UNISOURCE ENERGY CORP - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For The Quarterly Period Ended March 31, 2004

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

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 whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
UniSource Energy Corporation Yes _X__ No ____
Tucson Electric Power Company Yes ____ No _X__

At May 4, 2004, 34,143,167 shares of UniSource Energy Corporation's
Common Stock, no par value (the only class of Common Stock), were outstanding.

At May 4, 2004, 32,139,555 shares of Tucson Electric Power Company's
common stock, no par value, were outstanding, of which 32,139,434 were held by
UniSource Energy Corporation.

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This combined Form 10-Q 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.

TABLE OF CONTENTS

Page
Definitions...................................................................iv
Report of Independent Accountants..............................................1

PART I - FINANCIAL INFORMATION

Item 1. - Financial Statements
UniSource Energy Corporation
Comparative Condensed Consolidated Statements of Income.................2
Comparative Condensed Consolidated Statements of Cash Flows.............3
Comparative Condensed Consolidated Balance Sheets.......................4
Condensed Consolidated Statement of Changes in Stockholders' Equity.....5
Tucson Electric Power Company
Comparative Condensed Consolidated Statements of Income.................6
Comparative Condensed Consolidated Statements of Cash Flows.............7
Comparative Condensed Consolidated Balance Sheets.......................8
Condensed Consolidated Statement of Changes in Stockholders' Equity.....9
Notes to Condensed Consolidated Financial Statements
Note 1. Nature of Operations, Basis of Accounting Presentation and
Equity-Based Compensation.......................................10
Note 2. Proposed Acquisition of UniSource Energy........................11
Note 3. Regulatory Matters..............................................12
Note 4. TEP Credit Facility.............................................13
Note 5. Accounting Change: Accounting for Asset Retirement Obligations.14
Note 6. Accounting for Derivative Instruments and Trading Activities....14
Note 7. Business Segments...............................................15
Note 8. Millennium .....................................................16
Note 9. Commitments and Contingencies...................................18
Note 10. TEP Wholesale Accounts Receivable and Allowances................21
Note 11. UniSource Energy Earnings per Share (EPS).......................21
Note 12. Employee Benefits Plans.........................................22
Note 13. Equity-Based Compensation Plans.................................22
Note 14. Income and Other Taxes..........................................24
Note 15. New Accounting Pronouncements...................................25
Note 16. Supplemental Cash Flow Information..............................26
Note 17. Review by Independent Accountants...............................27

Item 2. - Management's Discussion and Analysis of Financial Condition and
Results of Operations
Overview of Consolidated Business.........................................28
UniSource Energy Consolidated
Results of Operations..................................................30
Contribution by Business Segment.......................................31
Liquidity and Capital Resources........................................31
Tucson Electric Power Company
Results of Operations..................................................33
Factors Affecting Results of Operations................................35
Liquidity and Capital Resources...............................................37

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TABLE OF CONTENTS
(concluded)

UniSource Energy Services
Results of Operations..................................................39
Factors Affecting Results of Operations................................40
Liquidity and Capital Resources........................................41
Millennium Energy Holdings, Inc.
Results of Operations..................................................42
Liquidity and Capital Resources........................................43
Critical Accounting Policies..............................................44
New Accounting Pronouncements.............................................49
Safe Harbor for Forward-Looking Statements................................50

Item 3. - Quantitative and Qualitative Disclosures about Market Risk........51

Item 4. - Controls and Procedures...........................................53

PART II - OTHER INFORMATION

Item 1. - Legal Proceedings.................................................54
Item 4. - Submission of Matters to a Vote of Security Holders...............54
Item 5. - Other Information
Additional Financial Data.................................................55
Non-GAAP Measure..........................................................55
SEC Reports Available on UniSource Energy's Website.......................56

Item 6. - Exhibits and Reports on Form 8-K..................................57

Signatures....................................................................57

Exhibit Index.................................................................58

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DEFINITIONS

The abbreviations and acronyms used in the 2004 First Quarter 10-Q 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.
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.
CPX.............................. California Power Exchange.
Credit Agreement................. Credit Agreement between TEP and a
syndicate of lenders, dated as of March
25, 2004.
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.

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.
Haddington....................... Haddington Energy Partners II, LP, a
limited partnership that funds
energy-related investments
Heating Degree Days.............. An index used to measure the impact of
weather on energy usage calculated by
subtracting the average of the high and
low daily temperatures from 65.
IDBs............................. Industrial development revenue or
pollution control revenue bonds.
IPS.............................. Infinite Power Solutions, Inc., a company
that develops thin-film batteries.
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

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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).
LIBOR............................ London Interbank Offered Rate
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............................ Purchase Power and Fuel Adjustor 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 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
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.
Sundt Generating Station......... H. Wilson Sundt Generating Station
(formerly known as the Irvington

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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.

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Report of Independent Accountants

Report of Independent Accountants

To the Board of Directors and Stockholders of
UniSource Energy Corporation and
to the Board of Directors of
Tucson Electric Power Company

We have reviewed the accompanying condensed consolidated balance sheet of
UniSource Energy Corporation and its subsidiaries (the Company) and Tucson
Electric Power Company and its subsidiaries (TEP) as of March 31, 2004 and the
related condensed consolidated statements of income and of cash flows for each
of the three-month periods ended March 31, 2004 and 2003 and the condensed
consolidated statement of changes in stockholders' equity for the three-month
period ended March 31, 2004. These financial statements are the responsibility
of the Company's and TEP's management.

We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures to
financial data and making inquiries of persons responsible for financial and
accounting matters. It is substantially less in scope than an audit conducted in
accordance with generally accepted auditing standards, the objective of which is
the expression of an opinion regarding the financial statements taken as a
whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should
be made to the accompanying condensed consolidated interim financial statements
for them to be in conformity with accounting principles generally accepted in
the United States of America.

We previously audited in accordance with auditing standards generally accepted
in the United States of America, the consolidated balance sheet and statement of
capitalization of the Company and TEP as of December 31, 2003, and the related
consolidated statements of income, of changes in stockholders' equity, and of
cash flows for the year then ended (not presented herein), and in our report
dated February 20, 2004 we expressed an unqualified opinion on those
consolidated financial statements. In our opinion, the information set forth in
the accompanying condensed consolidated balance sheets as of December 31, 2003
are fairly stated in all material respects in relation to the consolidated
balance sheets from which they have been derived.

Los Angeles, California
May 3, 2004

1

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS
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2

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UNISOURCE ENERGY CORPORATION
COMPARATIVE CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

4

UNISOURCE ENERGY CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY

9

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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NOTE 1. NATURE OF OPERATIONS, BASIS OF ACCOUNTING PRESENTATION AND EQUITY-BASED
COMPENSATION
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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 99.9% 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
85% of UniSource Energy's assets as of March 31, 2004. TEP generates, transmits
and distributes electricity. TEP serves approximately 369,000 retail electric
customers in a 1,155 square mile area in Pima and Cochise counties in Southern
Arizona. TEP also sells electricity to other utilities and power marketing
entities primarily located in the western U.S.

UES has no significant operations of its own, but owns all of the
common stock of UNS Gas, Inc. (UNS Gas) and UNS Electric, Inc. (UNS Electric).
On August 11, 2003, UniSource Energy completed the purchase of the Arizona gas
and electric system assets from Citizens Communications Company (Citizens) and
established two new operating companies, UNS Gas and 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. UNS Electric procures,
transmits and distributes electricity to approximately 82,000 retail electric
customers in the Mohave county of Northern Arizona and the Santa Cruz county of
Southern Arizona. UNS Gas procures, transports and distributes natural gas to
approximately 129,000 customers in Mohave, Yavapai, Coconino, and Navajo
counties in Northern Arizona and Santa Cruz county in Southern Arizona.

Millennium's unregulated businesses are described in Note 8 and UED's
services are described in Note 7.

References to "we" and "our" are to UniSource Energy and its
subsidiaries, collectively.

The accompanying quarterly financial statements of UniSource Energy and
TEP are unaudited but reflect all normal recurring accruals and other
adjustments which we believe are necessary for a fair presentation of the
results for the interim periods presented. These financial statements are
presented in accordance with the Securities and Exchange Commission's (SEC)
interim reporting requirements which do not include all the disclosures required
by accounting principles generally accepted in the United States of America
(GAAP) for audited annual financial statements. The year-end condensed balance
sheet data was derived from audited financial statements, but does not include
disclosures required by GAAP for audited annual financial statements. This
quarterly report should be reviewed in conjunction with UniSource Energy and
TEP's 2003 Annual Report on Form 10-K.

Weather, among other factors, causes seasonal fluctuations in TEP and
UES' sales; therefore, quarterly results are not indicative of annual operating
results. UniSource Energy and TEP have made minor reclassifications to the prior
year financial statements for comparative purposes. These reclassifications had
no effect on net income.

EQUITY-BASED COMPENSATION

UniSource Energy has two equity-based compensation plans, the 1994
Outside Director Stock Option Plan (Directors' Plan) and the 1994 Omnibus Stock
and Incentive Plan (Omnibus Plan). See Note 13. 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 as if we had applied the fair
value recognition provisions of Statement of Financial Accounting Standards No.
123, Accounting for Stock-Based Compensation, to all equity-based employee
compensation awards:

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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TEP:
---

The fair value of each stock option grant is estimated on the date of
grant using the Black-Scholes option-pricing model. There were no stock options
granted in the first quarter of 2004. For the 21,222 options granted under the
Directors' Plan in 2003, the following weighted average assumptions were used:

NOTE 2. PROPOSED ACQUISITION OF UNISOURCE ENERGY
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At a special meeting held on March 29, 2004, UniSource Energy's
shareholders voted to approve an acquisition agreement UniSource Energy entered
into on November 21, 2003 with Saguaro Acquisition Corp., a wholly-owned
indirect subsidiary of Saguaro Utility Group L.P. (Saguaro Utility), providing
for the acquisition of all of the common stock of UniSource Energy for $25.25
per share by an affiliate of Saguaro Utility. The acquisition agreement provides
that Saguaro Acquisition Corp. will merge with and into UniSource Energy, with
UniSource

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Energy surviving the merger as a wholly-owned indirect 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. In connection with the closing of the acquisition, 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. UniSource Energy expects 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 UniSource Energy's business pending the consummation of the
acquisition. Generally, unless UniSource Energy obtains Saguaro Acquisition
Corp.'s prior written consent, UniSource Energy must conduct business in the
ordinary course consistent with past practice and use all commercially
reasonable efforts to preserve substantially intact the present business
organization and present regulatory, business and employee relationships. In
addition, the acquisition agreement restricts certain 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 or certain regulatory approvals are not
obtained. In certain circumstances, upon the termination of the acquisition
agreement, UniSource Energy would be required to pay Saguaro Acquisition Corp.'s
expenses related to the acquisition agreement and a termination fee in an
aggregate amount of up to $25 million.

An affiliate of Saguaro Utility entered into a $410 million credit
agreement on March 25, 2004 that will be funded upon closing of the acquisition
of UniSource Energy. The credit agreement includes a $50 million revolving
credit facility for general corporate purposes and a $360 million term loan to
be used to fund a portion of the acquisition. The lenders' obligation to make
such loans are subject to various customary closing conditions.

The March 29, 2004 shareholder vote to approve the proposed merger
triggered vesting of all outstanding stock options under the Omnibus Plan, but
no additional compensation expense resulted from such vesting. See Note 13 for a
description of additional compensation expense recorded for the performance
shares due to accelerated vesting of the awards as a result of the March 29,
2004 shareholder vote.

NOTE 3. REGULATORY MATTERS
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REGULATORY ACCOUNTING

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),
require special accounting treatment for regulated companies to show the effect
of regulation. For example, in setting TEP's and UES' retail rates, the Arizona
Corporation Comission (ACC) may not allow TEP or UES to currently charge their
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 these 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

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o the service territory lacks competitive pressures to reduce rates below
the rates set by the regulator.

IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71

TEP

Upon approval by the ACC of a settlement agreement (TEP Settlement
Agreement) in November 1999, TEP discontinued application of FAS 71 for its
generation operations. TEP continues to apply FAS 71 to its regulated
operations, which include the transmission and distribution portions of its
business.

TEP's regulatory assets, net of regulatory liabilities, totaled $276
million at March 31, 2004. Regulatory assets of $22 million are not presently
included in rate base and consequently are not earning a return on investment.

TEP regularly assesses whether it can continue to apply FAS 71 to its
regulated operations. If TEP stopped applying FAS 71 to these 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 March 31, 2004, if
TEP had stopped applying FAS 71 to its remaining regulated operations, it would
have recorded an extraordinary after-tax loss of $167 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.

UES

UES' regulatory liabilities, net of regulatory assets, totaled $2
million at March 31, 2004. This amount includes a $0.2 million asset related to
underrecovered purchased gas costs under UNS Gas' Purchased Gas Adjuster (PGA),
and a $0.8 million liability related to overrecovered purchased power costs
under UNS Electric's Purchased Power and Fuel Adjuster Clause (PPFAC). 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 its regulatory
liabilities as income on its income statement. Based on the regulatory liability
balances, net of regulatory assets, at March 31, 2004, if UES had stopped
applying FAS 71 to its regulated operations, it would have recorded an
extraordinary after-tax gain 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.

RECENT REGULATORY ACTION FOR UES

In September 2003, the ACC approved a PGA surcharge of $0.1155 per
therm that took effect October 1, 2003. On March 23, 2004, the ACC approved the
termination of the surcharge effective October 31, 2004. At March 31, 2004, the
PGA balance was $0.2 million.

NOTE 4. TEP CREDIT FACILITY
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On March 25, 2004, TEP entered into a new $401 million credit
agreement. The agreement replaces the credit facilities provided under TEP's
$401 million credit agreement that would have expired in 2006. The new credit
agreement includes a $60 million revolving credit facility for general corporate
purposes and a $341 million letter of credit facility, to support $329 million
aggregate principal amount of tax-exempt variable rate bonds. The credit
agreement has a five year term through June 30, 2009 and is 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 and
sale-leasebacks. The credit agreement also contains several financial covenants
including: (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. The previous credit agreement had provided that dividends
could not exceed 65% of TEP's net income. The elimination of such covenant is
expected to satisfy, in part, one of the closing conditions contained in the
acquisition agreement that UniSource Energy entered into with Saguaro
Acquisition

13

Corp. by permitting TEP to dividend all of its net income to its shareholders.
The credit agreement also provides that under certain circumstances, certain
regulatory actions could result in a required reduction of the commitments. As
of March 31, 2004, TEP was in compliance with the terms of the Credit Agreement.

The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous credit agreement's weighted average letter of credit fee
of approximately 5%. The agreement also provides for letter of credit fronting
fees of 0.25%, which will reduce to 0.125% upon the closing of Saguaro
Acquisition Corp.'s acquisition of UniSource Energy; the previous agreement's
fronting fee was 0.25%. Unreimbursed drawings on a letter of credit bear a
variable rate of interest based on LIBOR plus 2.25% per annum. Interest savings
in 2004 will be partially offset by the write-off of fees associated with the
prior facility that were capitalized and being amortized through 2006 and the
amortization of fees associated with the entry of the new facility. TEP
wrote-off $2 million in fees associated with the prior facility in March 2004,
included in Long-Term Debt Interest Expense in UniSource Energy and TEP's income
statements.

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
leverage. The per annum rate currently in effect on borrowings under TEP's
revolving credit facility, based on its leverage, is LIBOR plus 2.25%. If TEP's
leverage were to change, the spread over LIBOR could range from 1.50% to 2.25%.
Also, TEP pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.

NOTE 5. ACCOUNTING CHANGE: ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS
- --------------------------------------------------------------------------------

TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. TEP also has certain environmental obligations at the San
Juan Generating Station (San Juan). TEP has estimated that its share of these
obligations will be approximately $38 million at the date of retirement. As of
March 31, 2004 and December 31, 2003, TEP had accrued approximately $1 million
for the final decommissioning of its generating facilities. This amount has been
recorded as an accrued asset retirement obligation on the UniSource Energy and
TEP balance sheets.

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. A final retirement occurs when an entire
transmission or distribution line is permanently removed from service. Interim
retirements occur as components of the system are replaced. 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 March 31, 2004 and
December 31, 2003, TEP had accrued $62 million and $60 million and UES had
accrued $1 million for the net cost of removal for interim retirements from its
transmission, distribution and general plant. These amounts have been recorded
as a regulatory liability on the UniSource Energy and TEP balance sheets.

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 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 of
$44 million and recognized the cumulative effect of accounting change as a gain
of $112 million ($67 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.

NOTE 6. ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND TRADING ACTIVITIES
- --------------------------------------------------------------------------------

TEP's, UES' and MEG's derivative activities are discussed fully in
UniSource Energy and TEP's 2003 Annual Report on Form 10-K.

TEP has a natural gas supply agreement under which it purchases all of
its gas requirements at spot market prices from Southwest Gas Corporation (SWG).
TEP also has agreements to purchase power that are

14

priced using spot market gas prices. These contracts meet the definition of
normal purchases and are not required to be marked to market. In the first
quarter of 2004, in an effort to minimize price risk on these purchases, TEP
entered into commodity price swap agreements under which TEP purchases gas at
fixed prices and simultaneously sells gas at spot market prices. The spot market
price in the swap agreements is tied to the same index as the purchases under
the SWG and purchased power contracts. These swap agreements, which will expire
during the summer months of 2004 through 2006, were entered into with the goal
of locking in fixed prices on at least 45% and not more than 80% of TEP's
expected summer monthly gas risk prior to entering into the month. The swap
agreements are marked to market on a monthly basis; however, since the
agreements satisfy the requirements for cash flow hedge accounting, the
unrealized gains and losses are recorded in Other Comprehensive Income, a
component of Common Stock Equity, rather than being reflected in the income
statement.

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;
o TEP's net unrealized gains and losses on commodity price swaps are
included in Other Comprehensive Income, which is a component of
Common Stock Equity; 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.

The net pre-tax unrealized gains and losses from TEP's forward
contracts were less than $1 million for each of the three month periods ended
March 31, 2004 and 2003. The net pre-tax realized and unrealized gains and
losses from MEG's trading activities were also less than $1 million for each of
the three month periods ended March 31, 2004 and 2003. The net pre-tax
unrealized gains and losses from TEP's commodity swap agreements recorded as
cash flow hedges and included in Other Comprehensive Income were just over $1
million as of March 31, 2004. TEP had no material cash flow hedges as of
December 31, 2003.

TEP's derivative assets and liabilities are reported in Other Current
Assets and Other Current Liabilities on TEP's balance sheet and in Trading
Assets and Trading Liabilities on UniSource Energy's balance sheet. The fair
value of TEP's derivative assets was $1 million at March 31, 2004 and the fair
value of TEP's derivative liabilities was less than $1 million at December 31,
2003. 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 $49 million at
March 31, 2004 and $22 million at December 31, 2003. The fair value of MEG's
trading liabilities was $44 million at March 31, 2004 and $19 million at
December 31, 2003.

Beginning January 1, 2004, the settlement of forward purchase and sales
contracts that do not result in physical delivery are recorded net as a
component of Electric Wholesale Sales in TEP's income statement. For the three
months ended March 31, 2004, $1 million in sales were netted against $1 million
in purchases, resulting in a small net gain.

NOTE 7. BUSINESS SEGMENTS
- --------------------------------------------------------------------------------

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. See Note 1.
(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.

15

Significant reconciling adjustments consist of the elimination of
intercompany activity and balances. Millennium recorded revenue from
transactions with TEP of $3 million and $2 million during the three-month
periods ended March 31, 2004 and March 31, 2003, 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.

We record our percentage share of the earnings of affiliated companies,
except for investments where we provide all of the financing, in which case we
recognize 100% of the losses. See Note 8.

We disclose selected financial data for our business segments in the
following table:

NOTE 8. MILLENNIUM
- --------------------------------------------------------------------------------

See Note 7 for selected financial data of Millennium.

Through affiliates, Millennium holds investments in unregulated energy
and emerging technology companies. As presented in Note 7, Millennium's assets
represent 7% of UniSource Energy's total assets at March 31, 2004 and 6% at
December 31, 2003. Under the acquisition agreement described in Note 2,
UniSource Energy is limited as to the amount it can invest in Millennium in the
future. 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 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. Millennium owns 99% of Global Solar. Millennium accounts for
Global Solar under the consolidation method and recognizes 100% of Global
Solar's losses. Global Solar recognizes expense when funding is used for
research, development and administrative costs. During the first quarter of
2004, Millennium made no contributions

16

to Global Solar. However, UniSource Energy provided $2 million to Global Solar
under a tax sharing agreement. Millennium has no remaining funding commitments
to Global Solar, other than the tax sharing agreement with UniSource Energy.

INFINITE POWER SOLUTIONS, INC. (IPS) develops thin-film lithium ion
batteries. Millennium owns 72% of IPS and accounts for it under the
consolidation method. IPS recognizes expense when funding is used for research,
development and administrative costs. During the first quarter of 2004,
Millennium funded its remaining debt commitment of $0.5 million to IPS. Dow
Corning Enterprises, Inc. (DCEI) made no additional contributions to IPS during
the same time period. In April 2004, Millennium and DCEI committed to loan up to
an additional $1 million each to IPS, and each funded $0.5 million of the
commitment at that time. Millennium's remaining debt commitment to IPS is
currently $0.5 million and is contingent on IPS' attainment of certain
performance criteria. Pursuant to the terms of the amended promissory notes with
IPS, Millennium and DCEI have the right to convert at any time the outstanding
debt amounts to equity ownership. 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%.

MICROSAT SYSTEMS, INC. (MicroSat) develops small-scale satellites under
a U.S. government contract. In February 2004, pursuant to a settlement
agreement, the contract was terminated and MicroSat granted the government
purpose rights to the design data and transferred all hardware assets developed
under the contract to the government in exchange for the elimination of further
cost-sharing obligations under the contract. These assets will be used under a
new contract between MicroSat and the government, and may be used by the
government for other satellite development contracts not involving MicroSat.
However, MicroSat retains the right to use the design data on other government
and commercial contracts. MicroSat had previously deferred $2 million, before
tax, of revenues earned under the original contract. These revenues have now
been recognized, and Millennium recorded the income in the first quarter of
2004. Millennium owns 35% of MicroSat and, as sole funder, recognizes 100% of
MicroSat's net losses. Millennium made no contributions to MicroSat during the
first quarter of 2004 and 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 6.

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% ownership. At March 31,
2004, Millennium had funded $9 million of this commitment, none of which was
funded during the first quarter of 2004. Millennium expects the balance to be
funded over the next three years. In March 2004, Haddington sold one of its
investments and recognized the related gain as income. Millennium's recorded
its share of Haddington's income in the first quarter 2004. In April 2004,
Millennium received a $7 million distribution from Haddington related to the
sale. Millennium accounts for its investment in Haddington 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. Another 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. As of March 31, 2004, Millennium had funded $2
million of this commitment, $0.6 million of which was funded during the first
quarter of 2004. 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 affiliation disclosed 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 own the remaining 50%. UniSource Energy's Chairman, President and
Chief Executive Officer is an alternate member of the board of directors of
AHMSA. 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

17

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. 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 32% interest in a 43 MW
power plant in Panama. Nations Energy intends to sell its interest in this
plant, the book value of which 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 March 31, 2004, 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. cover

MILLENNIUM COMMITMENTS

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 $4 million to Valley Ventures. Millennium's
only remaining debt commitment is $0.5 million to IPS. Millennium may commit to
provide additional funding to its investments in the future.

Global Solar had commitments totaling $1 million at March 31, 2004 and
December 31, 2003 to incur future expenses relating to government contracts.

NOTE 9. COMMITMENTS AND CONTINGENCIES
- --------------------------------------------------------------------------------

MILLENNIUM COMMITMENTS AND CONTINGENCY

See Note 8 for a description of Millennium's commitments and
contingency.

UNISOURCE ENERGY CONTINGENCIES

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 has agreed to pay Morgan Stanley a transaction
fee of up to $3 million, which includes their monthly advisory fee, in
connection with the acquisition. UniSource Energy paid Morgan Stanley $1 million
in November 2003 and $0.4 million in April 2004 upon shareholders approving the
transaction, and will pay Morgan Stanley $1 million contingent and payable upon
the acquisition closing.

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

18

$25 million.

Withdrawal of Litigation Concerning the Proposed Acquisition Agreement

On March 17, 2004, plaintiffs withdrew two shareholder derivative
lawsuits, McBride v. Pignatelli, et al. and Zetooney v. Pignatelli, et al.,
filed in the Superior Court of the State of Arizona on November 24, 2003, the
same day that UniSource Energy announced details of its proposed acquisition by
Saguaro Utility Group, L.P. UniSource Energy paid no consideration in connection
with the withdrawal of the lawsuits. In these two lawsuits, which were virtually
identical, the plaintiffs alleged 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.

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.

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 for the 9th Circuit. Oral arguement on the matter was
heard by the 9th Circuit on April 15, 2004, and a decision is pending.

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 alleged that PNM
violated its present Title V operating permit for Units 1, 3 and 4 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. PNM was
directed to make a written settlement offer on the remaining claim by May 28,
2004, with the plaintiffs directed to respond by June 11, 2004. A settlement
conference has been scheduled before the federal magistrate on July 1, 2004. The
trial will continue in the third quarter of 2004 if the parties are unable to
reach settlement.
settlement.

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 Units 1, 3, and 4. 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.

19

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.

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 March 31, 2004, TEP has recorded
$0.4 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.

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 $3 million in
commodity-related payments for MEG at March 31, 2004. 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.

20

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 10. TEP WHOLESALE ACCOUNTS RECEIVABLE AND ALLOWANCES
- --------------------------------------------------------------------------------

At March 31, 2004 and 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).

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 $23 million as of March 31, 2004 and $26 million at
December 31, 2003. Excluding the receivables from the CPX and the CISO, as
described above, substantially all of the March 31, 2004 wholesale receivable
balance has been collected as of the date of this filing.

NOTE 11. UNISOURCE ENERGY EARNINGS PER SHARE (EPS)
- --------------------------------------------------------------------------------

Basic EPS is computed by dividing net income (loss) 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
equity-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:

There were no antidilutive options as of March 31, 2004. The dilutive
share base for the quarter ended March 31, 2003 excludes 1,406,000 options and
contingently issuable shares due to their antidilutive effect as a result of
UniSource Energy's loss before cumulative effect of accounting change.

21

NOTE 12. EMPLOYEE BENEFITS 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. Concurrent with the
acquisition of the Arizona gas and electric assets from Citizens on August 11,
2003, UES assumed 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 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.

COMPONENTS OF NET PERIODIC BENEFIT COST

The components of net periodic benefit costs are as follows:

EMPLOYER CONTRIBUTIONS

We previously disclosed in our financial statements for the year ended
December 31, 2003 that TEP's and UES' expected pension plan contributions in
2004 were $6 million and $0.5 million, respectively. As of March 31, 2004, TEP
anticipates making contributions of $5 million in 2004 of which $1 million have
been made. UES presently anticipates contributing $1 million in 2004.

NOTE 13. EQUITY-BASED COMPENSATION PLANS
- -------------------------------------------------------------------------------

We account for UniSource Energy's two equity-based compensation plans,
the Directors' Plan and the Omnibus Plan, under the recognition and measurement
principles of APB 25 and related interpretations. See Note 1.

22

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 both of UniSource Energy's stock plans must be terminated
effective as of the closing of the merger. Additionally, both plans contain
"Change in Control" provisions that provide for accelerated vesting of awards
when certain conditions are met. The March 29, 2004 shareholder vote to approve
the proposed merger triggered 100% vesting of all awards under the Omnibus Plan.
The provision in the Directors Plan results in 100% vesting of all awards if and
when the merger is consummated.

At March 31, 2004, we had stock options, stock units and restricted
stock grants outstanding as discussed below.

STOCK OPTIONS

No stock options have been granted under the Directors' Plan in 2004. A
total of 21,222 stock options were granted under this plan during the
three-month period ended March 31, 2003. There were no stock options granted to
key employees under the Omnibus Plan during the three-month periods ended March
31, 2004 or 2003. Director stock option awards currently 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:

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 the first quarter of 2004 and 2003, we recognized
compensation expense of less than $0.1 million for dividend equivalents on stock
option grants.

RESTRICTED STOCK AND STOCK UNITS

In the first quarter of 2004 and 2003, we granted restricted stock
awards to directors totaling 6,480 shares and 5,157 shares, respectively. The
grant date fair value of the shares was $24.68 per share in 2004 and $17.44 per
share in 2003. Directors may elect to receive stock units in lieu of restricted
shares. As discussed above, Directors' awards were not affected by the
shareholder vote to approve the proposed merger. The restricted shares or stock
units become 100% vested on the third anniversary of the grant date, or on
consummation of the merger. Compensation expense equal to the fair market value
on the date of the award is recognized over the vesting

23

period. We recorded compensation expense of less than $0.1 million in the first
quarter of 2004 and 2003 related to these awards.

There were no new stock unit awards granted under the Omnibus Plan in
the first quarter of 2004 or 2003. 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. All stock unit awards under the Omnibus Plan
had fully vested as of March 6, 2004 and were not impacted by the shareholder
vote to approve the proposed merger. We recognized compensation expense related
to earlier awards of less than $0.1 million in each quarter.

PERFORMANCE SHARES

In May 2003, the Board of Directors approved a grant of performance
shares to key employees under the Omnibus Plan. The shares were to be awarded at
the end of a three-year performance period based on goal attainment. The grant
date fair value was $17.84 per share. Compensation expense was initially
recordedover the performance period based on the anticipated number and market
value of shares to be awarded. As a result of the shareholder vote to approve
the proposed merger, 53,566 performance shares vested and were distributed.
Compensation expense of $2 million was recorded in the first quarter of 2004 for
this award.

NOTE 14. INCOME AND OTHER TAXES
- --------------------------------------------------------------------------------

INCOME TAXES

The differences between the income tax expense (benefit) and the amount
obtained by multiplying pre-tax income (loss) before cumulative effect of
accounting change by the U.S. statutory federal income tax rate of 35% are as
follows:

The total Federal and State Income Tax Expense (Benefit) in the table
above is included on UniSource Energy and TEP's income statements.

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 electricity is delivered to
customers. Neither the amounts billed nor payable are reflected in the income
statement.

24

NOTE 15. 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 (FIN
46R). The primary objectives of FIN 46R 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 46R requires that both the primary beneficiary
and all other enterprises with a significant variable interest make
additional disclosures. For public companies, the revised FIN 46R
is effective for financial periods ending after March 15, 2004. The
adoption of FIN 46R did not and is not expected to 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 12 above.

In August 2003, the Emerging Issues Task Force (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. Beginning January
1, 2004, the realized gains and losses on derivative instruments that are not
held for trading purposes but are eventually net settled are shown net in the
income statement. The impact of adopting EITF 03-11 was immaterial as of March
31, 2004. See Note 6.

25

NOTE 16. SUPPLEMENTAL CASH FLOW INFORMATION
- --------------------------------------------------------------------------------

A reconciliation of net income to net cash flows from operating
activities follows:

NOTE 17. REVIEW BY INDEPENDENT ACCOUNTANTS
- --------------------------------------------------------------------------------

With respect to the unaudited condensed consolidated financial
information of UniSource Energy and TEP for the three-month period ended March
31, 2004 and 2003, PricewaterhouseCoopers LLP reported that they have applied
limited procedures in accordance with professional standards for a review of
such information. However, their separate report dated May 3, 2004 appearing
herein states that they did not audit and they do not express an opinion on that
unaudited condensed consolidated financial information. Accordingly, the degree
of reliance on their report on such information should be restricted in light of
the limited nature of the review procedures applied. PricewaterhouseCoopers LLP
is not subject to the liability provisions of Section 11 of the Securities Act
of 1933 (the Act) for their report on the unaudited condensed consolidated
financial information because that report is not a "report" or a "part" of a
registration statement prepared or certified by PricewaterhouseCoopers LLP
within the meaning of Sections 7 and 11 of the Act.

27

ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
- --------------------------------------------------------------------------------

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 the first quarter of 2004 compared with the
same period in 2003,
o factors which affect our results and outlook,
o liquidity, capital needs, capital resources, and contractual
obligations,
o dividends, and
o critical accounting policies.

Management's Discussion and Analysis should be read in conjunction with
UniSource Energy and TEP's 2003 Form 10-K and with the Condensed Consolidated
Financial Statements, beginning on page 2, which present the results of
operations for the three months ended March 31, 2004 and 2003. Management's
Discussion and Analysis explains the differences between periods for specific
line items of the Condensed Consolidated Financial Statements.

References in this report to "we" and "our" are to UniSource Energy and
its subsidiaries, collectively.

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.

TEP is the principal operating subsidiary of UniSource Energy and, at
March 31, 2004, represented approximately 85% 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 the three months ended March 31, 2004
include a full quarter 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 7%
of UniSource Energy's total assets, results from Millennium's unregulated
businesses had a significant impact on earnings reported by UniSource Energy for
the three months ended March 31, 2004 and 2003. UED's unregulated business
segment, which was established in February 2001, had a significant impact on
consolidated net income and cash flows in the fourth quarter of 2003 since the
financial closing of Springerville Unit 3 occurred on October 21, 2003. UED did
not have a significant impact on net income or cash flow in the first quarter of
2003 or 2004, nor is it expected to in future periods.

OUTLOOK AND STRATEGIES

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.

Pursuant to the terms of the acquisition agreement, Saguaro Acquisition
Corp., a wholly-owned and indirect subsidiary of Saguaro Utility, will merge
with and into UniSource Energy. UniSource Energy will be the surviving

28

corporation, but will become an indirect wholly-owned subsidiary of Saguaro
Utility. Trading in our 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.

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 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.

On March 25, 2004, an affiliate of Saguaro Utility entered into a $410
million credit agreement in connection with a commitment obtained by Saguaro
Utility from lenders in November 2003. The credit agreement will be funded upon
closing of the acquisition of UniSource Energy. It includes a $50 million
revolving credit facility for general corporate purposes and a $360 million term
loan to be used to fund a portion of the acquisition. The lenders' obligations
to make such loans are subject to various closing conditions customary for
credit facilities to be used in an acquisition of this type.

UniSource Energy's shareholders approved the acquisition agreement at
a special meeting on March 29, 2004. The acquisition still requires approval by
the Arizona Corporation Commission (ACC), the Securities and Exchange Commission
(SEC) under the Public Utility Holding Company Act and the Federal Regulatory
Commission (FERC) under the Federal Power Act, and the satisfaction of other
conditions set forth in the acquisition agreement. UniSource Energy filed an
application with the ACC for approval of the acquisition on December 29, 2003.
The waiting period under the Hart-Scott-Rodino Antitrust Improvement Act was
terminated on March 19, 2004. Saguaro Utility filed an application with the SEC
for approval of the acquisition on March 30, 2004. On April 7, 2004, UniSource
Energy and Saguaro Utility filed a joint application with FERC under the Federal
Power Act for approval of the acquisition.

On April 30, 2004, the staff of the ACC and other intervenors in the
ACC proceeding filed testimony relating to the proposed acquisition. In its
testimony, the staff of the ACC concluded that the lack of substantial
commitments by UniSource Energy and Saguaro Utility in a number of areas and the
financial risks created by a lack of financial protection of our utilities call
for disapproval of the acquisition as proposed. However, the staff testimony
suggested a number of conditions that, if agreed to, would, in their view,
significantly mitigate the risks associated with the acquisition. These
conditions address: financial protection of the utility businesses; service
quality and reliability; affiliate transactions; corporate governance;
regulatory oversight; and community presence. The Residential Utility Consumer
Office also filed testimony opposing the acquisition, expressing similar
concerns to those contained in the staff's testimony. UniSource Energy's
rebuttal testimony is due May 25, 2004 and a public hearing of the application
before an administrative law judge is scheduled for June 21, 2004.

Subject to the receipt of the required regulatory approvals and the
satisfaction of the other closing conditions contained in the acquisition
agreement, we expect to close the transaction in the second half of 2004.

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 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 Salt River Project
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

29

reliability for customers of UNS Electric.

o Continue to manage our existing Millennium investments to maximize
their value.

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.

UNISOURCE ENERGY CONSOLIDATED

RESULTS OF OPERATIONS
- ---------------------

Three Months Ended March 31, 2004 Compared with
the Three Months Ended March 31, 2003

UniSource Energy recorded net income of $7 million, or $0.19 per
average share of Common Stock, in the first quarter of 2004 compared with net
income of $53 million, or $1.58 per average share of Common Stock last year.
Results in the first quarter of 2003 include an after-tax gain of $67 million,
or $2.00 per average share of Common Stock, 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). The
net loss before the Cumulative Effect of Accounting Change was $14 million, or
$0.42 per average share of Common Stock. The following factors contributed to
the change in net income:

o A $49 million increase in utility gross margin (the sum of electric
retail revenues, electric wholesale revenues and gas revenues, less
fuel expense and purchased energy expense) resulting from:

- $49 million of gas revenues and $31 million of electric
revenues at UES;

- a $13 million increase in retail revenues at TEP resulting
from a 2% increase in the retail customer base,
colder-than-usual weather during the months of January and
February, and warmer-than-usual temperatures during the month
of March;

- a $9 million decline in purchased power expense at TEP,
resulting from fewer planned and unplanned outages at TEP's
generating facilities during the first quarter of 2004,
reducing the need to purchase replacement power to meet retail
demand; partially offset by:

- $53 million of purchased energy expense at UES.

o An $11 million increase in other operations and maintenance expense
(O&M) due to $11 million of O&M at UES.

o A $3 million increase in total interest expense due to $3 million of
long-term debt interest expense at UES.

o Income of $3 million (net of tax) related to Haddington Energy Partners
II, LP, (Haddington) one of Millennium's equity method investments.

o Expenses of $2 million related to the proposed acquisition of UniSource
Energy.

30

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.

LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------

UNISOURCE ENERGY CONSOLIDATED CASH FLOWS

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. Typically, 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. See Tucson Electric Power Company, Liquidity
and Capital Resources, Dividends, below.

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.

As of May 4, 2004, cash and cash equivalents available to UniSource
Energy was approximately $90 million.

31

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 the first quarter of 2004, net cash flows from operating activities
increased by $32 million compared with the same period in 2003. The following
factors contributed to the increase:

o a $54 million increase in cash receipts from retail and wholesale
energy customers, net of fuel and purchased energy costs, due to
energy sales at UES and increased retail electric sales at TEP;
partially offset by:

o an $11 million increase in income taxes and other taxes paid due
to taxes paid at UES and a larger final tax payment
related to prior year consolidated income tax returns;

o a $7 million increase in O&M due to $6 million of O&M at UES and
acquisition-related costs;

o a $5 million increase in wages paid due primarily to $4 million
of wages paid at UES and incentive compensation payments to
management pursuant to their employment arrangements triggered
by the shareholder approval of the proposed acquisition of
UniSource Energy; and

o $5 million of cash interest paid at UES.

Investing Activities

Net cash used for investing activities was $6 million lower in the
first quarter of 2004 compared with the same period in 2003, due primarily to a
$14 million decline in capital expenditures at TEP partially offset by $8
million of capital expenditures at UES. The lower capital expenditures at TEP
are primarily the result of the timing of expected projects.

Financing Activities

Net cash used for financing activities was $12 million higher in the
first quarter of 2004 compared with the same period in 2003. The following
factors contributed to the increase:

o TEP paid $9 million in debt issue costs related to the refinancing of
its Credit Agreement; and

o a $6 million increase in scheduled payments for TEP's capital lease
obligations; partially offset by:

o an increase in other cash inflows of $4 million related to cash
received from stock option exercises and new TEP and UES customer
deposits.

Our consolidated cash and cash equivalents decreased to $61 million at
March 31, 2004, from $101 million at December 31, 2003. We invest cash balances
in high-grade money market securities with an emphasis on preserving the
principal amounts invested.

In the event that we experience lower cash from operations in 2004, we
may 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.

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 Millennium's guarantee of
approximately $3 million in commodity-related payments

32

for MEG at March 31, 2004. 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

There have been no significant changes in our contractual obligations
or other commercial commitments from those reported in our 2003 Annual Report on
Form 10-K.

DIVIDENDS ON COMMON STOCK

The following table shows the declared dividends to UniSource Energy
shareholders for 2004.

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 March 31, 2004, UniSource Energy and TEP had, for federal and state
income tax filing purposes, the following carryforward amounts:

Of the $83 million in NOL carryforwards at UniSource Energy, $18
million is subject to limitation due to a reorganization of certain Millennium
entities in December 2002. The future use 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. The following discussion relates to TEP's
utility operations, unless otherwise noted.

33

TEP kWh 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, the
price of fuel, and the level of wholesale forward contract activity.

TEP kWh sales delivered and corresponding revenues for the quarter
ended March 31, 2004 compared with the quarter ended March 31, 2003 are detailed
below.

TEP's retail customer base increased by 2% to 369,644, while kWh sales
to retail customers increased by 10% in the first quarter of 2004 compared with
the same period last year. Kilowatt-hour sales to residential customers were up
11% and kWh sales to commercial customers were up 9%, resulting from customer
growth, cold weather during January and February, and unseasonably warm weather
in March compared with the same period last year. Heating degree days were up
28% in the first quarter of 2004 compared to last year. In March 2004, the high
temperature exceeded 80 degrees during 20 days, compared with nine days last
year. Copper prices were 63% higher in the first three months of 2004 compared
with the same period in 2003, leading to increased mining activity and a 26%
increase in kWh sales to TEP's mining customers. Revenues from TEP's mining
customers increased $3 million in the first quarter of 2004, benefiting from
increased demand and higher copper prices. The price of energy provided to TEP's
mining customers is indexed with the market price of copper. Total revenue from
sales to retail customers increased by 9% in 2003, reflecting higher kWh demand.

Wholesale kWh sales were down 5% compared with the first quarter of
2003. The availability of TEP's excess coal-fired generation was limited by
higher retail energy demand compared with the first quarter of 2003. In
addition, the increase in the regional supply of gas-generated energy allowed
TEP to decrease the use of less efficient gas generating units. Despite lower
wholesale kWh sales, wholesale revenues increased by $2 million, or 5%, due to
$1 million of net unrealized gains on forward sales contracts and a $2 million
reserve recorded in the first quarter of 2003 for doubtful accounts related to
wholesale sales made to the California Independent System Operator (CISO) and
the California Power Exchange (CPX) in 2001 and 2000. See Critical Accounting
Policies, TEP - Payment Defaults and Allowances for Doubtful Accounts, below.

Fuel and Purchased Power Expenses

Fuel expense at TEP's generating plants increased by $1 million, or 2%,
in the first quarter of 2004, compared with the same period in 2003, due to the
higher availability and use of TEP's coal-fired generating facilities. Many of
TEP's coal-fired generating facilities underwent major planned outages, as well
as unplanned outages, in the first quarter of 2003, limiting their availability.
Generation from TEP's low-cost coal facilities was up 441,000 MWh, or 19%, in
the first quarter of 2004, while generation from TEP's more costly gas-fired
facilities was down 92,000 MWh, or 88%, in the same period. The average cost of
fuel per kWh generated for the first quarter of 2004 was 1.71 cents, compared
with 1.92 cents for the first quarter of 2003. See Item 3. - Quantitative and
Qualitative Disclosures About Market Risk, below.

34

TEP's Purchased Power expense decreased $9 million, or 60%, in the
first quarter of 2004, compared with the same period in 2003. The higher
availability of TEP's coal-fired generating facilities reduced the need to
purchase replacement power compared to a year ago. TEP purchased 56% less
energy, or 209,000 MWh, in the first three months of 2004 compared with the same
period last year.

Other Operating Expenses

Other Operations and Maintenance expense increased by $3 million, or
6%, in the first quarter of 2004, compared with the same period in 2003, due to
higher incentive compensation and acquisition-related costs allocated to TEP.

Amortization of the Transition Recovery Asset (TRA) increased $5
million in the first quarter of 2004 compared with the same period in 2003.
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. TEP expects TRA
amortization to be $45 million in 2004, $56 million in 2005, $67 million in
2006, $73 million in 2007 and $38 million in 2008.

Other Income (Deductions)

TEP's income statement includes inter-company interest income of $2
million for the first quarter of 2004 compared with $3 million for the same
period in 2003. 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 income statement, this
Interest Income, as well as UniSource Energy's related interest expense, is
eliminated as an inter-company transaction.

Interest Expense

Total interest expense did not change in the first quarter of 2004
compared with the same period in 2003. Unamortized fees of $2 million that were
expensed as a result of the refinancing of TEP's Credit Agreement in March 2004
were partially offset by a $1 million decrease in capital lease interest
expense. Interest on capital leases was lower in the first quarter of 2004 due
to scheduled repayments of capital lease obligations. See Liquidity and Capital
Resources, TEP Cash Flows, Investing Activities, TEP Credit Agreement, below.

Income Tax Expense

Income tax expense, before Cumulative Effect of Accounting Change,
increased $6 million in the first quarter of 2004 compared with the same period
in 2003, due to higher pre-tax income.

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 from
accumulated depreciation, and reversed previously recorded deferred tax assets
of $44 million. The adoption of FAS 143 resulted in a reduction to depreciation
expense charged throughout the year because asset retirement costs are no longer
recorded as a component of depreciation expense. For the years 2004 and 2003,
this amount is approximately $6 million each year. See Critical Accounting
Policies - Accounting for Asset Retirement Obligations, below.

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 experience in California with
deregulation during 2000 and 2001 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 became eligible to
choose an alternate energy supplier.

35

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.

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.

RATES

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 TEP Settlement
Agreement, no rate case filed by TEP through 2008, including the June 2004
general filing, may result in a net rate increase. 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.

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.

The generating capacity in Arizona is expected to be 24,000 MW by the
end of 2004, which represents an increase of 53% as compared with the capacity
available at the end of 2000. A majority of this growth is the result of 15 new
or upgraded gas-fired generating units with a combined capacity of approximately
8,200 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 decreased in the first quarter of 2004 compared with
2003, as did the average prices for natural gas based on Permian Index.
Beginning in January 2004, all natural gas used by TEP plants originated from
the Permian Gas Basin. In previous years, most of TEP's gas supply was priced
according to the San Juan Basin Index.

Natural gas prices remained high throughout 2003 and into 2004 with
continued demand, storage and production concerns. These high gas and subsequent
power prices are currently expected to continue for at least the near-term
period. Starting in May 2004, the average forward around-the-clock market price
at Palo Verde for the balance of the year 2004 is estimated at approximately $49
per MWh, based on forward market broker quotes as of April 22, 2004. As a
result, we expect TEP's fuel and purchased power expense to be higher in 2004
than in 2003, depending on the actual volumes purchased. We cannot predict
whether these higher prices will continue, or whether changes in various factors
that influence demand and supply will cause prices to fall again during the
remainder of 2004.

36

We expect the market price and demand for capacity and energy to
continue to be influenced by the following factors during the next few years:

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 restrictions 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.

GENERATING RESOURCES

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
2005, as well as in later years, if adequate moisture is not received in the
watershed that supplies the area. 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).

The Operating Agents for the plants have negotiated supplemental
water contracts with the U.S. Bureau of Reclamation and the Jicarilla Apache
Nation for 2004 to assist the plants in meeting its water requirements in the
event of a water shortage. Additionally, negotiations are underway for
supplemental contracts for later years. 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.

LIQUIDITY AND CAPITAL RESOURCES

Cash from operations typically is the lowest in the first quarter and
highest in the third quarter due to TEP's summer peaking load. TEP's capital
requirements consist primarily of capital expenditures and optional and
mandatory redemptions of long-term debt and capital lease obligations.

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 energy prices, natural gas prices, availability of
coal-fired generation, 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.

37

Operating Activities

In the first quarter of 2004, net cash flows from operating activities
increased by $13 million compared with the same period in 2003. The following
factors contributed to the increase:

o an $18 million increase in cash receipts from retail and wholesale
electric customers, net of fuel and purchased energy costs, due
primarily to higher retail energy demand and lower purchased power
costs; and

o a $2 million decrease in capital lease interest paid due to lower
capital lease obligations outstanding; partially offset by:

o a $4 million increase in O&M costs due to costs related to the
acquisition of UniSource Energy;

o a $2 million increase in income taxes and other taxes paid due
primarily to a TEP payment of income taxes to UniSource Energy
pursuant to inter-company tax allocation procedures; and

o a $1 million increase in wages paid due to higher incentive
compensation.

Investing Activities

Net cash used for investing activities was $10 million lower in the
first quarter of 2004 compared with the same period in 2003, due primarily to a
$14 million decline in capital expenditures, partially offset by $4 million
invested in Springerville Lease Debt. Lower capital expenditures at TEP are
primarily the result of the timing of expected projects. We expect TEP's capital
expenditures to be approximately $106 million in 2004.

TEP is currently seeking approvals for the construction of a 62-mile,
345-kV transmission line from Tucson to Nogales, Arizona. The construction costs
are expected to be approximately $75 million. Through March 31, 2004,
approximately $9 million in engineering and environmental expenses have been
capitalized related to this project. If the transmission line does not proceed,
these costs will be immediately expensed.

Financing Activities

Net cash used for financing activities was $12 million higher in the
first quarter of 2004 compared with the same period in 2003. The following
factors contributed to the increase:

o $9 million paid in debt issue costs related to the refinancing of its
Credit Agreement; and

o a $6 million increase in scheduled payments for capital lease
obligations; partially offset by:

o an increase in other cash inflows of $3 million related to
interest received on the inter-company note to UniSource Energy
and new customer deposits.

TEP Credit Agreement
--------------------

On March 25, 2004, TEP entered into a new $401 million credit
agreement. The agreement replaces the credit facilities provided under TEP's
$401 million credit agreement that would have expired in 2006. The new credit
agreement includes a $60 million revolving credit facility for general corporate
purposes and a $341 million letter of credit facility, to support $329 million
aggregate principal amount of tax-exempt variable rate bonds. The credit
agreement has a five-year term, expiring June 30, 2009, and is 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 and
sale-leasebacks. The credit agreement also contains several financial covenants
including: (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. The previous credit agreement had provided that dividends
could not exceed 65% of TEP's net income. The elimination of such covenant is
expected to satisfy, in part, one of the closing conditions contained in the
acquisition agreement that UniSource Energy entered into with Saguaro
Acquisition Corp., by permitting TEP to dividend all of its net

38

income to its shareholders. The credit agreement also provides that under
certain circumstances, certain regulatory actions could result in a required
reduction of the commitments.

The letter of credit fee of 2.35% on the new facility is significantly
lower than the previous credit agreement's weighted average letter of credit fee
of approximately 5%. The agreement also provides for letter of credit fronting
fees of 0.25%, which will reduce to 0.125% upon the closing of Saguaro's
acquisition of UniSource Energy; the previous agreement's fronting fee was
0.25%. Unreimbursed drawings on a letter of credit bear a variable rate of
interest based on LIBOR plus 2.25% per annum. Interest savings in 2004 will be
partially offset by the March 2004 write-off of $2 million of fees associated
with the prior facility that were capitalized and being amortized through 2006
and the amortization of $9 million of fees associated with the entry of the new
facility.

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
leverage. The per annum rate currently in effect on borrowings under TEP's
revolving credit facility, based on its leverage, is LIBOR plus 2.25%. If TEP's
leverage were to change, the spread over LIBOR could range from 1.50% to 2.25%.
Also, TEP pays a commitment fee of 0.50% on the unused portion of the revolving
credit facility.

In January 2004, TEP borrowed $20 million under its revolving credit
facility and repaid it within 30 days. At March 31, 2004, there were no
outstanding borrowings under the revolving credit facility.

CONTRACTUAL OBLIGATIONS

There have been no significant changes in TEP's contractual obligations
or other commercial commitments from those reported in our 2003 Annual Report on
Form 10-K.

DIVIDENDS ON 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 March 31, 2004, the required
minimum net worth was $351 million. TEP's actual net worth at March 31, 2004,
was $392 million. As of March 31, 2004, TEP was in compliance with the terms of
the Credit Agreement.

The Citizens Settlement Agreement, as approved by the ACC, states that
TEP may not pay dividends to UniSource Energy in excess of 75% of its earnings
until TEP's common equity equals 40% of total capitalization (excluding capital
lease obligations). As of March 31, 2004, TEP's common equity equaled 26% 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 the capital
account. 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.

UNISOURCE ENERGY SERVICES

RESULTS OF OPERATIONS
- ---------------------

UES' net income for the first three months of 2004 was $5 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

In the first three months of 2004, UNS Electric's customer base grew by
1%, reaching 82,409 retail customers. The table below shows UNS Electric's kWh
sales and revenues for the three months ended March 31, 2004.

39

UNS Electric's utility gross margin (electric revenues less purchased
energy expense) was $10 million in the first three months of 2004. Purchased
energy expense was $21 million in the first three months of 2004. UNS Electric
purchases all of its energy requirements under a fixed price contract with PWCC,
thus purchased energy expense is a function of kWh sales volumes. Other O&M
expenses were $5 million for the period. UNS Electric's contribution to UES' net
income was $1 million for the first quarter of 2004.

UNS Gas

In the first three months of 2004, UNS Gas' customer base grew by 2%,
reaching 129,624 retail customers. The table below shows UNS Gas' therm sales
and revenues for the three months ended March 31, 2004.

UNS Gas' utility gross margin (gas revenues less purchased energy
expense) was $16 million in the first three months of 2004. Purchased energy
expense was $32 million in the first three months of 2004. UNS Gas purchases all
of its gas requirements under a supply and management agreement with BP Energy
Company, thus purchased energy expense is a function of therm sales volumes and
the price of natural gas. Other O&M expenses were $6 million for the period. UNS
Gas' contribution to UES' net income was $4 million for the first quarter of
2004. See Factors Affecting Results of Operations, Rates and Regulations,
Purchased Gas Adjustor, below.

FACTORS AFFECTING RESULTS OF OPERATIONS
- ---------------------------------------

COMPETITION

As required by the ACC Decision approving UniSource Energy's
acquisition of the Citizens Arizona gas and electric assets, on November 3,
2003, UNS Electric filed with the ACC an application for approval of 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.

40

RATES AND REGULATION

Purchased Gas Adjuster

UNS Gas' retail rates include a Purchased Gas Adjuster (PGA) mechanism
intended to address the volatility of natural gas prices and allows UNS Gas to
recover its costs through a price adjuster. 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.

In September 2003, the ACC approved a PGA surcharge of $0.1155 per
therm that took effect October 1, 2003. On March 23, 2004, the ACC approved the
termination of the surcharge effective October 31, 2004. The PGA balance yet to
be collected, as filed with the ACC, was approximately $ 4 million on March 31,
2004. The PGA balance recorded on our financial statements, which includes an
accrual for unbilled revenue, was approximately $0.2 million at March 31, 2004.

LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------

UES' capital requirements consist primarily of capital expenditures.
UES' forecast for capital expenditures for the year ending December 31, 2004 is
approximately $37 million. UES expects to generate sufficient internal cash
flows to fund its operating activities and construction expenditures during
2004. UES intends to obtain, or have made available to them through UniSource
Energy, a revolving credit facility to use for working capital purposes. This
facility is expected to be in place within the next five months.

Private Placement 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.

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 March 31, 2004.

CONTRACTUAL OBLIGATIONS

There have been no significant changes in UES' contractual obligations
or other commercial commitments from those reported in our 2003 Annual Report on
Form 10-K.

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 March 31, 2004, the
ratio of common equity to total capitalization for UNS Gas was 37% 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

41

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
- ---------------------

Through affiliates, Millennium holds investments in unregulated energy
and emerging technology companies. At March 31, 2004, Millennium's assets
represented 7% of UniSource Energy's total assets. 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 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.

Millennium's consolidated net income was $2 million for the three
months ended March 31, 2004 compared with a net loss of $5 million for the three
months ended March 31, 2003. The $7 million increase is primarily due to:

o income of $3 million, after tax, related to Millennium's investment in
Haddington;

o $1 million of after tax income related to certain revenues at MicroSat,
which Millennium recorded in the first quarter of 2004. MicroSat
develops small-scale satellites under a U.S. government contract and
had deferred $2 million, before tax, of revenues earned under the
contract. In February 2004, pursuant to a settlement agreement, the
contract was terminated and MicroSat granted the government purpose
rights to the design data and transferred all hardware assets
developed under the contract to the government in exchange for the
elimination of further cost-sharing obligations under the contract.
These assets will be used under a new contract between MicroSat and the
government, and may be used by the government for other satellite
development contracts not involving MicroSat. However, MicroSat
retains the right to use the design data on other government and
commercial contracts. The revenues previously deferred
under the original contract have been recognized by MicroSat;

o decreased net losses from development and manufacturing costs of Global
Solar's photovoltaic products;

o decreased net losses of less than $1 million each from Other Millennium
Investments, including Powertrusion, SES and MEG; and

o decreased net losses due to no longer having investments in ITN and
TruePricing.

The table below provides a breakdown of the net income and losses
recorded by Millennium. These results exclude sales and related costs
to TEP.

42

LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------

Under the acquisition agreement described in Overview of Consolidated
Businesses - Agreement and Plan of Merger above, UniSource Energy is limited as
to the amount it can invest in Millennium in the future. Consequently,
Millennium's ability to provide future funding for the operations of emerging
companies could be affected.

Technology Investments

During the first quarter of 2004, Millennium made no contributions to
Global Solar. However, UniSource Energy provided $2 million to Global Solar
under a tax sharing agreement. Millennium has no remaining funding commitments
to Global Solar, other than the tax sharing agreement with UniSource Energy.

During the first quarter of 2004, Millennium funded its remaining debt
commitment of $0.5 million to IPS. Dow Corning Enterprises, Inc. (DCEI) made no
additional contributions to IPS during the same time period. In April 2004,
Millennium and DCEI committed to loan up to an additional $1 million each to
IPS, and each funded $0.5 million of the commitment at that time. Millennium's
remaining debt commitment to IPS is currently $0.5 million and is contingent on
IPS' attainment of certain performance criteria. Pursuant to the terms of the
amended promissory notes with IPS, Millennium and DCEI have the right to convert
at any time the outstanding debt amounts to equity ownership. 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%.

Millennium made no contributions to MicroSat during the first quarter
of 2004 and has no further funding commitments to MicroSat.

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.

Other Millennium Investments

Millennium committed $15 million in capital, excluding fees, to
Haddington, a limited partnership which 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. At March 31, 2004, Millennium had funded $9 million of this
commitment, none of which was funded during the first quarter of 2004.
Millennium expects the balance to be funded over the next three years. In March
2004, Haddington sold one of its investments and recognized the related gain as
income. Millennium recorded its share of Haddington's income in the first
quarter of 2004. In April 2004, Millennium received a $7 million distribution
from Haddington related to this sale.

43

Millennium committed $6 million, including fees, to Valley Ventures
III, LP (Valley Ventures), a venture capital fund that invests in information
technology, microelectronics and biotechnology, primarily within the
southwestern U.S. Another member of the UniSource Energy Board of Directors is a
general partner of the company that manages the fund. As of March 31, 2004,
Millennium had funded $2 million of this commitment, $0.6 million of which was
funded during the first quarter of 2004. Millennium expects the balance to be
funded by the end of 2007.

Millennium Commitments

Millennium's funding levels and share ownership in its investments are
subject to change in the future. Millennium's outstanding equity commitments are
currently limited to $6 million to Haddington and $4 million to Valley Ventures.
Millennium's only remaining debt commitment is $0.5 million to IPS. Millennium
may commit to provide additional funding to its investments in the future.

Global Solar had commitments totaling $1 million at March 31, 2004 and
December 31, 2003 to incur future expenses relating to government contracts.

DIVIDENDS ON COMMON STOCK

Millennium did not pay any dividends to UniSource Energy in 2003 or the
first quarter of 2004.

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 the 2003 Annual Report on Form 10-K, Note 1 of Notes
to Consolidated Financial Statements - Nature of Operations and Summary of
Significant Accounting Policies.

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),
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 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 these 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.

IMPLICATIONS OF DISCONTINUING APPLICATION OF FAS 71

TEP

Upon approval by the ACC of a settlement agreement (TEP Settlement
Agreement) in November 1999, TEP discontinued application of FAS 71 for its
generation operations. TEP continues to apply FAS 71 to its regulated
operations, which include the transmission and distribution portions of its
business.

TEP's regulatory assets, net of regulatory liabilities, totaled $276
million at March 31, 2004. Regulatory assets of

44

$22 million are not presently included in rate base and consequently are not
earning a return on investment.

TEP regularly assesses whether it can continue to apply FAS 71 to its
regulated operations. If TEP stopped applying FAS 71 to these 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 March 31, 2004, if
TEP had stopped applying FAS 71 to its remaining regulated operations, it would
have recorded an extraordinary after-tax loss of $167 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.

UES

UES' regulatory liabilities, net of regulatory assets, totaled $2
million at March 31, 2004. 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 its regulatory liabilities as income on its income statement.
Based on the regulatory liability balances, net of regulatory assets, at March
31, 2004, if UES had stopped applying FAS 71 to its regulated operations, it
would have recorded an extraordinary after-tax gain 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.

ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS

TEP has identified legal obligations to retire generation plant assets
specified in land leases for its jointly-owned Navajo and Four Corners
Generating Stations. TEP also has certain environmental obligations at the San
Juan Generating Station. TEP has estimated that its share of these obligations
will be approximately $38 million at the date of retirement. As of March 31,
2004 and December 31, 2003, TEP had accrued $1.3 million and $1.2 million for
the decommissioning of its generating facilities. This amount is recorded as an
accrued asset retirement obligation on the UniSource Energy and TEP balance
sheets.

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. A
final retirement occurs when an entire transmission or distribution line is
permanently removed from service. Interim retirements occur as components of the
system are replaced. As a result, TEP is not recognizing the costs of final
removal of the transmission and distribution lines in the financial statements.
As of March 31, 2004 and December 31, 2003, TEP had accrued $62 million and $60
million for the net cost of removal for the interim retirements from its
transmission, distribution and general plant. The amount is shown as 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).

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. A
final retirement occurs when an entire transmission or distribution line is
permanently removed from service. Interim retirements occur as components of the
system are replaced. As a result, UES is not recognizing the cost of final
removal of the transmission and distribution lines in the financial statements.
As of March 31, 2004 and December 31, 2003, UES had accrued $1 million for the
net cost of removal for interim retirements from its transmission, distribution
and general plant. The amount is shown as 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

45

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.

TEP's reserve for electric wholesale accounts receivable on its balance
sheet was approximately $10 million at both March 31, 2004 and December 31,
2003.

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 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 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 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.

46

Based on the above assumptions, TEP will record pension expense of
approximately $8 million and other postretirement benefit expense of $6 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.

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.

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's, UES' and MEG's
derivative activities are described fully in UniSource Energy and TEP's 2003
Annual Report on Form 10-K.

TEP has a natural gas supply agreement under which it purchases all of
its gas requirements at spot market prices from Southwest Gas Corporation (SWG).
TEP also has agreements to purchase power that are priced using spot market gas
prices. These contracts meet the definition of normal purchases and are not
required to be marked to market. In the first quarter of 2004, in an effort to
minimize price risk on these purchases, TEP entered into commodity price swap
agreements under which TEP purchases gas at fixed prices and simultaneously
sells gas at spot market prices. The spot market price in the swap agreements is
tied to the same index as the purchases under the SWG and purchased power
contracts. These swap agreements, which will expire during the summer months of
2004 through 2006, were entered into with the goal of locking in fixed prices on
at least 45% and not more than 80% of TEP's expected summer monthly gas risk
prior to entering into the month. The swap agreements are marked to market on a
monthly basis; however, since the agreements satisfy the requirements for cash
flow hedge accounting, the unrealized gains and losses are recorded in Other
Comprehensive Income, a component of Common Stock Equity, rather than being
reflected in the income statement.

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.

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 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.

The market prices used to determine fair values for TEP's and MEG's
derivative instruments are estimated based

47

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;

o TEP's net unrealized gains and losses on commodity price swaps are
included in Other Comprehensive Income, which is a component of Common
Stock Equity; 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.

The net pre-tax unrealized gains and losses from TEP's forward
contracts were less than $1 million for each of the three month periods ended
March 31, 2004 and 2003. The net pre-tax realized and unrealized gains and
losses from MEG's trading activities were also less than $1 million for each of
the three month periods ended March 31, 2004 and 2003. The net pre-tax
unrealized gains and losses from TEP's commodity swap agreements recorded as
cash flow hedges and included in Other Comprehensive Income were just over $1
million as of March 31, 2004. TEP had no material cash flow hedges as of
December 31, 2003.

TEP's commodity swap agreements currently satisfy the requirements for
cash flow hedge accounting and are considered to be highly effective in
offsetting changes in the fair market value of the gas contracts being hedged.
The cash flow hedges are being assessed on an ongoing basis to ensure they
continue to qualify for hedge accounting. If the hedges become ineffective in
the future, the amounts included in Other Comprehensive Income will be reversed
and recorded as unrealized gains and losses in the income statement.

TEP's derivative assets and liabilities are reported in Other Current
Assets and Other Current Liabilities on TEP's balance sheet and in Trading
Assets and Trading Liabilities on UniSource Energy's balance sheet. The fair
value of TEP's derivative assets was $1 million at March 31, 2004 and the fair
value of TEP's derivative liabilities was less than $1 million at December 31,
2003. 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 $49 million at
March 31, 2004 and $22 million at December 31, 2003. The fair value of MEG's
trading liabilities was $44 million at March 31, 2004 and $19 million at
December 31, 2003.

Beginning January 1, 2004, the settlement of forward purchase and sales
contracts that do not result in physical delivery are recorded net as a
component of Electric Wholesale Sales in TEP's income statement. For the three
months ended March 31, 2004, $1 million in sales were netted against $1 million
in purchases, resulting in a small net gain.

See Market Risks - Commodity Price Risk in Item 3.

UNBILLED REVENUE

TEP's and UES' retail revenues include an estimate of MWhs/therms
delivered but unbilled at the end of each period. The unbilled revenue is
estimated by comparing the actual MWhs/therms consumed to the MWhs/therms billed
to TEP and UES retail customers. The excess of MWhs/therms consumed 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 months and decreases during the fall months. The
unbilled revenue amount for UES gas sales increases during the fall months and
decreases during the spring months, whereas, the unbilled revenue amount for UES
electric sales increases during the spring months and decreases during the fall
months.

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

48

a result of the TEP General Rate Case to be filed in June 2004. We are currently
reviewing the estimated useful lives of all our assets due to a variety of
factors including 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.

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. For the first
three months of 2004, depreciation expense related to generation assets was $9
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

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.

At March 31, 2004 and December 31, 2003, UniSource Energy and the
Millennium entities had a valuation allowance of $9 million relating to net
operating losses generated by the Millennium entities. In the future, if
UniSource Energy and the Millennium entities determine that all or a portion of
the losses 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 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 its net operating
loss and investment tax credit carryforward amounts, then UniSource Energy and
TEP would record additional 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 Outlook and Strategies - Agreement and Plan of Merger,
above.

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 (FIN 46R).
The primary objectives of FIN 46R 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 46R requires that
both the primary beneficiary and all other enterprises with a
significant variable interest make additional disclosures. For public
companies, the revised FIN 46R is effective for financial periods
ending after March 15, 2004. The adoption of FIN 46R did not and is
not expected to 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 12 of Notes to Condensed
Consolidated Financial Statements.

In August 2003, the Emerging Issues Task Force (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

49

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. Beginning January
1, 2004, the realized gains and losses on derivative instruments that are not
held for trading purposes but are eventually net settled are shown net in the
income statement. The impact of adopting EITF 03-11 was immaterial as of March
31, 2004.

SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS
- ------------------------------------------

This Quarterly Report on Form 10-Q 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 Quarterly Report on Form 10-Q.
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.

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.

50

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 3. - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- --------------------------------------------------------------------------------

The information contained in this Item updates, and should be read in
conjunction with, information included in Part II, Item 7A in UniSource Energy
and TEP's Annual Report on Form 10-K for the year ended December 31, 2003, in
addition to the interim condensed consolidated financial statements and
accompanying notes presented in Items 1 and 2 of this Form 10-Q.

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. The market risks resulting from changes in
interest rates and returns on marketable securities have not changed materially
from the market risks reported in the 2003 Form 10-K. For additional information
concerning risk factors, including market risks, see Safe Harbor for
Forward-Looking Statements, above.

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 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 energy 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 energy and natural gas 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 dictate that TEP can 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.

The majority of TEP's forward contracts are considered to be "normal
purchases and sales" of energy and are not

51

considered to be derivatives under Statement of Financial Accounting Standards
No. 133, Accounting for Derivative Instruments and Hedging Activities (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 using actively quoted prices obtained from brokers for the
appropriate energy product. 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. The net pre-tax unrealized gains and losses from
TEP's forward electricity contracts were less than $1 million for each of the
three month periods ended March 31, 2004 and 2003. This demonstrates the limited
derivative forward contract activity conducted by TEP and the limited impact on
TEP's operating results and financial condition.

TEP has two purchased power agreements for the period 2003 through
2006. During the first quarter of 2004, TEP purchased approximately 2,700 MWh
under these contracts; energy purchased under these agreements is adjusted for
changes in the price of natural gas.

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).

Natural gas prices remained high throughout 2003 and into 2004. In the
first quarter of 2004, the average price of natural gas was $5.02 per MMBtu
compared with $5.76 per MMBtu in the first quarter of 2003. 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 12,060 MWh, or less than 1% of total generation in the first
quarter of 2004, compared with approximately 103,689 MWh, or 4% of total
generation in 2003.

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 2007. As of
March 31, 2004 and December 31, 2003, the fair value of MEG's trading assets
combined with Emission Allowances it holds in escrow was $49 million and $22
million, respectively. The fair value of MEG's trading liabilities was $44
million at March 31, 2004 and $19 million at December 31, 2003. During the first
three months of 2004, MEG reflected a $1.6 million unrealized gain and a $1.4
million realized loss on its income statement, compared with an unrealized gain
of $1.7 million and a realized loss of $2.1 million in the first three months of
2003.

52

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 March 31, 2004, TEP's total
credit exposure related to its wholesale marketing activities (excluding
defaulted amounts owed by the CPX, the CISO and Enron), was approximately $6
million and MEG's total credit exposure related to its trading activities was
$17 million. TEP and MEG's credit exposure is diversified across approximately
30 counterparties. Approximately $3 million of TEP's 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 March 31, 2004, Nations Energy's receivable from Mirant Curacao is
approximately $10 million. The note is 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 4. - CONTROLS AND PROCEDURES
- --------------------------------------------------------------------------------

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 March 31, 2004. Based on such evaluation, 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. Since such evaluation there have not been any significant changes in
UniSource Energy and TEP's internal controls, over financial reporting that has,
or is reasonably likely to, materially affect these controls.

53

PART II - OTHER INFORMATION

ITEM 1. - LEGAL PROCEEDINGS
- --------------------------------------------------------------------------------

There have been no significant changes in our legal proceedings from
those reported in our 2003 Annual Report on Form 10-K, other than those listed
below:

Withdrawal of Litigation Concerning the Proposed Acquisition Agreement

On March 17, 2004, plaintiffs withdrew two shareholder derivative
lawsuits, McBride v. Pignatelli, et al. and Zetooney v. Pignatelli, et al.,
filed in the Superior Court of the State of Arizona on November 24, 2003, the
same day that UniSource Energy announced details of its proposed acquisition by
Saguaro Utility Group, L.P. UniSource Energy paid no consideration in connection
with the withdrawal of the lawsuits. In these two lawsuits, which were virtually
identical, the plaintiffs alleged 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.

We discuss other legal proceedings in Note 9 of Notes to Condensed
Consolidated Financial Statements.

ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- --------------------------------------------------------------------------------

UniSource Energy conducted a special meeting of shareholders on March
29, 2004. At that meeting, shareholders voted to approve the acquisition
agreement entered into on November 21, 2003 between UniSource Energy and Saguaro
Acquisition Corp., which is a wholly-owned indirect subsidiary of Saguaro
Utility Group, L.P.

There were 34,019,401 shares outstanding on the record date. The table
below summarizes the voting results.

54

ITEM 5. - OTHER INFORMATION
- --------------------------------------------------------------------------------

ADDITIONAL FINANCIAL DATA

NON-GAAP MEASURE

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.

*See Supplemental Cash Flow Information in Note 16 of Notes to the Consolidated
Financial Statements.

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 at the UniSource Energy main page.

Information contained at UniSource Energy's website is not part of any
report filed with, or furnished to, 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.

56

ITEM 6. - EXHIBITS AND REPORTS ON FORM 8-K
- --------------------------------------------------------------------------------

(a) Exhibits.

See Exhibit Index.

(b) Reports on Form 8-K.
- - 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.

- - 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.

- - UniSource Energy and TEP Form 8-K, dated March 31, 2004, filed
pursuant to Item 5 "Other Events," describing the refinancing of
TEP's credit facility and the results of the UniSource Energy
special shareholders' meeting held on March 29, 2004. Also filed
TEP's new credit facility and supplemental indenture as exhibits,
pursuant to Item 7 "Financial Statements and Exhibits."

- - UniSource Energy and TEP Form 8-K, dated May 4, 2004, furnished
pursuant to Item 12 "Disclosure of Results of Operations and
Financial Condition," announcing first quarter 2004 earnings for
UniSource Energy and TEP.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934,
each registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. The signature for each undersigned
company shall be deemed to relate only to matters having reference to such
company or its subsidiaries.

UNISOURCE ENERGY CORPORATION
(Registrant)

Date: May 7, 2004 /s/ Kevin P. Larson
---------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer

TUCSON ELECTRIC POWER COMPANY
(Registrant)

Date: May 7, 2004 /s/ Kevin P. Larson
---------------------------------------
Kevin P. Larson
Vice President and Principal
Financial Officer

57

EXHIBIT INDEX

12 - Computation of Ratio of Earnings to Fixed Charges - TEP.
15 - Letter regarding unaudited interim financial information.
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.
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).

*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.

58