and 2002, TEP
assumed that its plans' assets would generate a long-term rate of return of
8.75%. In establishing its assumption as to the expected return on plan assets,
TEP reviews the plans' asset allocation and develops return assumptions for each
asset class based on advice from an investment consultant and the plans' actuary
that includes both historical performance analysis and forward looking views of
the financial markets. Pension expense increases as the expected rate of return
on plan assets decreases. A 25 basis point change in the expected return on plan
assets would not have a significant impact on pension expense for 2004.
TEP increased the initial health care cost trend rate used in valuing
its postretirement benefit obligation to 12.1% at December 31, 2003. Assumed
health care cost trend rates have a significant effect on the amounts reported
for health care plans. A 1% increase in assumed health care cost trend rates
would increase the postretirement benefit obligation by approximately $5 million
and the related plan expense by approximately $1 million. A similar decrease in
assumed health care cost trend rates would decrease the postretirement benefit
obligation by approximately $5 million and the related plan expense by less than
$1 million.
TEP recorded a minimum pension liability of approximately $4 million at
December 31, 2003, compared with $7 million at December 31, 2002. Improved stock
market conditions offset a further reduction in the assumed discount rate.
Based on the above assumptions, TEP will record pension expense of
approximately $8 million and other postretirement benefit expense of $7 million
ratably throughout 2004. TEP will make required pension plan contributions of $5
million in 2004. TEP's other postretirement benefit plan is not funded. TEP
expects to make benefit payments to retirees under the postretirement benefit
plan of approximately $3 million in 2004.
UES
Concurrent with the acquisition of the Arizona gas and electric system
assets from Citizens on August 11, 2003, UES established a pension plan for
substantially all of its employees. UES did not assume the pension obligation
for employees' years of service with Citizens. UES performed an actuarial
valuation, as of the date of acquisition, to determine its pension expense for
the balance of 2003. A discount rate of 6.5% was assumed based on rates
available at that date and the duration of plan obligations.
UES discounted its future pension plan obligations using a rate of
6.25% at December 31, 2003. For UES' pension plan, a 25 basis point change in
the discount rate would have minimal effect on either the ABO or the related
pension expense. UES recorded a minimum pension liability of approximately $1
million at December 31, 2003. UES will record pension expense of $1 million in
2004. The pension plan is not yet funded but all required contributions will be
made in accordance with minimum funding standards. UES will make a pension plan
contribution of $1 million in 2004.
On the acquisition date, UES assumed the obligation to provide
postretirement benefits for a small population of former Citizens employees,
both active and retired. The obligation has been recorded at a discounted value
of $2 million using a discount rate of 5.25%. The plan is not funded. UES does
not expect postretirement medical benefit expenses to have a material impact on
its operations.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES
A derivative financial instrument or other contract derives its value
from another investment or designated benchmark. TEP enters into forward
contracts to purchase or sell a specified amount of capacity or energy at a
specified price over a given period of time, typically for one month, three
months, or one year, within established limits to take advantage of favorable
market opportunities. The majority of TEP's forward contracts are considered
normal purchases and sales and, therefore, are not required to be marked to
market. However, some of these forward contracts are considered to be
derivatives, which TEP marks to market by recording unrealized gains and losses
and adjusting the related assets and liabilities on a monthly basis to reflect
the market prices at the end of the month. TEP manages the risk of counterparty
default by performing financial
K-60
credit reviews, setting limits, monitoring exposures, requiring collateral when
needed, and using a standardized agreement which allows for the netting of
current period exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP. However, the contract terms allow UNS Gas
to lock in fixed prices on a portion of its gas purchases by entering into fixed
price forward contracts with BP at various times during the year. This enables
UNS Gas to provide more stable prices to its customers. These purchases are made
up to a year in advance with the goal of locking in fixed prices on at least 45%
and not more than 80% of the expected monthly gas consumption prior to entering
into the month. These forward contracts, as well as the main gas supply
contract, meet the definition of normal purchases and therefore are not required
to be marked to market.
Because of the complexity of derivatives, the FASB established a
Derivatives Implementation Group (DIG). To date, the DIG has issued more than
100 interpretations to provide guidance in applying Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities (FAS 133). As the DIG or the FASB continues to issue interpretations,
TEP, UNS Gas and UNS Electric may change the conclusions they have reached and,
as a result, the accounting treatment and financial statement impact could
change in the future.
MEG enters into swap agreements, options and forward contracts relating
to Emissions Allowances and coal. MEG also marks its trading contracts to market
by recording unrealized gains and losses on its trading activities and adjusting
the related assets and liabilities on a monthly basis to reflect the market
prices at the end of the month.
The market prices used to determine fair values for TEP's and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP's and MEG's derivative activities are reported as follows:
o TEP's net unrealized and realized gains and losses on forward sales
contracts are components of Electric
Wholesale Sales;
o TEP's net unrealized and realized gains and losses on forward purchase
contracts are components of Purchased
Power; and
o MEG's net unrealized and realized gains and losses on trading
activities are components of Other Operating Revenues. Although MEG's
realized gains and losses on trading activities are reported net on
UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of
cash flows.
TEP's net unrealized gains (losses) on forward contracts were as follows:
Years Ended December 31,
2003 2002 2001
-----------------------------------------------------------------------------------------
-Millions of Dollars-
Included in Electric Wholesale Sales $ (1) $ (1) $ 188
Included in Purchased Power Expense - 2 (189)
-----------------------------------------------------------------------------------------
The net pre-tax gains and losses from MEG's trading activities were
less than $1 million for each of the years ended December 31, 2003, 2002 and
2001.
At December 31, 2003, the fair value of TEP's derivative liabilities
was less than $1 million and is reported in Other Current Liabilities on TEP's
balance sheet. At December 31, 2002, TEP had no open forward contracts that were
considered derivatives. MEG's trading assets and liabilities are reported in
Trading Assets and Trading Liabilities on UniSource Energy's balance sheet. The
fair value of MEG's trading assets, including its Emissions Allowance inventory,
was $22 million at December 31, 2003 and $15 million at December 31,
K-61
2002. The fair value of MEG's trading liabilities was $19 million at December
31, 2003 and $10 million at December 31, 2002.
See Market Risks - Commodity Price Risk in Item 7A.
UNBILLED REVENUE - TEP AND UES
TEP's and UES' retail revenues include an estimate of MWhs/therms
delivered but unbilled at the end of each period. Unbilled revenues are
dependent upon a number of factors that require management's judgment including
estimates of retail sales and customer usage patterns. The unbilled revenue is
estimated by comparing the estimated MWhs/therms delivered to the MWhs/therms
billed to TEP and UES retail customers. The excess of MWhs/therms delivered over
MWhs/therms billed is then allocated to the retail customer classes based on
estimated usage by each customer class. TEP and UES then record revenue for each
customer class based on the various bill rates for each customer class. Due to
the seasonal fluctuations of TEP's actual load, the unbilled revenue amount
increases during the spring and summer months and decreases during the fall and
winter months. The unbilled revenue amount for UES gas sales increases during
the fall and winter months and decreases during the spring and summer months,
whereas, the unbilled revenue amount for UES electric sales increases during the
spring and summer months and decreases during the fall and winter months.
During the second quarter of 2004, we determined that the kWh
information used to estimate kWhs delivered to TEP's customers was, in general,
understated. Additionally, we determined that TEP's existing method of pricing
computed unbilled kWh sales quantities among customer classes was weighting
usage by lower-priced customers too heavily and weighting usage by higher-priced
customers too lightly. For TEP, the price paid by customers varies from a low of
3.7 cents per kWh for interruptible industrial load to a high of 13 cents per
kWh for small commercial customers, so that allocations among customer classes
are a significant element of unbilled revenues. Effective with the second
quarter of 2004, we changed the estimation methodology used to quantify unbilled
kWh sales and price the computed unbilled kWh sales quantities to more
accurately reflect actual usage and restated prior periods.
Under the revised estimation methodology, unbilled sales are estimated
for the month by reviewing the meter reading schedule and determining the number
of billed and unbilled kWhs for each cycle. Current month unbilled kWhs are
allocated by customer class. New unbilled revenue amounts are recorded and
unbilled revenue estimates from the prior month are reversed. The primary
difference between the prior estimation method and the current method results
from the reversal of the prior month's accrued unbilled revenue rather than a
methodology that had the effect of reversing unbilled kWhs, and a more precise
application of the current rates by customer class to kWhs unbilled at the end
of each month.
PLANT ASSET DEPRECIABLE LIVES - TEP AND UES
We calculate depreciation expense based on our estimate of the useful
lives of our plant assets. The estimated useful lives, and resulting
depreciation rates, used to calculate depreciation expense for the transmission
and distribution businesses of both UES and TEP have been approved by the ACC in
prior rate decisions. Depreciation rates for transmission and distribution
cannot be changed without ACC approval; however, TEP's rates may change in the
future as a result of the TEP General Rate Case filed in June 2004. We are
currently reviewing the estimated useful lives of all our assets due to a
variety of factors including TEP's need to file a depreciation study as part of
the June 2004 General Rate Case, the construction of Springerville Unit 3 and
the related environmental upgrades being made to Springerville Unit 2, new
information received from the operators of the remote generating stations, and
information received in connection with an analysis of FAS 143 retirement
obligations. See Item 1. -Business, TEP Electric Utility operations, Rates and
Regulations. The ACC is currently reviewing the status of electric competition
rules.
The estimated remaining useful lives of TEP's generating facilities are
based on management's best estimate of the economic life of the units. These
estimates are based on engineering estimates, economic analysis, and statistical
analysis of TEP's past experience in maintaining the stations. Individual
depreciation periods vary from plant to plant; however, we estimate that annual
depreciation expense would decrease by $10 million, $15 million, $19 million or
$21 million if the remaining useful lives of all our steam generation units were
increased by five, ten, fifteen or twenty years, respectively. In 2003,
depreciation expense related to generation
K-62
assets was $34 million, and our generation assets are currently depreciated over
periods ranging from 23 to 70 years from the original in-service dates.
DEFERRED TAX VALUATION - TEP AND MILLENNIUM
We record deferred tax liabilities for amounts that will increase
income taxes on future tax returns. We record deferred tax assets for amounts
that could be used to reduce income taxes on future tax returns. We record a
valuation allowance, or reserve, for the deferred tax asset amount that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
The valuation allowance of $9 million at December 31, 2003 and $22
million at December 31, 2002, which reduces the Deferred Tax Asset balance,
relates to net operating loss and investment tax credit carryforward amounts.
The decrease of $15 million reflects UniSource Energy's and TEP's expectation to
be able to use a portion of these carryforward amounts on future tax returns,
primarily based on guidance issued by the Internal Revenue Service in September,
2003.
In the future, if UniSource Energy and TEP determine that it is
probable that TEP will not be able to use all or a portion of the net operating
loss and investment tax credit carryforward amounts, then UniSource Energy and
TEP would record a valuation allowance and recognize tax expense. Factors that
could cause TEP to record a valuation allowance would be a change in expected
future taxable income or a change in tax filing status due to the proposed
acquisition. The valuation allowance of $9 million remaining at December 31,
2003 relates to losses generated by the Millennium entities. In the future if
UniSource Energy and the Millennium entities determine that all or a portion of
the remaining amounts may be used on tax returns, then UniSource Energy and the
Millennium entities would reduce the valuation allowance and recognize a tax
benefit of up to $9 million. The primary factor that could cause the Millennium
entities to recognize a tax benefit would be a change in expected future taxable
income.
NEW ACCOUNTING PRONOUNCEMENTS
-----------------------------
The FASB recently issued the following Statements of Financial
Accounting Standards (FAS) and FASB Interpretations (FIN):
o FIN 46, Consolidation of Variable Interest Entities, was issued in
January 2003, and was subsequently revised in December 2003. The
guidance addresses when a company should include in its financial
statements the assets and liabilities of another entity. The primary
objectives of FIN 46 are to provide guidance on the identification of
entities for which control is achieved through means other than through
voting rights (variable interest entities) and to determine when and
which business enterprises should consolidate the variable interest
entity (primary beneficiary). FIN 46 requires that both the primary
beneficiary and all other enterprises with a significant variable
interest make additional disclosures. For public companies, the
revised FIN 46 is effective for financial periods ending after March
15, 2004. Early application is permissible. Companies that
implemented FIN 46 prior to its revision may continue to apply that
guidance until the implementation date of the revision. The
adoption of FIN 46 and revisions did not and are not expected to have a
significant impact on our financial statements.
o FAS 149, Amendment of Statement 133 on Derivative Instruments and
Hedging Activities, was issued by the FASB in April 2003. FAS 149
amends and clarifies accounting for derivative instruments, including
certain derivative instruments embedded in other contracts, and for
hedging activities under FAS 133. FAS 149 is effective for contracts
entered into or modified after June 30, 2003, except as stated below,
and for hedging relationships designated after June 30, 2003. The
guidance is to be applied prospectively. The provisions of FAS 149
that relate to FAS 133 Implementation Issues that have been in effect
for fiscal quarters that began prior to June 15, 2003 are to be applied
in accordance with their respective effective dates. The adoption of
FAS 149 did not have a significant impact on our financial statements.
K-63
o FAS 132, Employers' Disclosures about Pensions and Other Postretirement
Benefits (revised 2003), was issued by the FASB in December 2003. FAS
132 requires additional disclosures about the assets, obligations, cash
flows, and net periodic benefit cost of defined benefit pension plans
and other defined benefit postretirement plans beyond those in the
original Statement 132 which it replaces. FAS 132, as revised, is
effective for fiscal years ending after December 15, 2003. The revised
disclosure requirements are included in Note 16.
The Emerging Issues Task Force (EITF) published Issue No. 01-08,
Determining Whether An Arrangement Contains a Lease (EITF 01-08), in May 2003.
EITF 01-08 discusses how to determine whether an arrangement contains a lease
and states that the evaluation of whether an arrangement conveys the right to
use property, plant, or equipment should be based on the substance of an
arrangement and that the property that is the subject of a lease must be
specified (explicitly or implicitly) either at inception of the arrangement or
at the beginning of the lease term. EITF 01-08 is effective for arrangements
entered into or modified after July 1, 2003. Since July 1, 2003, we have not
entered into any new arrangements, or modified any arrangements that would fall
under this EITF.
In August 2003, the EITF published Issue No. 03-11, Reporting Realized
Gains and Losses on Derivative Instruments That Are Subject to FASB Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities, and Not
"Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF 03-11). EITF
03-11 discusses whether realized gains and losses should be shown gross or net
in the income statement for contracts that are not held for trading purposes, as
defined in EITF 02-3, but are derivatives subject to FAS 133. Determining
whether realized gains and losses on derivative contracts not held for trading
purposes should be reported in the income statement on a gross or net basis is a
matter of judgment that depends on the relevant facts and circumstances with
respect to the various activities of the entity. Retroactive application of EITF
03-11 is not required. Therefore, any derivative instruments that are not held
for trading purposes but are subject to FAS 133 will be evaluated based on this
new guidance and will be reported accordingly in the financial statements
beginning January 1, 2004.
SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
------------------------------------------
This Annual Report on Form 10-K contains forward-looking statements
as defined by the Private Securities Litigation Reform Act of 1995. UniSource
Energy and TEP are including the following cautionary statements to make
applicable and take advantage of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995 for any forward-looking statements made
by or for UniSource Energy or TEP in this Annual Report on Form 10-K/A.
Forward-looking statements include statements concerning plans, objectives,
goals, strategies, future events or performance and underlying assumptions and
other statements that are not statements of historical facts. Forward-looking
statements may be identified by the use of words such as "anticipates,"
"estimates," "expects," "intends," "plans," "predicts," "projects," and similar
expressions. From time to time, we may publish or otherwise make available
forward-looking statements of this nature. All such forward-looking statements,
whether written or oral, and whether made by or on behalf of UniSource Energy or
TEP, are expressly qualified by these cautionary statements and any other
cautionary statements which may accompany the forward-looking statements. In
addition, UniSource Energy and TEP disclaim any obligation to update any
forward-looking statements to reflect events or circumstances after the date of
this report.
Forward-looking statements involve risks and uncertainties, which could
cause actual results or outcomes to differ materially from those expressed in
the forward-looking statements. We express our expectations, beliefs and
projections in good faith and believe them to have a reasonable basis. However,
we make no assurances that management's expectations, beliefs or projections
will be achieved or accomplished. We have identified the following important
factors that could cause actual results to differ materially from those
discussed in our forward-looking statements. These may be in addition to other
factors and matters discussed in other parts of this report:
1. Effects of restructuring initiatives in the electric industry and other
energy-related industries.
2. Effects of competition in retail and wholesale energy markets.
3. Changes in economic conditions, demographic patterns and weather
conditions in our retail service areas.
K-64
4. Supply and demand conditions in wholesale energy markets, including
volatility in market prices and illiquidity in markets, which are
affected by a variety of factors. These factors include the
availability of generating capacity in the western U.S., including
hydroelectric resources, weather, natural gas prices, the extent of
utility restructuring in various states, transmission constraints,
environmental regulations and cost of compliance, FERC regulation of
wholesale energy markets, and economic conditions in the western U.S.
5. The creditworthiness of the entities with which we transact business or
have transacted business.
6. Changes affecting our cost of providing electrical service including
changes in fuel costs, generating unit operating performance, scheduled
and unscheduled plant outages, interest rates, tax laws, environmental
laws, and the general rate of inflation.
7. Changes in governmental policies and regulatory actions with respect to
financing and rate structures.
8. Changes affecting the cost of competing energy alternatives, including
changes in available generating technologies and changes in the cost of
natural gas.
9. Changes in accounting principles or the application of such principles
to our businesses.
10. Changes in the depreciable lives of our assets.
11. Market conditions and technological changes affecting UniSource
Energy's unregulated businesses.
12. Ability to successfully integrate UES' businesses and achieve expected
earnings.
13. Unanticipated changes in future liabilities relating to employee
benefit plans due to changes in market values of its retirement plan
assets and health care costs.
14. The outcome of any ongoing litigation.
15. Ability to obtain financing through debt and/or equity issuance, which
can be affected by various factors, including interest rate
fluctuations and capital market conditions.
16. Ability to develop and operate Springerville Generating Station Unit 3
and achieve expected cost savings.
17. Ability to obtain necessary approvals and satisfy the other closing
conditions contained in the acquisition agreement, so that the
acquisition of UniSource Energy by an affiliate of Saguaro Utility can
occur in a timely manner.
ITEM 7A.-- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
--------------------------------------------------------------------------------
MARKET RISKS
We are exposed to various forms of market risk. Changes in interest
rates, returns on marketable securities, and changes in commodity prices may
affect our future financial results.
For additional information concerning risk factors, including market
risks, see Safe Harbor for Forward-Looking Statements, above.
Interest Rate Risk
TEP is exposed to risk resulting from changes in interest rates on
certain of its variable rate debt
K-65
obligations. At December 31, 2003 and 2002,
TEP's debt included $329 million of tax-exempt variable rate debt. The average
interest rate on TEP's variable rate debt (excluding letter of credit fees) was
1.07% in 2003 and 1.41% in 2002. TEP also has approximately $70 million in
outstanding principal amount of variable rate lease debt related to its
Springerville Common Facilities Leases. Interest on this lease debt is payable
at LIBOR plus 4.25%. The average interest rate on this lease debt was 4.58% in
2003 and 5.14% in 2002. A one percent increase (decrease) in average interest
rates would result in a decrease (increase) in TEP's pre-tax net income of
approximately $4 million.
Marketable Securities Risk
TEP is exposed to fluctuations in the return on its marketable
securities, comprised of investments in debt securities. At December 31, 2003
and 2002, TEP had marketable debt securities with an estimated fair value of
$198 million and $196 million. At December 31, 2003 and 2002, the fair value
exceeded the carrying value by $19 million and $4 million, respectively. These
debt securities represent TEP's investments in lease debt underlying certain of
TEP's capital lease obligations. Changes in the fair value of such debt
securities do not present a material risk to TEP, as TEP intends to hold these
investments to maturity.
Risk Management Committee
We have a Risk Management Committee responsible for the oversight of
commodity price risk and credit risk related to the wholesale energy marketing
activities of TEP, the emissions and coal trading activities of MEG, and the
fuel and power procurement activities at TEP and UES. Our Risk Management
Committee consists of officers from the finance, accounting, legal, wholesale
marketing, and the generation operations departments of UniSource Energy. To
limit TEP's, UES' and MEG's exposure to commodity price risk, the Risk
Management Committee sets trading and hedging policies and limits, which are
reviewed frequently to respond to constantly changing market conditions. To
limit TEP's, UES' and MEG's exposure to credit risk, the Risk Management
Committee reviews counterparty credit exposure, as well as credit policies and
limits on a quarterly basis and as needed.
Commodity Price Risk
We are exposed to commodity price risk primarily relating to changes in
the market price of electricity, natural gas, coal and Emission Allowances.
TEP
To manage its exposure to energy price risk, TEP enters into forward
contracts to buy or sell energy at a specified price and future delivery period.
Generally, TEP commits to future sales based on expected excess generating
capability, forward prices and generation costs, using a diversified market
approach to provide a balance between long-term, mid-term and spot energy sales.
TEP generally enters into forward purchases during its summer peaking period to
ensure it can meet its load and reserve requirements and account for other
contract and resource contingencies. TEP also enters into limited forward
purchases and sales to optimize its resource portfolio and take advantage of
locational differences in price. These positions are managed on both a
volumetric and dollar basis and are closely monitored using risk management
policies and procedures overseen by the Risk Management Committee. For example,
the risk management policies provide that TEP should not take a short position
in the third quarter and must have owned generation backing up all forward sales
positions at the time the sale is made. TEP's risk management policies also
restrict entering into forward positions with maturities extending beyond the
end of the next calendar year.
The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of electric energy and are not considered to be derivatives
under FAS 133. TEP records revenues on its "normal sales" and expenses on its
"normal purchases" in the period in which the energy is delivered. From time to
time, however, TEP enters into forward contracts that meet the definition of a
derivative under FAS 133. When TEP has derivative forward contracts, it marks
them to market on a daily basis using actively quoted prices obtained from
brokers for power traded over-the-counter at Palo Verde and at other
southwestern U.S. trading hubs. TEP believes that these broker quotations used
to calculate the mark-to-market values represent accurate measures of the fair
values of TEP's positions, because of the short-term nature of TEP's positions,
as limited by risk management policies, and the liquidity in the short-term
market. As of December 31, 2003, all of TEP's derivative forward contracts were
for settlement within twelve months. To adjust the value of its derivative
K-66
forward contracts to fair value on its income statement, TEP recorded an
unrealized loss of $0.4 million and an unrealized gain of $0.5 million,
respectively, on its income statements for the twelve months ended December 31,
2003 and December 31, 2002. This demonstrates the limited derivative forward
contract activity conducted by TEP and the limited impact on TEP's operating
results and financial condition.
TEP is also subject to commodity price risk from changes in the price
of natural gas. TEP typically uses generation from its facilities fueled by
natural gas to meet the summer peak demands of its retail customers and to meet
local reliability needs. Due to its increasing seasonal gas usage, TEP hedges a
portion of its natural gas purchases with fixed price contracts for a maximum of
three years, and purchases its remaining gas needs in the spot and short-term
markets through its supplier Southwest Gas Corporation (SWG).
In 2003, the average price of natural gas was $4.42 per MMBtu, or 68%
higher than 2002, due to low gas storage levels and reductions in gas
production. The increase in the regional supply of gas-generated energy and the
completion of a 500-kV transmission connection, however, allowed TEP to decrease
use of its less efficient gas generation units in favor of more economical
purchases of energy in the wholesale market. TEP's generation output fueled by
natural gas was approximately 433,000 MWh, or 4% of total generation in 2003,
compared with approximately 720,000 MWh, or 6% of total generation in 2002.
TEP entered into two purchased power agreements in 2003 for the period
2003 through 2006. During 2003, TEP purchased approximately 125,000 MWh under
these contracts; energy purchased under these agreements is
adjusted for changes in the price of natural gas.
UES
UES is also subject to commodity price risk, primarily from the changes
in the price of natural gas purchased for its UNS Gas customers. This risk is
mitigated through the PGA mechanism in UNS Gas' retail rates which provides an
adjustment to recover the actual costs of gas and transportation. UNS Gas
further reduces this risk by purchasing forward fixed price contracts for a
portion of its projected gas needs under its Price Stabilization Plan. UNS Gas
purchases between 45% and 80% of its estimated gas needs in this manner.
UNS Electric is not exposed to commodity price risk for its purchase of
electricity as it has a fixed price full-requirements supply agreement with PWCC
through May 2008.
MEG
During the fourth quarter of 2001, MEG began managing and trading
Emission Allowances, coal and related instruments. We manage the market risk of
this line of business by setting notional limits by product, as well as limits
to the potential change in fair market value under a 33% change in price or
volatility. We closely monitor MEG's trading activities, which include swap
agreements, options and forward contracts, using risk management policies and
procedures overseen by the Risk Management Committee. MEG marks its trading
positions to market on a daily basis using actively quoted prices obtained from
brokers and options pricing models for positions that extend through 2005. As of
December 31, 2003 and December 31, 2002, the fair value of MEG's trading assets
combined with Emission Allowances it holds in escrow was $21.5 million and $15.1
million, respectively. The fair value of MEG's trading liabilities was $18.8
million at December 31, 2003 and $10.3 million at December 31, 2002. During
2003, MEG reflected a $1 million unrealized gain and a $0.4 million realized
loss on its income statement, compared with an unrealized gain of $0.2 million
and a realized loss of $0.1 million in 2002.
Unrealized Gain (Loss) of MEG's Trading Activities
- Millions of Dollars -
-------------------------------------------------------------
Source of Fair Value Maturity Maturity Maturity over Total Unrealized
At December 31, 2003 0 - 6 mos. 6 - 12 mos. 1 yr. Gain (Loss)
--------------------------------------------------------------------------------------------------
Prices actively quoted $(0.8) $(0.9) $ - $(1.7)
Prices based on models and
other valuation methods 1.1 1.5 0.3 2.9
--------------------------------------------------------------------------------------------------
Total $ 0.3 $ 0.6 $0.3 $ 1.2
==================================================================================================
K-67
Credit Risk
UniSource Energy is exposed to credit risk in its energy-related
marketing and trading activities related to potential nonperformance by
counterparties. We manage the risk of counterparty default by performing
financial credit reviews, setting limits monitoring exposures, requiring
collateral when needed, and using a standard agreement which allows for the
netting of current period exposures to and from a single counterparty. Despite
such mitigation efforts, there is a potential for defaults by counterparties. In
the fourth quarter of 2000 and the first quarter of 2001, TEP was affected by
payment defaults by SCE and PG&E for amounts owed to the CPX and CISO. In the
fourth quarter of 2001, Enron defaulted on amounts owed to TEP for energy sales.
We calculate counterparty credit exposure by adding any outstanding
receivable (net of amounts payable if a netting agreement exists) to the
mark-to-market value of any forward contracts. As of December 31, 2003, TEP's
total credit exposure related to its wholesale marketing activities (excluding
defaulted amounts owed by the CPX, the CISO and Enron), was approximately $7
million and MEG's total credit exposure related to its trading activities was $8
million. TEP and MEG's credit exposure is diversified across approximately 27
counterparties. Approximately $5 million of exposure is to non-investment grade
companies.
UniSource Energy is also exposed to credit risk related to the sale of
assets owned by Nations Energy Corporation (Nations Energy). In September 2001,
Nations Energy sold its 26% equity interest in a power project located in
Curacao, Netherlands Antilles to Mirant Curacao Investments, Ltd. (Mirant
Curacao) a subsidiary of Mirant Corporation (Mirant). Nations Energy received $5
million in cash and an $11 million note receivable from Mirant Curacao. The note
was recorded at its net present value of $8 million using an 8% discount rate,
the discount being recognized as interest income over the five-year life of the
note. As of December 31, 2003, Nations Energy's receivable from Mirant Curacao
is approximately $10 million. The note is primarily included in Investments and
Other Property - Other on UniSource Energy's balance sheet. Payments on the note
receivable are expected as follows: $2 million in July 2004, $4 million in July
2005, and $5 million in July 2006. The note is guaranteed by Mirant Americas,
Inc., a subsidiary of Mirant. On July 14, 2003, Mirant, Mirant Americas, Inc.
and various other Mirant companies filed for Chapter 11 bankruptcy protection.
Mirant Curacao was not included in the Chapter 11 filings. Based on a review of
the projected cash flows for the power project, it appears Mirant Curacao will
have sufficient future cash flows to pay the note receivable and any applicable
interest. However, we cannot predict the ultimate outcome that Mirant's
bankruptcy will have on the collectibility of the note from Mirant Curacao.
Nations Energy will continue to evaluate the collectibility of the receivable,
but currently expects to collect the note in its entirety and has not recorded
any reserve for this note.
ITEM 8.-- CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
--------------------------------------------------------------------------------
See Item 15 for a list of the Consolidated Financial Statements that
are included in the following pages. See Note 20 of the Notes to Consolidated
Financial Statements.
K-68
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
UniSource Energy Corporation and to the
Board of Directors and Stockholders of
Tucson Electric Power Company
In our opinion, the consolidated financial statements listed in the index
appearing under Item 15(a)(1) presents fairly, the financial position of
UniSource Energy Corporation and its subsidiaries (the Company) and Tucson
Electric Power Company and its subsidiaries (TEP) at December 31, 2003 and 2002,
and the results of their operations and their cash flows for each of the three
years in the period ended December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. In addition, in
our opinion, the financial statement schedule listed in the index appearing
under Item 15(a)(2), presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements. These financial statements and financial statement
schedule are the responsibility of the Company's and TEP's management; our
responsibility is to express an opinion on these financial statements and
financial statement schedule based on our audits. We conducted our audits of
these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 22 to the consolidated financial statements, the Company
and TEP have restated their financial statements for unbilled revenue as of
December 31, 2003 and 2002 and for each of the three years in the period ended
December 31, 2003.
As discussed in Note 5 to the consolidated financial statements, the Company and
TEP changed the manner in which they account for asset retirement costs as of
January 1, 2003. As discussed in Note 7 to the consolidated financial
statements, the Company and TEP changed their method of accounting for
derivative instruments as of January 1, 2001.
PricewaterhouseCoopers LLP
February 20, 2004, except for Note 22, as to which the date is August 19, 2004
K-69
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF INCOME (Restated See Note 22)
Years Ended December 31,
2003* 2002* 2001*
-------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
Operating Revenues
Electric Retail Sales $746,578 $ 668,721 $ 675,173
Electric Wholesale Sales 151,111 157,108 921,280
Gas Revenue 46,520 - -
Other Revenues 28,546 13,747 16,851
-------------------------------------------------------------------------------------------------------------------------------
Total Operating Revenues 972,755 839,576 1,613,304
-------------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Fuel 210,163 209,712 258,761
Purchased Energy 131,147 43,171 731,623
Coal Contract Termination Fee - 11,250 -
Other Operations and Maintenance 217,930 188,910 179,036
Depreciation and Amortization 130,643 127,923 120,346
Amortization of Transition Recovery Asset 31,752 24,489 22,536
Taxes Other Than Income Taxes 48,115 45,508 46,213
-------------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 769,750 650,963 1,358,515
-------------------------------------------------------------------------------------------------------------------------------
Operating Income 203,005 188,613 254,789
-------------------------------------------------------------------------------------------------------------------------------
Other Income (Deductions)
Interest Income 20,493 20,654 14,600
Other Income 7,306 6,200 16,632
Other Expense (5,620) (8,026) (14,964)
-------------------------------------------------------------------------------------------------------------------------------
Total Other Income (Deductions) 22,179 18,828 16,268
-------------------------------------------------------------------------------------------------------------------------------
Interest Expense
Long-Term Debt 80,844 65,620 68,678
Interest on Capital Leases 84,080 87,801 90,559
Other Interest Expense, Net of Amounts Capitalized 1,708 1,130 (658)
-------------------------------------------------------------------------------------------------------------------------------
Total Interest Expense 166,632 154,551 158,579
-------------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes and Cumulative Effect of Accounting Change 58,552 52,890 112,478
Income Taxes 12,082 17,962 49,109
Income Before Cumulative Effect of Accounting Change 46,470 34,928 63,369
Cumulative Effect of Accounting Change - Net of Tax 67,471 - 470
-------------------------------------------------------------------------------------------------------------------------------
Net Income $ 113,941 $ 34,928 $ 63,839
===============================================================================================================================
Average Shares of Common Stock Outstanding (000) 33,828 33,665 33,398
===============================================================================================================================
Basic Earnings per Share
Income Before Cumulative Effect of Accounting Change $1.38 $1.04 $1.90
Cumulative Effect of Accounting Change - Net of Tax $1.99 - $0.01
Net Income $3.37 $1.04 $1.91
===============================================================================================================================
Diluted Earnings per Share
Income Before Cumulative Effect of Accounting Change $1.35 $1.02 $1.86
Cumulative Effect of Accounting Change - Net of Tax $1.97 - $0.01
Net Income $3.32 $1.02 $1.87
===============================================================================================================================
Dividends Paid per Share $0.60 $0.50 $0.40
===============================================================================================================================
See Notes to Consolidated Financial Statements.
* Certain amounts have been restated. See Note 22.
K-70
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2003 2002 2001
----------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
Cash Flows from Operating Activities
Cash Receipts from Electric Retail Sales $ 814,425 $ 731,404 $731,379
Cash Receipts from Electric Wholesale Sales 203,717 248,305 760,258
Cash Receipts from Gas Sales 38,171 - -
Other Cash Receipts 7,155 23,087 21,643
MEG Cash Receipts from Trading Activity 101,368 57,889 49
UED Springerville 3 Financial Closing Proceeds 43,265 - -
Interest Received 22,428 13,820 14,747
Income Tax Refunds Received 17,093 921 59
Performance Deposits (3,124) 6,147 (8,629)
Fuel Costs Paid (204,920) (201,124) (262,283)
Purchased Energy Costs Paid (185,647) (135,320) (544,472)
Wages Paid, Net of Amounts Capitalized (82,482) (75,479) (71,043)
Payment of Other Operations and Maintenance Costs (120,165) (126,623) (127,345)
MEG Cash Payments for Trading Activity (100,963) (63,766) -
Capital Lease Interest Paid (74,865) (68,975) (79,745)
Taxes Paid, Net of Amounts Capitalized (110,391) (106,550) (105,484)
Interest Paid, Net of Amounts Capitalized (73,565) (62,241) (64,814)
Income Taxes Paid (6,716) (29,238) (38,951)
Coal Contract Termination and Amendment Fees Paid - (26,649) -
Deposit-Second Mortgage Indenture (17,040) - -
Other (8,102) (12,645) (9,990)
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Operating Activities 259,642 172,963 215,379
----------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Capital Expenditures (137,282) (112,706) (121,735)
Purchase of Citizens Assets (223,430) - -
Proceeds from Investment in Springerville Lease Debt and Equity 12,078 3,078 -
Payments for Investment in Springerville Lease Debt and Equity - (138,067) (13,000)
Investments in and Loans to Equity Investees (2,072) (23,592) (18,474)
Proceeds from the Sale of Millennium Energy Businesses - - 16,631
Return of Nations Energy's Construction Deposits - - 15,574
Proceeds from the Sale of Real Estate - - 6,580
Other (26) 397 (2,423)
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Investing Activities (350,732) (270,890) (116,847)
----------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Proceeds from Borrowings under the Revolving Credit Facility 45,000 - -
Payments on Borrowings under the Revolving Credit Facility (45,000) - -
Proceeds from Issuance of Short-Term Debt 36,125 1,194 793
Repayments of Short-Term Debt (35,960) (1,078) (252)
Proceeds from Issuance of Long-Term Debt 160,000 - -
Repayment of Long-Term Debt (2,976) (2,138) (1,871)
Payment of Debt Issue Costs (3,283) (5,410) -
Payments on Capital Lease Obligations (42,657) (19,842) (26,015)
Common Stock Dividends Paid (20,208) (16,806) (13,376)
Other 10,387 4,781 7,339
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Financing Activities 101,428 (39,299) (33,382)
----------------------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 10,338 (137,226) 65,150
Cash and Cash Equivalents, Beginning of Year 90,928 228,154 163,004
----------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents, End of Year $ 101,266 $ 90,928 $228,154
======================================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-71
UNISOURCE ENERGY CORPORATION
CONSOLIDATED BALANCE SHEETS (Restated See Note 22)
December 31,
2003* 2002*
---------------------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
Utility Plant
Plant in Service $ 2,899,305 $ 2,598,884
Utility Plant under Capital Leases 748,239 747,556
Construction Work in Progress 105,804 59,926
---------------------------------------------------------------------------------------------------------------
Total Utility Plant 3,753,348 3,406,366
Less Accumulated Depreciation and Amortization (1,262,962) (1,178,547)
Less Accumulated Amortization of Capital Lease Assets (421,171) (391,915)
---------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net 2,069,215 1,835,904
---------------------------------------------------------------------------------------------------------------
Investments and Other Property
Investments in Lease Debt and Equity 178,789 191,867
Other 109,570 123,238
---------------------------------------------------------------------------------------------------------------
Total Investments and Other Property 288,359 315,105
---------------------------------------------------------------------------------------------------------------
Current Assets
Cash and Cash Equivalents 101,266 90,928
Trade Accounts Receivable 97,904 83,102
Unbilled Accounts Receivable 53,590 31,447
Allowance for Doubtful Accounts (11,522) (9,062)
Materials and Fuel Inventory 58,299 46,657
Trading Assets 21,507 15,150
Current Regulatory Assets 12,129 11,778
Deferred Income Taxes - Current 15,925 15,917
Interest Receivable - Current 11,561 12,178
Other 21,117 15,762
---------------------------------------------------------------------------------------------------------------
Total Current Assets 381,776 313,857
---------------------------------------------------------------------------------------------------------------
Regulatory and Other Assets
Transition Recovery Asset 274,182 305,934
Income Taxes Recoverable Through Future Revenues 49,849 57,044
Other Regulatory Assets 12,327 10,504
Other Assets 46,594 47,606
---------------------------------------------------------------------------------------------------------------
Total Regulatory and Other Assets 382,952 421,088
---------------------------------------------------------------------------------------------------------------
Total Assets $ 3,122,302 $ 2,885,954
===============================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
Capitalization
Common Stock Equity $ 556,472 $ 456,640
Capital Lease Obligations 762,968 801,611
Long-Term Debt 1,286,320 1,128,963
---------------------------------------------------------------------------------------------------------------
Total Capitalization 2,605,760 2,387,214
---------------------------------------------------------------------------------------------------------------
Current Liabilities
Current Obligations under Capital Leases 50,269 42,960
Current Maturities of Long-Term Debt 1,742 1,840
Accounts Payable 65,745 48,934
Interest Accrued 62,927 60,238
Trading Liabilities 18,753 10,255
Taxes Accrued 50,625 41,524
Accrued Employee Expenses 16,081 13,644
Other 15,839 7,659
---------------------------------------------------------------------------------------------------------------
Total Current Liabilities 281,981 227,054
---------------------------------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred Income Taxes - Noncurrent 96,270 39,051
Net Cost of Removal for Interim Retirements 60,998 54,748
Accrued Asset Retirement Obligation - 112,807
Other 77,293 65,080
---------------------------------------------------------------------------------------------------------------
Total Deferred Credits and Other Liabilities 234,561 271,686
---------------------------------------------------------------------------------------------------------------
Commitments and Contingencies (Note 15)
---------------------------------------------------------------------------------------------------------------
Total Capitalization and Other Liabilities $ 3,122,302 $ 2,885,954
===============================================================================================================
See Notes to Consolidated Financial Statements.
* Certain amounts have been restated. See Note 22.
K-72
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CAPITALIZATION (Restated See Note 22)
December 31,
2003 (1) 2002 (1)
----------------------------------------------------------------------------------------------------------------------------------
COMMON STOCK EQUITY - Thousands of Dollars -
Common Stock--No Par Value $ 668,022 $ 664,103
2003 2002
-------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding 33,787,941 33,578,959
Accumulated Deficit (109,706) (203,439)
Accumulated Other Comprehensive Loss (1,844) (4,024)
----------------------------------------------------------------------------------------------------------------------------------
Total Common Stock Equity 556,472 456,640
----------------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
----------------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 484,219 503,237
Springerville Coal Handling Facilities 129,415 132,333
Springerville Common Facilities 125,717 126,277
Sundt Unit 4 72,196 81,268
Other Leases 1,690 1,456
----------------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 813,237 844,571
Less Current Maturities (50,269) (42,960)
----------------------------------------------------------------------------------------------------------------------------------
Total Long-Term Capital Lease Obligations 762,968 801,611
----------------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
Issue Maturity Interest Rate
----------------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% 27,000 27,365
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 54,875 56,600
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs* 2018 - 2022 Variable** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
Senior Unsecured Notes 2008 - 2015 6.23% to 7.61% 160,000 -
Other Long-Term Debt 17 668
----------------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,288,062 1,130,803
Less Current Maturities (1,742) (1,840)
----------------------------------------------------------------------------------------------------------------------------------
Total Long-Term Debt 1,286,320 1,128,963
----------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $ 2,605,760 $ 2,387,214
==================================================================================================================================
*The Second Mortgage IDBs are backed by $341 million of LOCs (Tranche A and Tranche B) under TEP's Credit Agreement. TEP's
obligations under the Credit Agreement are collateralized with Second Mortgage Bonds. At December 31, 2003 and 2002, the annual LOC
fees (including fronting fees) were 4.25% of the Tranche A commitment and 5.75% of the Tranche B commitment.
**Weighted average interest rates on variable rate tax-exempt debt (IDBs) ranged from 0.78% to 1.88% during 2003 and 2002, and the
average interest rate on such debt was 1.07% in 2003 and 1.41% in 2002.
Unisource Energy also has stock options outstanding. See Note 18.
See Notes to Consolidated Financial Statements.
(1) Certain amounts have been restated. See Note 22.
K-73
UNISOURCE ENERGY CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Restated See Note 22)
Accumulated
Common Accumulated Other Total
Shares Common Earnings Comprehensive Stockholders'
Outstanding* Stock (Deficit)(1) Income (Loss) Equity(1)
------------------------------------------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------------------------------
- In Thousands -
Balances at December 31, 2000 33,219 657,507 $ (283,370) $ - $ 374,137
Effect on Prior Periods of Restatement 11,346 11,346
-------------- --------------
Balance at December 31, 2000 as Restated (272,024) 385,483
Comprehensive Income (Loss):
2001 Net Income - - 63,839 - 63,839
Cumulative Effect of Accounting Change
(net of $9,179,000 income tax benefit) - - - (13,827) (13,827)
Reversal of Unrealized Loss on Cash Flow Hedges
included in Cumulative Effect of Accounting Change
(net of $9,179,000 income tax expense) - - - 13,827 13,827
Unrealized Loss on Cash Flow Hedges
(net of $5,537,000 income tax benefit) - - - (8,340) (8,340)
Reversal of Unrealized Loss on Cash Flow Hedges
(net of $5,537,000 income tax expense) - - - 8,340 8,340
----------------
Total Comprehensive Income 63,839
----------------
Dividends Declared - - (13,376) - (13,376)
Shares Issued under Stock Compensation Plans 113 2,210 - - 2,210
Shares Purchased by Deferred Compensation
Trust Less Distributions (7) (215) - - (215)
Shares Issued for Stock Options 177 2,589 - - 2,589
Other - 603 - - 603
-----------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2001 33,502 662,694 (221,561) - 441,133
Comprehensive Income:
2002 Net Income - - 34,928 - 34,928
Minimum Pension Liability
(net of $2,639,000 income tax benefit) - - - (4,024) (4,024)
----------------
Total Comprehensive Income 30,904
----------------
Dividends Declared - - (16,806) - (16,806)
Shares Issued under Stock Compensation Plans 9 80 - - 80
Shares Distributed by Deferred Compensation Trust 3 48 - - 48
Shares Issued for Stock Options 65 934 - - 934
Other - 347 - - 347
------------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2002 33,579 664,103 (203,439) (4,024) 456,640
Comprehensive Income:
2003 Net Income - - 113,941 - 113,941
Minimum Pension Liability Adjustment
(net of $1,430,000 income tax expense) - - - 2,180 2,180
Total Comprehensive Income 116,121
Dividends Declared - - (20,208) - (20,208)
Shares Issued under Stock Compensation Plans 7 55 - - 55
Shares Distributed by Deferred Compensation Trust 3 52 - - 52
Shares Issued for Stock Options 199 3,489 - - 3,489
Other - 323 - - 323
---------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2003 33,788 $ 668,022 $(109,706) $ (1,844) $ 556,472
=================================================================================================================================
* UniSource Energy has 75 million authorized shares of common stock.
We describe limitations on our ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
(1) Certain amounts have been restated. See Note 22.
K-74
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF INCOME (Restated See Note 22)
Years Ended December 31,
2003* 2002* 2001*
---------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
Operating Revenues
Electric Retail Sales $ 691,503 $ 668,721 $ 675,173
Electric Wholesale Sales 151,030 157,108 921,280
Other Revenues 9,018 8,618 8,508
---------------------------------------------------------------------------------------------------------------------------------
Total Operating Revenues 851,551 834,447 1,604,961
---------------------------------------------------------------------------------------------------------------------------------
Operating Expenses
Fuel 210,163 209,712 258,761
Purchased Power 65,127 43,171 731,623
Coal Contract Termination Fee - 11,250 -
Other Operations and Maintenance 170,086 163,616 158,118
Depreciation and Amortization 121,037 124,054 117,063
Amortization of Transition Recovery Asset 31,752 24,489 22,536
Taxes Other Than Income Taxes 42,388 44,228 45,047
---------------------------------------------------------------------------------------------------------------------------------
Total Operating Expenses 640,553 620,520 1,333,148
---------------------------------------------------------------------------------------------------------------------------------
Operating Income 210,998 213,927 271,813
---------------------------------------------------------------------------------------------------------------------------------
Other Income (Deductions)
Interest Income 20,328 20,094 11,910
Interest Income - Note Receivable from UniSource Energy 10,242 9,329 9,330
Other Income 3,272 4,102 2,925
Other Expense (1,604) (1,779) (2,626)
---------------------------------------------------------------------------------------------------------------------------------
Total Other Income (Deductions) 32,238 31,746 21,539
---------------------------------------------------------------------------------------------------------------------------------
Interest Expense
Long-Term Debt 76,585 65,620 68,678
Interest on Capital Leases 84,053 87,783 90,506
Other Interest Expense, Net of Amounts Capitalized 66 446 (685)
---------------------------------------------------------------------------------------------------------------------------------
Total Interest Expense 160,704 153,849 158,499
---------------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes and
Cumulative Effect of Accounting Change 82,532 91,824 134,853
Income Taxes 21,090 36,434 57,545
---------------------------------------------------------------------------------------------------------------------------------
Income Before Cumulative Effect of Accounting Change 61,442 55,390 77,308
Cumulative Effect of Accounting Change - Net of Tax 67,471 - 470
---------------------------------------------------------------------------------------------------------------------------------
Net Income $ 128,913 $ 55,390 $ 77,778
=================================================================================================================================
See Notes to Consolidated Financial Statements.
*Certain amounts have been restated. See Note 22.
K-75
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2003 2002 2001
----------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
Cash Flows from Operating Activities
Cash Receipts from Electric Retail Sales $ 753,424 $ 731,404 $ 731,379
Cash Receipts from Electric Wholesale Sales 203,644 248,305 760,258
Interest Received 22,049 13,288 11,894
Interest Received from UniSource Energy 19,571 - 9,330
Income Tax Refunds Received 16,926 921 -
Fuel Costs Paid (204,920) (201,124) (262,283)
Purchased Power Costs Paid (119,635) (135,320) (544,472)
Wages Paid, Net of Amounts Capitalized (63,409) (60,871) (61,839)
Payment of Other Operations and Maintenance Costs (99,530) (105,844) (98,628)
Capital Lease Interest Paid (74,851) (68,911) (79,663)
Taxes Paid, Net of Amounts Capitalized (100,622) (101,866) (101,729)
Interest Paid, Net of Amounts Capitalized (73,071) (62,209) (64,830)
Income Taxes Paid (5,230) (29,109) (38,950)
Coal Contract Termination and Amendment Fees Paid - (26,649) -
Deposit-Second Mortgage Indenture (17,040) - -
Other 482 1,502 702
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Operating Activities 257,788 203,517 261,169
----------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Capital Expenditures (121,854) (103,307) (103,913)
Proceeds from Investment in Springerville Lease Debt and Equity 12,078 3,078 -
Payments for Investment in Springerville Lease Debt and Equity - (138,067) (15,167)
Purchase of North Loop Gas Turbine from UED - (14,853) -
Proceeds from the Sale of Real Estate - - 6,580
Other (670) (1,193) (274)
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Investing Activities (110,446) (254,342) (112,774)
----------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Proceeds from Borrowings under Revolving Credit Facility 45,000 - -
Payments on Borrowings under Revolving Credit Facility (45,000) - -
Repayments of Long-Term Debt (2,090) (2,114) (1,871)
Payment of Debt Issue Costs (788) (5,410) -
Dividends Paid to UniSource Energy (80,000) (35,000) (50,000)
Payments on Capital Lease Obligations (42,553) (19,544) (25,875)
Other (12,427) 8,991 319
----------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Financing Activities (137,858) (53,077) (77,427)
----------------------------------------------------------------------------------------------------------------------
Net Increase (Decrease) in Cash and Cash Equivalents 9,484 (103,902) 70,968
Cash and Cash Equivalents, Beginning of Year 55,778 159,680 88,712
----------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents, End of Year $ 65,262 $ 55,778 $ 159,680
======================================================================================================================
See Note 20 for supplemental cash flow information.
See Notes to Consolidated Financial Statements.
K-76
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED BALANCE SHEETS (Restated See Note 22)
December 31,
2003* 2002*
----------------------------------------------------------------------------------------------------------------------
ASSETS - Thousands of Dollars -
Utility Plant
Plant in Service $ 2,681,133 $ 2,598,884
Utility Plant under Capital Leases 747,533 747,556
Construction Work in Progress 82,210 59,926
----------------------------------------------------------------------------------------------------------------------
Total Utility Plant 3,510,876 3,406,366
Less Accumulated Depreciation and Amortization (1,257,585) (1,178,547)
Less Accumulated Amortization of Capital Lease Assets (421,135) (391,915)
----------------------------------------------------------------------------------------------------------------------
Total Utility Plant - Net 1,832,156 1,835,904
----------------------------------------------------------------------------------------------------------------------
Investments and Other Property
Investments in Lease Debt and Equity 178,789 191,867
Other 41,285 21,358
----------------------------------------------------------------------------------------------------------------------
Total Investments and Other Property 220,074 213,225
----------------------------------------------------------------------------------------------------------------------
Note Receivable from UniSource Energy 70,132 79,462
----------------------------------------------------------------------------------------------------------------------
Current Assets
Cash and Cash Equivalents 65,262 55,778
Trade Accounts Receivable 70,415 74,141
Unbilled Accounts Receivable 31,104 31,447
Allowance for Doubtful Accounts (11,034) (9,012)
Intercompany Accounts Receivable 10,938 14,851
Materials and Fuel Inventory 50,107 44,500
Current Regulatory Assets 8,969 11,778
Deferred Income Taxes - Current 18,847 15,917
Interest Receivable - Current 11,561 12,178
Other 8,444 8,407
----------------------------------------------------------------------------------------------------------------------
Total Current Assets 264,613 259,985
----------------------------------------------------------------------------------------------------------------------
Regulatory and Other Assets
Transition Recovery Asset 274,182 305,934
Income Taxes Recoverable Through Future Revenues 49,849 57,044
Other Regulatory Assets 11,973 10,504
Other Assets 43,651 46,752
----------------------------------------------------------------------------------------------------------------------
Total Regulatory and Other Assets 379,655 420,234
----------------------------------------------------------------------------------------------------------------------
Total Assets $ 2,766,630 $ 2,808,810
======================================================================================================================
CAPITALIZATION AND OTHER LIABILITIES
Capitalization
Common Stock Equity $ 406,054 $ 353,832
Capital Lease Obligations 762,323 801,508
Long-Term Debt 1,126,320 1,128,410
----------------------------------------------------------------------------------------------------------------------
Total Capitalization 2,294,697 2,283,750
----------------------------------------------------------------------------------------------------------------------
Current Liabilities
Current Obligations under Capital Leases 50,126 42,872
Current Maturities of Long-Term Debt 1,725 1,725
Accounts Payable 37,998 41,704
Intercompany Accounts Payable 8,413 14,520
Interest Accrued 58,620 60,238
Taxes Accrued 38,024 43,446
Accrued Employee Expenses 14,716 13,370
Other 8,063 7,543
----------------------------------------------------------------------------------------------------------------------
Total Current Liabilities 217,685 225,418
----------------------------------------------------------------------------------------------------------------------
Deferred Credits and Other Liabilities
Deferred Income Taxes - Noncurrent 128,336 71,989
Net Cost of Removal for Interim Retirements 60,417 54,748
Accrued Asset Retirement Obligation - 112,807
Other 65,495 60,098
----------------------------------------------------------------------------------------------------------------------
Total Deferred Credits and Other Liabilities 254,248 299,642
----------------------------------------------------------------------------------------------------------------------
Commitments and Contingencies (Note 15)
----------------------------------------------------------------------------------------------------------------------
Total Capitalization and Other Liabilities $ 2,766,630 $ 2,808,810
======================================================================================================================
See Notes to Consolidated Financial Statements.
*Certain amounts have been restated. See Note 22.
K-77
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENTS OF CAPITALIZATION (Restated see Note 22)
December 31,
2003 (1) 2002 (1)
------------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
COMMON STOCK EQUITY
Common Stock--No Par Value $ 655,534 $ 654,405
2003 2002
--------------------------------
Shares Authorized 75,000,000 75,000,000
Shares Outstanding* 32,139,555 32,139,555
Capital Stock Expense (6,357) (6,357)
Accumulated Deficit (241,279) (290,192)
Accumulated Other Comprehensive Loss (1,844) (4,024)
------------------------------------------------------------------------------------------------------------------------------------
Total Common Stock Equity 406,054 353,832
------------------------------------------------------------------------------------------------------------------------------------
PREFERRED STOCK
No Par Value, 1,000,000 Shares Authorized, None Outstanding - -
------------------------------------------------------------------------------------------------------------------------------------
CAPITAL LEASE OBLIGATIONS
Springerville Unit 1 484,219 503,237
Springerville Coal Handling Facilities 129,415 132,333
Springerville Common Facilities 125,717 126,277
Sundt Unit 4 72,196 81,268
Other Leases 902 1,265
------------------------------------------------------------------------------------------------------------------------------------
Total Capital Lease Obligations 812,449 844,380
Less Current Maturities (50,126) (42,872)
------------------------------------------------------------------------------------------------------------------------------------
Total Long-Term Capital Lease Obligations 762,323 801,508
------------------------------------------------------------------------------------------------------------------------------------
LONG-TERM DEBT
Issue Maturity Interest Rate
------------------------------------------------------------------------------------------------------------------------------------
First Mortgage Bonds
Corporate 2009 8.50% 27,000 27,365
Industrial Development Revenue Bonds (IDBs) 2006 - 2008 6.10% to 7.50% 54,875 56,600
First Collateral Trust Bonds 2008 7.50% 138,300 138,300
Second Mortgage IDBs** 2018 - 2022 Variable*** 328,600 328,600
Unsecured IDBs 2020 - 2033 5.85% to 7.13% 579,270 579,270
------------------------------------------------------------------------------------------------------------------------------------
Total Stated Principal Amount 1,128,045 1,130,135
Less Current Maturities (1,725) (1,725)
------------------------------------------------------------------------------------------------------------------------------------
Total Long-Term Debt 1,126,320 1,128,410
------------------------------------------------------------------------------------------------------------------------------------
Total Capitalization $ 2,294,697 $ 2,283,750
====================================================================================================================================
*UniSource Energy is the holder of all but 121 shares of TEP's outstanding common stock.
**The Second Mortgage IDBs are backed by $341 million of LOCs (Tranche A and Tranche B) under TEP's Credit Agreement. TEP's
obligations under the Credit Agreement are collateralized with Second Mortgage Bonds. At December 31, 2003 and 2002, the annual LOC
fees (including fronting fees) were 4.25% of the Tranche A commitment and 5.75% of the Tranche B commitment.
***Weighted average interest rates on variable rate tax-exempt debt (IDBs) ranged from 0.78% to 1.88% during 2003 and 2002, and the
average interest rate on such debt was 1.07% in 2003 and 1.41% in 2002.
See Notes to Consolidated Financial Statements.
(1) Certain amounts have been restated. See Note 22.
K-78
TUCSON ELECTRIC POWER COMPANY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (Restated See Note 22)
Accumulated
Capital Accumulated Other Total
Common Stock Earnings Comprehensive Stockholders'
Stock Expense (Deficit)(1) Income (Loss) Equity (1)
------------------------------------------------------------------------------------------------------------------------------------
- Thousands of Dollars -
Balances at December 31, 2000 $ 652,313 $ (6,357) $ (349,706) $ - $ 296,250
Effect on Prior Periods of Restatement 11,346 11,346
------- -------
Balance at December 31, 2000 as Restated (338,360) $ 307,596
Comprehensive Income (Loss):
2001 Net Income - - 77,778 - 77,778
Cumulative Effect of Accounting Change
(net of $9,179,000 income tax benefit) - - - (13,827) (13,827)
Reversal of Unrealized Loss on Cash Flow Hedges
included in Cumulative Effect of Accounting Change
(net of $9,179,000 income tax expense) - - - 13,827 13,827
Unrealized Loss on Cash Flow Hedges
(net of $5,537,000 income tax benefit) - - - (8,340) (8,340)
Reversal of Unrealized Loss on Cash Flow Hedges
(net of $5,537,000 income tax expense) - - - 8,340 8,340
---------------
Total Comprehensive Income 77,778
---------------
Dividend Paid - - (50,000) - (50,000)
Capital Contribution from UniSource Energy 1,592 - - - 1,592
Other 116 - - - 116
--------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2001 654,021 (6,357) (310,582) - 337,082
Comprehensive Income:
2002 Net Income - - 55,390 - 55,390
Minimum Pension Liability
(net of $2,639,000 income tax benefit) - - - (4,024) (4,024)
---------------
Total Comprehensive Income 51,366
----------------
Dividend Paid - - (35,000) - (35,000)
Capital Contribution from UniSource Energy 346 - - - 346
Other 38 - - - 38
--------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2002 654,405 (6,357) (290,192) (4,024) 353,832
Comprehensive Income:
2003 Net Income - - 128,913 - 128,913
Minimum Pension Liability Adjustment
(net of $1,430,000 income tax expense) - - - 2,180 2,180
---------------
Total Comprehensive Income 131,093
---------------
Dividend Paid - - (80,000) - (80,000)
Capital Contribution from UniSource Energy 1,129 - - - 1,129
--------------------------------------------------------------------------------------------------------------------------------
Balances at December 31, 2003 $ 655,534 $ (6,357) $ (241,279) $ (1,844) $ 406,054
====================================================================================================================================
We describe limitations on TEP's ability to pay dividends in Note 12.
See Notes to Consolidated Financial Statements.
(1) Certain amounts have been restated. See Note 22.
K-79
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED
--------------------------------------------------------------------------------
NOTE 1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
NATURE OF OPERATIONS
UniSource Energy Corporation (UniSource Energy) is an exempt holding
company under the Public Utility Holding Company Act of 1935. UniSource Energy
has no significant operations of its own, but owns substantially all of the
common stock of Tucson Electric Power Company (TEP) and all of the common stock
of UniSource Energy Services, Inc. (UES), Millennium Energy Holdings, Inc.
(Millennium) and UniSource Energy Development Company (UED).
TEP, a regulated public utility incorporated in Arizona since 1963, is
UniSource Energy's largest operating subsidiary and represented approximately
86% of UniSource Energy's assets as of December 31, 2003. TEP generates,
transmits and distributes electricity. TEP serves more than 367,000 retail
electric customers in a 1,155 square mile area in Southern Arizona. TEP also
sells electricity to other utilities and power marketing entities primarily
located in the western U.S.
On August 11, 2003, UniSource Energy completed the purchase of the Arizona
gas and electric system assets from Citizens Communications Company (Citizens)
and established UES to hold such assets. UES' businesses are described in Note
3.
Millennium's unregulated businesses are described in Note 8 and UED's
services are described in Note 6.
References to "we" and "our" are to UniSource Energy and its subsidiaries,
collectively.
BASIS OF PRESENTATION
On January 1, 1998, TEP and UniSource Energy exchanged all the outstanding
common stock of TEP on a share-for-share basis for the common stock of UniSource
Energy. Following the share exchange, in January 1998 TEP transferred the stock
of Millennium to UniSource Energy for a $95 million ten-year promissory note.
Approximately $25 million of this note represents a gain to TEP. TEP has not and
will not record this gain. Instead, this gain will be reflected as an increase
in TEP's common stock equity when UniSource Energy pays the principal portion of
the note which is required to be paid in 2008. In accordance with the Arizona
Corporation Commission (ACC) order authorizing the formation of the holding
company, the note bears interest at 9.78% payable every two years beginning
January 1, 2000. For the interest payment due January 1, 2004, UniSource Energy
paid TEP $20 million in December 2003. We expect that this intercompany note
will be repaid in full in connection with the proposed acquisition of UniSource
Energy. See Note 2.
We used the following accounting methods to report investments in
subsidiaries or other companies:
o Consolidation: The consolidation method is used where a majority of the
voting stock of a subsidiary is held and control over the subsidiary is
exercised. The accounts of the subsidiary are combined with the
accounts of the parent and intercompany balances and transactions are
eliminated.
o The Equity Method: The equity method is used to report corporate joint
ventures, partnerships, and affiliated company investments when the
ability to exercise significant influence over the operating and
financial policies of an investee company is demonstrated. The equity
method is typically used when 20% to 50% of the voting interest is
held. Under the equity method:
o The investment appears on a single line item on the balance sheet; and
o The net income (loss) from the entity is reflected in Other Income
on the income statements. For investments where UniSource Energy,
TEP, UES or Millennium is committed to providing all of the
financing, they recognize 100% of the losses (see Note 8).
o The Cost Method: The cost method is used when not enough shares are
owned to exercise significant influence over an investee company.
Typically the cost method is used for investments of less than 20% of
the voting interest in an investee company. Under the cost method:
K-80
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
o The investment appears on a single line item on the balance sheet; and
o Income from investee dividend distributions is reflected as Other
Income on the income statements; and - Loss is included in Other Income
on the income statements when impairment of the value of the
investment becomes evident.
USE OF ACCOUNTING ESTIMATES
Management makes estimates and assumptions when preparing financial
statements under accounting principles generally accepted in the United States
of America (GAAP). These estimates and assumptions affect:
o A portion of the reported amounts of assets and liabilities at the dates
of the financial statements;
o Our disclosures regarding contingent assets and liabilities at the dates
of the financial statements; and
o A portion of the reported revenues and expenses during the financial
statement reporting periods.
Because these estimates involve judgments, the actual amounts may differ
from the estimates.
ACCOUNTING FOR RATE REGULATION
The ACC and the Federal Energy Regulatory Commission (FERC) regulate
portions of TEP's and UES' utility accounting practices and electric rates. The
ACC has authority over certain rates charged to retail customers, the issuance
of securities, and transactions with affiliated parties. The FERC regulates
TEP's and UES' rates for wholesale power sales and transmission services.
TEP and UES generally use the same accounting policies and practices used
by unregulated companies for financial reporting under GAAP. However, sometimes
these principles, such as the Financial Accounting Standards Board's (FASB)
Statement of Financial Accounting Standards No. 71, Accounting for the Effects
of Certain Types of Regulation (FAS 71), require special accounting treatment
for regulated companies to show the effect of regulation. For example, in
setting TEP's and UES' retail rates, the ACC may not allow TEP or UES to
currently charge their customers to recover certain expenses, but instead may
require that these expenses be charged to customers in the future. In this
situation, FAS 71 requires that TEP and UES defer these items and show them as
regulatory assets on the balance sheet until TEP and UES are allowed to charge
their customers. TEP and UES then amortize these items as expense to the income
statement as those charges are recovered from customers. Similarly, certain
revenue items may be deferred as regulatory liabilities, which are also
eventually amortized to the income statement as rates to customers are reduced.
The conditions a regulated company must satisfy to apply the accounting
policies and practices of FAS 71 include:
o an independent regulator sets rates;
o the regulator sets the rates to recover specific costs of delivering
service; and
o the service territory lacks competitive pressures to reduce rates below
the rates set by the regulator.
CASH AND CASH EQUIVALENTS
UniSource Energy and TEP define Cash and Cash Equivalents as cash
(unrestricted demand deposits) and all highly liquid investments purchased with
an original maturity of three months or less.
UTILITY PLANT
TEP reports its utility plant on its balance sheets at cost. UES reports
the utility plant of its two operating companies, UNS Gas and UNS Electric, at
cost. Utility plant includes:
o Material and labor costs,
o Contractor costs,
o Construction overhead costs (where applicable), and
o An Allowance for Funds Used During Construction (AFUDC) or capitalized
interest during construction.
K-81
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
AFUDC reflects the cost of financing construction for transmission and
distribution projects with borrowed and equity funds.
TEP imputed the cost of capital on transmission and distribution
construction expenditures at an average of 8.43% in 2003, 8.40% in 2002 and
8.46% in 2001, to reflect the cost of using borrowed and equity funds to finance
construction. The component of AFUDC attributable to borrowed funds is included
as a reduction of Other Interest Expense on the income statement and totaled $1
million in 2003, 2002 and 2001. The equity component is included in Other Income
and totaled $1 million in 2003, 2002 and 2001.
The interest capitalized during construction of TEP's generation-related
construction projects is included as a reduction of Other Interest Expense on
the income statement and totaled $1 million in 2003, $0.5 million in 2002 and $1
million in 2001. The average capitalized interest rate during construction
applied to generation-related construction expenditures was 4.14% in 2003, 4.26%
in 2002 and 4.93% in 2001.
For the period August 11, 2003 through December 31, 2003, UES imputed the
cost of capital on construction expenditures at an average of 8.73% for UNS
Electric and 7.85% for UNS Gas. The component of AFUDC attributable to borrowed
funds is included as a reduction of Other Interest Expense on the income
statement and totaled $0.2 million in 2003. The equity component is included in
Other Income and totaled $0.2 million in 2003.
Depreciation
TEP and UES compute depreciation for owned utility plant on a
straight-line basis at rates based on the economic lives of the assets. See Note
9. The depreciation rates are approved by the ACC for all plant except TEP's
deregulated generation assets. The depreciable lives for TEP's generation plant
are based on remaining useful lives. Changes made to the depreciable lives of
TEP's generation plant are discussed in Note 9. The depreciation rates for
generation plant reflect interim retirements. Interim retirements of generation
plant, together with removal costs less salvage, are charged to accumulated
depreciation. The costs of planned major maintenance activities are recorded as
the costs are actually incurred and are not accrued in advance of the planned
maintenance. Planned major maintenance activities include the scheduled
overhauls at TEP's generation plants. Minor replacements and repairs are
expensed as incurred.
The depreciable lives for transmission, distribution, general and
intangible plant are based on average lives. The rates reflect estimated removal
costs, net of estimated salvage value for interim retirements. Retirements of
transmission plant, distribution plant, general plant and intangible plant,
together with the cost of removal less salvage, are charged to accumulated
depreciation. As of December 31, 2003, the net cost of removal of interim
retirements for transmission, distribution, general and intangible plant have
been reclassified from accumulated depreciation to a regulatory liability and
prior period amounts have been reclassified to conform to this presentation.
The average annual depreciation rates for TEP's utility plant were 3.78%
in 2003, 4.01% in 2002, and 3.88% in 2001. The average annual depreciation rates
for UES' utility plant for the period of August 11, 2003 through December 31,
2003 were 3.88% for UNS Electric and 1.47% for UNS Gas.
Computer Software Costs
TEP and UES capitalize all costs incurred to purchase computer software
and amortize those costs over the estimated economic life of the product.
Capitalized computer software costs would be immediately charged to expense if
the software is determined to be no longer useful. TEP's amortization of
capitalized computer software costs was $6 million in 2003, 2002 and 2001.
K-82
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
TEP Utility Plant under Capital Leases
TEP financed the following generation assets with capital leases:
o Springerville Common Facilities,
o Springerville Unit 1,
o Springerville Coal Handling Facilities, and
o Sundt (Irvington) Unit 4.
The following table shows the amount of lease expense incurred for TEP's
generation-related capital leases. We describe the lease terms in TEP Capital
Lease Obligations in Note 10.
Years Ended December 31,
2003 2002 2001
--------------------------------------------------------------------------------------------
-Millions of Dollars-
Lease Expense:
Interest Expense on Capital Leases $ 84 $ 88 $ 90
Amortization - Included in:
Operating Expenses - Fuel 4 4 4
Operating Expenses - Depreciation and Amortization 25 25 25
--------------------------------------------------------------------------------------------
Total Lease Expense $113 $117 $119
============================================================================================
MILLENNIUM AND UED PROPERTIES AND EQUIPMENT
Millennium's and UED's properties and equipment are included, net of
accumulated depreciation, in UniSource Energy's balance sheets in the
Investments and Other Property-Other line item. Properties and equipment are
stated at original cost and are depreciated using the straight-line method over
the estimated useful lives of the assets. Maintenance, repairs and minor
renewals are charged to expense as incurred, while major renewals and
betterments are capitalized.
DEBT
We defer costs related to the issuance of debt. These costs include
underwriters' commissions, discounts or premiums, and other costs such as legal,
accounting and regulatory fees and printing costs. We amortize these costs over
the life of the debt using the straight-line method, which approximates the
effective interest method.
TEP recognizes gains and losses on reacquired debt associated with the
generation portion of TEP's operations as incurred. TEP defers and amortizes the
gains and losses on reacquired debt associated with TEP's regulated operations
to interest income or interest expense over the remaining life of the original
debt.
UTILITY OPERATING REVENUES
TEP and UES record utility operating revenues when services are
provided or commodities are delivered to customers. Operating revenues include
unbilled revenues which are earned (service has been provided) but not billed by
the end of an accounting period. During the second quarter of 2004, we
determined that TEP's existing methodology for estimating unbilled revenues has
resulted in an under reporting of revenues in prior periods. As a result, as
described in Note 22, TEP changed its methodology for determining unbilled
revenues and restated prior year financial statements to give effect to the
change and correct the under reporting of revenues in those periods.
Under the revised estimation methodology, unbilled sales are estimated
for the month by reviewing the meter reading schedule and determining the number
of billed and unbilled kWhs for each cycle. Current month unbilled kWhs are
allocated by customer class. New unbilled revenue amounts are recorded and
unbilled revenue estimates from the prior month are reversed.
An Allowance for Doubtful Accounts is recorded as an expense and
reduces accounts receivable for revenue amounts that are estimated to become
uncollectible. TEP's Allowance for Doubtful Accounts was $11 million at
K-83
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
December 31, 2003 and $9 million at December 31, 2002. See Note 13 for further
discussion of TEP's wholesale accounts receivable and allowances. UES' Allowance
for Doubtful Accounts was $0.4 million at December 31, 2003.
REVENUE FROM LONG-TERM RESEARCH AND DEVELOPMENT CONTRACTS
UniSource Energy's income statements have included Global Solar's
long-term contract revenue in Other Operating Revenues since Global Solar was
consolidated on June 1, 2000. Global Solar recognized long-term contract revenue
of approximately $1 million in 2003, $1 million in 2002 and $2 million in 2001.
Global Solar recognized total annual research and development expense of
approximately $7 million in 2003 and 2002, and $9 million in 2001. These
expenses include both costs associated with revenue producing contracts and
internal development costs. Global Solar derives much of its revenue from
funding received under research and development contracts with various U.S.
governmental agencies. Revenues on these contracts are recognized as follows:
o Cost Reimbursement Contracts - Revenue is recognized as costs are
incurred;
o Cost Plus Fixed Fee Contracts - Revenues are recognized using the
percentage of completion method of accounting by relating contract
costs incurred to date to total contract costs; and
o Fixed Fee Contracts - Revenues are recognized when applicable milestones
are met.
Contract costs include direct material, direct labor and overhead costs.
FUEL AND PURCHASED ENERGY COSTS
TEP
Fuel inventory, primarily coal, is recorded at weighted average cost. TEP
uses full absorption costing. Under full absorption costing, all handling and
procurement costs are included in the cost of the inventory. Examples of these
costs are direct material, direct labor and overhead costs. TEP has long-term
contracts for the purchase and transportation of coal with expiration dates from
2006 through 2020. The contracts require TEP to pay a take-or-pay fee if certain
minimum quantities of coal are not purchased or transported. TEP expenses such
fees as they are incurred. See Fuel Purchase and Transportation Commitments in
Note 15, below. Fuel costs include coal mine reclamation expenses as they are
charged to TEP on an ongoing basis.
UES
UNS Electric defers differences between purchased energy costs and the
recovery of such costs in revenues. Future billings are adjusted for such
deferrals through use of a Purchased Power and Fuel Adjustment Clause (PPFAC)
approved by the ACC. The PPFAC allows for a revenue surcharge or surcredit (that
adjusts the customer's base rate for delivered purchased power) to collect or
return under or over recovery of costs. At December 31, 2003, UNS Electric had a
liability of $0.5 million for over recovered purchased power costs that is
included in Deferred Credits and Other Liabilities - Other on UniSource Energy's
consolidated balance sheet.
UNS Gas defers differences between actual gas purchase costs and the
recovery of such costs in revenues under a Purchased Gas Adjustor (PGA)
mechanism. The PGA mechanism is intended to address the volatility of natural
gas prices and allows UNS Gas to recover its costs through a price adjustor. The
PGA charge may be changed monthly based on an ACC approved mechanism that
compares the twelve-month rolling average gas cost to the base cost of gas,
subject to limitations on how much the price per therm may change in a twelve
month period. The difference between the actual cost of UNS Gas' gas supplies
and transportation contracts and that currently allowed by the ACC is deferred
and recovered or repaid through the PGA mechanism. When under or over recovery
trigger points are met, UNS Gas may request a PGA surcharge or surcredit with
the goal of collecting or returning the amount deferred from or to customers
over a twelve month period. At December 31, 2003, UNS Gas had a $3.2 million
asset for under recovered purchased gas costs that is included in Current
Regulatory Assets on UniSource Energy's consolidated balance sheet.
K-84
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
INCOME TAXES
We are required by GAAP to report some of our assets and liabilities
differently for our financial statements than we do for income tax purposes. The
tax effects of differences in these items are reported as deferred income tax
assets or liabilities in our balance sheets. We measure these tax assets and
liabilities using income tax rates that are currently in effect. Federal
Investment Tax Credits (ITC) as well as applicable state income tax credits are
accounted for as a reduction of income tax expense in the year in which the
credit arises.
We allocate income taxes to the subsidiaries based on their taxable income
and deductions as reported in the consolidated and/or combined tax return
filings.
EMISSIONS ALLOWANCES
Emissions Allowances are issued to qualifying utilities by the
Environmental Protection Agency (EPA) based on past operational history. Each
allowance permits emission of one ton of sulfur dioxide (SO2) in its vintage
year or a subsequent year. These allowances have no book value for accounting
purposes but may be sold if TEP does not need them for operations. TEP also may
purchase additional allowances if needed. See Note 15. TEP did not sell any
excess allowances in 2003. In 2002, TEP sold 4,000 allowances that were in
excess of those required for compliance to Millennium Environmental Group, Inc.
(MEG) at their fair market value of $0.5 million. This intercompany sale was
eliminated in UniSource Energy consolidation. MEG subsequently sold these
allowances to a third party.
DERIVATIVE FINANCIAL INSTRUMENTS
TEP enters into forward contracts to purchase or sell a specified amount
of capacity or energy at a specified price over a given period of time,
typically for one month, three months, or one year, within established limits to
take advantage of favorable market opportunities. The majority of TEP's forward
contracts are considered to be normal purchases and sales and, therefore, are
not required to be marked to market. However, some of these forward contracts
are considered to be derivatives, which TEP marks to market by recording
unrealized gains and losses and adjusting the related assets and liabilities on
a monthly basis to reflect the market prices at the end of the month.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market.
MEG enters into swap agreements, options and forward contracts relating to
Emissions Allowances and coal. MEG marks its trading contracts to market by
recording unrealized gains and losses and adjusting the related assets and
liabilities on a monthly basis to reflect the market prices at the end of the
month.
STOCK-BASED COMPENSATION (Restated - See Note 22)
At December 31, 2003, UniSource Energy had two stock-based compensation
plans, which are described in Note 18. We account for those plans under the
recognition and measurement principles of APB Opinion No. 25, Accounting for
Stock Issued to Employees (APB 25), and related interpretations.
Our stock options are granted with an exercise price equal to the market
value of the stock at the date of the grant. Accordingly, no compensation
expense is recorded for these awards. However, compensation expense is
recognized for restricted stock, stock unit, and performance share awards over
the performance/vesting period.
The following table illustrates the effect on UniSource Energy's net
income and earnings per share and TEP's net income had we applied the fair value
recognition provisions of Statement of Financial Accounting Standards No. 123,
Accounting for Stock-Based Compensation (FAS 123), to all stock-based employee
compensation awards:
K-85
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
UniSource Energy:
Years Ended December 31,
2003 2002 2001
--------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 113,941 $ 34,928 $ 63,839
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
850 486 544
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects (1,840) (1,757) (1,565)
--------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $112,951 $ 33,657 $ 62,818
====================================================================================================================
Earnings per Share:
Basic - As Reported $ 3.37 $ 1.04 $ 1.91
Basic - Pro Forma $ 3.34 $ 1.00 1.88
Diluted - As Reported $ 3.32 $ 1.02 $ 1.87
Diluted - Pro Forma $ 3.29 $ 0.98 $ 1.84
--------------------------------------------------------------------------------------------------------------------
TEP:
Years Ended December 31,
2003 2002 2001
--------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income - As Reported $ 128,913 $ 55,390 $ 77,778
Add: Stock-based employee compensation expense included in
reported net income, net of related tax effects
787 467 521
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects (1,761) (1,725) (1,539
--------------------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 127,939 $ 54,132 $ 76,760
====================================================================================================================
The fair value of each stock option grant is estimated on the date of
grant using the Black-Scholes option-pricing model with the following weighted
average assumptions:
2003 2002 2001
------------------------------------------------------------------- -- -------------- --- -------------- -- -----------
Expected life (years) 5 5 5
Interest rate 2.78% 1.45% 4.70%
Volatility 23.38% 23.74% 23.93%
Dividend yield 3.44% 2.83% 2.08%
Weighted-average grant-date fair value of options granted
during the period $2.92 $2.90 $4.27
------------------------------------------------------------------- -- -------------- --- -------------- -- -----------
K-86
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
NEW ACCOUNTING STANDARDS
The FASB recently issued the following Statements of Financial Accounting
Standards (FAS) and FASB Interpretations (FIN):
o FIN 46, Consolidation of Variable Interest Entities, was issued in January
2003, and was subsequently revised in December 2003. The guidance
addresses when a company should include in its financial statements the
assets and liabilities of another entity. The primary objectives of FIN 46
are to provide guidance on the identification of entities for which
control is achieved through means other than through voting rights
(variable interest entities) and to determine when and which business
enterprises should consolidate the variable interest entity (primary
beneficiary). FIN 46 requires that both the primary beneficiary and all
other enterprises with a significant variable interest make additional
disclosures. For public companies, the revised FIN 46 is effective for
financial periods ending after March 15, 2004. Early application is
permissible. Companies that implemented FIN 46 prior to its revision may
continue to apply that guidance until the implementation date of the
revision. The adoption of FIN 46 and revisions did not and are not
expected to have a significant impact on our financial statements.
o FAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities, was issued by the FASB in April 2003. FAS 149 amends and
clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and for hedging
activities under FAS 133. FAS 149 is effective for contracts entered into
or modified after June 30, 2003, except as stated below, and for hedging
relationships designated after June 30, 2003. The guidance is to be
applied prospectively. The provisions of FAS 149 that relate to FAS 133
Implementation Issues that have been in effect for fiscal quarters that
began prior to June 15, 2003 are to be applied in accordance with their
respective effective dates. The adoption of FAS 149 did not have a
significant impact on our financial statements.
o FAS 132, Employers' Disclosures about Pensions and Other Postretirement
Benefits (revised 2003), was issued by the FASB in December 2003. FAS 132
requires additional disclosures about the assets, obligations, cash flows,
and net periodic benefit cost of defined benefit pension plans and other
defined benefit postretirement plans beyond those in the original
Statement 132 which it replaces. FAS 132, as revised, is effective for
fiscal years ending after December 15, 2003. The revised disclosure
requirements are included in Note 16, below.
The Emerging Issues Task Force (EITF) published Issue No. 01-08,
Determining Whether An Arrangement Contains a Lease (EITF 01-08), in May 2003.
EITF 01-08 discusses how to determine whether an arrangement contains a lease
and states that the evaluation of whether an arrangement conveys the right to
use property, plant, or equipment should be based on the substance of an
arrangement and that the property that is the subject of a lease must be
specified (explicitly or implicitly) either at inception of the arrangement or
at the beginning of the lease term. EITF 01-08 is effective for arrangements
entered into or modified after July 1, 2003. Since July 1, 2003, we have not
entered into any new arrangements, or modified any arrangements that would fall
under this EITF.
In August 2003, the EITF also published Issue No. 03-11, Reporting
Realized Gains and Losses on Derivative Instruments That Are Subject to FASB
Statement No. 133, Accounting for Derivative Instruments and Hedging Activities,
and Not "Held for Trading Purposes" as Defined in EITF Issue No. 02-3 (EITF
03-11). EITF 03-11 discusses whether realized gains and losses should be shown
gross or net in the income statement for contracts that are not held for trading
purposes, as defined in EITF 02-3, but are derivatives subject to FAS 133.
Determining whether realized gains and losses on derivative contracts not held
for trading purposes should be reported in the income statement on a gross or
net basis is a matter of judgment that depends on the relevant facts and
circumstances with respect to the various activities of the entity. Retroactive
application of EITF 03-11 is not required. Therefore, any derivative instruments
that are not held for trading purposes but are subject to FAS 133 will be
evaluated based on this new guidance and will be reported accordingly in the
financial statements beginning January 1, 2004.
K-87
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
RECLASSIFICATIONS
UniSource Energy and TEP have made reclassifications to the prior year
financial statements for comparative purposes. See Note 5, Note 7 and Note 21.
These reclassifications had no effect on Net Income. UniSource Energy and TEP
have restated certain prior year amounts. See Note 22.
NOTE 2. PROPOSED ACQUISITION OF UNISOURCE ENERGY
------------------------------------------------
On November 21, 2003, UniSource Energy and Saguaro Acquisition Corp., a
Delaware corporation, entered into an acquisition agreement, providing for the
acquisition of all of the common stock of UniSource Energy for $25.25 per share
by an affiliate of Saguaro Utility Group L.P., an Arizona limited partnership
(Saguaro Utility), whose general partner is Sage Mountain, L.L.C. and whose
limited partners include investment funds affiliated with Kohlberg Kravis
Roberts & Co., L.P., J.P. Morgan Partners, LLC and Wachovia Capital Partners.
Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp., will merge with and into UniSource Energy. UniSource Energy will be the
surviving corporation, and will become an indirect wholly-owned subsidiary of
Saguaro Utility. Upon consummation of the acquisition, Saguaro Utility will
cause the surviving corporation to pay approximately $880 million in cash to
UniSource Energy's shareholders and holders of stock options, stock units,
restricted stock and performance shares awarded under our stock based
compensation plans.
UniSource Energy's shareholders will formally consider a proposal to
approve the acquisition agreement at a meeting scheduled for March 29, 2004. We
expect the acquisition, which is subject to several conditions, including
receipt of certain regulatory approvals, to occur in the second half of 2004.
The acquisition agreement contains operating covenants with respect to the
operations of our business pending the consummation of the acquisition.
Generally, unless UniSource Energy obtains Saguaro Acquisition Corp.'s prior
written consent, we must carry on our business in the ordinary course consistent
with past practice and use all commercially reasonable efforts to preserve
substantially intact our present business organization and present regulatory,
business and employee relationships. In addition, the acquisition agreement
restricts our activities, subject to the receipt of Saguaro Acquisition Corp.'s
prior written consent, including the issuance or repurchase of capital stock,
the amendment of organizational documents, acquisitions and dispositions of
assets, capital expenditures, incurrence of indebtedness, modification of
employee compensation and benefits, changes in accounting methods, discharge of
liabilities, and matters relating to UniSource Energy's investment in
Millennium.
Either UniSource Energy or Saguaro Acquisition Corp. may terminate the
acquisition agreement in certain circumstances, including if the acquisition is
not consummated by March 31, 2005, certain regulatory approvals are not obtained
or our shareholders fail to approve the transaction. In certain circumstances,
upon the termination of the acquisition agreement, UniSource Energy would be
required to pay Saguaro Acquisition Corp.'s expenses and a termination fee in an
aggregate amount of up to $25 million. See Note 15 for a description of
litigation related to the acquisition of UniSource Energy by Saguaro Acquisition
Corporation.
NOTE 3. ESTABLISHMENT OF UES
-----------------------------
On August 11, 2003, UniSource Energy acquired the Arizona gas and electric
system assets from Citizens for $223 million, comprised of the base purchase
price plus other operating capital adjustments and transaction costs. This
acquisition added over 128,000 retail gas customers and 81,000 retail electric
customers in Arizona to UniSource Energy's customer base as of December 31,
2003. UniSource Energy formed two new operating companies called UNS Gas, Inc.
(UNS Gas) and UNS Electric, Inc. (UNS Electric) to acquire these assets, as well
as an intermediate holding company, UES, to hold the common stock of UNS Gas and
UNS Electric. The operating results of UNS Gas, UNS Electric, and UES have been
included in UniSource Energy's consolidated financial statements since the
acquisition date.
K-88
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
The purchase price and the allocation of the assets acquired and the
liabilities assumed based on their estimated fair market values as of the
acquisition date are as follows:
Purchase Price: -Thousands of Dollars-
--------------------------------------------------------------
Cash Paid $ 218,558
Transaction Costs 4,872
--------------------------------------------------------------
Total Purchase Price $ 223,430
==============================================================
Allocation of Purchase Price: -Thousands of Dollars-
--------------------------------------------------------------
Property, Plant & Equipment $ 228,001
Current Assets 33,079
Regulatory Assets 384
Other Assets 580
Long-Term Debt (487)
Current Liabilities (31,142)
Deferred Credits and Other Liabilities (6,985)
--------------------------------------------------------------
Total Purchase Price $ 223,430
==============================================================
RATES AND REGULATION
Concurrent with the closing of the acquisition, retail rate increases for
customers of both UNS Electric and UNS Gas went into effect on August 11, 2003.
These rate increases were approved by the ACC on July 3, 2003, when it approved
the acquisition and the terms of the April 1, 2003 settlement agreement (UES
Settlement Agreement) among UniSource Energy, Citizens, and the ACC Staff.
UNS Gas
UNS Gas is regulated by the ACC with respect to retail gas rates, the
issuance of securities, and transactions with affiliated parties. UNS Gas'
retail gas rates include a monthly customer charge, a base rate charge for
delivery services and the cost of gas (expressed in cents per therm), and a PGA
mechanism.
The related ACC order and the UES Settlement Agreement include the
following terms related to UNS Gas rates:
o An increase in retail delivery base rates, effective August 11, 2003,
equivalent to a 20.9% overall increase over 2001 test year retail
revenues through a base rate increase.
o Fair value rate base of $142 million and allowed rate of return of
7.49%, based on a cost of capital of 9.05%, derived from a cost of
equity of 11.00% and a cost of debt of 7.75% (based on a capital
structure of 60% debt and 40% equity).
o The existing PGA rate may not change more than $0.15 per therm through
July 2004. Thereafter, the PGA rate may not change more than $0.10 per
therm.
Under the terms of the ACC order, UNS Gas may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Gas to
UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Gas is 35% at December 31, 2003.
On September 9, 2003, the ACC approved a new PGA surcharge of $0.1155 per
therm that took effect on October 1, 2003.
K-89
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
UNS Electric
UNS Electric is regulated by the ACC with respect to retail electric
rates, the issuance of securities, and transactions with affiliated parties, and
by the FERC with respect to wholesale power contracts and interstate
transmission service.
The ACC order and UES Settlement Agreement include the following terms
related to UNS Electric rates:
o A 22% overall increase in retail rates effective August 11, 2003 from
the rates previously in effect for Citizens. This reflects the
implementation of a PPFAC of $0.01825 per kWh, which combined with the
current base purchased power rate of $0.05194 per kWh, results in a new
PPFAC rate of $0.07019. This allows UNS Electric to fully recover the
cost of purchased power under its current contract with its sole energy
supplier, Pinnacle West Capital Corporation (PWCC).
o UNS Electric must attempt to renegotiate the PWCC purchase power
contract, and any savings that result from a renegotiated contract must
be allocated in a ratio of 90% to ratepayers and 10% to shareholders.
The ACC order also requires that TEP submit in its next general rate case
filing in June 2004, a feasibility study and consolidation plan, or a plan for
coordination of operations of UNS Electric's operations in Santa Cruz County
with those of TEP.
Under the terms of the ACC order, UNS Electric may not file a general rate
increase until August 2006 and any resulting rate increase shall not become
effective prior to August 1, 2007.
The UES Settlement Agreement also limits dividends payable by UNS Electric
to UniSource Energy to 75% of earnings until the ratio of common equity to total
capitalization reaches 40%. The ratio of common equity to total capitalization
for UNS Electric was 38% at December 31, 2003.
On November 3, 2003, UNS Electric filed a plan to open its service
territories to retail electric competition. The plan is subject to review and
approval by the ACC. As a result of the court decisions concerning the ACC's
Retail Electric Competition Rules, we are unable to predict when and how the ACC
will address this plan.
Income Statement Impact of Applying FAS 71
If UES had not applied FAS 71, net income would have been $2 million
greater, primarily as a result of the recovery of deferred purchased gas costs.
Future Implications of Discontinuing Application of FAS 71
UES' regulatory assets, net of regulatory liabilities, total $1 million at
December 31, 2003, and are all presently included in rate base and consequently
are earning a return on investment. If UES stopped applying FAS 71 to its
regulated operations, it would write off the related balances of its regulatory
assets as an expense and would write off its regulatory liabilities as income on
its income statement. Based on the regulatory asset and liability balances at
December 31, 2003, if UES had stopped applying FAS 71 to its regulated
operations, it would have recorded an extraordinary after-tax loss of $1
million. UES' cash flows would not be affected if it stopped applying FAS 71
unless a regulatory order limited its ability to recover the cost of its
regulatory assets.
K-90
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
UES COMMITMENTS
UNS Gas has firm transportation agreements with El Paso Natural Gas (EPNG)
and Transwestern Pipeline Company (Transwestern) with combined capacity
sufficient to meet its load requirements. EPNG provides gas transportation
service under a converted full requirements contract in which UNS Gas pays a
fixed reservation charge. This contract expires in August 2011. In July 2003,
FERC required the conversion of UNS Gas' full requirements status under the EPNG
agreement to contract demand starting on September 1, 2003. Upon conversion to
contract demand status, UNS Gas now has specific volume limits in each month and
specific receipt point rights from the available supply basins (San Juan and
Permian). These changes will reduce the amount of less expensive San Juan gas
available to UNS Gas. The impact, however, is not expected to be material. The
annual cost of the EPNG capacity after conversion to contract demand will not
change. The Transwestern contract expires in January 2007. The aggregate annual
minimum transportation charges are expected to be $4 million annually through
August 2011 for the EPNG contract and $3 million annually through January 2007
for the Transwestern contract. UNS Gas made payments under these contracts of $2
million in 2003.
UNS Electric imports the power it purchases over the Western Area Power
Administration's (WAPA) transmission lines. UNS Electric's transmission capacity
agreements with WAPA provide for annual rate adjustments and expire in February
2008 and June 2011. The contract that expires in 2008 also contains a capacity
adjustment clause. Under the terms of the agreements, UNS Electric's aggregate
minimum fixed transmission charges are expected to be approximately $6 million
in 2004 and $1 million in 2005 through 2011. UNS Electric made payments under
these contracts of $2 million in 2003.
NOTE 4. TEP REGULATORY MATTERS (Restated - See Note 22)
--------------------------------------------------------
Upon approval of the TEP Settlement Agreement in November 1999, TEP
discontinued regulatory accounting under FAS 71 for its generation operations.
TEP continues to report its transmission and distribution operations under FAS
71.
TEP Settlement Agreement
In November 1999, the ACC approved the TEP Settlement Agreement between
TEP and certain customer groups relating to recovery of TEP's transition costs
and standard retail rates. The TEP Settlement Agreement included:
o Consumer choice: By January 1, 2001, consumer choice for energy supply was
available to all customers.
o No rate increase: TEP's retail rates may not be increased until
December 31, 2008. TEP expects to recover the costs of transmission and
distribution under regulated unbundled rates both during and after this
period.
o Recovery of transition costs: TEP's rates include Fixed and Floating
Competition Transition Charge (CTC) components designated for the recovery
of transition costs, including generation-related regulatory assets and a
portion of TEP's generation plant assets. Retail rates will decrease by
the Fixed CTC amount after TEP has recovered $450 million or on December
31, 2008, whichever occurs first. The Floating CTC equals retail rates
less the price of retail electric service. The price of retail electric
service includes TEP's transmission and distribution charge and a market
energy component based on a market index for electric energy. Because
TEP's total retail rates are effectively frozen, the Floating CTC is
expected to allow TEP to recoup the balance of transition recovery assets
not otherwise recovered through the Fixed CTC. The Floating CTC will end
no later than December 31, 2008.
o General rate case: TEP is required to file a general rate case by June
1, 2004, including an updated cost-of-service study. TEP's rates cannot
be increased as a result of this general rate case. Any decrease
resulting from this rate case would be effective no sooner than June 1,
2005.
K-91
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Transition Recovery Asset
TEP's Transition Recovery Asset consists of generation-related regulatory
assets and a portion of TEP's generation plant asset costs. Transition costs
being recovered through the Fixed CTC include: (1) the Transition Recovery
Asset; (2) generation-related plant assets included in Plant in Service on the
balance sheet; and (3) excess capacity deferrals related to operating and
capital costs associated with Springerville Unit 2 which are being amortized as
an off-balance sheet regulatory asset. These transition costs were amortized as
follows:
Years Ended December 31,
2003 2002 2001
--------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Amortization of Transition Costs Being Recovered Through the Fixed CTC:
Transition Costs Being Recovered Through the Fixed CTC, beginning of year $ 348 $ 384 $ 418
Amortization of Transition Recovery Asset recorded on the income statement (32) (24) (22)
Amortization of Generation-Related Plant Assets (5) (3) (3)
Amortization of Excess Capacity Deferrals (off-balance sheet) (9) (9) (9)
--------------------------------------------------------------------------------------------------------------
Transition Costs Being Recovered Through the Fixed CTC, end of year $ 302 $ 348 $ 384
==============================================================================================================
The portion of the Transition Recovery Asset that is recorded on the
balance sheet was amortized as follows:
Years Ended December 31,
2003 2002 2001
-----------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Amortization of Transition Recovery Asset Recorded on the Balance Sheet:
Transition Recovery Asset, beginning of year $ 306 $ 330 $ 352
Amortization of Transition Recovery Asset recorded on the income statement (32) (24) (22)
-----------------------------------------------------------------------------------------------------------
Transition Recovery Asset, end of year $ 274 $ 306 $ 330
===========================================================================================================
The remaining transition costs being recovered through the Fixed CTC
differ from the Transition Recovery Asset recorded on the balance sheet as
follows:
December 31,
2003 2002
-----------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Transition Costs Being Recovered Through the Fixed CTC, end of year $ 302 $ 348
Unamortized Generation-Related Plant Assets (28) (33)
Unamortized Excess Capacity Deferrals (off-balance sheet) - (9)
-----------------------------------------------------------------------------------------------------------
Transition Recovery Asset, end of year $ 274 $ 306
===========================================================================================================
The remaining Transition Recovery Asset balance will be amortized as costs
are recovered through rates until TEP has recovered $450 million of transition
costs or until December 31, 2008, whichever occurs first.
K-92
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
OTHER REGULATORY ASSETS AND LIABILITIES
In addition to the Transition Recovery Asset related to TEP's generation
assets, the following regulatory assets and liabilities are being recovered
through TEP's transmission and distribution businesses:
December 31,
2003 2002
------------------------------------------------------------------------------
- In Millions-
Other Regulatory Assets
Income Taxes Recoverable Through Future Revenues $ 50 $ 57
Current Regulatory Assets 9 12
Other Regulatory Assets 12 11
------------------------------------------------------------------------------
Total Regulatory Assets $ 71 $ 80
==============================================================================
Other Regulatory Liabilities
Net Cost of Removal for Interim Retirements $ 60 $ 55
==============================================================================
Regulatory assets of approximately $21 million are not presently included
in rate base and consequently are not earning a return on investment. These
regulatory assets are being recovered through cost of service or are authorized
to be collected in future base rates. Current regulatory assets of $9 million
are related to differences between expenses recorded on the accrual basis for
GAAP accounting and on a pay-as-you-go basis for regulatory accounting. The
remaining recovery period generally ranges from 1 to 1.5 years. Regulatory
compliance costs of $9 million require specific rate action and the recovery
period will be determined in the rate case to be filed in 2004. The remaining $3
million represents unamortized loss on reacquired debt that is not included in
rate base, but the amortization of these costs is included in the ratemaking
calculation of the cost of debt, which is a component of the cost of capital
(rate of return). All regulatory assets are probable of recovery.
See Note 5 for a discussion of the amounts included in Other Regulatory
Liabilities.
INCOME STATEMENT IMPACT OF APPLYING FAS 71
The amortization of TEP's regulatory assets had the following effect on
UniSource Energy's and TEP's income statements:
Years Ended December 31,
2003 2002 2001
--------------------------------------------------------------------------------------
-Millions of Dollars-
Operating Expenses
Amortization of Transition Recovery Asset $ 32 $ 24 $ 22
Interest Expense
Long-Term Debt - 1 1
Income Taxes 7 7 5
--------------------------------------------------------------------------------------
If TEP had not applied FAS 71 in these years, the above amounts would have
been reflected in the income statements in prior periods. The reclassification
of TEP's generation-related regulatory assets to the Transition Recovery Asset
shortened the amortization period for these assets to nine years.
K-93
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
FUTURE IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71
TEP continues to apply FAS 71 to its regulated operations, which include
the transmission and distribution portions of its business. TEP regularly
assesses whether it can continue to apply FAS 71 to these operations. If TEP
stopped applying FAS 71 to its remaining regulated operations, it would write
off the related balances of its regulatory assets as an expense and its
regulatory liabilities as income on its income statement. Based on the
regulatory asset balances, net of regulatory liabilities, at December 31, 2003,
if TEP had stopped applying FAS 71 to its remaining regulated operations, it
would have recorded an extraordinary after-tax loss of approximately $172
million. While regulatory orders and market conditions may affect cash flows,
TEP's cash flows would not be affected if it stopped applying FAS 71 unless a
regulatory order limited its ability to recover the cost of its regulatory
assets.
NOTE 5. ACCOUNTING CHANGE: ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
(Restated - See Note 22)
------------------------------------------------------------------------
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 143, Accounting for Asset
Retirement Obligations (FAS 143). It requires entities to record the fair value
of a liability for a legal obligation to retire an asset in the period in which
the liability is incurred. A legal obligation is a liability that a party is
required to settle as a result of an existing or enacted law, statute, ordinance
or contract. When the liability is initially recorded, the entity should
capitalize a cost by increasing the carrying amount of the related long-lived
asset. Over time, the liability is adjusted to its present value by recognizing
accretion expense as an operating expense in the income statement each period,
and the capitalized cost is depreciated over the useful life of the related
asset. Upon settlement of the liability, an entity either settles the obligation
for its recorded amount or incurs a gain or loss if the actual costs differ from
the recorded amount.
Prior to adopting FAS 143, costs for final removal of all owned generation
facilities were accrued as an additional component of depreciation expense.
Under FAS 143, only the costs to remove an asset with legally binding retirement
obligations will be accrued over time through accretion of the asset retirement
obligation and depreciation of the capitalized asset retirement cost.
TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. The land on which these stations reside is leased from the
Navajo Nation. The provisions of the leases require the lessees to remove the
facilities upon request of the Navajo Nation at the expiration of the leases.
TEP also has certain environmental obligations at the San Juan Generating
Station (San Juan). TEP has estimated that its share of the cost to remove the
Navajo and Four Corners facilities and to settle the San Juan environmental
obligations will be approximately $38 million at the date of retirement. No
other legal obligations to retire generation plant assets were identified. As of
December 31, 2002, TEP had accrued $113 million for the final decommissioning of
its generating facilities. This amount has been reclassified from accumulated
depreciation to an accrued asset retirement obligation. As discussed below, this
amount was reversed for 2002 and included as part of the cumulative effect of
accounting change adjustment when FAS 143 was adopted on January 1, 2003.
TEP and UES have various transmission and distribution lines that operate
under land leases and rights of way that contain end dates and restorative
clauses. TEP and UES operate their transmission and distribution systems as if
they will be operated in perpetuity and would continue to be used or sold
without land remediation. As a result, TEP and UES are not recognizing the costs
of final removal of the transmission and distribution lines in their financial
statements. As of December 31, 2003, TEP had accrued $60 million and UES had
accrued $0.6 million for the net cost of removal for interim retirements from
its transmission, distribution and general plant. As of December 31, 2002, TEP
had accrued $55 million for these removal costs. These amounts have been
reclassified from accumulated depreciation to a regulatory liability.
K-94
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Millennium and UED have no asset retirement obligations.
Upon adoption of FAS 143 on January 1, 2003, TEP recorded an asset
retirement obligation of $38 million at its net present value of $1.1 million,
increased depreciable assets by $0.1 million for asset retirement costs,
reversed $112.8 million of costs previously accrued for final removal from
accumulated depreciation, reversed previously recorded deferred tax assets of
$44.2 million and recognized the cumulative effect of accounting change as a
gain of $111.7 million ($67.5 million net of tax). The adoption of FAS 143 also
resulted in a $6 million reduction of current depreciation expense charged
throughout the year because asset retirement costs are no longer recorded as a
component of depreciation expense.
The following table illustrates on a pro forma basis the amount of the
asset retirement obligation as if FAS 143 had been applied during all periods
presented:
Years Ended December 31,
2003 2002 2001
Actual Pro Forma Pro Forma
------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Asset Retirement Obligation, beginning of year $ 1,119 $ 1,017 $ 925
Accretion Expense 112 102 92
------------------------------------------------------------------------------------------------------
Asset Retirement Obligation, end of year $ 1,231 $ 1,119 $ 1,017
======================================================================================================
The following tables illustrate on a pro forma basis the effect on
UniSource Energy's net income and earnings per share and TEP's net income as if
FAS 143 had been in effect for all income statement periods presented:
UniSource Energy:
Years Ended December 31,
2002 2001
------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 34,928 $ 63,839
Adjustment to accrued expense (net of tax) as if FAS 143 had been
applied effective January 1, 2001 3,461 3,341
------------------------------------------------------------------------------------------------------
Pro Forma Net Income $ 38,389 $ 67,180
======================================================================================================
Basic Earnings per Share:
As Reported $ 1.04 $ 1.91
Adjustment to accrued expense (net of tax) as if FAS 143 had been
applied effective January 1, 2001 0.10 0.10
------------------------------------------------------------------------------------------------------
Pro Forma $ 1.14 $ 2.01
======================================================================================================
Diluted Earnings per Share:
As Reported $ 1.02 $ 1.87
Adjustment to accrued expense (net of tax) as if FAS 143 had been
applied effective January 1, 2001 0.10 0.10
----------------------------------------------------------------------------- ---------------- -------
Pro Forma $ 1.12 $ 1.97
============================================================================= ================ =======
K-95
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
TEP:
Years Ended December 31,
2002 2001
------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
Net Income - As Reported $ 55,390 $ 77,778
Adjustment to accrued expense (net of tax) as if FAS 143 had been applied
effective January 1, 2001 3,461 3,341
---------------------------------------------------------------------------------------------- ----------------
Pro Forma Net Income $ 58,851 $ 81,119
============================================================================================== ================
Amounts recorded under FAS 143 are subject to various assumptions and
determinations, such as determining whether a legal obligation exists to remove
assets, estimating the fair value of the costs of removal, estimating when final
removal will occur, and the credit-adjusted risk-free interest rates to be used
to discount future liabilities. Changes that may arise over time with regard to
these assumptions and determinations will change amounts recorded in the future
as expense for asset retirement obligations.
If TEP retires any asset at the end of its useful life, without a legal
obligation to do so, it will record retirement costs at that time as incurred or
accrued. TEP does not believe that the adoption of FAS 143 will result in any
change in retail rates since all matters relating to the rate-making treatment
of TEP's generating assets were determined pursuant to the TEP Settlement
Agreement.
NOTE 6. SEGMENT AND RELATED INFORMATION (Restated - See Note 22)
----------------------------------------------------------------
Based on the way we organize our operations and evaluate performance, we
have four reportable business segments:
(1) TEP, a vertically integrated electric utility business, is UniSource
Energy's largest subsidiary.
(2) UES is the holding company for UNS Gas, a regulated gas distribution
business; and UNS Electric, a regulated electric distribution utility
business. Results from UES are for the period from August 11, 2003 through
December 31, 2003 only (see Notes 1 and 3).
(3) Millennium holds interests in unregulated energy and emerging technology
businesses (see Note 8).
(4) UED develops generating resources and other project development
activities, including facilitating the expansion of the Springerville
Generating Station. Prior to September 2002, UED owned a 20 MW gas
turbine, which it leased to TEP. In September 2002, UED sold the turbine
to TEP for its net book value of $15 million.
Significant reconciling adjustments consist of the elimination of
intercompany activity and balances. Millennium recorded revenue from
transactions with TEP of $16 million, $14 million and $13 million in 2003, 2002
and 2001, respectively. TEP's related expense is reported in Other Operations
and Maintenance expense on its income statement. Millennium's revenue and TEP's
related expense are eliminated in UniSource Energy consolidation. Other
significant reconciling adjustments include the elimination of the intercompany
note between UniSource Energy and TEP, as well as the related interest income
and expense; and the elimination of UED's rental income and TEP's rental expense
from UED's turbine lease to TEP prior to UED's sale of the turbine to TEP in
September 2002.
As discussed in Note 1, we record our percentage share of the earnings of
affiliated companies when we hold a 20% to 50% voting interest, except for
investments where we provide all of the financing, in which case we recognize
100% of the losses. See Note 8. Our portion of the net income (loss) of the
entities in which TEP and Millennium own a 20-50% interest or have the ability
to exercise significant influence is shown below in Net Loss from Equity Method
Entities.
K-96
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
We disclose selected financial data for our business segments in the
following tables:
Segments UniSource
----------------------------------- Reconciling Energy
2003 TEP UES Millennium UED Adjustments Consolidated
----------------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Income Statement
Operating Revenues-External $ 851 $ 103 $ 8 $ 11 $ - $ 973
Operating Revenues-Intersegment 1 - 16 - (17) -
Depreciation and Amortization 121 5 5 - - 131
Amortization of Transition Recovery Asset 32 - - - - 32
Interest Income 31 - - - (11) 20
Net Loss from Equity Method Entities - - (3) - - (3)
Interest Expense 161 4 1 - 1 167
Income Tax (Benefit) Expense 21 2 (10) 5 (6) 12
Net Income (Loss) 129 3 (16) 7 (9) 114
Cash Flow Statement
Capital Expenditures (122) (14) (1) - - (137)
Investments in and Loans to Equity Method Entities - - (2) - - (2)
Balance Sheet
Total Assets 2,767 306 144 3 (98) 3,122
Investments in Equity Method Entities 5 - 31 - - 36
----------------------------------------------------------------------------------------------------------------------------------
2002
----------------------------------------------------------------------------------------------------------------------------------
Income Statement
Operating Revenues-External $ 834 $ 5 $ - $ - $ 839
Operating Revenues-Intersegment - 14 3 (17) -
Depreciation and Amortization 124 4 - - 128
Amortization of Transition Recovery Asset 24 - - - 24
Interest Income 29 1 - (9) 21
Net Loss from Equity Method Entities (1) (3) - - (4)
Interest Expense 154 1 - - 155
Income Tax (Benefit) Expense 36 (15) 1 (4) 18
Net Income (Loss) 55 (16) 1 (5) 35
Cash Flow Statement
Capital Expenditures (103) (10) - - (113)
Purchase of North Loop Gas Turbine from UED (15) - 15 - -
Investments in and Loans to Equity Method Entities - (24) - - (24)
Balance Sheet
Total Assets 2,809 151 38 (112) 2,886
Investments in Equity Method Entities 6 35 - - 41
----------------------------------------------------------------------------------------------------------------------------------
2001
----------------------------------------------------------------------------------------------------------------------------------
Income Statement
Operating Revenues-External $ 1,605 $ 8 $ - $ - $ 1,613
Operating Revenues-Intersegment - 13 2 (15) -
Depreciation and Amortization 117 3 - - 120
Amortization of Transition Recovery Asset 23 - - - 23
Interest Income 21 3 - (9) 15
Net Loss from Equity Method Entities (1) (10) - - (11)
Interest Expense 159 - - - 159
Income Tax (Benefit) Expense 58 (5) - (4) 49
Net Income (Loss) 78 (9) 1 (6) 64
Cash Flow Statement
Capital Expenditures (104) (17) (1) - (122)
Investments in and Loans to Equity Method Entities - (18) - - (18)
Balance Sheet
Total Assets 2,825 176 27 (102) 2,926
Investments in Equity Method Entities 7 14 - - 21
----------------------------------------------------------------------------------------------------------------------------------
K-97
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
NOTE 7. ACCOUNTING FOR DERIVATIVE INSTRUMENTS, TRADING ACTIVITIES AND HEDGING
ACTIVITIES
------------------------------------------------------------------------------
On January 1, 2001, TEP recorded an after-tax gain of less than $1 million
in its income statement for the cumulative effect of adopting Statement of
Financial Accounting Standards No. 133, Accounting for Derivative Instruments
and Hedging Activities (FAS 133). TEP enters into forward contracts to purchase
or sell a specified amount of capacity or energy at a specified price over a
given period of time, typically for one month, three months, or one year, within
established limits to take advantage of favorable market opportunities. In
general, TEP enters into forward purchase contracts when market conditions
provide the opportunity to purchase energy for its load at prices that are below
the marginal cost of its supply resources or to supplement TEP's own resources
(i.e., during plant outages and summer peaking periods). TEP enters into forward
sales contracts when TEP forecasts that it has excess supply and the market
price of energy exceeds its marginal cost. The majority of TEP's forward
contracts are considered to be normal purchases and sales and, therefore, are
not required to be marked to market. However, some of these forward contracts
are considered to be derivatives, which TEP marks to market by recording
unrealized gains and losses and adjusting the related assets and liabilities on
a monthly basis to reflect the market prices at the end of the month. TEP
manages the risk of counterparty default by performing financial credit reviews,
setting limits, monitoring exposures, requiring collateral when needed, and
using a standardized agreement which allows for the netting of current period
exposures to and from a single counterparty.
UNS Gas and UNS Electric do not currently have any contracts that are
required to be marked to market. UNS Gas does have a natural gas supply and
management agreement under which it purchases substantially all of its gas
requirements at market prices from BP Energy Company (BP). However, the contract
terms allow UNS Gas to lock in fixed prices on a portion of its gas purchases by
entering into fixed price forward contracts with BP at various times during the
year. This enables UNS Gas to provide more stable prices to its customers. These
purchases are made up to a year in advance with the goal of locking in fixed
prices on at least 45% and not more than 80% of the expected monthly gas
consumption prior to entering into the month. These forward contracts, as well
as the main gas supply contract, meet the definition of normal purchases and
therefore are not required to be marked to market.
MEG, a wholly-owned subsidiary of Millennium, began operations in November
2001 and enters into swap agreements, options and forward contracts relating to
Emissions Allowances and coal. MEG marks its trading contracts to market by
recording unrealized gains and losses and adjusting the related assets and
liabilities on a monthly basis to reflect the market prices at the end of the
month.
The market prices used to determine fair values for TEP's and MEG's
derivative instruments are estimated based on various factors including broker
quotes, exchange prices, over the counter prices and time value.
TEP's and MEG's derivative activities are reported as follows:
o TEP's net unrealized and realized gains and losses on forward sales
contracts are components of Electric Wholesale Sales;
o TEP's net unrealized and realized gains and losses on forward purchase
contracts are components of Purchased Power; and
o MEG's net unrealized and realized gains and losses on trading
activities are components of Other Operating Revenues. Although MEG's
realized gains and losses on trading activities are reported net on
UniSource Energy's income statement, the related cash receipts and cash
payments are reported separately on UniSource Energy's statement of
cash flows.
TEP's net unrealized gains (losses) on forward contracts were as follows:
Years Ended December 31,
2003 2002 2001
------------------------------------------------------------------------------
-Millions of Dollars-
Included in Electric Wholesale Sales $ (1) $ (1) $ 188
Included in Purchased Power Expense - 2 (189)
------------------------------------------------------------------------------
K-98
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
The net pre-tax gains and losses from MEG's trading activities were less
than $1 million for each of the years ended December 31, 2003, 2002 and 2001.
At December 31, 2003, the fair value of TEP's derivative liabilities was
less than $1 million and is reported in Other Current Liabilities on TEP's
balance sheet. At December 31, 2002, TEP had no open forward contracts that were
considered derivatives. MEG's trading assets and liabilities are reported in
Trading Assets and Trading Liabilities on UniSource Energy's balance sheet. The
fair value of MEG's trading assets, including its Emissions Allowance inventory,
was $22 million at December 31, 2003 and $15 million at December 31, 2002. The
fair value of MEG's trading liabilities was $19 million at December 31, 2003 and
$10 million at December 31, 2002.
TEP treated certain forward sale and purchase contracts as cash flow
hedges when it adopted FAS 133 and recorded an unrealized gain/loss related to
these hedges in Other Comprehensive Income. However, during 2001, new guidance
was issued by the FASB which provided that certain forward power purchase or
sale agreements, including capacity contracts, could be excluded from the
requirements of FAS 133. TEP implemented this new guidance in 2001 and
determined that the items designated as cash flow hedges upon adoption could be
excluded from the FAS 133 requirements. Therefore, as these contracts settled in
2001, TEP reversed the unrealized gain/loss included in Other Comprehensive
Income and recorded the realized gain/loss in the income statement. As of
December 31, 2003 and December 31, 2002, TEP had no material cash flow hedges.
NOTE 8. MILLENNIUM
-------------------
See Note 6 for selected financial data of Millennium.
Through affiliates, Millennium holds investments in unregulated energy and
emerging technology companies. As presented in Note 6, Millennium's assets
represent 5% in 2003 and 2002 of UniSource Energy's total assets. Under the
acquisition agreement described in Note 2, UniSource Energy is limited as to the
amount it can invest in Millennium. Consequently, Millennium's ability to
provide future funding for the operations of emerging companies could be
affected.
Millennium accounts for these investments under the consolidation and
equity methods. In some cases, Millennium is an investment's sole funder. When
this is the case, Millennium recognizes 100% of an investment's losses, because
as sole provider of funds it bears all of the financial risk. To the extent that
an investment becomes profitable and Millennium has recognized losses in excess
of its percentage ownership, Millennium will recognize 100% of an investment's
net income until Millennium's recognized losses equal its ownership percentage
of losses.
A brief summary of Millennium's investments follows:
Global Solar Energy, Inc. (Global Solar) primarily develops and
manufactures light weight thin-film photovoltaic cells and panels. Global
Solar's target markets have included military, space and commercial
applications. In 2003, Millennium increased its ownership of Global Solar to 99%
from 87%. Millennium accounts for Global Solar under the consolidation method
and recognizes 100% of Global Solar's losses. In 2003, Millennium funded debt
and equity contributions of $10 million to Global Solar. Global Solar recognizes
expense when the funding is used for research, development and administrative
costs. Millennium has no remaining funding commitments to Global Solar.
Infinite Power Solutions, Inc. (IPS) develops thin-film lithium ion
batteries. Millennium's ownership in IPS was reduced in 2003 from 77% to 72%.
Millennium accounts for IPS under the consolidation method. In 2003, Millennium
provided IPS debt and equity funding of $3 million. In 2003, Dow Corning
Enterprises, Inc. (DCEI) continued to support IPS with preferred equity and debt
contributions totaling $2 million. IPS recognizes expense when funding is used
for research, development and administrative costs. At December 31, 2003,
Millennium had committed less than an additional $1 million to IPS. In early
2004 these funds were drawn by IPS. DCEI holds warrants to purchase additional
preferred shares of IPS that if exercised, could result in Millennium's
ownership of IPS being reduced to as low as 59%.
K-99
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
MicroSat Systems, Inc. (MicroSat) develops small-scale satellites under
U.S. government contracts. In February 2004, MicroSat obtained confirmation that
the unfunded cost share commitment under this contract had been eliminated. The
change and related adjustments will be reflected in 2004. In 2003, Millennium
reduced its ownership of MicroSat to 35% from 49%. Millennium made no
contributions to MicroSat in 2003. As sole funder, Millennium recognizes 100% of
MicroSat's net losses. Millennium has no further funding commitments to
MicroSat.
MEG is a wholly-owned subsidiary of Millennium, which manages and trades
emissions allowances, coal, and related financial instruments. MEG's activities
are described in Note 7.
Haddington Energy Partners II, LP (Haddington) funds energy-related
investments. A member of the UniSource Energy Board of Directors has an
investment in Haddington and is a managing director of the general partner of
the limited partnership. Millennium committed $15 million in capital, excluding
fees, to Haddington in exchange for approximately 31% of Haddington. At December
31, 2003, Millennium has funded $9 million of this commitment, of which $2
million was funded in 2003. Millennium expects the balance to be funded in the
next three years. Millennium accounts for the investment under the equity
method.
Valley Ventures III, LP (Valley Ventures) is a venture capital fund that
invests in information technology, microelectronics and biotechnology, primarily
within the Southwestern U.S. A different member of the UniSource Energy Board of
Directors is a general partner of the company that manages the fund. Millennium
committed $6 million, including fees, to the fund and owns approximately 15% of
the fund. Millennium had funded $1 million of this commitment as of December 31,
2003. Millennium expects the balance to be funded by the end of 2007. Millennium
accounts for this investment under the equity method due to an ability to
exercise significant influence over the fund based on the related party
disclosure above.
Carboelectrica Sabinas, S. de R.L. de C.V. (Sabinas) is a Mexican limited
liability company created to develop up to 800 megawatts (MW) of coal-fired
generation in the Sabinas region of Coahuila, Mexico. Sabinas also owns 19.5% of
Minerales de Monclova, S.A. de C.V. (Mimosa). Mimosa is an owner of coal and
associated gas reserves. Mimosa supplies metallurgical coal to the Mexican steel
industry and thermal coal to the major electric utility in Mexico. Millennium
owns 50% of Sabinas. Altos Hornos de Mexico, S.A. de C.V. (AHMSA) and affiliates
also own 50%. Also, UniSource Energy's Chairman, President and Chief Executive
Officer is a member of the board of directors of AMHSA. Since 1999, both AHMSA
and Mimosa are parties to a suspension of payments procedure, under applicable
Mexican law, which is the equivalent of a U.S. Chapter 11 proceeding. Under
certain circumstances, Millennium has the right to sell (a put option) its
interest in Sabinas to an AHMSA affiliate for $20 million plus an accrued
service fee. These circumstances include failure of Sabinas to reach financial
closing on the generation project within a specified time. Millennium's put
option is secured by collateral initially valued in excess of $20 million. In
2003 Millennium received $1 million of returned capital from the investment.
Millennium accounts for the investment in Sabinas under the equity method,
however Sabinas accounts for its investment in Mimosa under the cost method.
Nations Energy Corporation (Nations Energy) is wholly owned by Millennium.
Through subsidiaries, Nations Energy has a 40% interest in a 43 MW power plant
in Panama. Nations Energy intends to sell its interest in this plant, whose book
value is currently less than $1 million.
Nations Energy Contingency
In September 2001, Nations Energy sold its 26% equity interest in a power
project located in Curacao, Netherlands Antilles to Mirant Curacao Investments,
Ltd. (Mirant Curacao) a subsidiary of Mirant Corporation (Mirant). Nations
Energy received $5 million in cash and an $11 million note receivable from
Mirant Curacao. The note was recorded at its net present value of $8 million
using an 8% discount rate, the discount being recognized as interest income over
the five-year life of the note. As of December 31, 2003, Nations Energy's
receivable from Mirant Curacao is approximately $10 million. The note is
primarily included in Investments and Other Property - Other on UniSource
Energy's balance sheet. Payments on the note receivable are expected as follows:
$2 million in July 2004, $4 million in July 2005, and $5 million in July 2006.
K-100
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
The note is guaranteed by Mirant Americas, Inc., a subsidiary of Mirant.
On July 14, 2003, Mirant, Mirant Americas, Inc. and various other Mirant
companies filed for Chapter 11 bankruptcy protection. Mirant Curacao was not
included in the Chapter 11 filings. Based on a review of the projected cash
flows for the power project, it appears Mirant Curacao will have sufficient
future cash flows to pay the note receivable and any applicable interest.
However, we cannot predict the ultimate outcome that Mirant's bankruptcy will
have on the collectibility of the note from Mirant Curacao. Nations Energy will
continue to evaluate the collectibility of the receivable, but currently expects
to collect the note in its entirety and has not recorded any reserve for this
note.
Millennium Commitments
Millennium is currently finalizing possible future commitments to each of
its investments to help insure that these investments conform to Millennium's
business plans. Millennium's funding levels and share ownership are subject to
change in the future. Millennium's outstanding equity commitments are currently
limited to $6 million to Haddington and $5 million to Valley Ventures.
Millennium's only remaining debt commitment, to IPS, was funded in early 2004.
Millennium may commit to provide additional funding to its investments in the
future.
Global Solar and MicroSat have commitments to incur future expenses
relating to government contracts. The following is a table of remaining
government contract commitments at:
December 31,
2003 2002 2001
---------------------------------------------------------------------------
-Millions of Dollars-
Global Solar $ 1 $ 3 $ -
MicroSat - 6 8
---------------------------------------------------------------------------
Total $ 1 $ 9 $ 8
===========================================================================
NOTE 9. UTILITY PLANT AND JOINTLY-OWNED FACILITIES
---------------------------------------------------
UTILITY PLANT
The following table shows Utility Plant in Service by company and major
class at December 31:
2003 2002
----------------------------------------------------------------------------------------------------------------------
- Millions of Dollars -
UniSource UniSource
Energy Energy
TEP UES Consolidated TEP UES Consolidated
----------------------------------------------------------------------------------------------------------------------
Plant in Service:
Electric Generation Plant $1,187 $ 5 $1,192 $1,166 $ - $1,166
Electric Transmission Plant 531 11 542 515 - 515
Electric Distribution Plant 780 61 841 741 - 741
Gas Distribution Plant - 120 120 - - -
Gas Transmission Plant - 9 9 - - -
General Plant 133 10 143 130 - 130
Intangible Plant 49 2 51 46 - 46
Electric Plant Held for Future
Use 1 - 1 1 - 1
------------------------------- -- ---------- ------------- ---------------- ------------ ----------- ----------------
Total Plant in Service $2,681 $ 218 $2,899 $2,599 $ - $2,599
=============================== == ========== ============= ================ ============ =========== ================
Utility Plant under Capital
Leases $ 747 $ 1 $ 748 $ 747 $ - $ 747
=============================== == ========== ============= ================ ============ =========== ================
K-101
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Intangible Plant primarily represents computer software costs. TEP's
unamortized computer software costs were $24 million as of December 31, 2003 and
$28 million as of December 31, 2002. UES' unamortized computer software costs
were $2 million as of December 31, 2003.
All Utility Plant under Capital Leases is used in TEP's generation
operations.
The depreciable lives currently used by TEP are as follows:
Major Class of Utility Plant in Service Depreciable Lives
---------------------------------------------------- ------------------------
Electric Generation Plant 23-70 years
Electric Transmission Plant 10-50 years
Electric Distribution Plant 24-60 years
General Plant 5-45 years
Intangible Plant 3-10 years
---------------------------------------------------- ------------------------
In the second quarter of 2002, TEP increased its estimates of useful lives
by 20 years for its Sundt Generating Station gas-fired generating units and by
15 years for its internal combustion turbines. The changes in estimates
decreased depreciation expense from 2001 levels by $4 million in 2003 and by $3
million in 2002. TEP continues to evaluate the depreciable lives of its other
generating stations.
See TEP Utility Plant in Note 1 and TEP Capital Lease Obligations in Note
10.
The depreciable lives currently used by UES are as follows:
Major Class of Utility Plant in Service Depreciable Lives
---------------------------------------------------- ------------------------
Electric Generation Plant 23-40 years
Electric Transmission Plant 11-45 years
Electric Distribution Plant 14-26 years
Gas Distribution Plant 17-48 years
Gas Transmission Plant 37-55 years
General Plant 3-33 years
---------------------------------------------------- ------------------------
JOINTLY-OWNED FACILITIES
At December 31, 2003, TEP's interests in generating stations and
transmission systems that are jointly-owned with other utilities were as
follows:
Percent Plant Construction
Owned by TEP in Work in Accumulated
Service * Progress Depreciation
-------------------------------------- -------------- ------------ ---------------- ----------------
-Millions of Dollars-
San Juan Units 1 and 2 50.0% $295 $10 $203
Navajo Station Units 1, 2 and 3 7.5 126 4 66
Four Corners Units 4 and 5 7.0 80 2 64
Transmission Facilities 7.5 to 95.0 225 - 146
-------------------------------------- -------------- ------------ ---------------- ----------------
Total $726 $16 $479
====================================== ============== ============ ================ ================
*Included in Utility Plant shown above.
TEP has financed or provided funds for the above facilities and TEP's
share of their operating expenses is reflected in the income statements. See
Note 15 for commitments related to TEP's jointly-owned facilities.
K-102
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
NOTE 10. DEBT AND CAPITAL LEASE OBLIGATIONS
--------------------------------------------
UNISOURCE ENERGY DEBT
UniSource Energy summarizes its consolidated long-term debt in the
statements of capitalization.
Bridge Loan
In August 2003, UniSource Energy borrowed $35 million from a financial
institution in the form of short-term debt to help finance the purchase of
Citizens Arizona electric and gas utility assets. The funds were used as an
equity contribution in the capitalization of UES. On October 24, 2003, as
required by the debt agreement, UniSource Energy repaid the $35 million loan
upon the financial close of the Springerville Unit 3 project. See Note 14.
TEP LONG-TERM DEBT
Long-term debt matures more than one year from the date of the financial
statements. TEP summarizes its long-term debt in the statements of
capitalization.
TEP made the required sinking fund payments of $2 million on its First
Mortgage IDBs in each of 2003 and 2002. TEP redeemed $0.4 million of its 8.5%
First Mortgage Bonds in each of 2003 and 2002. TEP did not issue any new bonds
in 2003 or 2002.
TEP OTHER DEBT AND AGREEMENTS
First and Second Mortgage
TEP's first and second mortgage indentures create liens on and security
interests in most of TEP's utility plant assets, with the exception of
Springerville Unit 2. San Carlos Resources Inc., a wholly-owned subsidiary of
TEP, holds title to Springerville Unit 2. Utility Plant under Capital Leases is
not subject to such liens or available to TEP creditors, other than the lessors.
The net book value of TEP's utility plant subject to the lien of the indentures
was $1,124 million at December 31, 2003.
Bank Credit Agreement
In November 2002, TEP entered into a new $401 million Credit Agreement to
replace the credit facilities provided under its then existing $441 million
Credit Agreement that would have expired December 30, 2002. The new agreement
provided a $60 million Revolving Credit Facility and two Letter of Credit
facilities (Tranche A and Tranche B; collectively, LOC) totaling $341 million.
The Revolving Credit Facility, used to provide liquidity for general corporate
purposes, is a 364-day facility that was to expire on November 13, 2003. In
October 2003, TEP's revolving credit lenders agreed to extend the Revolving
Credit Facility under the same terms and conditions to November 11, 2004. The
LOC secures the payment of principal and interest on $329 million of tax-exempt
variable rate bonds (IDBs). Tranche A provides $135 million and expires in
January 2006; Tranche B provides $206 million and expires in November 2006. The
facilities are collateralized by $401 million of Second Mortgage Bonds.
The Credit Agreement contains a number of restrictive covenants, including
restrictions on additional indebtedness, liens, sale of assets or mergers and
sale-leasebacks. The proposed acquisition of UniSource Energy by an affiliate of
Saguaro Utility, as discussed in Note 2, is not restricted by these covenants.
The Credit Agreement also contains several financial covenants including net
worth, cash coverage and leverage tests. As of December 31, 2003, TEP was in
compliance with these financial covenants.
K-103
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
At December 31, 2003 and 2002, TEP had no outstanding borrowings under the
Revolving Credit Facility. When TEP borrows under the Revolving Credit Facility,
the borrowing costs are at a variable interest rate consisting of a spread over
the London Interbank Offered Rate (LIBOR) or an alternate base rate. The spread
is based upon a pricing grid tied to TEP's credit ratings. Also, TEP pays an
annual commitment fee on the unused portion of the Revolving Credit Facility and
a fee on the LOC facilities. The chart below shows the per annum rates and fees
in effect on TEP's Credit Facilities as of December 31, 2003, based on its
credit ratings, as well as the possible range of rates and fees if TEP's credit
ratings were to change:
Current Rate / Range of
Fee Rates / Fees
-------------------------------------------------------- ------------------ ------------------------
Revolving Credit Facility
o Commitment Fee 0.35% 0.25% to 0.40%
o Borrowing Rate (spread over LIBOR) 4.00% 3.50% to 4.25%
Tranche A LOCs (including LOC Fronting Fee) 4.25% 3.75% to 4.50%
Tranche B LOCs (including LOC Fronting Fee) 5.75% 5.75%
-------------------------------------------------------- ------------------ ------------------------
TEP CAPITAL LEASE OBLIGATIONS
The terms of TEP's capital leases are as follows:
o The Sundt Lease has an initial term to January 2011 and provides for
renewal periods of two or more years through 2020.
o The Springerville Common Facilities Leases have an initial term to
December 2017 for one lease and January 2021 for the other two leases,
subject to optional renewal periods of two or more years through 2025.
o The Springerville Unit 1 Leases have an initial term to January 2015
and provide for renewal periods of three or more years through 2030.
o The Springerville Coal Handling Facilities Leases have an initial term
to April 2015 and provide for one renewal period of six years, then
additional renewal periods of five or more years through 2035.
Springerville Lease Debt and Equity
TEP held Springerville Unit 1 lease debt totaling $100 million at December
31, 2003 and $108 million at December 31, 2002. In 2003, TEP made no additional
purchases of Springerville Unit 1 lease debt, but received principal payments
related to its investment in Springerville Unit 1 lease debt of $7 million. In
2002, TEP purchased $36 million of Springerville Unit 1 lease debt.
At December 31, 2003 and December 31, 2002, TEP held $79 million and $84
million, respectively, of Springerville Coal Handling Facilities lease debt and
equity. TEP purchased a 13% ownership interest in the Springerville Coal
Handling Facilities Leases for $13 million in December 2001 and all $96 million
of the debt related to these capital leases in January 2002. In March 2002, TEP
terminated the lease related to its equity interest and cancelled the associated
debt. As a result of the lease termination, TEP recorded a $21 million reduction
to the capital lease obligation, a $27 million reduction of its investment, and
a $6 million increase in the capital lease asset, which represents the residual
value of TEP's interest in the leased asset and is carried at cost.
TEP recognizes interest income on these investments. TEP's purchases of
lease debt and equity are reflected in investing activities on TEP's cash flow
statements.
K-104
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
In 1985, TEP sold and leased back its undivided one-half ownership
interest in the common facilities at the Springerville Generating Station. Under
the terms of the Springerville Common Facilities Leases, TEP must periodically
arrange for refinancing or refunding of the secured notes underlying the leases
prior to the named date in order to avoid a special event of loss. TEP was
required to arrange for the refinancing of the lease debt prior to the special
event of loss date of June 30, 2003 or the leases would have been terminated and
TEP would have been required to repurchase the facilities for $125 million. TEP
finalized the arrangements for the refinancing of $70 million of lease debt on
June 26, 2003 and the special event of loss date was reset for June 30, 2006.
TEP incurred a total of $0.3 million in debt costs related to the refinancing.
These costs were deferred and are being amortized over a three year period.
Interest on the new debt is payable at LIBOR plus 4.25%. The LIBOR rate is reset
every six months and the rate in effect on December 31, 2003 was 0.99%, which
resulted in a total interest rate on the lease debt of 5.24% at year end. Prior
to the refinancing, the interest rate was LIBOR plus 2.50%.
UES LONG-TERM DEBT
Senior Unsecured Notes
On August 11, 2003, UNS Gas and UNS Electric issued a total of $160
million of aggregate principal amount of senior unsecured notes in a private
placement. Proceeds from the note issuance were paid to Citizens to purchase the
Arizona gas and electric system assets. UNS Gas issued $50 million of 6.23%
notes due August 11, 2011 and $50 million of 6.23% notes due August 11, 2015.
UNS Electric issued $60 million of 7.61% notes due August 11, 2008. All three
series of notes may be prepaid with a make-whole call premium reflecting a
discount rate equal to an equivalent maturity U.S. Treasury security yield plus
50 basis points. UNS Gas and UNS Electric incurred a total of $2 million in debt
costs related to the issuance of the notes. These costs were deferred and are
being amortized over the life of the notes. The notes are guaranteed by UES.
The note purchase agreements for both UNS Gas and UNS Electric contain
certain restrictive covenants, including restrictions on transactions with
affiliates, mergers, liens to secure indebtedness, restricted payments,
incurrence of indebtedness, and minimum net worth. For purposes of these notes,
net worth equals common stock equity less amounts attributable to minority
interests and intangible assets not recoverable through rates. The actual and
required minimum net worth levels at December 31, 2003 were as follows:
Required
Minimum Net Actual
Worth Net Worth
-------------------------------------------------------------
-Millions of Dollars-
UES $ 50 $ 90
UNS Gas 43 53
UNS Electric 26 37
-------------------------------------------------------------
The incurrence of indebtedness covenant requires each of UNS Gas and UNS
Electric to meet certain tests before an additional dollar of indebtedness may
be incurred. These tests include (a) a ratio of Consolidated Long-Term Debt to
Consolidated Total Capitalization of no greater than 0.67 to 1.00 prior to
September 30, 2004, and no greater than 0.65 to 1.00 after September 30, 2004,
and (b) an Interest Coverage Ratio (a measure of cash flow to cover interest
expense) of at least 2.50 to 1.00. However, UNS Gas and UNS Electric may,
without meeting these tests, refinance indebtedness and incur short-term debt in
an amount not to exceed $7 million in the case of UNS Gas, and $5 million in the
case of UNS Electric. Neither UNS Gas, nor UNS Electric, may declare or make
distributions or dividends (restricted payments) on their common stock unless
(a) immediately after giving effect to such action no default or event of
default would exist under such company's note purchase agreement and (b)
immediately after giving effect to such action, such company would be permitted
to incur an additional dollar of indebtedness under the debt incurrence test for
such company. As of December 31, 2003, UNS Gas and UNS Electric were in
compliance with the terms of the note purchase agreements.
K-105
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
MEG LINE OF CREDIT
MEG has a $5 million bank line of credit for the purpose of issuing
letters of credit to counterparties to support its emissions allowance and coal
trading activities. As of December 31, 2003, MEG had $5 million in outstanding
LOCs. This facility expires in March 2005.
MATURITIES AND SINKING FUND REQUIREMENTS
Long-term debt, including sinking funds, and lease obligations mature on
the following dates:
Scheduled
IDBs Long-Term Capital UniSource
Supported Debt Lease TEP Energy
by LOCs Retirements Obligations Total UES Total
---------------------------- -------------- ---------------- -------------- -------------- ------------ -------------
-Millions of Dollars-
2004 $ - $ 2 $ 120 $ 122 $ - $ 122
2005 - 2 120 122 - 122
2006 329 21 122 472 - 472
2007 - 1 127 128 - 128
2008 - 29 120 149 61 210
---------------------------- -------------- ---------------- -------------- -------------- ------------ -------------
Total 2004 - 2008 329 55 609 993 61 1,054
Thereafter - 744 836 1,580 100 1,680
Less: Imputed Interest - - (633) (633) - (633)
---------------------------- -------------- ---------------- -------------- -------------- ------------ -------------
Total $ 329 $ 799 $ 812 $ 1,940 $ 161 $ 2,101
============================ ============== ================ ============== ============== ============ =============
NOTE 11. FAIR VALUE OF FINANCIAL INSTRUMENTS
---------------------------------------------
The carrying values and fair values of financial instruments are as
follows:
December 31,
2003 2002
----------------------------------------------------------------- ------------------------- -------------------------
Carrying Fair Carrying Fair
Value Value Value Value
---------------------------------------------------------------- ------------- ------------ ------------ ------------
-Millions of Dollars-
Assets:
TEP Springerville Lease Debt Securities (included in
Investments and Other Property) $ 179 $ 198 $ 192 $ 196
Liabilities:
TEP First Mortgage Bonds - Fixed Rate:
Corporate 27 27 27 28
IDBs 55 55 57 57
First Collateral Trust Bonds 138 155 138 140
TEP Second Mortgage Bonds - IDBs (Variable Rate) 329 329 329 329
TEP Unsecured IDBs - Fixed Rate 579 582 579 569
UES Senior Unsecured Notes 160 160 - -
---------------------------------------------------------------- ------------- ------------ ------------ ------------
See Note 10 for a description of TEP's investment in Springerville Lease
Debt. TEP intends to hold the $179 million investment in Springerville Lease
Debt Securities to maturity ($46 million matures through January 1, 2009, $78
million matures through July 1, 2011, and $55 million matures through January 1,
2013). This investment is stated at amortized cost, which means the purchase
cost has been adjusted for the amortization of the premium and discount to
maturity. TEP bases the fair value of this investment on quoted market prices
for the same or similar debt.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
TEP considers the principal amounts of variable rate debt outstanding to
be reasonable estimates of their fair value. TEP determined the fair value of
its fixed rate obligations including the Corporate First Mortgage Bonds, the
First Mortgage Bonds-IDBs, First Collateral Trust Bonds and the Unsecured IDBs
by calculating the present value of the cash flows of each fixed rate
obligation. TEP used a rate consistent with market yields generally available as
of December 2003 for 2003 amounts and December 2002 for 2002 amounts for bonds
with similar characteristics with respect to credit rating, time-to-maturity,
and the tax status of the bond coupon for federal income tax purposes. The use
of different market assumptions and/or estimation methodologies may yield
different estimated fair value amounts.
UES considers the principal amounts of the $160 million of senior
unsecured notes issued in August 2003 to be reasonable estimates of their fair
value. In addition to being issued recently, the notes were privately placed and
not assigned credit ratings by the major credit rating agencies, making the
notes difficult to value based on bonds with comparable credit ratings,
time-to-maturity, and trading patterns.
The carrying amounts of our current assets and liabilities approximate
fair value.
NOTE 12. STOCKHOLDERS' EQUITY
------------------------------
DIVIDEND LIMITATIONS
UniSource Energy
In February 2004, UniSource Energy declared a quarterly dividend to the
shareholders of $0.16 per share of UniSource Energy Common Stock. The dividend,
totaling approximately $5 million, was paid on March 10, 2004 to common
shareholders of record as of February 17, 2004. In 2003, UniSource Energy paid
quarterly dividends to the shareholders of $0.15 per share, for a total of $0.60
per share, or $20 million, for the year. During 2002, UniSource Energy paid
quarterly dividends to the shareholders of $0.125 per share, for a total of
$0.50 per share, or $17 million, for the year. During 2001, UniSource Energy
paid quarterly dividends to the shareholders of $0.10 per share, for a total of
$0.40 per share, or $13 million, for the year.
Our ability to pay cash dividends on common stock outstanding depends, in
part, upon cash flows from our subsidiaries: TEP, UES, Millennium and UED.
Additionally, pending consummation of the acquisition discussed in Note 2,
UniSource Energy's quarterly dividend payment is limited to no more than $0.16
per share in 2004 and $0.17 per share in 2005.
TEP
TEP paid dividends of $80 million in 2003, $35 million in 2002, and $50
million in 2001. UniSource Energy is the primary holder of TEP's common stock.
TEP met the following requirements before paying these dividends:
o Bank Credit Agreement
During 2001 and 2002, TEP's bank Credit Agreement allowed TEP to pay
dividends as long as TEP maintained compliance with the agreement and met its
financial covenants. TEP's new Credit Agreement as of November 2002 applies
those same restrictions as well as restricting TEP's dividends to 65% of TEP's
consolidated net income as long as the Tranche B LOCs are outstanding.
o ACC Holding Company Order
The ACC Holding Company Order does not allow TEP to pay dividends in
excess of 75% of its annual earnings until TEP's equity ratio equals 37.5% of
total capitalization, excluding capital lease obligations. The UES Settlement
Agreement, as approved by the ACC, modifies this dividend limitation so that it
will remain in place until TEP's common equity equals 40% of total
capitalization (excluding capital lease obligations).
o Federal Power Act
This Act states that dividends shall not be paid out of funds properly
included in capital accounts. TEP's 2003, 2002 and 2001 dividends were paid from
current year earnings.
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UES
UES did not pay any dividends to UniSource Energy in 2003. UES' ability to
pay dividends is limited by restrictions placed on its subsidiaries, UNS Gas and
UNS Electric. As discussed in Note 3, the UES Settlement Agreement limits
dividends payable by both UNS Gas and UNS Electric to UniSource Energy to 75% of
earnings until the ratio of common equity to total capitalization reaches 40%.
Additionally, the terms of the senior unsecured note agreements entered into by
both UNS Gas and UNS Electric contain dividend restrictions. See Note 10.
Millennium and UED
Millennium did not pay any dividends to UniSource Energy in 2003, 2002 or
2001. UED paid a dividend to UniSource Energy of $50 million in 2003. UED did
not pay any dividends in 2002 or 2001. Millennium and UED have no dividend
restrictions.
UNISOURCE ENERGY SHAREHOLDER RIGHTS PLAN
In March 1999, UniSource Energy adopted a Shareholder Rights Plan. As of
April 1, 1999, each Common Stock shareholder receives one Right for each share
held. Each Right initially allows shareholders to purchase UniSource Energy's
Series X Preferred Stock at a specified purchase price. However, the Rights are
exercisable only if a person or group (the "acquirer") acquires or commences a
tender offer to acquire 15% or more of UniSource Energy Common Stock. Each Right
would entitle the holder (except the acquirer) to purchase a number of shares of
UniSource Energy Common or Preferred Stock (or, in the case of a merger of
UniSource Energy into another person or group, common stock of the acquiring
person) having a fair market value equal to twice the specified purchase price.
At any time until any person or group has acquired 15% or more of the Common
Stock, UniSource Energy may redeem the Rights at a redemption price of $0.001
per Right. The Rights trade automatically with the Common Stock when it is
bought and sold. The Rights expire on March 31, 2009. The proposed acquisition
of UniSource Energy, as discussed in Note 2, will not be an event that triggers
the provisions of the Shareholder Rights Plan as the proposed acquisition was
approved by the UniSource Energy Board of Directors.
NOTE 13. TEP Wholesale Accounts Receivable and Allowances
----------------------------------------------------------
At December 31, 2003, TEP's Allowance for Doubtful Accounts on the balance
sheet includes $10 million related to 2001 and 2000 sales to the California
Power Exchange (CPX) and the California Independent System Operator (CISO). At
December 31, 2002, the allowance for these receivables was approximately $8
million.
CPX and CISO
TEP's collection shortfall from the CPX and the CISO was approximately $9
million for sales made in 2000 and $7 million for sales made in 2001. Since that
time, the FERC has held hearings and the FERC staff has proposed various
methodologies for calculating amounts of refunds/offsets applicable to wholesale
sales made into the CISO's spot markets from October 2000 to June 2001. As of
December 31, 2002, TEP had reserved $8 million, or 50%, of its outstanding
receivable based on the amount TEP believed would be collected. Based upon a
FERC order in March 2003 (as reaffirmed by the FERC on October 16, 2003), TEP
estimated that it may receive approximately $6 million of its $16 million
receivable. This represents amounts owed to TEP net of TEP's estimated refund
liability. Therefore, in the first quarter of 2003, TEP increased its reserve
for sales to the CPX and the CISO by $2 million by recording a reduction of
wholesale revenues.
There are several other outstanding legal issues, complaints and lawsuits
concerning the California energy crisis related to the FERC, wholesale power
suppliers, Southern California Edison Company, Pacific Gas and Electric Company,
the CPX and the CISO. We cannot predict the outcome of these issues or lawsuits.
We believe, however, that TEP is adequately reserved for its transactions with
the CPX and the CISO.
TEP's Accounts Receivable from Electric Wholesale Sales are included in
Trade Accounts Receivable on the balance sheet. TEP's wholesale receivables, net
of allowances, totaled $26 million at December 31, 2003 and $31 million at
December 31, 2002. Excluding the receivables from the CPX and the CISO, as
described above,
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--------------------------------------------------------------------------------
substantially all of the December 31, 2003 wholesale receivable balance has been
collected as of the date of this filing.
Enron
In late 2001, Enron filed for bankruptcy protection. At that time, TEP had
an outstanding receivable from Enron of $0.8 million. In early 2003, a FERC
order recommended that Enron no longer be allowed to trade and within a few days
thereafter, Enron was delisted from its stock exchange. As a result, in the
first quarter of 2003, TEP increased its allowance for doubtful accounts for its
sales to Enron by $0.4 million, to fully reserve its $0.8 million receivable
from Enron. In November 2003, TEP unconditionally sold its claim against Enron
for $0.5 million and reversed both the recorded receivable and the related
allowance.
NOTE 14. SPRINGERVILLE EXPANSION
On October 21, 2003 (the Closing Date), UED, TEP, Tri-State Generation and
Transmission Association, Inc. (Tri-State) and Salt River Project Agricultural
Improvement and Power District (SRP) entered into an Amended and Restated Joint
Development Agreement, which provides for the development of two 400 MW
coal-fired units at TEP's existing Springerville Generating Station by parties
other than TEP.
On the Closing Date, TEP transferred the right to construct Unit 3,
together with associated rights, to Tri-State. Tri-State completed financing of
Unit 3 on that date and immediately began construction. Once the unit is
completed, Tri-State will lease 100% of Unit 3 through a 34-year leveraged lease
agreement with GE Structured Finance and will take 300 MW of the 400 MW
capacity.
Under the Joint Development Agreement, SRP will purchase 100 MW of Unit
3's capacity from Tri-State under a 30-year power purchase agreement and will
have the right to construct and own Unit 4 at a later date. If SRP decides to
construct Unit 4, TEP and Tri-State may be required to find a replacement
purchaser for SRP's 100 MW power purchase obligation from Unit 3. If TEP and
Tri-State are unable to find a replacement purchaser, TEP would then purchase
100 MW of output from Unit 4, beginning with its commercial operation.
TEP executed contracts to provide operating, maintenance and other
services to Units 3 and 4. TEP also agreed to purchase up to 100 MW of Tri-State
system capacity for no more than five years from the time Unit 3 begins
commercial operation, which we expect to occur in December 2006. TEP will
benefit from approximately $90 million in upgraded emissions control equipment
for Units 1 and 2 and other facilities at the Springerville Generating Station
that will be paid for by the Unit 3 project. Due to the transfer of Unit 3
rights to Tri-State, in November 2003 TEP deposited $17 million with TEP's
Second Mortgage Trustee.
On the Closing Date, UED received reimbursement of all project development
costs which it incurred in connection with Units 3 and 4 of approximately $29
million, plus a development fee (including accrued interest on development funds
advanced) of $11 million. We recognized the development fee as income in the
fourth quarter of 2003. On October 24, 2003, UniSource Energy repaid its $35
million short-term bridge loan with the proceeds.
NOTE 15. COMMITMENTS AND CONTINGENCIES
---------------------------------------
TEP COMMITMENTS
Purchase and Transportation Commitments
In 2003, the ACC issued the Track B Order which defined the competitive
bidding process TEP must use to obtain capacity and energy requirements beyond
what is supplied by TEP's existing resources. For the period 2003 through 2006,
TEP estimated this to be approximately 0.5% of its retail load in the first year
and gradually increasing over the period. This order further required TEP to bid
out short-term energy purchases that it estimated it will make in the 2003 to
2006 period. The order does not require TEP to purchase any power that it deems
to be uneconomical, unreasonable or unreliable. In 2003, TEP entered into two
power purchase agreements for the period 2003 through 2006 as listed below:
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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--------------------------------------------------------------------------------
o PPL Energy Plus, LLC supplied 37 MW from June 2003 through December 2003
and will supply 75 MW from January 2004 through December 2006, under a
unit contingent contract.
o Panda Gila River generating station will supply 50 MW on-peak from June
through September, from 2003 (which has been supplied) through 2005, under
a unit contingent contract between TEP and Panda Gila River, L.P.
These purchases are intended to provide adequate reserve margins during
the summer peak period. In 2003, TEP made $7 million of payments under these
contracts.
TEP has several long-term contracts for the purchase and transportation of
coal with expiration dates from 2006 through 2020. The total amount paid under
these contracts depends on the number of tons of coal purchased and transported.
All of these contracts (i) include a price adjustment clause that will affect
the future cost of coal and (ii) require TEP to pay a take-or-pay charge or
liquidated damages if certain minimum quantities of coal are not purchased
and/or transported. TEP's present fuel requirements are in excess of the
take-or-pay minimums. At times, TEP has purchased coal from other suppliers,
resulting in take-or-pay minimum charges, but a lower overall cost of fuel. TEP
made payments under these contracts of $167 million in 2003, $161 million in
2002, and $173 million in 2001.
TEP entered into a Gas Procurement Agreement with Southwest Gas
Corporation effective June 1, 2001 with a primary term of five years. The
contract provided for a minimum volume obligation during the first two years of
10 million MMBtus annually. TEP negotiated new pricing and a lower minimum
annual volume obligation of 4 million MMBtus for 2004. However, TEP expects to
use more gas than this minimum requirement. In the event TEP purchases fewer
MMBtus, TEP is obligated to pay only the transportation component for any
shortfall. TEP will negotiate terms for the remaining life of the contract in
late 2004. TEP made payments under this contract of $34 million in 2003, $33
million in 2002 and $28 million in 2001.
At December 31, 2003, TEP estimates its future minimum payments under
these contracts to be:
Purchase
Obligations
------------------------------------ -- ------------------------
-Millions of Dollars-
2004 $ 91
2005 90
2006 87
2007 77
2008 77
------------------------------------ -- ------------------------
Total 2004 - 2008 422
Thereafter 424
------------------------------------ -- ------------------------
Total $ 846
==================================== == ========================
Operating Leases
TEP, Millennium, UES and UED have entered into operating leases, primarily
for office facilities and computer equipment, with varying terms, provisions,
and expiration dates. UniSource Energy's consolidated operating lease expense
was $3 million in each of 2003, 2002 and 2001. TEP's operating lease expense was
$2 million in each of 2003, 2002, and 2001. UniSource Energy and TEP's estimated
future minimum payments under non-cancelable operating leases at December 31,
2003 are as follows:
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UNISOURCE ENERGY, TEP AND SUBSIDIARIES
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UniSource Energy
Consolidated TEP
------------------------- -------------------- --------------------
-Millions of Dollars-
2004 $ 3 $ 1
2005 2 1
2006 2 1
2007 2 1
2008 1 1
------------------------- -------------------- --------------------
Total 2004 - 2008 10 5
Thereafter 6 1
------------------------- -------------------- --------------------
Total $ 16 $ 6
========================= ==================== ====================
Environmental Regulation
The 1990 Federal Clean Air Act Amendments call for reductions of SO2 and
nitrogen oxide (NOx) emissions in two phases. TEP is subject only to Phase II of
the SO2 and NOx emissions reductions which was effective January 1, 2000. All of
TEP's generating facilities (except existing internal combustion turbines) are
affected. TEP capitalized $11 million in 2003 and $8 million in 2002 and 2001 in
construction costs to comply with environmental requirements and expects to
capitalize $6 million in 2004 and 2005. In addition, TEP recorded expenses of $8
million in 2003 and $6 million in 2002 and 2001 related to environmental
compliance, including the cost of lime used to scrub the stacks. TEP expects
environmental expenses to be $7 million in 2004 and 2005.
In 1993, TEP's generating units affected by Phase II were allocated SO2
Emissions Allowances based on past operational history. Beginning in the year
2000, Phase II generating units were required to hold Emissions Allowances equal
to the level of emissions in the compliance year or pay penalties and offset
excess emissions in future years. TEP had sufficient Emissions Allowances to
comply with the Phase II SO2 regulations for compliance year 2003. However, due
to increased energy output and potential changes in the legislation affecting
SO2 Emission Allowances allocation, TEP may have to purchase additional
Emissions Allowances for future compliance years. Based on current estimates of
additional required Emissions Allowances and market prices, TEP believes that
purchases of Emissions Allowances will not have a material effect on TEP.
The EPA has issued a determination that coal and oil-fired electric
utility steam generating units must control their mercury emissions. Final
regulations are expected to be issued in December 2004. TEP may incur additional
costs to comply with recent and future changes in federal and state
environmental laws, regulations and permit requirements at existing electric
generating facilities. Compliance with these changes may result in a reduction
in operating efficiency.
Income Tax Assessments
In 2003, the Arizona Department of Revenue issued a preliminary audit
report regarding its examination of state income tax returns for the period of
1990 through 2000. The initial review of the report resulted in a combined
additional expense of $1 million recorded on TEP and Nations Energy.
In 2002, the IRS audit for 1997-2000 was settled, and after reviewing the
impact of the audit findings as well as the effect of tax positions established
in relation to future tax years, TEP reversed $1 million of the deferred tax
valuation allowance. See Note 16.
In 2001, the IRS audit of 1994, 1995 and 1996 tax years was settled. After
reviewing the impact of the final assessment on TEP's accrued tax liabilities
and the potential for assessments related to later tax years, no adjustments to
the deferred tax valuation allowance were deemed necessary in 2001.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
UES COMMITMENTS
See Note 3 for a description of UES' commitments.
MILLENNIUM COMMITMENTS AND CONTINGENCY
See Note 8 for a description of Millennium's commitments and contingency.
UNISOURCE ENERGY CONTINGENCIES
Litigation Concerning the Proposed Acquisition Agreement
On November 24, 2003 two shareholder derivative lawsuits, McBride v.
Pignatelli, et al. and Zetooney v. Pignatelli, et al., were filed in the
Superior Court of the State of Arizona relating to the acquisition. In these two
lawsuits, which are virtually identical, the plaintiffs allege that UniSource
Energy's Board of Directors, in its consideration and approval of the
acquisition agreement, breached its fiduciary duty to UniSource Energy's
shareholders in approving the acquisition agreement. The plaintiffs, who request
that their suits be permitted to proceed as class actions, seek damages and an
order from the court declaring that UniSource Energy's Board of Directors has
breached its fiduciary duties to UniSource Energy's shareholders, ordering that
UniSource Energy's Board of Directors take the steps specified in the complaint
to correct the alleged breaches of fiduciary duty and enjoining the acquisition
from proceeding. UniSource Energy believes that these lawsuits are without merit
and will vigorously defend them.
Acquisition Fees
UniSource Energy has entered into agreements with New Harbor Incorporated
(New Harbor) and Morgan Stanley & Co. Incorporated (Morgan Stanley) in
connection with the acquisition of UniSource Energy by Saguaro Utility. The
transaction fee payable to New Harbor is $9 million. UniSource Energy paid New
Harbor $2 million upon announcement of the transaction in November 2003, with
the balance of the transaction fee contingent and payable upon the closing of
the transaction. UniSource Energy paid Morgan Stanley $1 million in November
2003, and will pay Morgan Stanley $0.4 million contingent and payable upon
shareholders approving the transaction and $1 million contingent and payable
upon the acquisition closing. UniSource Energy has agreed to pay Morgan Stanley
a transaction fee of up to $4 million, including their monthly advisory fee, in
connection with the acquisition.
In certain circumstances, in the event of termination of the acquisition
agreement, UniSource Energy would be required to pay Saguaro Acquisition Corp.'s
expenses and a termination fee in an aggregate amount of up to $25 million.
TEP CONTINGENCIES
Springerville Generating Station Complaint
Environmental activist groups have expressed concerns regarding the
construction of any new units at the Springerville Generating Station. In
January 2003, environmental activist groups appealed an ACC Order affirming the
ACC's approval of the expansion at the Springerville Generating Station to the
Superior Court of the State of Arizona. On October 22, 2003, the Superior Court
affirmed the ACC's issuance of the Certificate of Environmental Compatibility
for Springerville Generating Station. The Court granted TEP and the ACC's motion
for summary judgment from the environmental activist groups. The environmental
activist groups appealed the Superior Court decision on December 30, 2003 and
filed an amended notice of appeal on January 2, 2004.
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In November 2001, the Grand Canyon Trust (GCT), an environmental activist
group, filed a complaint in U.S. District Court against TEP for alleged
violations of the Clean Air Act at the Springerville Generating Station. The
complaint alleged that more stringent emission standards should apply to Units 1
and 2. These standards would require new permits and the installation of
additional facilities, meeting Best Available Control Technology standards, for
the continued operation of Units 1 and 2. In 2002, the U.S. District Court
granted TEP's motion for summary judgment on one of the primary issues in the
case: whether TEP commenced construction within 18 months and/or by March 19,
1979, after the original 1977 air permit covering Units 1 and 2 was issued. The
Court found that TEP had commenced construction of the Springerville Generating
Station in the time periods required by the original permits. There were two
remaining allegations: that (a) TEP discontinued construction for a period of 18
months or longer and did not complete construction in a reasonable period of
time, and (b) TEP did not commence construction, for purposes of New Source
Performance Standard applicability, by September 18, 1978. On March 4, 2003, the
U.S. District Court determined that the GCT had not commenced the case on a
timely basis and dismissed the case. The GCT has appealed this decision to the
U.S. Court of Appeals.
TEP believes these claims are without merit and intends to vigorously
contest them.
Litigation and Claims Related to San Juan Generating Station
On May 16, 2002, the GCT and the Sierra Club filed a citizen lawsuit under
the Clean Air Act in federal district court in New Mexico against Public Service
Company of New Mexico (PNM) as operator of San Juan. TEP owns 50% of San Juan
Units 1 and 2, which equates to 19.8% of the total San Juan Station. The lawsuit
alleges two violations of the Clean Air Act and related regulations and permits.
One of the two claims, concerning the initial permitting of San Juan, was
dismissed by the court in August 2003. The remaining claim went to trial in
November 2003 with a decision expected in early 2004, and alleged that PNM
violated its present Title V operating permit by exceeding the 20% opacity
standard on numerous occasions between 1998 and 2002; opacity is a means to
monitor the particulate matter contained in an emission.
In September 2003, the New Mexico Environment Department (NMED) notified
PNM, operator of San Juan, of alleged excess emissions and opacity in violation
of the permits at San Juan. The NMED issued a draft compliance order assessing
unspecified civil penalties. PNM has entered into discussions with the NMED
concerning the alleged excess emissions and opacity violations. No compliance
order has been issued in this matter.
Based on the information available to date, TEP does not believe
resolution of these matters will be material to TEP.
Postretirement and Pension Benefit Costs at Various Generating Stations
The coal suppliers to Springerville Generating Station and each of TEP's
remote generating stations have submitted demands for payment by TEP of
postretirement and pension benefit costs for these coal suppliers' employees
under the coal supply agreements with TEP. Peabody Western Coal Company
(Peabody), the coal supplier to the Navajo Generating Station, has filed a
lawsuit against the participants at Navajo, including TEP, for retiree
postretirement benefit costs. TEP owns 7.5% of the Navajo Generating Station. In
December 2003, the Navajo participants and Peabody agreed to stay the discovery
process in this litigation until August 31, 2004 to give the parties time to
explore a possible settlement. To the extent that amounts become known and
payment probable, TEP will record a liability for additional postretirement and
pension benefit costs at the Springerville, Navajo, and San Juan Generating
Stations. TEP does not expect any settlement to be material to TEP.
The claim for postretirement at Four Corners was settled as part of the
coal contract extension. TEP paid $0.3 million for postretirement benefits in
settlement in September 2003.
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Environmental Reclamation at Remote Generating Stations
TEP pays on-going reclamation costs at each of its remote generating
stations, and it is probable that TEP will have to pay a portion of final
reclamation costs at the coal mines which supply the remote generating stations.
In June 2003, TEP received an estimate of the reclamation liability at the coal
mine that supplies San Juan in which post-term reclamation activities are
assumed to occur over a 16-year period beginning in 2028. The expected aggregate
undiscounted reclamation liability totals $122 million of which TEP's portion of
the liability, based on its ownership of San Juan, totals $24 million. The
present value of TEP's liability for post-term reclamation at a 10%
credit-adjusted risk free rate approximates $7 million at December 31, 2017, the
expiration date of the coal supply agreement, and will be recognized over the
remaining term of the coal supply agreement. At December 31, 2003, TEP has
recorded $0.3 million of its post-term reclamation liability at San Juan.
Amounts recorded for post-term reclamation are subject to various assumptions
and determinations, such as estimating the costs of reclamation, estimating when
final reclamation will occur, and the credit-adjusted risk-free interest rate to
be used to discount future liabilities. Changes that may arise over time with
regard to these assumptions and determinations will change amounts recorded in
the future as expense for post-term reclamation. TEP does not believe that
recognition of its post-term reclamation obligation at San Juan will be material
to TEP in any single year since recognition occurs over the remaining 14 year
life of its coal supply agreement.
Although a cost is probable at TEP's other remote generating stations, it
is not possible at this time to reasonably estimate the amount of any obligation
for final reclamation because remediation alternatives have not yet advanced to
the stage where a reasonable estimate of any cost can be made. As amounts become
known, TEP will recognize a liability for final reclamation over the remaining
lives of its coal supply agreements.
RESOLUTION OF TEP COMMITMENTS AND CONTINGENCIES
Litigation Related to San Juan Coal Company
In August 2003, San Juan Coal Company, the coal supplier to San Juan,
entered into a settlement agreement with Dugan Production Corp. (Dugan). The San
Juan Coal Company, through leases with the federal government and the State of
New Mexico, owns coal interests with respect to an underground mine. Dugan,
through leases with the federal government, the State of New Mexico and certain
private parties, owns certain oil and gas interests in portions of the land used
for the underground mine. Dugan alleged that San Juan Coal Company's underground
coal mining operations have or will interfere with Dugan's gas production and
will reduce the amount of natural gas that Dugan would otherwise be entitled to
recover. The settlement agreement provides that San Juan Coal Company will
compensate Dugan for any remaining gas production from a well when San Juan Coal
Company determines that mining activity is close enough to warrant shutting down
a well. Dugan agreed not to drill any additional wells. This settlement is not
expected to be material to TEP.
Sundt Coal Contract Termination
In the third quarter of 2002, TEP terminated a coal supply agreement for
the Sundt Generating Station. As a result, TEP recorded a pre-tax charge of $11
million and made an $11 million payment in the third quarter of 2002. The
additional expense was mitigated by TEP not being required to make a take-or-pay
penalty payment of approximately $3 million for the year 2002 and subsequent
years.
San Juan Coal Contract Amendment
In September 2000, TEP terminated the San Juan Generating Station's coal
supply contract and entered into a new coal supply contract, replacing two
surface mining operations with one underground operation. To terminate the
contract, TEP made a $15 million payment in December 2002. In September 2000, as
a result of this scheduled payment, TEP recorded a pre-tax $13 million Coal
Contract Amendment Fee expense and a non-current liability which equaled the
present value of the $15 million payment. TEP recognized interest expense,
included in the Interest Imputed on Losses Recorded at Present Value line item
on the income statements, and increased its liability until the payment was
made.
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GUARANTEES AND INDEMNITIES
In the normal course of business, UniSource Energy and certain
subsidiaries, including TEP, enter into various agreements providing financial
or performance assurance to third parties on behalf of certain subsidiaries. We
enter into these agreements primarily to support or enhance the creditworthiness
of a subsidiary on a stand-alone basis. The most significant of these guarantees
are 1) UES' guarantee of $160 million of aggregate principal amount of senior
unsecured notes issued by UNS Gas and UNS Electric to purchase the Citizens
Arizona gas and electric system assets, 2) UniSource Energy's guarantee of
approximately $22 million in natural gas transportation and supply payments in
addition to building lease payments for UNS Gas, UNS Electric, and subsidiaries
of Millennium, and 3) Millennium's guarantee of approximately $5 million in
commodity-related payments for MEG at December 31, 2003. To the extent
liabilities exist under the contracts subject to these guarantees, such
liabilities are included in UniSource Energy's consolidated balance sheets.
In addition, UniSource Energy and its subsidiaries have indemnified the
purchasers of interests in certain investments from additional taxes due for
years prior to the sale. The terms of the indemnifications provide for no
limitation on potential future payments; however, we believe that we have abided
by all tax laws and paid all tax obligations. We have not made any payments
under the terms of these indemnifications to date.
We believe that the likelihood UniSource Energy, TEP, UES, or Millennium
would be required to perform or otherwise incur any significant losses
associated with any of these guarantees or indemnities is remote.
NOTE 16. INCOME AND OTHER TAXES (Restated - See Note 22)
--------------------------------------------------------
INCOME TAXES
Deferred tax assets (liabilities) consist of the following:
UniSource Energy TEP
------------------------------- -----------------------------
December 31, December 31,
2003 2002 2003 2002
------------------------------------------------------- ----------------- --------------- -------------- ---------------
-Millions of Dollars-
Gross Deferred Income Tax Liabilities
Plant - Net $ (479) $ (397) $ (477) $ (397)
Income Taxes Recoverable Through Future
Revenues Regulatory Asset (20) (23) (20) (23)
Transition Recovery Asset (108) (122) (108) (122)
Other (30) (26) (26) (24)
------------------------------------------------------- ----------------- --------------- -------------- ---------------
Gross Deferred Income Tax Liability (637) (568) (631) (566)
------------------------------------------------------- ----------------- --------------- -------------- ---------------
Gross Deferred Income Tax Assets
Capital Lease Obligations 337 350 337 351
Net Operating Loss Carryforwards (NOL) 20 5 11 (8)
Investment Tax Credit Carryforwards 8 5 8 5
Alternative Minimum Tax Credit (AMT) 88 97 85 93
Accrued Postretirement Benefits 17 16 17 16
Emission Allowance Inventory 14 15 14 15
Coal Contract Termination Fees 16 18 16 18
Springerville Coal Handling Facility 7 9 7 9
Reserve for Uncollectible Accounts 4 4 4 4
Unregulated Investment Losses 30 23 1 1
Other 25 25 22 21
------------------------------------------------------- ----------------- --------------- -------------- ---------------
Gross Deferred Income Tax Asset 566 567 522 525
Deferred Tax Assets Valuation Allowance (9) (22) - (15)
------------------------------------------------------- ----------------- --------------- -------------- ---------------
Net Deferred Income Tax Liability $ (80) $ (23) $ (109) $ (56)
======================================================= ================= =============== ============== ===============
K-115
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
The net deferred income tax liability is included in the balance sheets in
the following accounts:
UniSource Energy TEP
---------------------------- ---------------------------
December 31, December 31,
2003 2002 2003 2002
--------------------------------------------------------- --------------- --------------- -------------- ---------------
-Millions of Dollars-
Deferred Income Taxes - Current Assets $ 16 $ 16 $ 19 $ 16
Deferred Income Taxes - Noncurrent Liabilities (96) (39) (128) (72)
--------------------------------------------------------- --------------- --------------- -------------- ---------------
Net Deferred Income Tax Liability $ (80) $ (23) $ (109) $ (56)
========================================================= =============== =============== ============== ===============
We record deferred tax liabilities for amounts that will increase income
taxes on future tax returns. We record deferred tax assets for amounts that
could be used to reduce income taxes on future tax returns. We record a Deferred
Tax Assets Valuation Allowance for the amount of Deferred Tax Assets that we may
not be able to use on future tax returns. We estimate the valuation allowance
based on our interpretation of the tax rules, prior tax audits, tax planning
strategies, scheduled reversal of deferred tax liabilities, and projected future
taxable income.
The valuation allowance of $9 million at December 31, 2003 and $22 million
at December 31, 2002, which reduces the Deferred Tax Asset balance, relates to
NOL and Investment Tax Credit (ITC) carryforward amounts. The decrease of $15
million reflects UniSource Energy's and TEP's expectation to be able to use a
portion of these carryforward amounts on future tax returns, primarily based on
guidance issued by the Internal Revenue Service in September 2003. In the future
if UniSource Energy and TEP determine that it is probable that TEP will not be
able to use all or a portion of the NOL and ITC carryforward amounts, then
UniSource Energy and TEP would record a valuation allowance and recognize tax
expense. Factors that could cause TEP to record a valuation allowance would be a
change in expected future taxable income or a change in tax filing status due to
the proposed acquisition. See Note 2, Proposed Acquisition of UniSource Energy.
The valuation allowance of $9 million remaining at December 31, 2003 relates to
losses generated by the Millennium entities. In the future, if UniSource Energy
and the Millennium entities determine that all or a portion of the remaining
amounts may be used on tax returns, then UniSource Energy and the Millennium
entities would reduce the valuation allowance and recognize a tax benefit of up
to $9 million. The primary factor that could cause the Millennium entities to
recognize a tax benefit would be a change in expected future taxable income.
In 2002, the Deferred Tax Assets Valuation Allowance decreased $1 million
due primarily to the settlement of audits. In 2001, there was no change in the
Deferred Tax Assets Valuation Allowance.
In 2003, the deferred tax liability for timing differences related to
Plant-Net increased $82 million. This increase is primarily due to the reversal
of previously recorded deferred tax assets of $44 million related to the
adoption of FAS 143 (see Note 5), and the recognition of additional deferred tax
liabilities of $8 million due to the election of bonus depreciation for federal
income tax purposes and $30 million due to a change in the method of
capitalizing indirect costs for income tax purposes.
TEP had a net intercompany tax payable to affiliates of $2.0 million at
December 31, 2003 and zero at December 31, 2002. These amounts are included in
TEP's intercompany accounts on its balance sheet.
In 2003, UniSource Energy recognized $0.8 million of tax and interest
expense in anticipation of settlement of state income tax audits and settlement
of a state sales tax audit. These amounts are included in current and deferred
tax expense (benefit) in the following table.
In 2002, UniSource Energy recognized a tax benefit of $1.5 million as a
result of final agreement with the IRS on audit issues and a tax benefit of $1.0
million from recognition of losses generated by the sale of a Nations Energy
foreign entity.
K-116
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
In 2003, the tax effect of the exercise of certain employee stock options
that are recognized differently for financial reporting and tax purposes was not
recorded as a timing difference, but rather was credited to shareholder's
equity. This resulted in a $0.8 million increase to the capital of UniSource
Energy. Additionally, in 2003, UniSource Energy and TEP incurred certain legal
and advisory fees that result in no current or future tax deductions, creating
current tax expense with no deferred asset, otherwise known as a permanent
difference.
Income tax expense (benefit) included in the income statements consists of
the following:
UniSource Energy TEP
-------------------------------- ------------------------------
Years Ended December 31,
2003 2002 2001 2003 2002 2001
--------------------------------------------------------- ---------- ---------- ---------- --------- ---------- ---------
-Millions of Dollars-
Current Tax Expense
Federal $ 11 $ 20 $ 25 $ 14 $ 23 $ 26
State 5 7 11 7 8 11
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Total 16 27 36 21 31 37
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Deferred Tax Expense (Benefit)
Federal 12 (1) 17 16 9 23
State (1) (7) (4) (1) (3) (2)
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Total 11 (8) 13 15 6 21
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Reduction in Valuation Allowance - Benefit (15) (1) - (15) (1) -
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Total Federal and State Income Tax Expense Before
Cumulative Effect of Accounting Change 12 18 49 21 36 58
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Tax on Cumulative Effect of Accounting Change (See
Note 5) 44 - - 44 - -
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Total Federal and State Income Tax Expense Including
Cumulative Effect of Accounting Change $ 56 $ 18 $ 49 $ 65 $ 36 $ 58
========================================================= ========= =========== ========== ======== ========== ==========
The differences between the income tax expense and the amount obtained by
multiplying pre-tax income by the U.S. statutory federal income tax rate of 35%
are as follows:
UniSource Energy TEP
----------------------------- ------------------------------
Years Ended December 31,
2003 2002 2001 2003 2002 2001
--------------------------------------------------------- ---------- ---------- ---------- --------- ---------- ---------
-Millions of Dollars-
Federal Income Tax Expense at Statutory Rate $ 21 $ 19 $ 40 $ 29 $ 33 $ 48
State Income Tax Expense, Net of Federal
Deduction 3 2 5 4 4 6
Depreciation Differences (Flow Through Basis) 4 4 5 4 4 5
Federal/State Credits (2) (4) - (2) (4) -
Reduction in Valuation Allowance - Benefit (15) (1) - (15) (1) -
Other 1 (2) (1) 1 - (1)
--------------------------------------------------------- --------- ----------- ---------- -------- ---------- ----------
Total Federal and State Income Tax Expense Before
Cumulative Effect of Accounting Change $ 12 $ 18 $ 49 $ 21 $ 36 $ 58
========================================================= ========= =========== ========== ======== ========== ==========
The Total Federal and State Income Tax Expense in the tables above is
included on UniSource Energy and TEP's income statements.
K-117
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
At December 31, 2003, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts:
UniSource Energy TEP
----------------------------------------- ------------------------------------------
Amount Expiring Amount Expiring
----------------------- ----------------- ------------------------ -----------------
-Millions of Dollars- Year -Millions of Dollars- Year
------------------------------ ----------------------- ----------------- --- ------------------------ -----------------
Net Operating Losses $ 55 2006-2023 $ 32 2006-2009
Investment Tax Credit 8 2004-2023 8 2004-2023
AMT Credit 88 - 85 -
------------------------------ ----------------------- ----------------- --- ------------------------ -----------------
Of the $55 million in NOL carryforward, $18 million is subject to
limitation. Due to a reorganization of certain Millennium entities in December
2002, $18 million of Federal and State net operating losses are subject to
limitation. The future utilization of these losses is dependant upon the
generation of sufficient future taxable income at the separate company level.
OTHER TAXES
TEP and UES act as conduits or collection agents for excise tax (sales
tax) as well as franchise fees and regulatory assessments. They record
liabilities payable to governmental agencies when they bill their customers for
these amounts. Neither the amounts billed nor payable are reflected in the
income statement.
NOTE 17. EMPLOYEE BENEFIT PLANS
--------------------------------
PENSION BENEFIT PLANS
TEP and UES maintain noncontributory, defined benefit pension plans for
substantially all regular employees and certain affiliate employees. Benefits
are based on years of service and the employee's average compensation. TEP and
UES fund the plans by contributing at least the minimum amount required under
Internal Revenue Service regulations. Additionally, we provide supplemental
retirement benefits to certain employees whose benefits are limited by IRS
benefit or compensation limitations.
OTHER POSTRETIREMENT BENEFIT PLANS
TEP provides limited health care and life insurance benefits for retirees.
All regular employees may become eligible for these benefits if they reach
retirement age while working for TEP or an affiliate.
TEP amended its other postretirement benefit plan to cap Medicare
supplement payments for all current retirees under age 65 and all classified
employees retiring after December 31, 2002 and eliminate post-65 medical
benefits for all salaried employees retiring after January 1, 2002. These
amendments required TEP to recalculate benefits related to participants' past
service. TEP is amortizing the change in the benefit cost from these plan
amendments on a straight-line basis over 10 years.
UniSource Energy acquired the Arizona gas and electric system assets from
Citizens on August 11, 2003, assuming a $2 million liability for postretirement
medical benefits for current retirees and a small group of active employees. The
majority of UES employees do not currently participate in the postretirement
medical plan.
The ACC allows TEP and UES to recover postretirement costs through rates
only as benefit payments are made to or on behalf of retirees. The
postretirement benefits are currently funded entirely on a pay-as-you-go basis.
Under current accounting guidance, TEP and UES cannot record a regulatory asset
for the excess of expense calculated per Statement of Financial Accounting
Standards No. 106, Employers' Accounting for Postretirement Benefits Other Than
Pensions, over actual benefit payments.
The actuarial present values of the pension benefit obligations and other
postretirement benefit plans were measured at December 1. The change in benefit
obligation and plan assets and reconciliation of the funded status are as
follows:
K-118
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Other Postretirement
Pension Benefits Benefits
------------------------------------------------------
Years Ended December 31,
2003 2002 2003 2002
---------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Change in Benefit Obligation
Benefit Obligation at Beginning of Year $ 133 $ 117 $ 59 $ 59
Actuarial (Gain) Loss 16 10 3 8
Interest Cost 9 8 4 4
Service Cost 5 4 2 2
Benefits Paid (5) (6) (2) (2)
Plan Amendments 4 - - (12)
Acquisition - - 2 -
---------------------------------------------------------------------------------------------------------------------------
Benefit Obligation at End of Year 162 133 68 59
---------------------------------------------------------------------------------------------------------------------------
Change in Plan Assets
Fair Value of Plan Assets at Beginning of Year 106 120 - -
Actual Return on Plan Assets 20 (14) - -
Benefits Paid (5) (6) (2) (2)
Employer Contributions 3 6 2 2
---------------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at End of Year 124 106 - -
---------------------------------------------------------------------------------------------------------------------------
Reconciliation of Funded Status to Balance Sheet
Funded Status (Difference between Benefit
Obligation and Fair Value of Plan Assets) (38) (27) (68) (59)
Unrecognized Net (Gain) Loss 37 34 33 32
Unrecognized Prior Service Cost 15 14 (11) (12)
---------------------------------------------------------------------------------------------------------------------------
Net Amount Recognized in the Balance Sheets $ 14 $ 21 $ (46) $ (39)
===========================================================================================================================
Amounts Recognized in the Balance Sheets
Consist of:
Prepaid Pension Costs Included in Other Assets $ 10 $ 13 $ - $ -
Accrued Benefit Liability Included in Other Liabilities (9) (10) (46) (39)
Intangible Asset Included in Other Assets 10 11 - -
Accumulated Other Comprehensive Income 3 7 - -
-------------------------------------------------------------------------------------------------------------------------
Net Amount Recognized $ 14 $ 21 $ (46) $ (39)
=========================================================================================================================
The accumulated benefit obligation for all defined benefit pension plans
was $130 million and $109 million at December 31, 2003 and 2002, respectively.
December 31,
2003 2002
--------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Information for Pension Plans with an Accumulated
Benefit Obligation in Excess of Plan Assets:
Projected Benefit Obligation at End of Year $ 87 $ 71
Accumulated Benefit Obligation at End of Year 70 59
Fair Value of Plan Assets at End of Year $ 61 $ 50
--------------------------------------------------------------------------------------------------------------------------
K-119
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
The components of net periodic benefit costs are as follows:
Pension Benefits Other Postretirement Benefits
----------------------------------- ------------------------------------
Years Ended December 31,
2003 2002 2001 2003 2002 2001
--------------------------------------------------- ------------ ----------- ---------- ----------- ----------- ------------
-Millions of Dollars-
Components of Net Periodic Cost
Service Cost $ 5 $ 5 $ 4 $ 2 $ 2 $ 2
Interest Cost 9 8 7 4 4 4
Expected Return on Plan Assets (9) (11) (12) - - -
Prior Service Cost Amortization 2 2 2 (1) - -
Recognized Actuarial (Gain) Loss 2 - (2) 2 2 2
Amortization of Transition Asset - - - - - -
-------------------------------------------------- ------------ ----------- ---------- ----------- ----------- -----------
Net Periodic Benefits Cost (Benefit) $ 9 $ 4 $ (1) $ 7 $ 8 $ 8
================================================== ============ =========== ========== =========== =========== ===========
For all pension plans, prior service costs are amortized on a
straight-line basis over the average remaining service period of employees
expected to receive benefits under the plan.
Additional Information Other Postretirement
Pension Benefits Benefits
----------------------------------------------------
Years Ended December 31,
2003 2002 2003 2002
--------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Minimum Pension Liability Included in
Other Comprehensive Income $3 $7 N/A N/A
Other Postretirement
Pension Benefits Benefits
------------------------ ---------------------------
2003 2002 2003 2002
----------------------------------------------------------------------- ----------- ------------ -------------- ------------
Weighted-Average Assumptions Used to Determine
Benefit Obligations as of December 1,
Discount Rate 6.25% 6.75% 5.50% 6.75%
Rate of Compensation Increase 4.00% 4.00% - -
Other Postretirement
Pension Benefits Benefits
------------------------ ---------------------------
2003 2002 2003 2002
------------------------------------------------------------------------ ----------- ------------ ------------- -------------
Weighted-Average Assumptions Used to Determine
Net Periodic Benefit Cost for Years Ended December 31,
Discount Rate 6.75% 7.25% 6.75% 7.25%
Rate of Compensation Increase 4.00% 4.00% - -
Expected Return on Plan Assets 8.75% 9.00% - -
Net periodic benefit cost is subject to various assumptions and
determinations, such as the discount rate, the rate of compensation increase,
and the expected return on plan assets. We estimated the expected return on plan
assets based on a review of the plans' asset allocations and consultations with
a third-party investment consultant and the plans' actuary considering market
and economic indicators, historical market returns, correlations and volatility,
central banks' and government treasury departments' forecasts and objectives,
and recent professional or academic research. Changes that may arise over time
with regard to these assumptions and determinations will change amounts recorded
in the future as net periodic benefit cost.
K-120
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
December 31,
2003 2002
------------------------------------------------------------------------------------------------------------------------------------
Assumed Health Care Cost Trend Rates
Health Care Cost Trend Rate Assumed for Next Year 12.10% 12.00%
Ultimate Health Care Cost Trend Rate Assumed 5.00% 5.00%
Year that the Rate Reaches the Ultimate Trend Rate 2013 2011
------------------------------------------------------------------------------------------------------------------------------------
Assumed health care cost trend rates have a significant effect on the
amounts reported for health care plans. A one-percentage-point change in assumed
health care cost trend rates would have the following effects on the December
31, 2003 amounts:
One-Percentage-Point One-Percentage-Point
Increase Decrease
------------------------------------------------------------------------------------------------------------------------------------
-Millions of Dollars-
Effect on Total of Service and Interest Cost Components $ 1 $ (1)
Effect on Postretirement Benefit Obligation $ 5 $ (5)
------------------------------------------------------------------------------------------------------------------------------------
Plan Assets
TEP calculates the market-related value of plan assets using the fair
value of plan assets on the measurement date. TEP's pension plan asset
allocations at December 31, 2003 and 2002, by asset category are as follows:
Plan Assets
December 31,
2003 2002
--------------------------------------------------------------------------------------------------------------------
Asset Category
Equity Securities 68.1% 59.2%
Debt Securities 18.2% 24.1%
Real Estate 13.7% 15.1%
Other - 1.6%
---------------------------------------------------------------------------------------------------------------------
Total 100.0% 100.0%
=====================================================================================================================
TEP's investment policy for the pension plans targets a range of exposure
to the various asset classes surrounding the following allocations: equity
securities 65%, debt securities 23% and real estate 12%. TEP rebalances the
portfolio periodically when the portfolio allocation is not within the desired
range of exposure. The plan seeks to provide returns in excess of the portfolio
benchmark. The portfolio benchmark consists of the following indices: 55% S&P
500; 10% MSCI EAFE; 23% Lehman Aggregate; and 12% NCREIF. A third party
investment consultant track's the plan's portfolio relative to the benchmark and
provides quarterly investment reviews which consist of a performance and risk
assessment on all investment managers and on the portfolio.
Certain managers within the plan use, or have authorization to use,
derivative financial instruments for risk management purposes or as a part of
their investment strategy. Currency hedges have also been used for defensive
purposes. Leverage is used by real estate managers but is limited by investment
policy.
The UES pension plan is not yet funded but is expected to follow a similar
investment policy and target asset allocation strategy.
K-121
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Contributions
TEP expects to contribute $6 million to its pension plans in 2004 and UES
expects to contribute $0.5 million.
DEFINED CONTRIBUTION PLANS
TEP and UES sponsor defined contribution savings plans that are offered to
all eligible employees. Certain affiliate employees are also eligible to
participate. The plans are qualified 401(k) plans under the Internal Revenue
Code. In a defined contribution plan, the benefits a participant is to receive
result from regular contributions to a participant account. Participants direct
the investment of contributions to certain funds in their account. Matching
contributions to participant accounts are made under these plans. Matching
contributions to these plans were approximately $3 million in each of 2003, 2002
and 2001.
NOTE 18. STOCK-BASED COMPENSATION PLANS
----------------------------------------
We have two stock-based compensation plans, the 1994 Outside Director
Stock Option Plan (Directors' Plan) and the 1994 Omnibus Stock and Incentive
Plan (Omnibus Plan). The Directors' Plan provided for annual awards of
non-qualified stock options and restricted shares or stock units to each
eligible director. The Omnibus Plan allowed the Compensation Committee, a
committee of non-employee directors, to grant the following types of awards to
each eligible employee: stock options; stock appreciation rights; restricted
stock; stock units; performance shares; and dividend equivalents.
Under the Directors' Plan and the Omnibus Plan, we were previously
authorized to grant up to a total of 324,000 and 4.1 million shares,
respectively. The acquisition agreement discussed in Note 2 limits the amount of
capital stock that UniSource Energy can issue under its stock plans, and
requires that all of UniSource Energy's stock plans must be terminated effective
as of the closing of the acquisition.
At December 31, 2003, we had stock options, stock units, performance
shares and restricted stock grants outstanding as discussed below.
Stock Options
We granted stock options to key TEP and Millennium employees and members
of the Board of Directors during 2003, 2002, and 2001. All stock options were
granted at exercise prices equal to the market price of the common stock at the
grant date. Options vest over three years, become exercisable in one-third
increments on each anniversary date of the grant and expire on the tenth
anniversary of the grant.
A summary of the stock option activity of the Directors' Plan and Omnibus
Plan is as follows:
2003 2002 2001
-------------------------------------------------------------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
-------------------------------------------------------------------------------------------------------------------------
Options Outstanding,
Beginning of Year 2,576,469 $15.77 2,075,421 $15.05 1,918,264 $14.36
Granted 120,236 $17.77 590,000 $18.14 410,000 $17.96
Exercised (199,400) $13.72 (64,851) $14.42 (177,602) $14.56
Forfeited (14,625) $14.23 (24,101) $15.43 (75,241) $14.60
-------------- --------------- --------------
Options Outstanding,
End of Year 2,482,680 $16.04 2,576,469 $15.77 2,075,421 $15.05
============== =============== ==============
Options Exercisable,
End of Year 1,676,803 $15.27 1,441,829 $14.47 1,081,349 $14.38
Exercise Price Range of Options Outstanding at December 31, 2003: $11.00 to $18.84
Weighted Average Remaining Contractual Life at December 31, 2003: 6.30 years
-------------------------------------------------------------------------------------------------------------------------
K-122
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
As discussed in Note 1, we apply APB 25 in accounting for our stock option
plans. We have not recognized any compensation cost for these options because
our stock options are granted with an exercise price equal to the market value
of the stock at the grant date. We have also adopted the disclosure-only
provisions of FAS 123. We present, in Note 1, the effect on net income and
earnings per share as if the company had applied the fair value recognition
provisions of FAS 123, as required by FAS 148.
Stock options awarded on January 1, 2002 accrue dividend equivalents that
are paid in cash on the earlier of the date of exercise of the underlying option
or the date the option expires. Compensation expense is recognized as dividends
are declared. In 2003 and 2002, we recognized compensation expense of $0.3
million for dividend equivalents on stock option grants.
Restricted Stock and Stock Units
In 2003 and 2002, we granted restricted stock awards to directors totaling
5,157 shares and 4,644 shares, respectively. The grant date fair value of the
shares was $17.44 per share in 2003 and $19.35 per share in 2002. Directors may
elect to receive stock units in lieu of restricted shares. The restricted shares
or stock units become 100% vested on the third anniversary of the grant date.
Compensation expense equal to the fair market value on the date of the award is
recognized over the vesting period. We recorded compensation expense of less
than $0.1 million in 2003 and 2002 related to these awards.
There were no new stock unit awards granted under the Omnibus Plan in
2003, 2002 or 2001. When awards are granted, compensation expense equal to the
fair market value on the date of the award is recognized over a three or four
year vesting period. We recognized compensation expense related to earlier
awards of less than $1 million in each of the last three years.
Fully vested but undistributed stock unit awards accrue dividend
equivalent stock units based on the fair market value of common shares on the
date the dividend is paid. Compensation expense is recognized when dividends are
declared. We recorded compensation expense of $0.2 million in 2003 for dividend
equivalent stock units.
Performance Shares
In May 2003, the Board of Directors approved a grant of performance shares
to key employees under the Omnibus Plan. The shares may be awarded at the end of
a three-year performance period based on goal attainment. Exceptional
performance will result in an award of 134,000 shares. The grant date fair value
was $17.84 per share. Compensation expense is recorded over the performance
period based on the anticipated number and market value of shares to be awarded.
Compensation expense of $0.7 million was recorded in 2003 for this new incentive
plan.
NOTE 19. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
---------------------------------------------------
Basic EPS is computed by dividing net income by the weighted average
number of common shares outstanding during the period. Diluted EPS assumes that
proceeds from the hypothetical exercise of stock options and other stock-based
awards are used to repurchase outstanding shares of stock at the average fair
market price during the reporting period. The numerator in calculating both
basic and diluted earnings per share for each period is Net Income. The
following table shows the effects of potential dilutive common stock on the
weighted average number of shares:
K-123
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Years Ended December 31,
2003 2002 2001
-------------------------------------------------------------------------------------------------------------------------
- In Thousands-
Denominator:
Average Shares of Common Stock Outstanding 33,828 33,665 33,398
Effect of Dilutive Securities:
Warrants - 81 143
Options and Stock Issuable under Employee Benefit Plans and
the Directors' Plan 511 476 625
-------------------------------------------------------------------------------------------------------------------------
Total Shares 34,339 34,222 34,166
=========================================================================================================================
Options to purchase an average of 274,000 and 525,000 shares of common
stock were outstanding during the years 2003 and 2002, respectively, but were
not included in the computation of diluted EPS because the options' exercise
price was greater than the average market price of the common stock.
At December 31, 2003, UniSource Energy had no outstanding warrants. There
were 4.6 million warrants that were exercisable into TEP common stock until
December 15, 2002, when they expired. The dilutive effect of these warrants was
the same as it would have been if the warrants were exercisable into UniSource
Energy Common Stock.
NOTE 20. SUPPLEMENTAL CASH FLOW INFORMATION (Restated - See Note 22)
---------------------------------------------------------------------
A reconciliation of net income to net cash flows from operating activities
follows:
UniSource Energy
-----------------------------------------------
Years Ended December 31,
2003 2002 2001
------------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income $113,941 $ 34,928 $ 63,839
Adjustments to Reconcile Net Income
To Net Cash Flows
Cumulative Effect of Accounting Change-Net of Tax (67,471) - (470)
Depreciation and Amortization Expense 130,643 127,923 120,346
Depreciation Recorded to Fuel and Other O&M Expense 6,230 5,701 6,001
Coal Contract Amendment Fee - (14,248) -
Amortization of Transition Recovery Asset 31,752 24,489 22,536
Net Unrealized Loss (Gain) on TEP Forward Electric Sales 761 1,302 (187,721)
Net Unrealized (Gain) Loss on TEP Forward Electric Purchases (378) (1,835) 189,036
Net Unrealized (Gain) Loss on MEG Trading Activities (1,046) (188) 32
Amortization of Deferred Debt-Related Costs included in
Interest Expense 2,972 2,058 1,996
Provision for Bad Debts 4,820 1,688 (529)
Deferred Income Taxes 20,369 2,587 7,693
Losses from Equity Method Entities 2,984 3,560 2,516
Gain on Sale of Nations Energy's Curacao Project - - (10,737)
Gain on Sale of Real Estate (467) - (1,572)
Other 23,083 (15,811) 1,264
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (18,622) 37,591 (9,011)
Materials and Fuel Inventory (7,412) (2,118) (653)
Accounts Payable (7,944) (35,193) 17,626
Interest Accrued 13,151 18,542 10,191
Taxes Accrued 10,353 (8,331) 1,418
Other Current Assets (7,011) (12,199) (14,094)
Other Current Liabilities 8,934 2,517 (4,328)
------------------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Operating Activities $259,642 $172,963 $215,379
==============================================================================================================================
K-124
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
TEP
-----------------------------------------------
Years Ended December 31,
2003 2002 2001
---------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Net Income $128,913 $ 55,390 $ 77,778
Adjustments to Reconcile Net Income
To Net Cash Flows
Cumulative Effect of Accounting Change-Net of Tax (67,471) - (470)
Depreciation and Amortization Expense 121,037 124,054 117,063
Depreciation Recorded to Fuel and Other O&M Expense 6,230 5,701 6,001
Coal Contract Amendment Fee - (14,248) -
Amortization of Transition Recovery Asset 31,752 24,489 22,536
Net Unrealized Loss (Gain) on Forward Electric Sales 761 1,302 (187,721)
Net Unrealized (Gain) Loss on Forward Electric Purchases (378) (1,835) 189,036
Amortization of Deferred Debt-Related Costs included in
Interest Expense 2,921 2,058 1,996
Provision for Bad Debts 4,460 1,688 (529)
Deferred Income Taxes 22,395 15,707 17,581
(Gains) Losses from Equity Method Entities (142) 530 1,812
Interest Accrued on Note Receivable from UniSource Energy (10,242) (9,329) -
Gain on Sale of Real Estate (467) - (1,572)
Other (4,587) (2,757) 6,214
Changes in Assets and Liabilities which Provided (Used)
Cash Exclusive of Changes Shown Separately
Accounts Receivable (8,717) 32,318 (9,418)
Materials and Fuel Inventory (5,607) (1,331) 165
Accounts Payable 8,225 (35,011) 15,238
Interest Accrued 28,576 18,542 10,191
Taxes Accrued 1,281 (3,663) (145)
Other Current Assets 581 (12,771) (1,229)
Other Current Liabilities (1,733) 2,683 (3,358)
---------------------------------------------------------------------------------------------------------------------------
Net Cash Flows - Operating Activities $257,788 $203,517 $261,169
===========================================================================================================================
Non-cash investing and financing activities of UniSource Energy and TEP
that affected recognized assets and liabilities but did not result in cash
receipts or payments were as follows:
Years Ended December 31,
2003 2002 2001
---------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
Capital Lease Obligations $ 10,731 $ 11,604 $ 20,743
Capital Lease Asset*
Note Receivable Received From the Sale of Nations Energy's
Curacao Project* - - 8,300
---------------------------------------------------------------------------------------------------------------------------
* This item is a non-cash investing activity of Millennium, and therefore,
is not reflected on TEP's financial statements.
The non-cash change in capital lease obligations represents interest
accrued for accounting purposes in excess of interest payments in 2003, 2002,
and 2001.
On August 11, 2003, UniSource Energy acquired the Arizona gas and electric
system assets from Citizens for $223 million, comprised of the base purchase
price plus other operating capital adjustments and transaction
K-125
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
costs. In conjunction with the acquisition, liabilities were assumed as follows:
- Thousands of Dollars -
---------------------------------------------------------------------------------------------------------------------
Fair Value of Assets Acquired $262,044
Liabilities Assumed 38,614
---------------------------------------------------------------------------------------------------------------------
Assets/Liabilities Purchased $223,430
=====================================================================================================================
Cash Paid for Citizens Assets $218,558
Transaction Costs 4,872
---------------------------------------------------------------------------------------------------------------------
Total Purchase Price $223,430
=====================================================================================================================
NOTE 21. QUARTERLY FINANCIAL DATA (UNAUDITED) (Restated - See Note 22)
------------------------------------------------------------------------
Our quarterly financial information has not been audited but, in
management's opinion, includes all adjustments necessary for a fair
presentation. Our utility business is seasonal in nature with the peak sales
periods generally occurring during the summer months. Accordingly, comparisons
among quarters of a year may not represent overall trends and changes in
operations.
In the third quarter of 2002, TEP began reporting purchase and sale
transactions under a Resource Management agreement with one of its
counterparties on a net basis, because TEP's purchases and sales to this
counterparty exactly offset each other and are made only for scheduling
purposes. TEP reclassified Purchased Power related to its purchases from the
counterparty as a reduction of Electric Wholesale Sales related to its sales to
the counterparty. This reclassification to a net presentation was based on TEP's
interpretation of EITF 99-19, "Reporting Revenue Gross as a Principal versus Net
as an Agent". In the fourth quarter of 2003, TEP identified an additional
contract with a subsidiary of the same counterparty that required a similar
reclassification.
In the fourth quarter of 2003, TEP changed its income statement
presentation of unrealized gains and losses on derivatives. Net unrealized gains
and losses on forward sales contracts are now presented as a component of
electric wholesale sales and net unrealized gains and losses on forward purchase
contracts are presented as a component of purchased power expense consistent
with the presentation of realized gains and losses on such contracts. Previously
the unrealized gains and losses on forward sales and purchase contracts were
combined in a separate line item under operating revenues.
These reclassifications and the effects of the restatement (discussed in
Note 22) on previously reported quarterly information are outlined below.
UniSource Energy
-----------------------------------------------------------
First Second Third Fourth
-----------------------------------------------------------------------------------------------------------------------------------
-Thousands of Dollars-
(except per share data)
2003
Operating Revenues as Previously Reported $ 173,166 $211,341 $ 302,798 $281,230
Reclassifications 491 733 134 -
Restatement (1,410) 3,999 1,320 (1,047)
-----------------------------------------------------------------------------------------------------------------------------------
Operating Revenues as Restated $ 172,247 $216,073 $ 304,252 $280,183
===================================================================================================================================
Operating Income as Previously Reported $ 13,133 $ 42,212 $ 82,574 $ 61,427
Reclassifications 464 903 - -
Restatement (1,528) 3,866 1,145 (1,191)
-----------------------------------------------------------------------------------------------------------------------------------
Operating Income as Restated $12,069 $ 46,981 $ 83,719 $ 60,236
====================================================================================================================================
Income (Loss) Before Cumulative Effect of Accounting Change $ (15,125) $ 6,920 $ 27,376 $ 27,299
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 52,346 6,920 27,376 27,299
K-126
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
UniSource Energy
-----------------------------------------------------------
First Second Third Fourth
-Thousands of Dollars-
(except per share data)
Basic EPS:
Income (Loss) Before Cumulative Effect of Accounting Change $ (0.45) $ 0.20 $ 0.81 $ 0.81
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.81 0.81
Diluted EPS:
Income (Loss) Before Cumulative Effect of Accounting Change (0.45) 0.20 0.80 0.79
Cumulative Effect of Accounting Change - Net of Tax 2.00 - - -
Net Income 1.55 0.20 0.80 0.79
2002
Operating Revenues as Previously Reported $ 171,195 $227,203 $ 258,765 $199,278
Reclassifications (2,682) (202) (8,505) (8,148)
Restatement (1,372) 2,365 2,355 (677)
------------------------------------------------------------------------------------------------------------------------------------
Operating Revenues as Restated $ 167,141 $229,366 $ 252,615 $190,453
====================================================================================================================================
Operating Income as Previously Reported $ 24,686 $ 51,971 $ 65,430 $ 41,993
Reclassifications 663 756 - 375
Restatement (1,362) 2,375 2,387 (661)
------------------------------------------------------------------------------------------------------------------------------------
Operating Income as Restated $ 23,987 $ 55,102 $ 67,817 $ 41,707
====================================================================================================================================
Net Income (Loss) $ (7,137) $ 13,322 $ 24,260 $ 4,483
Basic EPS (0.21) 0.40 0.72 0.13
Diluted EPS (0.21) 0.39 0.71 0.13
TEP
------------------------------------------------------
First Second Third Fourth
----------------------------------------------------------------------------- ------------------------------------------------------
-Thousands of Dollars-
2003
Operating Revenues as Previously Reported $ 172,547 $209,956 $ 264,415 $200,413
Reclassifications 490 733 136 -
Restatement (1,410) 3,999 1,320 (1,048)
------------------------------------------------------------------------------------------------------------------------------------
Operating Revenues as Restated $ 171,627 $214,688 $ 265,871 $199,365
====================================================================================================================================
Operating Income as Previously Reported $ 20,706 $ 51,053 $ 85,870 $ 49,710
Reclassifications 463 903 - -
Restatement (1,528) 3,869 1,145 (1,193)
------------------------------------------------------------------------------------------------------------------------------------
Operating Income as Restated $ 19,641 $ 55,825 $ 87,015 $48,517
====================================================================================================================================
Interest Income - Note Receivable from UniSource Energy $ 2,525 $ 2,554 $ 2,581 $ 2,582
Income (Loss) Before Cumulative Effect of Accounting Change (8,100) 13,511 32,194 23,837
Cumulative Effect of Accounting Change - Net of Tax 67,471 - - -
Net Income 59,371 13,511 32,194 23,837
K-127
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
2002
Operating Revenues as Previously Reported $ 169,577 $226,362 $ 257,243 $198,132
Reclassifications (2,682) (202) (8,506) (8,148)
Restatement (1,372) 2,365 2,354 (676)
----------------------------------------------------------------------------------------------------------------------------------
Operating Revenues as Restated $ 165,523 $228,525 $ 251,091 $189,308
==================================================================================================================================
Operating Income as Previously Reported $ 29,170 $ 58,163 $ 72,054 $ 50,009
Reclassifications 663 756 - 375
Restatement (1,362) 2,375 2,385 (661)
----------------------------------------------------------------------------------------------------------------------------------
Operating Income as Restated $ 28,471 $ 61,294 $ 74,439 $ 49,723
==================================================================================================================================
Interest Income - Note Receivable from UniSource Energy $ 2,301 $ 2,325 $ 2,352 $ 2,351
Net Income (Loss) (2,753) 18,901 28,003 11,239
EPS is computed independently for each of the quarters presented.
Therefore, the sum of the quarterly EPS amounts may not equal the total for the
year.
The principal unusual items for TEP and UniSource Energy include:
TEP and UniSource Energy
o First Quarter 2003: TEP recorded an after-tax gain of $67 million for
the cumulative effect of adopting FAS 143. See Note 5.
o Fourth Quarter 2003: TEP recognized a $15 million tax benefit due to a
reduction in its NOL valuation allowance. See Note 16. UniSource Energy
recorded $3 million of acquisition-related fees, 80% of which were
allocated to TEP. These fees do not result in a current or future tax
deduction. See Note 16.
o Third Quarter 2002: TEP recorded a one-time $11 million pre-tax expense
related to the termination of the Sundt coal contract. See Note 15. TEP
also recognized a $2 million tax benefit due to the resolution of various
tax items. See Note 16.
UniSource Energy
o Fourth Quarter 2003: UED recognized an $11 million pre-tax development
fee for closing the Springerville expansion project. See Note 14. This
quarter also includes the first full quarter of activity for UES which
was established on August 11, 2003. UES contributed Operating Revenues
of $69 million, Operating Income of $7 million and Net Income of $3
million to fourth quarter results.
o Third Quarter 2002: Millennium recognized a $3 million tax benefit due to
the resolution of various tax items. See Note 16.
NOTE 22. CHANGE IN UNBILLED REVENUE ESTIMATION METHODOLOGY AT TEP
------------------------------------------------------------------
TEP's and UES' retail revenues include an estimate of MWhs/therms
delivered but unbilled at the end of each period. Unbilled revenues are
dependent upon a number of factors that require management's judgment including
estimates of retail sales and customer usage patterns. The unbilled revenue is
estimated by comparing the estimated MWhs/therms delivered to the MWhs/therms
billed to TEP and UES retail customers. The excess of MWhs/therms delivered over
MWhs/therms billed is then allocated to the retail customer classes based on
estimated usage by each customer class. TEP and UES then record revenue for each
customer class based on the various bill rates for each customer class. Due to
the seasonal fluctuations of TEP's actual load, the unbilled revenue amount
increases during the spring and summer months and decreases during the fall and
winter months. The unbilled revenue amount for UES gas sales increases during
the fall and winter months and
K-128
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
decreases during the spring and summer months, whereas, the unbilled revenue
amount for UES electric sales increases during the spring and summer months and
decreases during the fall and winter months.
During the second quarter of 2004, we determined that the kWh
information used to estimate kWhs delivered to TEP's customers was, in general,
understated. Additionally, we determined that TEP's existing method of pricing
computed unbilled kWh sales quantities among customer classes was weighting
usage by lower-priced customers too heavily and weighting usage by higher-priced
customers too lightly. For TEP, the price paid by customers varies from a low of
3.7 cents per kWh for interruptible industrial load to a high of 13 cents per
kWh for small commercial customers, so that allocations among customer classes
are a significant element of unbilled revenues. Effective with the second
quarter of 2004, we changed the estimation methodology used to quantify unbilled
kWh sales and price the computed unbilled kWh sales quantities to more
accurately reflect actual usage and restated prior periods.
Under the revised estimation methodology, unbilled sales are estimated
for the month by reviewing the meter reading schedule and determining the number
of billed and unbilled kWhs for each cycle. Current month unbilled kWhs are
allocated by customer class. New unbilled revenue amounts are recorded and
unbilled revenue estimates from the prior month are reversed. The primary
difference between the prior estimation method and the current method results
from the reversal of the prior month's accrued unbilled revenue rather than a
methodology that had the effect of reversing unbilled kWhs, and a more precise
application of the current rates by customer class to kWhs unbilled at the end
of each month.
The effect on prior periods of this restatement was an increase in
Common Stock Equity at January 1, 2001 of $11 million. The Consolidated
Statements of Income and Changes in Stockholders' Equity for the three years in
the period ended December 31, 2003 and the Consolidated Balance Sheets and
Consolidated Statements of Capitalization as of December 31, 2003 and 2002 of
UniSource Energy and TEP have been restated to correct the under reported
revenues. The change in methodology and correction of under reported revenues
resulted in the following revisions to the consolidated financial statements:
K-129
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------------------------------
Consolidated Statements of Income
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As As
Previously Previously
Reported As Restated Reported As Restated
-------------------------------------------------------------------------------------------------------------------------------
Year Ended 2003 -Thousands of Dollars-
---------------
Electric Retail Sales $743,718 $746,578 $688,643 $691,503
Operating Revenues 969,895 972,755 848,691 851,551
Amortization of Transition Recovery Asset 31,184 31,752 31,184 31,752
Total Operating Expenses 769,182 769,750 639,985 640,553
Operating Income 200,713 203,005 208,706 210,998
Income Taxes 11,114 12,082 20,122 21,090
Income Before Cumulative Effect of Accounting Change 45,146 46,470 60,118 61,442
Net Income 112,617 113,941 127,589 128,913
Basic EPS:
----------
Income (Loss) Before Cumulative Effect of Accounting Change 1.34 1.38
Net Income 3.33 3.37
Diluted EPS:
-----------
Income (Loss) Before Cumulative Effect of Accounting Change 1.31 1.35
Net Income 3.28 3.32
Year Ended 2002
---------------
Electric Retail Sales $666,049 $668,721 $666,049 $668,721
Operating Revenues 836,904 839,576 831,775 834,447
Amortization of Transition Recovery Asset 24,554 24,489 24,554 24,489
Total Operating Expenses 651,028 650,963 620,585 620,520
Operating Income 185,876 188,613 211,190 213,927
Income Taxes 16,878 17,962 35,350 36,434
Net Income 33,275 34,928 53,737 55,390
Basic EPS:
---------
Net Income 0.99 1.04
Diluted EPS:
-----------
Net Income 0.97 1.02
K-130
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (continued)
--------------------------------------------------------------------------------
Consolidated Statements of Income
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As Previously As
Reported As Restated Previously As Restated
Reported
--------------------------------------------------------------------------------------------------------------------------------
Year Ended 2001 -Thousands of Dollars-
---------------
Electric Retail Sales $ 670,117 $ 675,173 $ 670,117 $ 675,173
Operating Revenues 1,608,248 1,613,304 1,599,905 1,604,961
Amortization of Transition Recovery Asset 21,609 22,536 21,609 22,536
Total Operating Expenses 1,357,588 1,358,515 1,332,221 1,333,148
Operating Income 250,660 254,789 267,684 271,813
Income Taxes 47,474 49,109 55,910 57,545
Income Before Cumulative Effect of Accounting Change 60,875 63,369 74,814 77,308
Net Income 61,345 63,839 75,284 77,778
Basic EPS:
----------
Income (Loss) Before Cumulative Effect of Accounting Change 1.83 1.90
Net Income 1.84 1.91
Diluted EPS:
------------
Income (Loss) Before Cumulative Effect of Accounting Change 1.79 1.86
Net Income 1.80 1.87
Consolidated Balance Sheets
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As As
Previously As Previously As
Reported Restated Reported Restated
--------------------------------------------------------------------------------------------------------------------------------
December 31, 2003 -Thousands of Dollars-
-----------------
Trade Accounts Receivable $ 89,449 $ 97,904 $ 61,960 $ 70,415
Unbilled Accounts Receivable 30,118 53,590 7,632 31,104
Total Current Assets 349,849 381,776 232,686 264,613
Transition Recovery Asset 275,936 274,182 275,936 274,182
Total Regulatory and Other Assets 384,706 382,952 381,409 379,655
Total Assets 3,092,129 3,122,302 2,736,457 2,766,630
Common Stock Equity 539,655 556,472 389,237 406,054
Total Capitalization 2,588,943 2,605,760 2,277,880 2,294,697
Taxes Accrued 42,136 50,625 29,535 38,024
Total Current Liabilities 273,492 281,981 209,196 217,685
Deferred Income Taxes - Noncurrent 91,403 96,270 123,469 128,336
Total Capitalization and Other Liabilities 3,092,129 3,122,302 2,736,457 2,766,630
K-131
UNISOURCE ENERGY, TEP AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - AS RESTATED (concluded)
--------------------------------------------------------------------------------
Consolidated Balance Sheets
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As As
Previously As Previously As
Reported Restated Reported Restated
--------------------------------------------------------------------------------------------------------------------------------
December 31, 2002 -Thousands of Dollars-
-----------------
Trade Accounts Receivable $ 75,787 $ 83,102 $ 66,826 $ 74,141
Unbilled Accounts Receivable 9,910 31,447 9,910 31,447
Total Current Assets 285,005 313,857 231,133 259,985
Transition Recovery Asset 307,120 305,934 307,120 305,934
Total Regulatory and Other Assets 422,274 421,088 421,420 420,234
Total Assets 2,858,288 2,885,954 2,781,144 2,808,810
Common Stock Equity 441,147 456,640 338,339 353,832
Total Capitalization 2,371,721 2,387,214 2,268,257 2,283,750
Taxes Accrued 33,850 41,524 35,772 43,446
Total Current Liabilities 219,380 227,054 217,744 225,418
Deferred Income Taxes - Noncurrent 34,552 39,051 67,490 71,989
Total Capitalization and Other Liabilities 2,858,288 2,885,954 2,781,144 2,808,810
Consolidated Statements of Capitalization
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As As
Previously As Previously As
Reported Restated Reported Restated
--------------------------------------------------------------------------------------------------------------------------------
December 31, 2003 -Thousands of Dollars-
-----------------
Accumulated Deficit $ (126,523) $ (109,706) $ (258,096) $ (241,279)
Total Common Stock Equity 539,655 556,472 389,237 406,054
Total Capitalization 2,588,943 2,605,760 2,277,880 2,294,697
Consolidated Statements of Capitalization
UniSource Energy TEP
--------------------------------------------------------------------------------------------------------------------------------
As As
Previously As Previously As
Reported Restated Reported Restated
--------------------------------------------------------------------------------------------------------------------------------
December 31, 2002 -Thousands of Dollars-
-----------------
Accumulated Deficit $ (218,932) $ (203,439) $ (305,685) $ (290,192)
Total Common Stock Equity 441,147 456,640 338,339 353,832
Total Capitalization 2,371,721 2,387,214 2,268,257 2,283,750
K-132
Schedule II - Valuation and Qualifying Accounts
Additions-
Beginning Charged to Ending
Description Balance Income Deductions Balance
----------------------------------------------------------------------------------------------------------------------
Year Ended December 31, -Millions of Dollars-
Deferred Tax Assets Valuation Allowance (1)
2003 $ 22 $ 2 $ 15 $ 9
2002 16 7 1 22
2001 16 - - 16
Allowance for Doubtful Accounts (2)
2003 $ 9 $ 5 $ 3 $ 11
2002 9 2 2 9
2001 10 1 2 9
----------------------------------------------------------------------------------------------------------------------
(1) The deferred tax assets valuation allowance reduces the deferred tax asset
balance. It relates to NOL and ITC carryforward amounts. UniSource, TEP and
Subsidiaries charged approximately $7 million to income in 2002 relating to the
limitation on the utilization of operating losses generated by certain
Millennium entities. UniSource, TEP and Subsidiaries reduced the deferred tax
assets valuation in 2002 due to the settlement of Internal Revenue Service
audits. UniSource, TEP and Subsidiaries charged $2 million to income in 2003
relating to the limitation on the utilization of operating losses generated by
certain Millennium entities. UniSource, TEP and Subsidiaries reduced the
deferred tax assets valuation in 2003 primarily based on guidance issued by the
Internal Revenue Service in September, 2003 (see Note 16 of Notes to
Consolidated Financial Statements).
(2) TEP recorded $7 million of expense in the first quarter of 2001 and $9
million in the fourth quarter of 2000 to reserve for uncollectible amounts
related to sales to the state of California in 2000 and the first quarter of
2001. TEP reversed $8 million of the $16 million reserve in the fourth quarter
of 2001. In the first quarter of 2003, TEP increased its reserve for sales to
the CPX and the CISO by $2 million by recording a reduction of wholesale
revenues. Deductions principally reflect amounts charged off as uncollectible,
less amounts recovered (see Note 13 of Notes to Consolidated Financial
Statements).
K-133
ITEM 9.-- CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
--------------------------------------------------------------------------------
None.
ITEM 9A.-- CONTROLS AND PROCEDURES
--------------------------------------------------------------------------------
Except as noted below with respect to unbilled revenues, UniSource
Energy and TEP have disclosure controls and procedures to ensure that material
information recorded, processed, summarized and reported in their filings with
the SEC is on an accurate and timely basis. Management of UniSource Energy and
TEP, with the participation of the principal executive officer and principal
financial officer of UniSource Energy and TEP have evaluated these disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended) as of December 31, 2003. Based on
such evaluation, with the exception of the unbilled revenue matter discussed
below, the principal executive officer and principal financial officer of
UniSource Energy and TEP have concluded that such disclosure controls and
procedures were, as of such date, effective at ensuring that material
information is recorded, processed, summarized and reported accurately and
within the time periods specified by the SEC's rules and forms.
There has been no change in UniSource Energy or TEP's internal control
over financial reporting that occurred during the most recent fiscal quarter
that has materially affected, or is reasonably likely to materially affect
UniSource Energy' or TEP's internal control over financial reporting except as
described below:
During the second quarter of 2004, we determined that we had a material
weakness in internal control over TEP's existing methodology of estimating
unbilled revenues. As a result, we restated the financial statements included in
this Form 10-K.
During the second quarter of 2004, we determined that the kWh
information used to estimate kWhs delivered to TEP's customers was, in general,
understated. Additionally, we determined that TEP's existing method of pricing
computed unbilled kWh sales quantities among customer classes was weighting
usage by lower-priced customers too heavily and weighting usage by higher-priced
customers too lightly. For TEP, the price paid by customers varies from a low of
3.7 cents per kWh for interruptible industrial load to a high of 13 cents per
kWh for small commercial customers, so that allocations among customer classes
are a significant element of unbilled revenues. Effective with the second
quarter of 2004, we changed the estimation methodology used to quantify unbilled
kWh sales and price the computed unbilled kWh sales quantities to more
accurately reflect actual usage and restated prior periods.
In addition to restating our financial statements, subsequent to the
date of our evaluation, we implemented changes to improve controls over
estimating unbilled revenue.
Also during the second quarter of 2004, we engaged an independent
consulting firm to test various aspects of our general information technology
controls primarily in the area of network access controls. The consultant made
several recommendations, which we implemented by the end of July 2004. While we
are not aware of any impacts to date on our financial reporting from not having
had these controls in place before, we believe these improvements to controls
will enhance data integrity controls subsequent to the date of our evaluation.
K-134
PART III
ITEM 10.-- DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTS
--------------------------------------------------------------------------------
DIRECTORS
Certain of the individuals serving as Directors of UniSource Energy
also serve as the Directors of TEP. Information concerning Directors will be
contained under Election of Directors in UniSource Energy's Proxy Statement
relating to the 2004 Annual Meeting of Shareholders, which will be filed with
the SEC not later than 120 days after December 31, 2003, which information is
incorporated herein by reference.
EXECUTIVE OFFICERS - UNISOURCE ENERGY
Executive Officers of UniSource Energy, who are elected annually by
UniSource Energy's Board of Directors, are as follows:
Executive
Officer
Name Age Position(s) Held Since
-----------------------------------------------------------------------------------------------------------------------
James S. Pignatelli 60 Chairman, President and Chief Executive Officer 1998
Michael J. DeConcini 39 Senior Vice President, Investments and Planning 1999
Dennis R. Nelson 53 Senior Vice President, Utility Services 1998
Karen G. Kissinger 49 Vice President, Controller and Chief Compliance Officer 1998
Kevin P. Larson 47 Vice President, Chief Financial Officer and Treasurer 2000
Steven W. Lynn 57 Vice President, Communications and Government Relations 2003
Vincent Nitido, Jr. 48 Vice President, General Counsel and Chief Administrative Officer 2000
Catherine A. Nichols 45 Corporate Secretary 2003
--------------------------------------------------------------------------------------------------------- -------------
James S. Pignatelli Mr. Pignatelli joined TEP as Senior
Vice President in August 1994 and was elected Senior
Vice President and Chief Operating Officer in 1996.
He was named Senior Vice President and Chief
Operating Officer of UniSource Energy in January
1998, and Executive Vice President and Chief
Operating Officer of TEP in March 1998. On June 23,
1998, Mr. Pignatelli was named Chairman, President
and CEO of UniSource Energy and TEP. Prior to joining
TEP, he was President and Chief Executive Officer
from 1988 to 1993 of Mission Energy Company, a
subsidiary of SCE Corp.
Michael J. DeConcini Mr. DeConcini joined TEP in 1988 and served in
various positions in finance, strategic planning and
wholesale marketing. He was Manager of TEP's
Wholesale Marketing Department in 1994, adding
Product Development and Business Development in 1997.
In November 1998, he was elected Vice President of
MEH, and elected Vice President, Strategic Planning
of UniSource Energy in February 1999. He was named
Senior Vice President, Investments and Planning of
UniSource Energy in October 2000. Mr. DeConcini was
elected Senior Vice President and Chief Operating
Officer of the Energy Resources business unit of TEP,
effective January 1, 2003.
Dennis R. Nelson Mr. Nelson joined TEP as a staff attorney in 1976.
He was manager of the Legal Department from 1985 to
1990. He was elected Vice President, General Counsel
and Corporate Secretary in January 1991. He was
named Vice President, General Counsel and Corporate
Secretary of UniSource Energy in January 1998. Mr.
Nelson was named Senior Vice President and General
Counsel of TEP in November 1998. In December 1998 he
was named Chief Operating Officer, Corporate Services
of TEP. In October 2000, he was named Senior Vice
President, Governmental Affairs of UniSource Energy
and Senior Vice President and Chief Operating
Officer of the Energy Resources business unit of TEP.
Mr. Nelson was elected Senior Vice President of
Utility Services, effective January 1, 2003 and named
Chief Operating Officer of UES on August 11, 2003.
K-135
Karen G. Kissinger Ms. Kissinger joined TEP as Vice President and
Controller in January 1991. She was named
Vice President, Controller and Principal Accounting
Officer of UniSource Energy in January 1998. In
November 1998, Ms. Kissinger was also named Chief
Information Officer of TEP. She was named Chief
Compliance Officer of UniSource Energy and TEP,
effective January 1, 2003.
Kevin P. Larson Mr. Larson joined TEP in 1985 and thereafter held
various positions in its finance department and at
TEP's investment subsidiaries. In January 1991, he
was elected Assistant Treasurer of TEP and named
Manager of Financial Programs. He was elected
Treasurer of TEP in August 1994 and Vice President in
March 1997. In October 2000, he was elected Vice
President and Chief Financial Officer of both
UniSource Energy and TEP and remains Treasurer of
both organizations.
Steven W. Lynn Mr. Lynn joined TEP in 2000 as Manager of Corporate
Relations for UniSource Energy and was named Manager
of Corporate Relations of both TEP and UniSource
Energy during 2000. In January 2003, he was elected
Vice President of Communications and Government
Relations at UniSource Energy and TEP. Prior to
joining TEP, Mr. Lynn was an owner-partner from 1984
- 2000 of Nordensson Lynn & Associates, Inc., a
Tucson-based advertising, marketing and public
relations firm.
Vincent Nitido, Jr. Mr. Nitido joined TEP as a staff attorney in 1991.
He was promoted to Manager of the Legal Department
in 1994, and elected Vice President and Assistant
General Counsel in 1998. In October 2000, he was
elected Vice President, General Counsel of both
UniSource Energy and TEP and Corporate Secretary
of UniSource Energy. Mr. Nitido was also named Chief
Administrative Officer of UniSource Energy and TEP,
effective January 1, 2003.
Catherine A. Nichols Ms. Nichols joined TEP as a staff attorney
in 1989. She was promoted to Manager of the Legal
Department and elected Corporate Secretary of TEP in
1998. She assumed the additional role of Manager of
the Human Resources Department in 1999. Ms. Nichols
was elected Corporate Secretary of UniSource Energy,
effective January 1, 2003, and remains Corporate
Secretary of TEP.
EXECUTIVE OFFICERS - TUCSON ELECTRIC POWER COMPANY
Executive Officers of TEP, who are elected annually by TEP's Board of
Directors, are:
Executive
Officer
Name Age Position(s) Held Since
--------------------------------------------------------------------------------------------------------------------
James S. Pignatelli 60 Chairman, President and Chief Executive Officer 1994
Michael J. DeConcini 39 Senior Vice President, Energy Resources Business Unit 2003
Steven J. Glaser 46 Senior Vice President and Chief Operating Officer, Transmission 1994
and Distribution Business Unit
Thomas A. Delawder 57 Vice President, Energy Resources Business Unit 1985
Thomas N. Hansen 53 Vice President / Technical Advisor 1992
Karen G. Kissinger 49 Vice President, Controller and Chief Compliance Officer 1991
Kevin P. Larson 47 Vice President, Chief Financial Officer and Treasurer 1994
Steven W. Lynn 57 Vice President, Communications and Government Relations 2003
Vincent Nitido, Jr. 48 Vice President, General Counsel and Chief Administrative Officer 1998
James Pyers 62 Vice President, Utility Distribution Business Unit, Operations 1998
Catherine A. Nichols 45 Corporate Secretary 1998
--------------------------------------------------------------------------------------------------------------------
James S. Pignatelli See description shown under UniSource Energy
Corporation above.
Michael J. DeConcini See description shown under UniSource Energy
Corporation above.
K-136
Steven J. Glaser Mr. Glaser joined TEP in 1990 as a Senior Attorney in
charge of Regulatory Affairs. He was Manager of
TEP's Legal Department from 1992 to 1994, and Manager
of Contracts and Wholesale Marketing from 1994 until
elected Vice President, Business Development. In
1995, he was named Vice President, Wholesale/Retail
Pricing and System Planning. He was named Vice
President, Energy Services in 1996 and Vice
President, Rates and Regulatory Support and
Utility Distribution Company Energy Services in
November 1998. In October 2000, he was
named Senior Vice President and Chief Operating
Officer of the Transmission and Distribution business
unit.
Thomas A. Delawder Mr. Delawder joined TEP in 1974 and
thereafter served in various engineering and
operations positions. In April 1985 he was named
Manager, Systems Operations and was elected Vice
President, Power Supply and System Control in
November 1985. In February 1991, he became Vice
President, Engineering and Power Supply and in
January 1992 he became Vice President, System
Operations. In 1994, he became Vice President of the
Energy Resources business unit.
Thomas N. Hansen Mr. Hansen joined TEP in December 1992 as Vice
President, Power Production. Prior to joining TEP,
Mr. Hansen was Century Power Corporation's Vice
President, Operations from 1989 and Plant Manager at
Springerville from 1987 through 1988. In 1994, he
was named Vice President / Technical Advisor.
Karen G. Kissinger See description shown under UniSource Energy
Corporation above.
Kevin P. Larson See description shown under UniSource Energy
Corporation above.
Steven W. Lynn See description shown under UniSource Energy
Corporation above.
Vincent Nitido, Jr. See description shown under UniSource Energy
Corporation above.
James Pyers Mr. Pyers joined TEP in 1974 as a Supervisor.
Thereafter, he held various supervisory positions and
was promoted to Manager of Customer Service
Operations in February 1998. Mr. Pyers was elected
Vice President, Utility Distribution business unit,
Operations in November 1998.
Catherine A. Nichols See description shown under UniSource Energy
Corporation above.
ITEM 11.-- EXECUTIVE COMPENSATION
--------------------------------------------------------------------------------
Information concerning Executive Compensation will be contained under
Executive Compensation and Other Information in UniSource Energy's Proxy
Statement relating to the 2004 Annual Meeting of Shareholders, which will be
filed with the SEC not later than 120 days after December 31, 2003, which
information is incorporated herein by reference.
ITEM 12.-- SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
--------------------------------------------------------------------------------
GENERAL
At March 10, 2004, UniSource Energy had outstanding 34,029,653 shares
of Common Stock. As of March 10, 2004, the number of shares of Common Stock
beneficially owned by all directors and officers of UniSource Energy as a group
amounted to approximately 4.5% of the outstanding Common Stock.
At March 10, 2004, UniSource Energy owned greater than 99.9% of the
outstanding shares of common stock of TEP.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
Information concerning the security ownership of certain beneficial
owners of UniSource Energy will be
K-137
contained under Security Ownership of Certain Beneficial Owners in UniSource
Energy's Proxy Statement relating to the 2004 Annual Meeting of Shareholders,
which will be filed with the SEC not later than 120 days after December 31,
2003, which information is incorporated herein by reference.
SECURITY OWNERSHIP OF MANAGEMENT
Information concerning the security ownership of the Directors and
Executive Officers of UniSource Energy and TEP will be contained under Security
Ownership of Management in UniSource Energy's Proxy Statement relating to the
2004 Annual Meeting of Shareholders, which will be filed with the SEC not later
than 120 days after December 31, 2003, which information is incorporated herein
by reference.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
Information concerning securities authorized for issuance under equity
compensation plans will be contained under Securities Authorized for Issuance
under Equity Compensation Plans in UniSource Energy's Proxy Statement relating
to the 2004 Annual Meeting of Shareholders, which will be filed with the SEC not
later than 120 days after December 31, 2003, which information is incorporated
herein by reference.
ITEM 13.-- CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------------------------------
Information concerning certain relationships and related transactions
of UniSource Energy and TEP will be contained under Transactions with Management
and Others and Compensation Committee Interlocks and Insider Participation in
UniSource Energy's Proxy Statement relating to the 2004 Annual Meeting of
Shareholders, which will be filed with the SEC not later than 120 days after
December 31, 2003, which information is incorporated herein by reference.
ITEM 14. - PRINCIPAL ACCOUNTANT FEES AND SERVICES
--------------------------------------------------------------------------------
Information concerning principal accountant fees and services will be
contained in UniSource Energy's Proxy Statement relating to the 2004 Annual
Meeting of Shareholders, which will be filed with the SEC not later than 120
days after December 31, 2003, which information is incorporated herein by
reference.
PART IV
ITEM 15.-- EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
--------------------------------------------------------------------------------
Page
(a) 1. Consolidated Financial Statements as of December 31, 2003
and 2002 and for Each
of the Three Years in the Period Ended
December 31, 2003
UniSource Energy Corporation
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 70
Consolidated Statements of Cash Flows 71
Consolidated Balance Sheets 72
Consolidated Statements of Capitalization 73
Consolidated Statements of Changes in Stockholders' Equity 74
Notes to Consolidated Financial Statements 80
Tucson Electric Power Company
Report of Independent Registered Public Accounting Firm 69
Consolidated Statements of Income 75
Consolidated Statements of Cash Flows 76
K-138
Consolidated Balance Sheets 77
Consolidated Statements of Capitalization 78
Consolidated Statements of Changes in Stockholders' Equity 79
Notes to Consolidated Financial Statements 80
2. Financial Statement Schedule
Schedule II
Valuation and Qualifying Accounts 130
3. Exhibits.
Reference is made to the Exhibit Index commencing on page 141.
(b) Reports on Form 8-K
o UniSource Energy and TEP Form 8-K, dated August 20, 2003 regarding the
acquisition by UniSource Energy of the Citizens Arizona gas and
electric assets.
o UniSource Energy Form 8-K dated August 26, 2003 regarding the
acquisition by UniSource Energy of the Citizens Arizona gas and
electric assets.
o UniSource Energy Form 8-K dated October 2, 2003 regarding the
acquisition by UniSource Energy of the Citizens Arizona gas and
electric assets.
o UniSource Energy and TEP Form 8-K, dated October 23, 2003 furnished
pursuant to Item 12 "Disclosure of Results of Operations and Financial
Condition", announcing third quarter 2003 earnings for UniSource Energy
and TEP.
o UniSource Energy and TEP Form 8-K, dated November 21, 2003, regarding
the proposed acquisition of UniSource Energy by Saguaro Acquisition
Corp.
o UniSource Energy and TEP Form 8-K, dated January 28, 2004, furnished
pursuant to Item 9 "Regulation FD Disclosure," providing
reconciliations of non-GAAP financial measures in connection with a
proposed refinancing of TEP's credit facilities.
o UniSource Energy and TEP Form 8-K, dated February 17, 2004, furnished
pursuant to Item 12 "Disclosure of Results of Operations and Financial
Condition," announcing fourth quarter and year-end 2003 earnings for
UniSource Energy and TEP.
K-139
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
UNISOURCE ENERGY CORPORATION
Date: August 24, 2004 By: /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: August 24, 2004 /s/ James S. Pignatelli*
----------------------------------------
James S. Pignatelli
Chairman of the Board, President and
Principal Executive Officer
Date: August 24, 2004 /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: August 24, 2004 /s/ Karen G. Kissinger*
----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: August 24, 2004 /s/ Lawrence J. Aldrich*
----------------------------------------
Lawrence J. Aldrich
Director
Date: August 24, 2004 /s/ Larry W. Bickle*
----------------------------------------
Larry W. Bickle
Director
Date: August 24, 2004 /s/ Elizabeth T. Bilby*
----------------------------------------
Elizabeth T. Bilby
Director
K-140
Date: August 24, 2004 /s/ Harold W. Burlingame*
----------------------------------------
Harold W. Burlingame
Director
Date: August 24, 2004 /s/ John L. Carter*
----------------------------------------
John L. Carter
Director
Date: August 24, 2004 /s/ Robert A. Elliott*
----------------------------------------
Robert A. Elliott
Director
Date: August 24, 2004 /s/ Kenneth Handy*
----------------------------------------
Kenneth Handy
Director
Date: August 24, 2004 /s/ Warren Y. Jobe*
----------------------------------------
Warren Y. Jobe
Director
Date: August 24, 2004 By: /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
as attorney-in-fact for each
of the persons indicated
K-141
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
TUCSON ELECTRIC POWER COMPANY
Date: August 24, 2004 By: /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Date: August 24, 2004 /s/ James S. Pignatelli*
----------------------------------------
James S. Pignatelli
Chairman of the Board, President and
Principal Executive Officer
Date: August 24, 2004 /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
Principal Financial Officer
Date: August 24, 2004 /s/ Karen G. Kissinger*
----------------------------------------
Karen G. Kissinger
Principal Accounting Officer
Date: August 24, 2004 /s/ Lawrence J. Aldrich*
----------------------------------------
Lawrence J. Aldrich
Director
Date: August 24, 2004 /s/ Elizabeth T. Bilby*
----------------------------------------
Elizabeth T. Bilby
Director
Date: August 24, 2004 /s/ Harold W. Burlingame*
----------------------------------------
Harold W. Burlingame
Director
K-142
Date: August 24, 2004 /s/ John L. Carter*
----------------------------------------
John L. Carter
Director
Date: August 24, 2004 /s/ Robert A. Elliott*
----------------------------------------
Robert A. Elliott
Director
Date: August 24, 2004 /s/ Kenneth Handy*
----------------------------------------
Kenneth Handy
Director
Date: August 24, 2004 /s/ Warren Y. Jobe*
----------------------------------------
Warren Y. Jobe
Director
Date: August 24, 2004 By: /s/ Kevin P. Larson
----------------------------------------
Kevin P. Larson
as attorney-in-fact for each
of the persons indicated
K-143
EXHIBIT INDEX
*2(a) -- Agreement and Plan of Exchange, dated as of March 20, 1995,
between TEP, UniSource Energy and NCR
Holding, Inc.
*2(b) -- Agreement and Plan of Merger between UniSource Energy
Corporation and Saguaro Acquisition Corp., dated as of November
21, 2003. (Form 8-K dated November 21, 2003, File No. 1-13739 -
Exhibit 10.)
*3(a) -- Restated Articles of Incorporation of TEP, filed with the
ACC on August 11, 1994, as amended by Amendment to Article
Fourth of the Company's Restated Articles of Incorporation,
filed with the ACC on May 17, 1996. (Form 10-K for year ended
December 31, 1996, File No. 1-5924 -- Exhibit 3(a).)
*3(b) -- Bylaws of TEP, as amended May 20, 1994. (Form 10-Q for the
quarter ended June 30, 1994, File No.1-5924 -- Exhibit 3.)
*3(c) -- Amended and Restated Articles of Incorporation of UniSource
Energy. (Form 8-A/A, dated January 30, 1998, File No. 1-13739
-- Exhibit 2(a).)
*3(d) -- Bylaws of UniSource Energy, as amended December 11, 1997.
(Form 8-A, dated December 23, 1997, File No. 1-13739 -- Exhibit
2(b).)
*4(a)(1) -- Indenture dated as of April 1, 1941, to The Chase National Bank
of the City of New York, as Trustee.(Form S-7, File No. 2-59906
-- Exhibit 2(b)(1).)
*4(a)(2) -- First Supplemental Indenture, dated as of October 1, 1946.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(2).)
*4(a)(3) -- Second Supplemental Indenture dated as of October 1, 1947.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(3).)
*4(a)(4) -- Third Supplemental Indenture, dated as of April 1, 1949.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(4).)
*4(a)(5) -- Fourth Supplemental Indenture, dated as of December 1, 1952.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(5).)
*4(a)(6) -- Fifth Supplemental Indenture, dated as of January 1, 1955.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(6).)
*4(a)(7) -- Sixth Supplemental Indenture, dated as of January 1, 1958.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(7).)
*4(a)(8) -- Seventh Supplemental Indenture, dated as of November 1, 1959.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(8).)
*4(a)(9) -- Eighth Supplemental Indenture, dated as of November 1, 1961.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(9).)
*4(a)(10) -- Ninth Supplemental Indenture, dated as of February 20, 1964.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(10).)
*4(a)(11) -- Tenth Supplemental Indenture, dated as of February 1, 1965.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(11).)
*4(a)(12) -- Eleventh Supplemental Indenture, dated as of February 1, 1966.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(12).)
K-144
*4(a)(13) -- Twelfth Supplemental Indenture, dated as of November 1, 1969.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(13).)
*4(a)(14) -- Thirteenth Supplemental Indenture, dated as of January 20,
1970. (Form S-7, File No. 2-59906 -- Exhibit 2(b)(14).)
*4(a)(15) -- Fourteenth Supplemental Indenture, dated as of September 1,
1971. (Form S-7, File No. 2-59906 -- Exhibit 2(b)(15).)
*4(a)(16) -- Fifteenth Supplemental Indenture, dated as of March 1, 1972.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(16).)
*4(a)(17) -- Sixteenth Supplemental Indenture, dated as of May 1, 1973.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(17).)
*4(a)(18) -- Seventeenth Supplemental Indenture, dated as of November 1,
1975. (Form S-7, File No. 2-59906 -- Exhibit 2(b)(18).)
*4(a)(19) -- Eighteenth Supplemental Indenture, dated as of November 1,
1975. (Form S-7, File No. 2-59906 -- Exhibit 2(b)(19).)
*4(a)(20) -- Nineteenth Supplemental Indenture, dated as of July 1, 1976.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(20).)
*4(a)(21) -- Twentieth Supplemental Indenture, dated as of October 1, 1977.
(Form S-7, File No. 2-59906 -- Exhibit 2(b)(21).)
*4(a)(22) -- Twenty-first Supplemental Indenture, dated as of November 1,
1977. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(v).)
*4(a)(23) -- Twenty-second Supplemental Indenture, dated as of January 1,
1978. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(w).)
*4(a)(24) -- Twenty-third Supplemental Indenture, dated as of July 1,
1980. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(x).)
*4(a)(25) -- Twenty-fourth Supplemental Indenture, dated as of October 1,
1980. (Form 10-K for year ended December 31, 1980, File No.
1-5924 -- Exhibit 4(y).)
*4(a)(26) -- Twenty-fifth Supplemental Indenture, dated as of April 1,
1981. (Form 10-Q for quarter ended March 31, 1981, File No.
1-5924 -- Exhibit 4(a).)
*4(a)(27) -- Twenty-sixth Supplemental Indenture, dated as of April 1,
1981. (Form 10-Q for quarter ended March 31, 1981, File No.
1-5924 -- Exhibit 4(b).)
*4(a)(28) -- Twenty-seventh Supplemental Indenture, dated as of October
1, 1981. (Form 10-Q for quarter ended September 30, 1982, File
No. 1-5924 -- Exhibit 4(c).)
*4(a)(29) -- Twenty-eighth Supplemental Indenture, dated as of June 1,
1990. (Form 10-Q for quarter ended June 30, 1990, File No.
1-5924 -- Exhibit 4(a)(1).)
*4(a)(30) -- Twenty-ninth Supplemental Indenture, dated as of December 1,
1992. (Form S-1, Registration No. 33-55732 -- Exhibit
4(a)(30).)
*4(a)(31) -- Thirtieth Supplemental Indenture, dated as of December 1,
1992. (Form S-1, Registration No. 33-55732 -- Exhibit
4(a)(31).)
*4(a)(32) -- Thirty-first Supplemental Indenture, dated as of May 1,
1996. (Form 10-K for the year ended December 31, 1996, File No.
1-5924 -- Exhibit 4(a)(32).)
K-145
*4(a)(33) -- Thirty-second Supplemental Indenture, dated as of May 1,
1996. (Form 10-K for the year ended December 31, 1996, File No.
1-5924 -- Exhibit 4(a)(33).)
*4(a)(34) -- Thirty-third Supplemental Indenture, dated as of May 1, 1998.
(Form 10-Q for the quarter ended June 30, 1998, File No. 1-5924
-- Exhibit 4(a).)
*4(a)(35) -- Thirty-fourth Supplemental Indenture dated as of August 1,
1998. (Form 10-Q for the quarter ended June 30, 1998, File No.
1-5924 -- Exhibit 4(b).)
*4(b)(1) -- Installment Sale Agreement, dated as of December 1, 1973,
among the City of Farmington, New Mexico, Public Service
Company of New Mexico and TEP. (Form 8-K for the month of
January 1974, File No. 0-269
-- Exhibit 3.)
*4(b)(2) -- Ordinance No. 486, adopted December 17, 1973, of the City of
Farmington, New Mexico. (Form 8-K for the month of January
1974, File No. 0-269 -- Exhibit 4.)
*4(b)(3) -- Amended and Restated Installment Sale Agreement dated as of
April 1, 1997, between the City of Farmington, New Mexico and
TEP relating to Pollution Control Revenue Bonds, 1997 Series A
(Tucson Electric Power Company San Juan Project). (Form 10-Q
for the quarter ended March 31, 1997, File No.
1-5924 -- Exhibit 4(a).)
*4(b)(4) -- City of Farmington, New Mexico Ordinance No. 97-1055,
adopted April 17, 1997, authorizing Pollution Control Revenue
Bonds, 1997 Series A (Tucson Electric Power Company San Juan
Project). (Form 10-Q for the quarter ended March 31, 1997, File
No. 1-5924 -- Exhibit 4(b).)
*4(c)(1) -- Loan Agreement, dated as of October 1, 1982, between the
Pima County Authority and TEP relating to Floating Rate Monthly
Demand Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Sundt Project). (Form 10-Q for
the quarter ended September 30, 1982, File No. 1-5924 --
Exhibit 4(a).)
*4(c)(2) -- Indenture of Trust, dated as of October 1, 1982, between the
Pima County Authority and Morgan Guaranty authorizing Floating
Rate Monthly Demand Industrial Development Revenue Bonds, 1982
Series A (Tucson Electric Power Company Sundt Project). (Form
10-Q for the quarter ended September 30, 1982, File No.
1-5924 -- Exhibit 4(b).)
*4(c)(3) -- First Supplemental Loan Agreement, dated as of March 31,
1992, between the Pima County Authority and TEP relating to
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Sundt Project). (Form S-4, Registration
No. 33-52860 -- Exhibit 4(h)(3).)
*4(c)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Sundt Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(h)(4).)
*4(d)(1) -- Loan Agreement, dated as of December 1, 1982, between the
Pima County Authority and TEP relating to Floating Rate Monthly
Demand Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Projects). (Form 10-K for the
year ended December 31, 1982, File No. 1-5924 -- Exhibit
4(k)(1).)
*4(d)(2) -- Indenture of Trust, dated as of December 1, 1982, between
the Pima County Authority and Morgan Guaranty authorizing
Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1982 Series A (Tucson Electric Power Company Projects).
(Form 10-K for the year ended December 31, 1982, File No.
1-5924 -- Exhibit 4(k)(2).)
*4(d)(3) -- First Supplemental Loan Agreement, dated as of March 31,
1992, between the Pima County Authority and TEP relating to
Industrial Development Revenue Bonds, 1982 Series A (Tucson
Electric Power Company Projects). (Form S-4, Registration No.
33-52860 -- Exhibit 4(i)(3).)
*4(d)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Pima County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1982 Series A
(Tucson Electric Power Company Projects). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(i)(4).)
K-146
*4(e)(1) -- Loan Agreement, dated as of December 1, 1983, between the
Apache County Authority and TEP relating to Floating Rate
Monthly Demand Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1983, File No.
1-5924 -- Exhibit 4(l)(1).)
*4(e)(2) -- Indenture of Trust, dated as of December 1, 1983, between
the Apache County Authority and Morgan Guaranty authorizing
Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series A (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1983, File No. 1-5924 -- Exhibit 4(l)(2).)
*4(e)(3) -- First Supplemental Loan Agreement, dated as of December 1,
1985, between the Apache County Authority and TEP relating to
Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series A (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(k)(3).)
*4(e)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty
relating to Floating Rate Monthly Demand Industrial Development
Revenue Bonds, 1983 Series A (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(k)(4).)
*4(e)(5) -- Second Supplemental Loan Agreement, dated as of March 31,
1992, between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(k)(5).)
*4(e)(6) -- Second Supplemental Indenture of Trust, dated as of March
31, 1992, between the Apache County Authority and Morgan
Guaranty relating to Industrial Development Revenue Bonds, 1983
Series A (Tucson Electric Power Company Springerville Project).
(Form S-4, Registration No. 33-52860 -- Exhibit 4(k)(6).)
*4(f)(1) -- Loan Agreement, dated as of December 1, 1983, between the
Apache County Authority and TEP relating to Variable Rate
Demand Industrial Development Revenue Bonds, 1983 Series B
(Tucson Electric Power Company Springerville Project). (Form
10-K for the year ended December 31, 1983, File No. 1-5924 --
Exhibit 4(m)(1).)
*4(f)(2) -- Indenture of Trust, dated as of December 1, 1983, between
the Apache County Authority and Morgan Guaranty authorizing
Variable Rate Demand Industrial Development Revenue Bonds, 1983
Series B (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1983, File No.
1-5924 -- Exhibit 4(m)(2).)
*4(f)(3) -- First Supplemental Loan Agreement, dated as of December 1,
1985, between the Apache County Authority and TEP relating to
Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series B (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(l)(3).)
*4(f)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty
relating to Floating Rate Monthly Demand Industrial Development
Revenue Bonds, 1983 Series B (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(l)(4).)
*4(f)(5) -- Second Supplemental Loan Agreement, dated as of March 31,
1992, between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series B (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(l)(5).)
K-147
*4(f)(6) -- Second Supplemental Indenture of Trust, dated as of March
31, 1992, between the Apache County Authority and Morgan
Guaranty relating to Industrial Development Revenue Bonds, 1983
Series B (Tucson Electric Power Company Springerville Project).
(Form S-4, Registration No. 33-52860 -- Exhibit 4(l)(6).)
*4(g)(1) -- Loan Agreement, dated as of December 1, 1983, between the
Apache County Authority and TEP relating to Variable Rate
Demand Industrial Development Revenue Bonds, 1983 Series C
(Tucson Electric Power Company Springerville Project). (Form
10-K for year ended December 31, 1983, File No. 1-5924 --
Exhibit 4(n)(1).)
*4(g)(2) -- Indenture of Trust, dated as of December 1, 1983, between
the Apache County Authority and Morgan Guaranty authorizing
Variable Rate Demand Industrial Development Revenue Bonds, 1983
Series C (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1983, File No.
1-5924 -- Exhibit 4(n)(2).)
*4(g)(3) -- First Supplemental Loan Agreement, dated as of December 1,
1985, between the Apache County Authority and TEP relating to
Floating Rate Monthly Demand Industrial Development Revenue
Bonds, 1983 Series C (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(m)(3).)
*4(g)(4) -- First Supplemental Indenture, dated as of December 1, 1985,
between the Apache County Authority and Morgan Guaranty
relating to Floating Rate Monthly Demand Industrial Development
Revenue Bonds, 1983 Series C (Tucson Electric Power Company
Springerville Project). (Form 10-K for the year ended December
31, 1987, File No. 1-5924 -- Exhibit 4(m)(4).)
*4(g)(5) -- Second Supplemental Loan Agreement, dated as of March 31,
1992, between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1983 Series C (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(m)(5).)
*4(g)(6) -- Second Supplemental Indenture of Trust, dated as of March
31, 1992, between the Apache County Authority and Morgan
Guaranty relating to Industrial Development Revenue Bonds, 1983
Series C (Tucson Electric Power Company Springerville Project).
(Form S-4, Registration No. 33-52860 -- Exhibit 4(m)(6).)
*4(h) -- Reimbursement Agreement, dated as of September 15, 1981, as
amended, between TEP and Manufacturers Hanover Trust Company.
(Form 10-K for the year ended December 31, 1984, File No.
1-5924 -- Exhibit 4(o)(4).)
*4(i)(1) -- Loan Agreement, dated as of December 1, 1985, between the
Apache County Authority and TEP relating to Variable Rate
Demand Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form
10-K for the year ended December 31, 1985, File No. 1-5924 --
Exhibit 4(r)(1).)
*4(i)(2) -- Indenture of Trust, dated as of December 1, 1985, between
the Apache County Authority and Morgan Guaranty authorizing
Variable Rate Demand Industrial Development Revenue Bonds, 1985
Series A (Tucson Electric Power Company Springerville Project).
(Form 10-K for the year ended December 31, 1985, File No.
1-5924 -- Exhibit 4(r)(2).)
*4(i)(3) -- First Supplemental Loan Agreement, dated as of March 31,
1992, between the Apache County Authority and TEP relating to
Industrial Development Revenue Bonds, 1985 Series A (Tucson
Electric Power Company Springerville Project). (Form S-4,
Registration No. 33-52860 -- Exhibit 4(o)(3).)
K-148
*4(i)(4) -- First Supplemental Indenture of Trust, dated as of March 31,
1992, between the Apache County Authority and Morgan Guaranty
relating to Industrial Development Revenue Bonds, 1985 Series A
(Tucson Electric Power Company Springerville Project). (Form
S-4, Registration No. 33-52860 -- Exhibit 4(o)(4).)
*4(j)(1) -- Indenture of Mortgage and Deed of Trust dated as of December
1, 1992, to Bank of Montreal Trust Company, Trustee. (Form S-1,
Registration No. 33-55732 -- Exhibit 4(r)(1).)
*4(j)(2) -- Supplemental Indenture No. 1 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series A, dated as
of December 1, 1992. (Form S-1, Registration No. 33-55732 --
Exhibit 4(r)(2).)
*4(j)(3) -- Supplemental Indenture No. 2 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series B, dated as
of December 1, 1997. (Form 10-K for year ended December 31,
1997, File No. 1-5924
-- Exhibit 4(m)(3).)
*4(j)(4) -- Supplemental Indenture No. 3 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series, dated as
of August 1, 1998. (Form 10-Q for the quarter ended June 30,
1998, File No. 1-5924
-- Exhibit 4(c).)
*4(j)(5) -- Supplemental Indenture No. 4 creating a series of bonds
designated Second Mortgage Bonds, Collateral Series C, dated as
of November 1, 2002. (Form 8-K dated November 27, 2002, File
Nos. 1-05924 and 1-13739 -- Exhibit 99.2.)
*4(k)(1) -- Loan Agreement, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and TEP relating
to Pollution Control Revenue Bonds, 1997 Series A (Tucson
Electric Power Company Navajo Project). (Form 10-Q for the
quarter ended March 31, 1997, File No. 1-5924 -- Exhibit 4(c).)
*4(k)(2) -- Indenture of Trust, dated as of April 1, 1997, between
Coconino County, Arizona Pollution Control Corporation and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1997 Series A (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(d).)
*4(l)(1) -- Loan Agreement, dated as of April 1, 1997, between Coconino
County, Arizona Pollution Control Corporation and TEP relating
to Pollution Control Revenue Bonds, 1997 Series B (Tucson
Electric Power Company Navajo Project). (Form 10-Q for the
quarter ended March 31, 1997, File No. 1-5924 --Exhibit 4(e).)
*4(l)(2) -- Indenture of Trust, dated as of April 1, 1997, between
Coconino County, Arizona Pollution Control Corporation and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1997 Series B (Tucson Electric
Power Company Navajo Project). (Form 10-Q for the quarter ended
March 31, 1997, File No. 1-5924 -- Exhibit 4(f).)
*4(m)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series A
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924
-- Exhibit 4(a).)
*4(m)(2) -- Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1997 Series A (Tucson
Electric Power Company Project). (Form 10-Q for the quarter
ended September 30, 1997, File No. 1-5924 -- Exhibit 4(b).)
K-149
*4(n)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series B
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924
-- Exhibit 4(c).)
*4(n)(2) -- Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1997 Series B (Tucson
Electric Power Company Project). (Form 10-Q for the quarter
ended September 30, 1997, File No. 1-5924 -- Exhibit 4(d).)
*4(o)(1) -- Loan Agreement, dated as of September 15, 1997, between The
Industrial Development Authority of the County of Pima and TEP
relating to Industrial Development Revenue Bonds, 1997 Series C
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended September 30, 1997, File No. 1-5924
-- Exhibit 4(e).)
*4(o)(2) -- Indenture of Trust, dated as of September 15, 1997, between
The Industrial Development Authority of the County of Pima and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1997 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter
ended September 30, 1997, File No. 1-5924 -- Exhibit 4(f).)
*4(p)(1) -- Loan Agreement, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
TEP relating to Pollution Control Revenue Bonds, 1998 Series A
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended March 31, 1998, File No. 1-5924 -- Exhibit 4(a).)
*4(p)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series A (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(b).)
*4(q)(1) -- Loan Agreement, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
TEP relating to Pollution Control Revenue Bonds, 1998 Series B
(Tucson Electric Power Company Project). (Form 10-Q for the
quarter ended March 31, 1998, File No. 1-5924 -- Exhibit 4(c).)
*4(q)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Pollution Control Revenue Bonds, 1998 Series B (Tucson Electric
Power Company Project). (Form 10-Q for the quarter ended March
31, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(r)(1) -- Loan Agreement, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
TEP relating to Industrial Development Revenue Bonds, 1998
Series C (Tucson Electric Power Company Project). (Form 10-Q
for the quarter ended March 31, 1998, File No. 1-5924 --
Exhibit 4(e).)
*4(r)(2) -- Indenture of Trust, dated as of March 1, 1998, between The
Industrial Development Authority of the County of Apache and
First Trust of New York, National Association, authorizing
Industrial Development Revenue Bonds, 1998 Series C (Tucson
Electric Power Company Project). (Form 10-Q for the quarter
ended March 31, 1998, File No. 1-5924 -- Exhibit 4(f).)
*4(s)(1) -- Indenture of Trust, dated as of August 1, 1998, between TEP
and the Bank of Montreal Trust Company. (Form 10-Q for the
quarter ended June 30, 1998, File No. 1-5924 -- Exhibit 4(d).)
*4(t)(1) -- Rights Agreement dated as of March 5, 1999, between
UniSource Energy Corporation and The Bank of New York, as
Rights Agent. (Form 8-K dated March 5, 1999, File No. 1-13739
-- Exhibit 4.)
K-150
*10(a)(1) -- Lease Agreements, dated as of December 1, 1984, between
Valencia and United States Trust Company of New York, as
Trustee, and Thomas B. Zakrzewski, as Co-Trustee, as amended
and supplemented. (Form 10-K for the year ended December 31,
1984, File No. 1-5924 -- Exhibit 10(d)(1).)
*10(a)(2) -- Guaranty and Agreements, dated as of December 1, 1984,
between TEP and United States Trust Company of New York, as
Trustee, and Thomas B. Zakrzewski, as Co-Trustee. (Form 10-K
for the year ended December 31, 1984, File No. 1-5924 --
Exhibit 10(d)(2).)
*10(a)(3) -- General Indemnity Agreements, dated as of December 1, 1984,
between Valencia and TEP, as Indemnitors; General Foods Credit
Corporation, Harvey Hubbell Financial, Inc. and J. C. Penney
Company, Inc. as Owner Participants; United States Trust
Company of New York, as Owner Trustee; Teachers Insurance and
Annuity Association of America as Loan Participant; and Marine
Midland Bank, N.A., as Indenture Trustee. (Form 10-K for the
year ended December 31, 1984, File No. 1-5924 -- Exhibit
10(d)(3).)
*10(a)(4) -- Tax Indemnity Agreements, dated as of December 1, 1984,
between General Foods Credit Corporation, Harvey Hubbell
Financial, Inc. and J. C. Penney Company, Inc., each as
Beneficiary under a separate Trust Agreement dated December 1,
1984, with United States Trust of New York as Owner Trustee,
and Thomas B. Zakrzewski as Co-Trustee, Lessor, and Valencia,
Lessee, and TEP, Indemnitors. (Form 10-K for the year ended
December 31, 1984, File No. 1-5924 -- Exhibit 10(d)(4).)
*10(a)(5) -- Amendment No. 1, dated December 31, 1984, to the Lease
Agreements, dated December 1, 1984, between Valencia and United
States Trust Company of New York, as Owner Trustee, and Thomas
B. Zakrzewski as Co-Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(5).)
*10(a)(6) -- Amendment No. 2, dated April 1, 1985, to the Lease
Agreements, dated December 1, 1984, between Valencia and United
States Trust Company of New York, as Owner Trustee, and Thomas
B. Zakrzewski as Co-Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(6).)
*10(a)(7) -- Amendment No. 3, dated August 1, 1985, to the Lease
Agreements, dated December 1, 1984, between Valencia and United
States Trust Company of New York, as Owner Trustee, and Thomas
Zakrzewski as Co-Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(7).)
*10(a)(8) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States
Trust Company of New York as Owner Trustee, and Thomas
Zakrzewski as Co-Trustee, under a Trust Agreement dated as of
December 1, 1984, with General Foods Credit Corporation as
Owner Participant. (Form 10-K for the year ended December 31,
1986, File No. 1-5924 -- Exhibit 10(e)(8).)
*10(a)(9) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States
Trust Company of New York as Owner Trustee, and Thomas
Zakrzewski as Co-Trustee, under a Trust Agreement dated as of
December 1, 1984, with J. C. Penney Company, Inc. as Owner
Participant. (Form 10-K for the year ended December 31, 1986,
File No. 1-5924 -- Exhibit 10(e)(9).)
*10(a)(10) -- Amendment No. 4, dated June 1, 1986, to the Lease Agreement,
dated December 1, 1984, between Valencia and United States
Trust Company of New York as Owner Trustee, and Thomas
Zakrzewski as Co-Trustee, under a Trust Agreement dated as of
December 1, 1984, with Harvey Hubbell Financial Inc. as Owner
Participant. (Form 10-K for the year ended December 31, 1986,
File No. 1-5924 -- Exhibit 10(e)(10).)
K-151
*10(a)(11) -- Lease Amendment No. 5 and Supplement No. 2, to the Lease
Agreement, dated July 1, 1986, between Valencia, United States
Trust Company of New York as Owner Trustee, and Thomas
Zakrzewski as Co-Trustee and J. C. Penney as Owner Participant.
(Form 10-K for the year ended December 31, 1986, File No.
1-5924 -- Exhibit 10(e)(11).)
*10(a)(12) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and
General Foods Credit Corporation as Owner Participant. (Form
10-K for the year ended December 31, 1988, File No.
1-5924 -- Exhibit 10(f)(12).)
*10(a)(13) -- Lease Amendment No. 5, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and
Harvey Hubbell Financial Inc. as Owner Participant. (Form 10-K
for the year ended December 31, 1988, File No. 1-5924
-- Exhibit 10(f)(13).)
*10(a)(14) -- Lease Amendment No. 6, to the Lease Agreement, dated June 1,
1987, between Valencia, United States Trust Company of New York
as Owner Trustee, and Thomas Zakrzewski as Co-Trustee and J. C.
Penney Company, Inc. as Owner Participant. (Form 10-K for the
year ended December 31, 1988, File No. 1-5924
-- Exhibit 10(f)(14).)
*10(a)(15) -- Lease Supplement No. 1, dated December 31, 1984, to Lease
Agreements, dated December 1, 1984, between Valencia, as Lessee
and United States Trust Company of New York and Thomas B.
Zakrzewski, as Owner Trustee and Co-Trustee, respectively
(document filed relates to General Foods Credit Corporation;
documents relating to Harvey Hubbell Financial, Inc. and JC
Penney Company, Inc. are not filed but are substantially
similar). (Form S-4, Registration No. 33-52860 -- Exhibit
10(f)(15).)
*10(a)(16) -- Amendment No. 1, dated June 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, General Foods Credit
Corporation, as Owner Participant, United States Trust Company
of New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(12).)
*10(a)(17) -- Amendment No. 1, dated June 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J. C. Penney Company, Inc.,
as Owner Participant, United States Trust Company of New York,
as Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form 10-K for the year ended December 31,
1986, File No. 1-5924 -- Exhibit 10(e)(13).)
*10(a)(18) -- Amendment No. 1, dated June 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, Harvey Hubbell Financial,
Inc., as Owner Participant, United States Trust Company of New
York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(14).)
*10(a)(19) -- Amendment No. 2, dated as of July 1, 1986, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J. C. Penney Company, Inc.,
as Owner Participant, United States Trust Company of New York,
as Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(f)(19).)
K-152
*10(a)(20) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, General Foods Credit
Corporation, as Owner Participant, United States Trust Company
of New York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee.
(Form S-4, Registration No. 33-52860 -- Exhibit 10(f)(20).)
*10(a)(21) -- Amendment No. 2, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, Harvey Hubbell Financial,
Inc., as Owner Participant, United States Trust Company of New
York, as Owner Trustee, Teachers Insurance and Annuity
Association of America, as Loan Participant, and Marine Midland
Bank, N.A., as Indenture Trustee. (Form S-4, Registration No.
33-52860 -- Exhibit 10(f)(21).)
*10(a)(22) -- Amendment No. 3, dated as of June 1, 1987, to the General
Indemnity Agreement, dated as of December 1, 1984, between
Valencia and TEP, as Indemnitors, J. C. Penney Company, Inc.,
as Owner Participant, United States Trust Company of New York,
as Owner Trustee, Teachers Insurance and Annuity Association of
America, as Loan Participant, and Marine Midland Bank, N.A., as
Indenture Trustee. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(f)(22).)
*10(a)(23) -- Supplemental Tax Indemnity Agreement, dated July 1, 1986,
between J. C. Penney Company, Inc., as Owner Participant, and
Valencia and TEP, as Indemnitors. (Form 10-K for the year ended
December 31, 1986, File No. 1-5924 -- Exhibit 10(e)(15).)
*10(a)(24) -- Supplemental General Indemnity Agreement, dated as of July
1, 1986, among Valencia and TEP, as Indemnitors, J. C. Penney
Company, Inc., as Owner Participant, United States Trust
Company of New York, as Owner Trustee, Teachers Insurance and
Annuity Association of America, as Loan Participant, and Marine
Midland Bank, N.A., as Indenture Trustee. (Form 10-K for the
year ended December 31, 1986, File No. 1-5924 -- Exhibit
10(e)(16).)
*10(a)(25) -- Amendment No. 1, dated as of June 1, 1987, to the
Supplemental General Indemnity Agreement, dated as of July 1,
1986, among Valencia and TEP, as Indemnitors, J. C. Penney
Company, Inc., as Owner Participant, United States Trust
Company of New York, as Owner Trustee, Teachers Insurance and
Annuity Association of America, as Loan Participant, and Marine
Midland Bank, N.A., as Indenture Trustee.
(Form S-4, Registration No. 33-52860 -- Exhibit 10(f)(25).)
*10(a)(26) -- Valencia Agreement, dated as of June 30, 1992, among TEP, as
Guarantor, Valencia, as Lessee, Teachers Insurance and Annuity
Association of America, as Loan Participant, Marine Midland
Bank, N.A., as Indenture Trustee, United States Trust Company
of New York, as Owner Trustee, and Thomas B. Zakrzewski, as
Co-Trustee, and the Owner Participants named therein relating
to the Restructuring of Valencia's lease of the coal-handling
facilities at the Springerville Generating Station. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(f)(26).)
*10(a)(27) -- Amendment, dated as of December 15, 1992, to the Lease
Agreements, dated December 1, 1984, between Valencia, as
Lessee, and United States Trust Company of New York, as Owner
Trustee, and Thomas B. Zakrzewski, as Co-Trustee. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(f)(27).)
*10(b)(1) -- Lease Agreements, dated as of December 1, 1985, between TEP
and San Carlos Resources Inc. (San Carlos) (a wholly-owned
subsidiary of the Registrant) jointly and severally, as Lessee,
and Wilmington Trust Company, as Trustee, as amended and
supplemented. (Form 10-K for the year ended December 31, 1985,
File No. 1-5924 -- Exhibit 10(f)(1).)
K-153
*10(b)(2) -- Tax Indemnity Agreements, dated as of December 1, 1985,
between Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Finance Co., each as beneficiary under
a separate trust agreement, dated as of December 1, 1985, with
Wilmington Trust Company, as Owner Trustee, and William J.
Wade, as Co-Trustee, and TEP and San Carlos, as Lessee. (Form
10-K for the year ended December 31, 1985, File No. 1-5924 --
Exhibit 10(f)(2).)
*10(b)(3) -- Participation Agreement, dated as of December 1, 1985, among
TEP and San Carlos as Lessee, Philip Morris Credit Corporation,
IBM Credit Financing Corporation, and Emerson Finance Co. as
Owner Participants, Wilmington Trust Company as Owner Trustee,
The Sumitomo Bank, Limited, New York Branch, as Loan
Participant, and Bankers Trust Company, as Indenture Trustee.
(Form 10-K for the year ended December 31, 1985, File No.
1-5924 -- Exhibit 10(f)(3).)
*10(b)(4) -- Restructuring Commitment Agreement, dated as of June 30,
1992, among TEP and San Carlos, jointly and severally, as
Lessee, Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Capital Funding, William J. Wade, as
Owner Trustee and Co-Trustee, respectively, The Sumitomo Bank,
Limited, New York Branch, as Loan Participant and United States
Trust Company of New York, as Indenture Trustee. (Form S-4,
Registration No. 33-52860 -- Exhibit 10(g)(4).)
*10(b)(5) -- Lease Supplement No. 1, dated December 31, 1985, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee Trustee and
Co-Trustee, respectively (document filed relates to Philip
Morris Credit Corporation; documents relating to IBM Credit
Financing Corporation and Emerson Financing Co. are not filed
but are substantially similar). (Form S-4, Registration No.
33-52860 -- Exhibit 10(g)(5).)
*10(b)(6) -- Amendment No. 1, dated as of December 15, 1992, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, as Lessor. (Form S-1, Registration No.
33-55732 -- Exhibit 10(g)(6).)
*10(b)(7) -- Amendment No. 1, dated as of December 15, 1992, to Tax
Indemnity Agreements, dated as of December 1, 1985, between
Philip Morris Credit Corporation, IBM Credit Financing
Corporation and Emerson Capital Funding Corp., as Owner
Participants and TEP and San Carlos, jointly and severally, as
Lessee. (Form
S-1, Registration No. 33-55732 -- Exhibit 10(g)(7).)
*10(b)(8) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Philip Morris
Capital Corporation as Owner Participant. (Form 10-K for the
year ended December 31, 1999, File No.
1-5924 -- Exhibit 10(b)(8).)
*10(b)(9) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with IBM Credit Financing
Corporation as Owner Participant. (Form 10-K for the year ended
December 31, 1999, File No.
1-5924 -- Exhibit 10(b)(9).)
*10(b)(10) -- Amendment No. 2, dated as of December 1, 1999, to Lease
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Emerson Finance Co.
as Owner Participant. (Form 10-K for the year ended December
31, 1999, File No. 1-5924 -- Exhibit 10(b)(10).)
K-154
*10(b)(11) -- Amendment No. 2, dated as of December 1, 1999, to Tax
Indemnity Agreement, dated as of December 1, 1985, between TEP
and San Carlos, jointly and severally, as Lessee, and Philip
Morris Capital Corporation as Owner Participant, beneficiary
under a Trust Agreement dated as of December 1, 1985, with
Wilmington Trust Company and William J. Wade, as Owner Trustee
and Co-Trustee, respectively, together as Lessor. (Form 10-K
for the year ended December 31, 1999, File No. 1-5924 --
Exhibit 10(b)(11).)
*10(b)(12) -- Amendment No. 2, dated as of December 1, 1999, to Tax
Indemnity Agreement, dated as of December 1, 1985, between TEP
and San Carlos, jointly and severally, as Lessee, and IBM
Credit Financing Corporation as Owner Participant, beneficiary
under a Trust Agreement dated as of December 1, 1985, with
Wilmington Trust Company and William J. Wade, as Owner Trustee
and Co-Trustee, respectively, together as Lessor. (Form 10-K
for the year ended December 31, 1999, File No. 1-5924 --
Exhibit 10(b)(12).)
*10(b)(13) -- Amendment No. 2, dated as of December 1, 1999, to Tax
Indemnity Agreement, dated as of December 1, 1985, between TEP
and San Carlos, jointly and severally, as Lessee, and Emerson
Finance Co. as Owner Participant, beneficiary under a Trust
Agreement dated as of December 1, 1985, with Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, together as Lessor. (Form 10-K for the year ended
December 31, 1999, File No. 1-5924 -- Exhibit 10(b)(13).)
*10(b)(14) -- Amendment No. 3 dated as of June 1, 2003, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Philip Morris
Capital Corporation as Owner Participant.
*10(b)(15) -- Amendment No. 3 dated as of June 1, 2003, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with IBM Credit, LLC as
Owner Participant.
*10(b)(16) -- Amendment No. 3 dated as of June 1, 2003, to Lease
Agreements, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Wilmington Trust
Company and William J. Wade, as Owner Trustee and Co-Trustee,
respectively, under a Trust Agreement with Emerson Finance Co.
as Owner Participant.
*10(b)(17) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Philip Morris
Capital Corporation as Owner Participant, beneficiary under a
Trust Agreement dated as of December 1, 1985, with Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, together as Lessor.
*10(b)(18) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and IBM Credit, LLC
as Owner Participant, beneficiary under a Trust Agreement dated
as of December 1, 1985, with Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
together as Lessor.
*10(b)(19) -- Amendment No. 3 dated as of June 1, 2003, to Tax Indemnity
Agreement, dated as of December 1, 1985, between TEP and San
Carlos, jointly and severally, as Lessee, and Emerson Finance
Co. as Owner Participant, beneficiary under a Trust Agreement
dated as of December 1, 1985, with Wilmington Trust Company and
William J. Wade, as Owner Trustee and Co-Trustee, respectively,
together as Lessor.
*10(c)(1) -- Amended and Restated Participation Agreement, dated as of
November 15, 1987, among TEP, as Lessee, Ford Motor Credit
Company, as Owner Participant, Financial Security Assurance
Inc., as Surety, Wilmington Trust Company and William J. Wade
in their respective individual capacities as provided therein,
but otherwise solely as Owner Trustee and Co-Trustee under the
Trust Agreement, and Morgan Guaranty, in its individual
capacity as provided therein, but Secured Party. (Form 10-K for
the year ended December 31, 1987, File No. 1-5924 -- Exhibit
10(j)(1).)
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*10(c)(2) -- Lease Agreement, dated as of January 14, 1988, between
Wilmington Trust Company and William J. Wade, as Owner Trust
Agreement described therein, dated as of November 15, 1987,
between such parties and Ford Motor Credit Company, as Lessor,
and TEP, as Lessee. (Form 10-K for the year ended December 31,
1987, File No. 1-5924 -- Exhibit 10(j)(2).)
*10(c)(3) -- Tax Indemnity Agreement, dated as of January 14, 1988,
between TEP, as Lessee, and Ford Motor Credit Company, as Owner
Participant, beneficiary under a Trust Agreement, dated as of
November 15, 1987, with Wilmington Trust Company and William J.
Wade, Owner Trustee and Co-Trustee, respectively, together as
Lessor. (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 10(j)(3).)
*10(c)(4) -- Loan Agreement, dated as of January 14, 1988, between the
Pima County Authority and Wilmington Trust Company and William
J. Wade in their respective individual capacities as expressly
stated, but otherwise solely as Owner Trustee and Co-Trustee,
respectively, under and pursuant to a Trust Agreement, dated as
of November 15, 1987, with Ford Motor Credit Company as Trustor
and Debtor relating to Industrial Development Lease Obligation
Refunding Revenue Bonds, 1988 Series A (TEP's Sundt Project).
(Form 10-K for the year ended December 31, 1987, File No.
1-5924 -- Exhibit 10(j)(4).)
*10(c)(5) -- Indenture of Trust, dated as of January 14, 1988, between
the Pima County Authority and Morgan Guaranty authorizing
Industrial Development Lease Obligation Refunding Revenue
Bonds, 1988 Series A (Tucson Electric Power Company Sundt
Project). (Form 10-K for the year ended December 31, 1987, File
No. 1-5924 -- Exhibit 10(j)(5).)
*10(c)(6) -- Lease Amendment No. 1, dated as of May 1, 1989, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee
and Co-trustee, respectively under a Trust Agreement dated as
of November 15, 1987 with Ford Motor Credit Company. (Form 10-K
for the year ended December 31, 1990, File No. 1-5924
-- Exhibit 10(i)(6).)
*10(c)(7) -- Lease Supplement, dated as of January 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee
and Co-Trustee, respectively, under a Trust Agreement dated as
of November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(8).)
*10(c)(8) -- Lease Supplement, dated as of March 1, 1991, between TEP,
Wilmington Trust Company and William J. Wade as Owner Trustee
and Co-Trustee, respectively, under a Trust Agreement dated as
of November 15, 1987, with Ford. (Form 10-K for the year ended
December 31, 1991, File No. 1-5924 -- Exhibit 10(i)(9).)
*10(c)(9) -- Lease Supplement No. 4, dated as of December 1, 1991,
between TEP, Wilmington Trust Company and William J. Wade as
Owner Trustee and Co-Trustee, respectively, under a Trust
Agreement dated as of November 15, 1987, with Ford. (Form 10-K
for the year ended December 31, 1991, File No. 1-5924 --
Exhibit 10(i)(10).)
*10(c)(10) -- Supplemental Indenture No. 1, dated as of December 1, 1991,
between the Pima County Authority and Morgan Guaranty relating
to Industrial Lease Development Obligation Revenue Project.
(Form 10-K for the year ended December 31, 1991, File No.
1-5924 -- Exhibit 10(I)(11).)
*10(c)(11) -- Restructuring Commitment Agreement, dated as of June 30,
1992, among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, and Morgan
Guaranty, as Indenture Trustee and Refunding Trustee, relating
to the restructuring of the Registrant's lease of Unit 4 at the
Sundt Generating Station. (Form S-4, Registration No. 33-52860
-- Exhibit 10(i)(12).)
*10(c)(12) -- Amendment No. 1, dated as of December 15, 1992, to Amended
and Restated Participation Agreement, dated as of November 15,
1987, among TEP, as Lessee, Ford Motor Credit Company, as Owner
Participant, Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, Financial Security
Assurance Inc., as Surety, and Morgan Guaranty, as Indenture
Trustee. (Form S-1, Registration No. 33-55732 -- Exhibit
10(h)(12).)
K-156
*10(c)(13) -- Amended and Restated Lease, dated as of December 15, 1992,
between TEP, as Lessee and Wilmington Trust Company and William
J. Wade, as Owner Trustee and Co-Trustee, respectively, as
Lessor. (Form S-1, Registration No. 33-55732 -- Exhibit
10(h)(13).)
*10(c)(14) -- Amended and Restated Tax Indemnity Agreement, dated as of
December 15, 1992, between TEP, as Lessee, and Ford Motor
Credit Company, as Owner Participant. (Form S-1, Registration
No. 33-55732 -- Exhibit 10(h)(14).)
*10(d) -- Power Sale Agreement for the years 1990 to 2011, dated as of
March 10, 1988, between TEP and Salt River Project Agricultural
Improvement and Power District. (Form 10-K for the year ended
December 31, 1987, File No. 1-5924 -- Exhibit 10(k).)
*10(e) -- Participation Agreement, dated as of June 30, 1992, among
TEP, as Lessee, various parties thereto, as Owner Wilmington
Trust Company and William J. Wade, as Owner Trustee and
Co-Trustee, respectively, and LaSalle National Bank, as
Indenture Trustee relating to TEP's lease of Springerville Unit
1. (Form S-1, Registration No. 33-55732 -- Exhibit 10(u).)
*10(f) -- Lease Agreement, dated as of December 15, 1992, between TEP,
as Lessee and Wilmington Trust Company and William J. Wade, as
Owner Trustee and Co-Trustee, respectively, as Lessor. (Form
S-1, Registration No. 33-55732 -- Exhibit 10(v).)
*10(g) -- Tax Indemnity Agreements, dated as of December 15, 1992,
between the various Owner Participants parties thereto and TEP,
as Lessee. (Form S-1, Registration No. 33-55732 -- Exhibit
10(w).)
*10(h) -- Restructuring Agreement, dated as of December 1, 1992,
between TEP and Century Power Corporation. (Form S-1,
Registration No. 33-55732 -- Exhibit 10(x).)
*10(i) -- Voting Agreement, dated as of December 15, 1992, between TEP
and Chrysler Capital Corporation (documents relating to CILCORP
Lease Management, Inc., MWR Capital Inc., US West Financial
Services, Inc. and Philip Morris Capital Corporation are not
filed but are substantially similar). (Form S-1, Registration
No. 33-55732 -- Exhibit 10(y).)
*10(j)(1) -- Wholesale Power Supply Agreement between TEP and Navajo
Tribal Utility Authority dated January 5, 1993. (Form 10-K for
the year ended December 31, 1992, File No. 1-5924 -- Exhibit
10(t).)
*10(j)(2) -- Amended and Restated Wholesale Power Supply Agreement
between TEP and Navajo Tribal Utility Authority, dated June 25,
1997. (Form 10-Q for the quarter ended June 30, 1997, File No.
1-5924 -- Exhibit 10.)
+*10(k) -- 1994 Omnibus Stock and Incentive Plan of UniSource Energy.
(Form S-8 dated January 6, 1998, File No.333-43767.)
+*10(l) -- Management and Directors Deferred Compensation Plan of
UniSource Energy. (Form S-8 dated January 6, 1998, File No.
333-43769.)
+*10(m) -- TEP Supplemental Retirement Account for Classified Employees.
(Form S-8 dated May 21, 1998, File No.333-53309.)
+*10(n) -- TEP Triple Investment Plan for Salaried Employees. (Form S-8
dated May 21, 1998, File No. 333-53333.)
+*10(o) -- UniSource Energy Management and Directors Deferred
Compensation Plan. (Form S-8 dated May 21, 1998, File No.
333-53337.)
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+10(p) -- Officer Change in Control Agreement between TEP and
currently in effect with Thomas A. Delawder, Michael DeConcini,
Steven J. Glaser, Thomas N. Hansen, Neil Holstad, Karen G.
Kissinger, Kevin P. Larson, Steven W. Lynn, Dennis R. Nelson,
Vincent Nitido, Jr., James S. Pignatelli, and James Pyers dated
as of December 4, 1998.
*10(q)(1) -- Sworn Statement by UniSource Energy Principal Executive
Officer Regarding Facts and Circumstances Relating to Exchange
Act Filings pursuant to SEC Order No. 4-460. (Form 8-K dated
August 9, 2002, File No. 1-13739 -- Exhibit 99.1.)
*10(q)(2) -- Sworn Statement by UniSource Energy Principal Financial
Officer Regarding Facts and Circumstances Relating to Exchange
Act Filings pursuant to SEC Order No. 4-460. (Form 8-K dated
August 9, 2002, File No. 1-13739 -- Exhibit 99.2.)
+*10(r) -- Amended and Restated UniSource Energy 1994 Outside Director
Stock Option Plan of UniSource Energy. (Form S-8 dated
September 9, 2002, File No. 333-99317.)
*10(s)(1) -- Asset Purchase Agreement dated as of October 29, 2002, by
and between UniSource Energy and Citizens Communications
Company relating to the Purchase of Citizens' Electric Utility
Business in the State of Arizona. (Form 8-K dated October 31,
2002, File No. 1-13739 -- Exhibit 99-1.)
*10(s)(2) -- Asset Purchase Agreement dated as of October 29, 2002, by
and between UniSource Energy and Citizens Communications
Company relating to the Purchase of Citizens' Gas Utility
Business in the State of Arizona. (Form 8-K dated October 31,
2002, File No. 1-13739 -- Exhibit 99-2.)
*10(t) -- Credit Agreement dated as of November 14, 2002, among TEP,
Toronto Dominion (Texas), Inc., as Administrative Agent, The
Bank of New York and Union Bank of California as Co-Syndication
Agents, Credit Suisse First Boston as Documentation Agent, TD
Securities (USA) Inc. and Credit Suisse First Boston as Co-Lead
Arrangers and Joint Bookrunners, the lenders party hereto, and
the issuing banks party hereto. (Form 8-K dated November 27,
2002, File Nos. 1-5924 and 1-13739 -- Exhibit 99-1.)
*10(u) -- Note Purchase and Guaranty Agreement dated August 11, 2003
among UNS Gas, Inc., and UniSource Energy Services, Inc., and
certain institutional investors. (Form 8-K dated August 11,
2003, File Nos. 1-5924
and 1-13739 - Exhibit 99.2.)
*10(v) -- Note Purchase and Guaranty Agreement dated August 11, 2003
among UNS Electric, Inc., and UniSource Energy Services, Inc.,
and certain institutional investors. (Form 8-K dated August 11,
2003, File Nos.
1-5924 and 1-13739 - Exhibit 99.3.)
12 -- Computation of Ratio of Earnings to Fixed Charges -- TEP.
21 -- Subsidiaries of the Registrants.
23 -- Consents of experts.
24(a) -- Power of Attorney -- UniSource Energy.
24(b) -- Power of Attorney -- TEP.
31(a) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley Act
- UniSource Energy, by James S. Pignatelli.
31(b) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act - UniSource Energy, by Kevin P. Larson.
31(c) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act - TEP, by James S. Pignatelli.
K-158
31(d) -- Certification Pursuant to Section 302 of the Sarbanes-Oxley
Act - TEP, by Kevin P. Larson.
**32 - Statements of Corporate Officers (pursuant to Section 906
of the Sarbanes-Oxley Act of 2002).
(*) Previously filed as indicated and incorporated herein by reference.
(+) Management contracts or compensatory plans or arrangements required to be
filed as exhibits to this Form 10-K by item 601(b)(10)(iii) of Regulation
S-K.
**Pursuant to Item 601(b)(32)(ii) of Regulation S-K, this certificate is not
being filed for purposes of Section 18 of the Securities Act of 1934.
K-159